EIA 2002 MACROECONOMICS II

The Classical Economics Theory

Equilibrium Output And Employment
Content

A. Introduction
B. Production
C. Employment
o Labour Demand
o Labour Supply
D. Equilibrium Output and Employment
o Determinants of Output and Employment
o Supply Determined Nature of Output and Employment
E. Aggregate Supply Curve In Classical Economy
F. Conclusion

LECTURE 1 2
A. Introduction
▪ The term Macroeconomics originated in the 1930s

▪ That decade witnessed substantial progress in the study of aggregative economic questions

▪ After a long period in which Microeconomic questions dominated the field of economics, the forces that determine
income, employment and prices had been receiving greater attention since the turn of the century

▪ The products of this research were theories of the “business cycles” and accompanying policy prescriptions for
stabilizing economic activity

▪ The book containing this theory was “The General Theory Of Employment, Interest and Money” by “JOHN
MAYNARD KEYNES” in 1936, and the process of change in economic thinking that resulted from this work has
been called the “Keynesian Revolution”

▪ But revolution against what? What was the old orthodoxy? Keynes termed it “CLASSICAL ECONOMICS”, as it was
before Keynes General Theory

LECTURE 1 3
Cont.’
■ The pre Keynesian era (period before 1936) refers to the period of economic thoughts of classical, Keynes used the term classical to
refer to virtually all economists who had written on macroeconomic questions before 1936

■ More conventional modern terminology distinguishes between two period in the development of economic theory before 1930

■ The term ‘Classical’ has been used in economic literature to refer to different group of economists dominated by the work of Adam Smith
(Wealth of Nations, 1776), David Ricardo (Principles of political economy, 1st ed., 1817), and John Stuart Mill ( Principles of Political
Economy, 1st ed.,1848)

■ The second, termed the Neo-Classical period, had as its most prominent English representatives Alfred Marshall ( Principles of
Economics, 8th ed., 1920) and A.C Pigou (The Theory of Unemployment, 1933)

■ The theoretical advances distinguishing the classical and neo-classical periods were related primarily to microeconomic theory

■ Keynes felt that the macroeconomic theory of the two periods was homogeneous enough to be dealt with as a whole

■ The classical had not produced any unified macroeconomic theory though some macroeconomic thoughts could be traced into their
writings

■ Their macroeconomic thoughts were in the form of certain ‘Postulates’

LECTURE 1 4
Cont.’
■ Revolution against the doctrine of mercantilism
■ Mercantilists: Rise of the nation-state in Europe during the 16th and 17th centuries
■ Two tenets attacked by classics:
❑ Bullionism – wealth and power of a nation were determined by its stock of precious metals
❑ Need for state action to direct the development of the capitalist system – develop home industry, reduce consumption of imported goods as well as
develop human and natural resources
❑ State needs to regulate the capitalist system – ensuring markets existed for all goods produced
❑ In the SR, an increase in money would lead to an increase in demand for commodities and would stimulate production and employment

■ Classicalists:
❑ Importance of real factors (increased stocks of factors of production and advances in techniques of production) in determining the ‘wealth of nations’
❑ No state control (free market mechanism or non-interventionist approach)
❑ Money as a means of exchange (no intrinsic value)

Mercantilist Classical Economists

Wealth determined by stock of precious metals – gold and silver
Intervention of state to secure favourable balance of trade –
export subsidies, import duties and development of colonies to
provide export markets
Money as only a means of exchange and real variables such as
factors of production and technology determines wealth
Self-adjusting tendencies of economy – government intervention
is unnecessary as supply creates its own demand

LECTURE 1 5
B. Production
ASSUMPTIONS:
▪ Production function – the relationship between total inputs and total
▪ Market clears
outputs for a given level of technology.
▪ Income is at full employment
ഥ ,𝑁
𝑌=𝐹 𝐾
▪ Firms and individuals have perfect
where 𝑌 = real output
information about relevant prices
𝐾 = stock of capital (plant & equipment)
▪ Firms are perfect competitors (price takers)
𝑁 = quantity of homogeneous labour input
▪ Labour demand and labour supply are
determined by real wages ▪ For the SR, 𝑌 varies directly with 𝑁 because 𝐾 is assumed fixed,
technology and population are assumed constant
▪ W and P are perfectly flexible

LECTURE 1 7
Cont.’ Panel (a)
▪ Output are produced by the efficient utilization of each level of labor input.

▪ A few characteristics:
❑ Below 2 units of 𝑁, the function is a straight line: constant returns to
scale
❑ Between 2 unit and 5 unit of labor, additional labor will lead to
increment in output but size of the increment declines: diminishing
returns to scale
❑ Above 5 unit of labor, increment in labor causes no increment to
output: negative returns to scale

Panel (b)
▪ Marginal production of labour (𝑀𝑃𝑁) where
𝑀𝑃𝑁 = (Δ𝑌/Δ𝑁)
𝑀𝑃𝑁 = addition to total output due to the addition of a unit of labour
(slope of the production function)
❑ 𝐵𝐶 – constant marginal product of labor
❑ 𝐶𝐹 – 𝑀𝑃𝑁 is positive but declining
❑ After 𝐹 – the 𝑀𝑃𝑁 curve hit horizontal axis – negative returns to scale

▪ Thus, the MPN is measured by the slope of the production function and is a
downward sloping curve when plotted against employment (refer fig 3.1 (b)),
as slope of the production function (𝑀𝑃𝑁) is positive but decreases as we
move along the curve

▪ Classical: Labour employed would be determined by the forces of demand

and supply in the labour market
LECTURE 1 8
B. Employment
ASSUMPTIONS:
▪ Market works well

▪ Firms and individuals optimise

▪ They have perfect information about relevant prices

▪ No barriers to the adjustment of money wages; the market clears

▪ Firms are perfect competitors who choose their output level so as to maximize profits

▪ As in the SR, output is varied solely by changing the labour input - decision on quantity of the labour
input can maximize firm’s profits

LECTURE 1 9
a. Labour Demand
▪ Classical economists assumed that the quantity of labour employed would be determined by the forces of demand and supply in the labour
market
▪ Firms will continue to increase output until the MC of producing a unit of output = MR received from sales
❑ MC (which is marginal cost of labour as labour is the only input) = MR (which is equal to P)
▪ And, the marginal cost of each additional unit of output is the marginal labour cost, being labour is the only variable factor input, therefore,
❑ Marginal cost = Marginal labour cost
▪ In other words, in making its decision whether to hire additional labour, a profit maximizing competitive firm will compare extra revenue from
the increased production that results from added labour to extra cost of hiring that additional unit of labour
▪ For the perfectly competitive firm, marginal revenue is equal to product price
❑ 𝑀𝑅 = 𝑃
▪ Marginal labour cost equals the money wage divided by the number of unit of output produced by the additional unit of labour
▪ Thus, marginal cost (𝑀𝐶𝑖) of the firm is equal to the money wage (𝑊) divided by the marginal product of labour for that firm (𝑀𝑃𝑁𝑖)
𝑊
❑ 𝑀𝐶𝑖 =
𝑀𝑃𝑁𝑖

▪ The condition for short run profit maximization in the perfectly competitive market is :-
❑ 𝑀𝑅 = 𝑀𝐶
❑ 𝑃 = 𝑊 / 𝑀𝑃𝑁𝑖
▪ Alternatively:
❑ 𝑴𝑷𝑵𝒊 = 𝑾/𝑷 ……………………………………Profit maximizing condition
❑ Where , 𝑊/𝑃 is the real wage – the payment to labour measured in units of output i.e. in real terms
LECTURE 1 10
Cont.’
■ For example, suppose the price 𝑃 of a bag is RM 2 per unit , and a worker earns a wage 𝑊 of RM 6 per hour
■ The real wage 𝑊/𝑃 is :-
❑ 𝑊/𝑃 = 6/2 =3 bags per hour
■ In this example , the firm keeps hiring workers as long as each additional worker would produce at least 3 bags per hour
■ When the 𝑴𝑷𝑵 falls below 3 bags per hour, hiring additional workers is no longer profitable
■ Hence, the condition for profit maximisation shows, to maximize profits the firm will go on hiring labour till the marginal product of labour
equals the real wages paid by the firm
■ From this profit maximizing condition, the demand for labour schedule for the firm plotted against the real wages, is the marginal product of
labour schedule as shown in fig 3.2

o Fig. 3.2 shows how the MPN depends on the amount of

labour employed (holding the firm’s capital stock constant),
which is the 𝑀𝑃𝑁 schedule

o Because the 𝑀𝑃𝑁 diminishes as the amount of labour

increases, this curve slopes downward

o For any given real wage, the firm hires up to the point at which
the 𝑀𝑃𝑁 equals the real wage

o Hence, 𝐌𝐏𝐍 schedule is the firm’s labour demand schedule

LECTURE 1
11
Cont.’ ▪ If it employs less than 3 units i.e. say 2 units of labour , the marginal product of labour
▪ The condition for profit maximization is where the exceeds the real wage 𝑀𝑃𝑁 > 𝑊/𝑃
real wage (𝑊/𝑃) is equated with the marginal ❑ The firm can increase its profits by hiring additional labour. Alternatively, at a
product of labour (𝑀𝑃𝑁) higher labour input i.e. say 4 units of labour , the marginal product of labour falls
▪ Therefore, the firm maximizes its profits by short of the real wage 𝑀𝑃𝑁 < 𝑊/𝑃
employing (3) units of labour if the real wage is 8 ❑ The payment to labour will exceed the real product of the marginal worker, and
marginal cost will exceed product price. Therefore, the firm will reduce the number
of labour inputs employed to increase profits
▪ Thus, the profit maximizing quantity of labour demanded by a firm at each level of the
real wages is given by quantity of labour input that equates the real wage and marginal
product of labour
▪ Hence, 𝑴𝑷𝑵 is the firm’s demand curve for labour. This implies that as 𝑀𝑃𝑁 is
downward sloping, so labour demand depends inversely on the level of real wages
▪ The higher the real wages , lesser is the number of labour input . The aggregate
demand curve for labour is the horizontal summation of the individual firm’s demand
curves. For each real wage this curve will give the sum of quantities of labour input
demanded by the firms in the economy
The Aggregate Demand Function is written as :
𝑾
𝑵𝒅 = − 𝒇 ( ) ……… Aggregate Labour Demand function
𝑷

LECTURE 1 12
b. Labour Supply
▪ Labour services are supplied by individual workers in the economy
▪ Classical economists assumed that each individual attempts to maximize their utility or satisfaction in his
life
▪ The level of utility depends positively on “real income” (which gives command over goods and services), and
“leisure” ( leisure hours are also a necessary commodity as they provides satisfaction to the individual)
▪ There is a trade-off between the two goals, income and leisure
▪ Out of 24 hours in a day, an individual has to divide his time into working hours and leisure hours
▪ Income can be increased only by working and work reduces the available leisure time
▪ So, there is an inverse relationship between hours worked and leisure hours
▪ Labour supply curve is derived from the income-leisure trade–off, how individual allocates one 24 hour
period between leisure hours and hour worked

LECTURE 1 13
Cont.’ Panel a
Real Income a. The income-leisure trade- ▪ Horizontal axis is the total number of hours (maximum of 24)
W/P = NSJ
𝑊
= 4.0
off which are available to an individual over a given period of time
𝑃

▪ These hours can be either used for work or for leisure

𝑊
C
▪ We measure leisure hours from right to left and work hours per
=3.0
𝑃
36

𝑊
day from left to right
B
▪ The vertical axis shows the real income which is equal to the
= 2.0
𝑃
24
U3
real wages (𝑊/𝑃) multiplied by the number of hours an
A
12 U2 individual works
▪ The curved lines in the graph, 𝑈1, 𝑈2 , 𝑈3 are the indifference
U1
curves
0 9 8 6 0 Nj
▪ Each indifference curve shows the different combinations of
b. The labor supply curve income and leisure that give the same level of satisfaction to
W/P
the individual so, he is indifferent to these combinations on
𝑁𝐽𝑆
same 𝑈
▪ The higher the indifference curve and to the right, the more is
C
4.0
the level of satisfaction associated with it
B ▪ For example, all points on 𝑈3 represent greater satisfaction than
3.0
A any point on 𝑈2
2.0 ▪ An individual tries to achieve the highest possible indifference
curve in order to maximize his satisfaction

6 8 9 Nj
LECTURE 1 14
Cont.’ ▪ The slope of the indifference curve is called marginal rate of
Real Income a. The income-leisure trade-
W/P = NSJ off
substitution as it measures the substitution ratio between the
𝑊
𝑃
= 4.0
two goods
𝑊
𝑃
=3.0 C ▪ The slope of the indifference curve represents the rate at which
36
the individual is willing to trade-off leisure for income - the
𝑊
𝑃
= 2.0
B
increase in income the person would have to receive to be just
24
U3 as well off after giving up a unit of leisure
A ▪ The indifference curve becomes steeper as we move from right
12 U2 to left on the same curve
U1 ▪ For example – for the 15th hour of work, one would require
9 8 6 0 Nj
greater compensation to maintain same level of satisfaction
0
than the 5th hour of work.
W/P b. The labor supply curve ▪ The straight lines originating from point 𝑂 on the horizontal axis
𝑁𝐽𝑆 represents individual’s budget line
▪ The slope of the budget line is the real wage, as the individual
C can trade-off leisure for income at a rate equal to the hourly
4.0 real wage (𝑊/𝑃)
B
3.0 ▪ The higher is the real wage, the steeper is the budget line,
A reflecting the fact that at a higher real wage an individual who
2.0
increases hours of work by one unit will receive a larger
increment of income than would have received at the lower real
wage
6 8 9 Nj

LECTURE 1 15
Cont.’
Real Income
▪
▪
Three budget lines, corresponding to real wages rates of 2.0, 3.0 and 4.0
For any given real wage rate, in order to maximize utility, the individual will choose
a. The income-leisure trade-
W/P = NSJ the point where the indifference curve is tangent to the budget line corresponding
off
𝑊
𝑃
= 4.0 to that particular wage rate
▪ At this point, the slope of the indifference curve is equal to the slope of the
𝑊
C
36
𝑃
=3.0
budget line
▪ This implies that the rate at which the individual is willing to trade-off leisure for
𝑊 income (the slope of the indifference curve) is equal to rate at which he is able to
𝑃
= 2.0
B
24 trade-off( the slope of the budget line)
U3
▪ At a real wage of 2.0, the individual worker attains equilibrium at point 𝐴 working
A for 6 hours of labour services), and spending 18 hours on leisure and a real
12 U2
income of 12
U1
▪ When the real wage rises to 3.0, the workers reaches equilibrium at point 𝐵
working for 8 hours of work and spending 16 hours on leisure and then at real
0 9 8 6 0 Nj wage of 4.0, points like 𝐶 can be derived
▪ More labour services are supplied at the higher real wage rate
W/P b. The labor supply curve

𝑁𝐽𝑆 Panel b
▪ Using this fact, we can arrive at the supply curve for labour – Panel (b)
C ▪ On the horizontal axis measuring number of hours worked from left to right and
4.0 real wage rate on the vertical axis
B ▪ By plotting the points 𝐴, 𝐵 and 𝐶 from Panel (a) giving the amount of labour (in
3.0 terms of working hours) the individual worker will supply at real wage rate, we
A
obtain the upward-sloping labour supply curve
2.0
▪ The Aggregate Labour Supply Curve is obtained by a horizontal summation of all
the individual labour supply curves and gives the total labour supplied at each
level of the real wage. It can be written as :
6 8 9 Nj
𝑵𝒔 = + 𝒇 (𝑾/𝑷) ……………… Aggregate Labour Supply function
LECTURE 1 16
Cont.’
▪ The classical labour supply theory depicts two features :
❑ Labour supply is determined by real wage not the money wage.
o As the real wage increase, leisure decreases and working hours increases
o Either money wage or price (or both) change, the number of hours worked are determined by moving
along the labour supply curve

❑ The supply curve of labour is positively sloped that is, more labour is assumed to be supplied at higher real
wage rates.
o More labour is assumed to be supplied at higher real wage rates – higher price for leisure in terms of
foregone income
o At higher wages, workers will choose less leisure – substitution effect
o At higher wages, workers will achieve a higher level of real income and at higher levels of real income,
leisure may become more desirable relative to further increment in income. This enables him to indulge
in more leisure activities which is only possible if he works less – income effect
o Beyond a certain level of wage rate, the income effect outweighs the substitution effect. This will cause
the labour supply curve to bend backwards towards the vertical axis and takes a negative slope
▪ In the derivation of labour supply curve, the substitution effect is greater than the income effect, so the supply
curve of labour is positively sloped
❑ It is assumed that every time real wage rises, substitution effect outweighs the income effect and
hence the aggregate supply curve of labour has a positive slope, throughout – Industrialised
Nations LECTURE 1 17
C. Equilibrium Output and Employment
▪ So far, the following relationships have been derived:
❑ 𝑌 = 𝑓 ( 𝐾ത , 𝐿 ) …. Aggregate Production Function
𝑊
❑ 𝑁𝑑 = 𝑓 ( ) …. Labour Demand Function
𝑃
𝑊
❑ 𝑁𝑠 = 𝑓 ( ) …. Labour Supply Function
𝑃

▪ These relationships, together with the equilibrium

condition for the labour market, determine output,
employment and the real wage in the classical system

▪ Fig. 3.4 (a) shows the determination of the equilibrium

levels of employment (𝑁0) and the real wages
(𝑊/𝑃0) at the point of intersection between the
aggregate labour demand and labour supply curves

▪ From the equilibrium level of employment, the

equilibrium level of output (𝑌0) given by the production
function can be determined as shown in Fig 3.4(b)

LECTURE 1 18
a. Determinants of Output and Employment
Endogenous Variables Exogenous Variables

▪ They are determined within or by the model, such as output,
employment and the real wage are designated as the endogenous
variables in the classical model.
▪ They are determined outside the model
▪ In the classical model, when exogenous variables are changed, then
output and employment will change
▪ The factors that determines the output and employment are those
that influence the positions of the labour demand and labour supply
curves and the position of the aggregate production function.

Labour Demand Curve Labour Supply Curve

▪ Depends on the Production function, as it is the slope of the
production function
▪ When the production function shifts that is, the productivity of
labour changes because of technological changes, then the
demand curve for labour shifts
▪ The production function also shifts as the capital sock changes over
time which leads to change in the position of labour demand curve
▪ It is the size of the labour force. An increase in population will shift
the labour supply curve to the right
▪ Change in individual tastes and preferences: Individuals express
their labour-leisure trade-off by indifference curves. With changes in
individual’s preference functions the labour supply curve also shifts.

In the Classical model, the levels of output and employment are determined
solely by factors operating at supply side of the market

LECTURE 1 19
b. Supply Determined Nature of Output and Employment
▪ The supply determined nature of output and employment is a crucial feature of the
classical system
▪ Fig.3.5(a) - the aggregate labour supply and aggregate labour demand curves as
functions of the real wage (𝑊/𝑃)
▪ Fig.3.5(b) - the labour supply and labour demand curves as functions of the money
wage rate, (𝑊)
▪ In fig.3.5(b) : for plotting the labour demand curve against the money wage, we
use the fact that the labour demand is equivalent to Marginal product of labour
(MPN) which is a function of real wages, that is;
❑ 𝑵𝑫 = 𝑴𝑷𝑵 = 𝑾/𝑷
▪ The quantity of labour that will be demanded at any given money wage, depends on
the price level
▪ The firm will choose the level of employment at which
❑ 𝑾 = 𝑴𝑷𝑵 . 𝑷
▪ A rise in the price level ( 𝑃1 , 2𝑃1 , 3𝑃1) will shifts the labour demand curve to the
right (from 𝑀𝑃𝑁. 𝑃1 to 𝑀𝑃𝑁. 2𝑃1 to 𝑀𝑃𝑁. 3𝑃1) plotted against the money wage
▪ For a given money wage, more labour is demanded at higher price levels because
of lower real wage rate and the demand for labour varies inversely with real wage

LECTURE 1 rate 20
Cont.’ ▪ Similarly, in fig.3.5(b): for plotting the labour supply curve against
the money wage, we draw a positively sloped curve such as
𝑁𝑠(𝑃1) which gives the amount of labour supplied for each value
of the money wage, given that the price level is 𝑃1
▪ The curve is upward sloping because at the given price level a
higher money wage is a higher real wage
▪ For a given money wage each price level will mean a different real
wage and hence, a different amount of labour supplied
▪ A rise in the price level (𝑃1, 2𝑃1, 3𝑃1) shifts the labour supply
curve upward to the left (from 𝑁𝑆. 𝑃1 to 𝑁𝑆. 2𝑃1 to 𝑁𝑠. 3𝑃1)
▪ In other words, for a given money wage, less labour is supplied at
higher price levels because of lower real wage rate, and the
supply of labour varies directly with the real wage rate
▪ As both, the Nd and Ns depends only on the real wage, so an
equi-proportional increase (or decrease) in both the money wage
and the price level, leave the real wage unchanged at
(𝑊1/𝑃1) which corresponds to the unchanged quantity of labour

LECTURE 1
demanded and quantity of labour supplied at level 𝑁1.
21
D. Aggregate Supply Curve in the Classical Model
▪ The aggregate supply curve in the macroeconomics is same as microeconomic concept
of the firm’s supply curve (in fig 3.6 the classical aggregate supply curve has been
constructed by using the analysis of fig 3.5(b))
▪ At a price level of 𝑃1 and money wage 𝑊1, employment is 𝑁1 and the resultant output is
𝑦1
▪ When the price level rises (from 𝑃1 to 2𝑃1), keeping money wage constant, the real wage
rate (𝑊/𝑃) will fall
▪ As a result, the labour demand curve, when plotted against the money wage rate (in fig
3.5(b)) will shift to the right, that is, firms demand more labour at lower real wage rate,
(at 𝑁2), and the labour supply curve, when plotted against the money wage rate (in fig
3.5(b)) will shift to the left, that is, supply of labour decreases
▪ As a result, there will be an excess demand of labour (i.e. shortage of labour ) equal to
𝑁2 − 𝑁’2 units of labour, thus the money wage will rise
▪ This results in money wages to rise in order to expand employment and money wages
will continue to rise, as long as there is an excess demand of labour
▪ Equilibrium will be attained only when money wages have risen to a level where demand
for labour is equal to supply of labour (that is, the entire excess demand is wiped out)
▪ This position is attained at point where the new money wage rate is 2𝑊1, which has
increased proportionately with the price level. i.e.,
❑ Increase in money wage = increase in price
▪ Higher prices provide a spur to output only if they are not matched by proportionately
higher money wages – only if lower they lower real wage
▪ Equilibrium in the labour market requires that money wages rise proportionately with
prices to maintain the equilibrium real wage in that market
▪ As it can be seen in fig 3.5(b), at this point,
❑ the initial real wage rate is restored (2𝑊1 / 2𝑃1 = 𝑊1 /𝑃1) and
❑ employment is restored at its original level of 𝑁1, consequently output supplied is
equal to 𝑌1 (same output supplied at 𝑃1).
LECTURE 1 ▪ Vertical Aggregate Supply Curve 22
Cont.’
▪ The aggregate supply curve is vertical - higher price levels are
accompanied with proportionate higher levels of the money
wage rate in the labour market, the employment and the
output will remain the same (at L1 and Y1 respectively)
irrespective of the price level
▪ In the Classical model, the vertical supply curve illustrates that
the level of output is determined completely from supply side

▪ As output and employment are supply determined, the level of

aggregate demand will have no affect on output
Factors that do
not Affect Output ▪ Factors such as the quantity of money, level of government
spending and the level of demand for investment goods by the
business sector are all demand-side factors that have no role in
determining the equilibrium level of output and employment in
LECTURE 1 the classical model 23
 E. Conclusion
☺ Supply-determined nature of output and employment
☺ Vertical aggregate supply curve according to the assumption made about the labour market
☺ The labour and product market are characterised as auction market – labour and output to be continually in
equilibrium and in which all participants make decisions based on announced real wage rates and product
prices, based on the assumptions:
i. Perfectly flexible prices and wages; and
ii. Perfect information on the part of all market participants about market prices

☺ Equilibrium determines employment and output – the equilibrium must be achieved

☺ Prices and wages must be perfectly flexible in SR
☺ Perfect information about market prices
o supplier and purchasers must know the relevant trading prices
o selling and buying of labour at a given money wage (W)
o Workers and employers know the command over commodities that will result from such a wage (W/P)

LECTURE 1 24
Cont.’
▪ The period before Keynes General Theory was considered as ▪ Both aggregate labour demand and aggregate labour supply are

classical. functions of real wage.

▪ According to classical economists, real factors determines ▪ The aggregate labour demand curve is a downward sloping curve.

the level of output and employment. ▪ The aggregate labour supply curve is an upward sloping positively

▪ The classical economists believed in the efficacy of free sloped curve due to greater substitution effect than income effect.

market mechanism. ▪ Intersection of labour demand and labour supply forces,

▪ As per the classical thought, the equilibrium level of income determines equilibrium in labour market which in turn together

can be only at full-employment level. with the production function determines the equilibrium level of

▪ The factors of production and the production technology- output.

determines the economy’s output of goods and services. ▪ Equilibrium level of output and employment is restored in the

▪ A perfectly competitive firm will demand labour such that it economy if the rise in the price level is accompanied by

maximizes its profits. It will go on hiring labour till the MPN is proportionate rise in the money wage rate. That results in vertical

equal to the real wage. Hence, the MPN curve is the firm’s aggregate supply curve.

demand curve for labour. ▪ The vertical aggregate supply curve in the classical model

▪ The supply of labour by an individual worker depends upon his illustrates the supply determined nature of output.

choice between ‘work’ and ‘leisure’. ▪ The demand side factors will not play any role in determining the
equilibrium level of output and employment in the classical model.

LECTURE 1 25