A PROJECT

ON

“The Classical Theory of Income and Employment”

Supervised By Submitted by:

Ms. Renu Arora Khushi Sharma

Asst. Professor Semester- 4
KSLW Roll No- 24

KANORIA SCHOOL OF LAW FOR WOMEN, JAIPUR

JUNE, 2024

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 CERTIFICATE

Ms. Renu Arora Date: 24 June, 2024

Asst. Professor
KSLW

This is to certify that Khushi Sharma, a student of semester-I, has carried out a project titled
“The Classical Theory of Income and Employment” under my supervision. It is an
investigation report of a minor research project. The student has completed research work in
stipulated time and according to the norms prescribed for the purpose.

Ms. Renu Arora

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 ACKNOWLEDGEMENT

I have written this project “The Classical Theory of Income and Employment” under the

supervision of Ms. Renu Arora Kanoria School of Law for Women, Jaipur. Her valuable

suggestions here in have helped me immensely in making this work and developing an

analytical approach to this work. I extend my sincere gratitude to Principal Dr. Vartika Arora

for constant encouragement at every step. I am extremely grateful to the librarian and library

staff of the college for the support and cooperation extended by them from time to time.

I would also like to extend my appreciation to my parents and all those unseen hands that

helped me at every stage of my project.

Khushi Sharma

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OBJECTIVE OF THE STUDY

 Analyze how supply and demand determine wages, prices, and employment levels in an
economy.
 Explore the theory's assertion that economies naturally tend toward full employment through
self-adjusting market mechanisms.
 Investigate the importance of wage and price flexibility in restoring economic equilibrium.
 Examine the concept that "supply creates its own demand," ensuring that all output produced
will be purchased.
 Understand how interest rates balance savings and investment, influencing overall economic
activity.
 Study the role of labor and capital in determining income and employment levels.

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RESEARCH METHODOLOGY

The present research study is mainly doctrinal and analytical. Doctrinal researches one of the
fundamental methodologies of legal research, but increasingly research looks beyond pure
doctrinal analysis. Keeping this in view, the researcher has gone through different books,
journals, web references, E-journals, reports etc. The relevant material is collected from the
secondary sources. Materials and information are collected from both legal sources like books.

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 TABLE OF CONTENT

Cover page I
Certificate II
Acknowledgement III
Objective of Studying IV
Research Methodology V
Chapter I 1-2
Introduction

Chapter II 3-4
Saving, Investment and the Rate of Interest
The Money Market
Chapter III 5-6
Price-Wage Flexibility
Wage-Price Flexibility
Keynes’ Criticism

Conclusion VII
Bibliography VIII

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 CHAPTER-I
INTRODUCTION

The basic contention of classical economists was that “given flexible wages and prices, a competitive market
economy would operate at full employment. That is, economic forces would always be generated to ensure
that the demand for labour would always equal its supply”. In the classical model the equilibrium levels of
income and employment were supposed to be determined largely in the labour market.

The classical theory of income and employment is a fundamental concept in economics that seeks to explain
the relationship between a nation's income, employment, and the factors that determine them. Developed by
classical economists such as Adam Smith, David Ricardo, and John Stuart Mill, this theory laid the
groundwork for understanding how an economy functions and how it can achieve long-term growth and
stability.

Assumptions of the Classical Theory

The classical theory of income and employment is based on several key assumptions 1. These assumptions
help to simplify the complex workings of an economy and provide a theoretical framework for analysis:

1. **Full Employment**: The classical theory assumes that there is always full employment in the
economy. This means that all available resources, including labor, are fully utilized.

2. **Flexible Wages and Prices**: According to the classical theory, wages and prices are
flexible and adjust freely in response to changes in supply and demand. This flexibility
ensures that markets clear and that there are no persistent imbalances that can lead to
unemployment or inflation.

3. **Say's Law**: Say's Law, named after the French economist Jean-Baptiste Say, is a key
component of the classical theory. It states that supply creates its own demand. In other words, the
production of goods and services generates income, which in turn creates demand for those goods
and services.

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Labor Market and Wages
In the classical theory, the labor market plays a crucial role in determining both income and employment.
According to classical economists, wages are determined by the supply and demand for labor. If the supply
of labor exceeds the demand, wages will decrease, incentivizing firms to hire more workers and increasing
employment. Conversely, if the demand for labor exceeds the supply, wages will increase, leading to a
decrease in employment as firms cannot afford to hire as many workers.

Savings and Investment

The classical theory also emphasizes the role of savings and investment in the economy. According to
classical economists, saving is a crucial driver of investment and economic growth. When individuals save a
portion of their income, it becomes available for investment by firms. This investment, in turn, leads to
increased production, job creation, and overall economic 2 expansion. Thus, in the classical theory, saving is
seen as a virtuous act that contributes to the long-term prosperity3 of the economy.

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 CHAPTER-II

Saving, Investment and the Rate of Interest:

There is, of course, a serious omission in Say’s Law. If the recipients of income in this simple model save a
portion of their income, consumption expenditure will fall short of total output and supply would no longer
create its own demand. Consequently, there would be unsold goods, falling prices, cutbacks in production,
unemployment and falling incomes4.
However, the classical economists ruled out this possibility by suggesting that saving would not really in a
deficiency of total demand, because each and every rupee saved would be automatically invested by
business firms. That is, investment would occur to fill any consumption ‘gap’ caused by saving leakage.

In fact, businessmen produce not only consumption goods for sale to households but investment (capital)
goods for sale to other firms (or to one another). The latter constitute a considerable portion of society’s total
output. In other words, investment spending by business will add to the income-expenditure stream.
This may fill any consumption gap arising from saving. Thus, if private business firms as a group intend to
invest as much as households want to save, Say’s Law will hold and the levels of national income and
employment will remain constant.

To illustrate Say’s law consider Fig. . It shows a simplified version of the circular flow of income diagram.
There are only two sectors—households and private business firms. Households receive income exactly
equal to the value of goods and services produced.

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Part of this income is spent on consumption goods, the balance is saved. Thus consumption demand falls
short of the total value of production (GNP) by the amount of saving, which is made up by demand for
capital goods (i.e., investment demand). Thus so long as investment and saving are equal, aggregate demand
(i.e., consumption demand plus investment demand) will always be equal to the total value of production.

The Money Market:

The classicists also argued that capitalism contained a very special market—the money market—which
would ensure saving investment equality and thus would guarantee full employment. According to them the
rate of interest (the price paid for the use of money) was determined by the demand for and the supply5 of
capital. The demand for capital is investment and its supply is saving.

So the rate of interest is determined by the saving-investment mechanism. The equilibrium rate of interest is
one which brings about S-I equality. Any imbalance between S and I would be brought about by changes in
the rate of interest (r). If S exceeds I, r will fall. This will stimulate investment. The process will continue
until and unless the equality is restored. The converse is also true. See Fig. , which is self-explanatory.

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 CHAPTER-III

Price-Wage Flexibility:

The classicists also argued that the level of output which producers can sell depends not only upon the level
of aggregate demand but also upon the levels of product prices. Thus even if the interest rate fails to equate
the desired S of the household sector with the desired I of private business firms, any resulting decline in
total spending would be neutralised by proportionate decline in the price level.

That is, Rs. 100 will buy two shirts at Rs. 50, but Rs. 50 will buy the same number of shirts provided their
price falls to Rs. 25. Therefore, if households somehow succeeded in saving more than what business firms
were willing to invest, the resulting fall in total spending would not result in a decline in real output, real
income, and the level of employment provided product prices also declined in the same proportion as
aggregate expenditure.

According to classical economists competition among sellers would ensure price flexibility6. A general
decline in demand in product market will force competing producers to lower their prices to clear their
accumulated surpluses.

Thus the result of excess saving would be to lower prices. This will raise the value of money and permit
non-savers to acquire more goods and services with a fixed money income. Saving would, therefore, lower
prices but not output and employment.

Wage-Price Flexibility:

But this is not perhaps the whole truth. A fall in product prices would reduce resource prices—particularly
wage rates—in the process. Thus wage rates have to decline significantly to permit businesses to produce
profitably at the new lower prices.

The classical econo-mists thought that & decline in product demand would automatically be translated into a
fall in demand for labour and other resources. The immediate result would be an excess supply in the labour
market, i.e., unemployment at the existing wage rate. The wage rate will fall.

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The producers who were reluctant to employ all workers at the original wage rate will now find it profitable
to employ extra workers at lower wage rate. And competition among unemployed workers would force them
to accept lower wages rather than remain unemployed. The process would come to a halt only when the
wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate would be
established.

Thus, involuntary unemployment was a logical impossibility in the classical model. Anyone willing to work
at the market determined wage rate would be able to find jobs readily and people would have substantial
choice of jobs.

Keynes’ Criticism:
Keynes criticised the classical theory on three main grounds:

 Saving depends on national income and is not affected by changes in interest rates. Investment may,
of course, be influenced by it, although it depends on future profit expectations. Thus S-I equality
through adjustment in interest rate is ruled out. So, Say’s Law will no longer hold.

 The labour market is far from perfect because of the existence of trade unions and government
intervention in the form of imposition of minimum wage laws. Thus, wages are unlikely to be
flexible. Trade unions may succeed in raising wages even when there is no excess demand for
labour, rather there is excess supply.
Wages are more inflexible downward than upwards. So, a fall in demand (when S exceeds I) will
lead to fall in production and employment. The problem is not one of involuntary idleness of
resources including manpower.

 Keynes also argued that’ even if wages and prices were flexible a free enterprise economy would not
always be able to achieve automatic full employment. In a depression economy monetary policy
would lose its effectiveness and would be unable to influence the rate of interest and thus the volume
of investment and the level of income. The interest 7 inelasticity of investment has been a subject
matter of much debate and controversy.

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 CONCLUSION

The classical theory of income and employment, rooted in the works of economists such as Adam Smith,
David Ricardo, and John Stuart Mill, posits that markets are self-regulating systems that inherently adjust to
achieve full employment and optimal resource allocation through the forces of supply and demand. According
to this theory, any deviation from full employment is considered temporary, as wages and prices are flexible
and adjust to restore equilibrium. The classical model assumes that savings and investment are balanced by
interest rates, and that money primarily serves as a medium of exchange, not influencing real variables like
output and employment in the long run. It emphasizes the role of production factors, such as labor and capital,
and posits that labor markets function efficiently, with unemployment arising only due to frictional or
voluntary reasons rather than structural issues. The theory relies on Say's Law, which asserts that "supply
creates its own demand," implying that production inherently generates the necessary income to purchase all
goods produced, thus negating the possibility of a general glut. However, the classical theory has faced
significant criticism, particularly during the Great Depression, for its inability to account for prolonged periods
of high unemployment and underutilization of resources. Critics, most notably John Maynard Keynes, argued
that wages and prices are not as flexible as classical economists assumed, and that aggregate demand plays a
crucial role in determining overall economic activity. Keynesians contend that during recessions, government
intervention is necessary to boost demand and achieve full employment. Despite its limitations, the classical
theory laid the foundation for later economic models and remains a significant point of reference in
understanding the mechanics of market economies, particularly in highlighting the importance of long-term
supply-side factors and the self-correcting nature of markets under certain conditions.

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 BIBLIOGRAPHY

BOOKS:

 E.K. Hunt, "History of Economic Thought: A Critical Perspective", 3rd Edition (2002)

 Walter Altis, "The Classical Theory of Economic Growth", 2 nd Edition (2000)

WEBSITES:
 www.economicsdiscussion.net
 www.britannica.com
 www.studocu.com
 www.perplexity.ai
 www.egyankosh.ac.in
 www.imf.org

 www.wikipedia.org

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