THE DETERMINANTS OF

OUTPUT AND EMPLOYMENT IN

THE CLASSICAL MODEL

THE CLASSICAL AGGREGATE SUPPLY CURVE

Chapter 3.5 in Macroeconomics (Froyen)

1
 THE DETERMINANTS OF OUTPUT AND EMPLOYMENT
IN THE CLASSICAL MODEL
In the classical model, the factors that determine output and employment are those
factors that determine the positions of the labour supply and demand curves and the
position of the aggregate production function.
The production function is shifted by technical change that alters the amount of
output forthcoming for given input levels.
The production function also shifts as the capital stock changes over time.
The labour demand curve is the MPL curve, the slope of the production function.
Consequently, the position of the labour demand curve will shift if the productivity
of labour changes because of technical change or capital formation.

2
THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL
From the derivation of the labour supply curve, one can see that this relationship
would change as the size of the labour force changes. For example, population
growth would shift the labour supply curve out to the right.
The labor supply curve would also shift with changes in individuals’ preferences
regarding labour–leisure trade-offs.
In other words, exogenous factors are the shifting parameters for the production
function, labour demand and labour supply curves.
A common feature of the factors determining output in the classical model is that
all are variables affecting the supply side of the market for output.
In the classical model, the levels of output and employment are determined
solely by supply-side factors.
3
Part a depicts labour market
equilibrium at the real wage (W/P)0
at equilibrium point A. In the
aggregate, labour supply equals
labour demand, Nd (DL)= Ns (SL).
Equilibrium employment is N0 .
Substitution of equilibrium
employment into the production
function in part b determines
equilibrium aggregate output, Y0
at point A.

4
 SL W/P SL
W/P
S *L
(W/P)*e (W/P)e
(W/P)e
D*L = MPL* (W/P)*e
DL = MPL
DL = MPL
Le L
Le L e
*
L* e L Y*e
Y*e
Y* =AF(K*,L) Y
e Y=AF(K,L)
Y Y=AF(K,L)
e

L
Le L
Le L e
*
L* e

5
THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL

Because the supply-determined nature of output and employment is a crucial feature of the
classical system, it is worthwhile to demonstrate this property more formally.
In order to see that, we consider the features of the labour supply and demand functions more
closely.
In part a of the Figure below, we reproduce the aggregate supply and demand curves for
labour. Here labour supply and demand curves are shown as functions of the real wage
In part b plots labour supply and labour demand as functions of the nominal - money wage
( W ).

6
 Part a shows equilibrium employment
(at N1 ) where labour supply equals
labour demand. In part b, labour
supply and demand are plotted as
functions of the money wage.
Increases in the price level (from P1 to
2P1 , then to 3P1 ) shift the labour
supply and demand schedules upward
proportionately. The money wage rises
proportionately with the price level
(from W1 to 2W1, then to 3W1 ). The
real wage and level of employment are
unchanged.

(=Nd3)
7
(=N )
d
2
 THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL

For labour supply, we can 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. Workers are interested in the real wage, so each price level will have a
different curve.
For a given money wage each price level will mean a different real wage and, hence, a
different amount of labour supplied.

8
THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL

At a price level of 2P1, or twice that of P1, the labour supply curve in part b shifts to Ns (2P1) ; less
labour is supplied for any money wage because at the higher price level a given money wage
corresponds to a lower real wage.
A rise in the price level shifts the labour supply schedule (plotted against the money wage)
upward to the left.
That the individual worker is interested only in the real wage can be seen from the fact that the
same level of labour (N1) is supplied at a money wage of W1 and a price level of P1
(real wage = W1 / P1 ) as at money wage and price combinations of (2W1 , 2P1 ) or (3W1 , 3P1 )
(real wage = W1 / P1 at both points).
Equiproportional increases (or decreases) in both money wages and the price level leave the
quantity of labour supplied unchanged.

9
 THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL
Now consider the labour demand curve plotted against the money wage.
We know that the labour demand and MPL (Marginal Product of Labour) schedules are equivalent.
The condition met at all points along the labour demand curve is :
W / P = MPL
If we want to know the quantity of labour that will be demanded at any money wage, as was the case
for the quantity supplied, the answer depends on the price level.
Given the money wage, the firm will choose the level of employment at which
W = MPL . P
This equation has a simple interpretation. For profit maximization, the money wage paid to the
additional worker (W) must just equal the worker’s contribution to the firm’s revenue.
The worker’s contribution to money revenues equals his or her marginal product multiplied by the
product price (MPL . P), which is termed the marginal revenue product of labour (MRPL) .
10
THE DETERMINANTS OF OUTPUT AND EMPLOYMENT IN
THE CLASSICAL MODEL

At successively higher price levels (P1 , 2P1, 3P1) the labour demand curve plotted
against the money wage shifts to the right (from MPL . P1 to MPL . 2P1 to MPL .
3P1)
For a given money wage, more labour is demanded at higher price levels
because that money wage corresponds to a lower real wage rate.
The demand for labour depends on the real wage. Equiproportional increases in
the money wage and the price level from (W1 , P1) to (2W1, 2P1) and (3W1, 3P1)
leave labour demand unchanged at level N1.
They leave the real wage unchanged at W1 / P1 , which corresponds to the
demand N1 in part a .
11
 LABOUR MARKET

Y= AF (K,N) PRODUCT MARKET

Y1

12
 CLASSICAL AGGREGATE SUPPLY FUNCTION

From the information in Figure above, we can construct the classical aggregate
supply function —a relationship that makes clear the supply-determined nature of
output in the classical model.
The aggregate supply curve is the macroeconomic analog to the microeconomic
concept of the firm’s supply curve.
For the firm, the supply curve gives the output forthcoming at each level of the
product price.
As we have seen, for the perfectly competitive firm, profits are maximized, where
marginal cost (W / MPLi for the i th firm) equals product price (P), or equivalently,
where the marginal product of labour equals the real wage :
MPLi = W / P
13
 CLASSICAL AGGREGATE SUPPLY FUNCTION
The individual firm takes the money wage as given in deciding on the optimal output to
supply and therefore the quantity of labour to hire.
One firm would not expect its effort to hire more labour to cause the money wage to
change because the firm is a small part of the overall market.
Because the money wage is assumed to be fixed, the output supply curve for the firm is
positively sloped.
Higher prices mean lower real wages; consequently, the firm demands more labour and
produces more output.
AS Aggregate Supply
P Curve for an
Individual Firm

Y
14
 CLASSICAL AGGREGATE SUPPLY FUNCTION

In constructing the aggregate supply curve for the economy, we can not assume
that the money wage remains fixed as output and labour input are varied.
The money wage must adjust to maintain equilibrium in the labour market.
With this important difference, the aggregate supply curve addresses the same
question as its microeconomic analog: How will the level of output supplied vary
when we change the product price?

15
 CLASSICAL AGGREGATE SUPPLY FUNCTION
 In the Figure below we construct the classical aggregate supply function.
 Consider output supplied at the three successively higher price levels, P1 , 2P1, and 3P1 .

 At price level P1 and money wage W1, employment was N1 and we assume that the resulting output is Y1, as
shown in the Figure below.
 How will output supplied vary as we go to a price level of 2P1 ?

 At a price level of 2P1, if the money wage remained at W1, we can see from the Figure about labour market
(part b) that labour demand would increase to N2 .
 The higher price would mean a lower real wage, and firms would try to expand both employment and output.
 However, the money wage will not remain at W1. At a price level of 2P1 the labour supply curve in the
Figure about labour market (part b) will have shifted to Ns (2P1), and at a money wage of W1 , labour supply
will be only N2’ units.

 There will be an excess demand for labour equal to (N2 - N2’ ) units and the money wage will rise.

16
 CLASSICAL AGGREGATE SUPPLY FUNCTION

The process at work here is one of some firms responding to higher prices by attempting
to expand employment and production.
To expand employment, they raise nominal wages in an effort to bid workers away from
other firms.
Firms that lag in the process of raising nominal wages suffer higher quit rates and lose
workers.
This process of rising nominal wages will stop only when the nominal wage has
increased sufficiently to reequilibrate supply and demand in the labour market.

17
 CLASSICAL AGGREGATE SUPPLY FUNCTION

Reequilibration occurs at a money wage of 2W1, where the money wage has increased
proportionately with the price level.
At this point, the initial real wage is restored, and employment is back at its original
level.
Consequently, output supplied at price level 2P1 is equal to Y1, the same output level for
price level P1.
At a still higher price level of 3P1, the money wage rises to 3W1, but again, output is
unchanged at Y1.

18
 CLASSICAL AGGREGATE SUPPLY FUNCTION

The aggregate supply curve is vertical. Higher prices provide an incentive for
higher output only if they are not matched by proportionately higher money wages
—only if they lower the real wage.
However, given the assumptions we have made, equilibrium in the labour
market requires that nominal wages rise proportionately with prices to maintain
the equilibrium real wage in that market.
The vertical aggregate supply curve illustrates the supply-determined nature of
output in the classical model.

19
(AS)

The vertical classical aggregate

supply curve reflects the fact that
higher values of the price level
require proportionately higher
levels of the money wage for labour
market equilibrium. The real wage,
employment, and therefore level of
output are the same at P1 , 2P1 , and
3P1 .

(= YF
Full Employment
Output ) 20
 FACTORS THAT DO NOT AFFECT OUTPUT IN THE
CLASSICAL MODEL

Which factors will not affect output and employment in the classical model ?
Since output and employment are supply determined, the level of aggregate demand
will have no effect on output and employment.
Factors such as the quantity of money, level of government spending, and level of
demand for investment goods by the business sector are all demand-side factors that
have no role in determining output and employment.
The case of government tax policy is more complex. Changes in taxes, to the degree
that they affect the demand side, will not affect output or employment.
But changes in tax rates also have incentive or supply-side effects that do matter for
output and employment.

21
 SUMMARY

The striking feature of the classical model is the supply-determined nature of output and
employment. This property follows from the vertical aggregate supply curve.
The classical aggregate supply curve is vertical because of the assumptions we have made
about the labour market.
In general, the labour and product markets can be characterized by the term auction
market .
Labour and output are assumed to be traded in markets that are continually in equilibrium
and in which all participants make decisions based on announced real wage rates and
product prices.

22
 SUMMARY
Especially, two assumptions implicit in this classical representation of the labour market
are as follows :
-Perfectly flexible prices and wages;
Both prices and nominal wages are perfectly flexible in the short run.
-Perfect information on the part of all market participants about market prices.
Both suppliers and purchasers of labour must know the relevant trading prices.
This condition requires that when selling and buying labour at a given money wage (W),
both workers and employers know the command over commodities that will result from
such a wage (W / P ).
These two assumptions, essential for the nature of the classical equilibrium theory of
employment and output, are the elements of the classical theory that Keynes attacked.

23