Classical Theory of

Employment

Introduction
The term Classical was associated with economist like Karl
Marx.
According to Classical theory of Income, full employment is a
normal feature of capitalist economy.
According to this theory, unemployment will be for a short
period of time.
Classical theory believed that unemployment is caused only
when people begin to save more than they invest.

Assumptions

Rational man
Perfect competition
Constant technology
Money is only a medium of exchange
Flexibility of prices
Relation between real and money wages
Equality between savings and investment

Explanation of Classical Theory

of Employment
Classical theory of employment is based on two facts:
a) Flexibility of Wages, Interest and Prices
b) Says Law of Markets

Flexibility of Wages, Interest and

Prices
Flexibility of wages
Demand and supply of labor depend on real wages.
Real Wages = Money Wages/Price level
Demand for labor increases with fall in their real wage and remove
unemployment so that full employment position can be restored in an
economy.
ND = f(W/P)
ND = Demand for Labor
W/P = Real wage
NS = f(W/P)
NS= Supply of Labor
W/P = Real wage
ND=NS

Wages

Employment

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Flexibility of rate of interest:
According to classical economist, if savings and investments are not
equal then changes in the rate of interest will equate saving and
investment and equilibrium will be established.
Both saving and investment depend upon rate of interest.
I= f ( r)
I = Investment
r = Rate of Interest
S = f ( r)
S= Savings
r = Rate of Interest
I=S

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Flexibility of Price level
Under equilibrium situation,
Aggregate Demand (MV) = Aggregate Supply (PT)
M= Supply of Money
V= Velocity of circulation (amount of units of money
circulated in the economy)
P= Price level
T= Trade transactions
If velocity of money and trade transactions remain constant then,
P = f (M)

Says Law of Markets

It is also another base of classical theory of employment.
This law sates that Supply creates its own demand.
When a producer produces goods and pays wages to workers,
the workers, in turn, buy those goods in the market. Thus the
very act of supplying (producing) goods implies a demand for
them. It is in this way that supply creates its own demand.
Says law of market believed that whatever amount of output
is produced, it will be sold in entirely.
More production will promote more employment.
According to classical theory, it is only under full employment
situation that economy can be in equilibrium.

Implications
Full employment is a normal feature of capitalist economy.
Equilibrium is possible under full employment situation.
By reducing money wages, real wage can be reduced. As a
result, full employment can be achieved.
Laissez faire policy should be implemented.
Flexible Wage rate
Entire income on consumption and investment should be spent
by people.
Savings and investments are equal.

Criticism
Weaknesses of Says law of markets
Employment cannot be increased by General Money Wage cut
Absence of Automatic Adjustment (The rich possess much
wealth but they do not spend the whole of it on consumption.
The poor lack money to purchase consumption goods. Thus
there is general deficiency of aggregate demand in relation to
aggregate supply which leads to overproduction and
unemployment in the economy. This, in fact, led to the Great
Depression. )

Continue..
Saving and Investment are not interest elastic. (saving
depended upon the level of income and investment is
determined not only by rate of interest but by the marginal
efficiency of capital)
Rejection of Laissez faire policy
Ignores the problems of short period.
Deals only with full employment
Not based on empirical facts