Classical Theory on Wage and Employment (With Diagram) | Macro Economics

Let us make an in-depth study of the classical theory on wage and employment.

The simple Classical theory of employment is based on two fundamental postulates.

The first is that “wage is equal to the marginal product of labour” Accepting the law of Diminishing Marginal Productivity as employment increases, any increase in employment is necessarily associated with lower real wage rates.

If, however, unemployment still persists, it must be due to the refusal of the workers to accept the lower real wage rate which corresponds to the reduced marginal product of their labour.

The second postulate of the Classical theory is that “the existing real wage is equal to the marginal disutility of employment”. That is, “the utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment”.

Keynes expressed it thus:

“That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of employee a persons themselves) to induce the volume of labour actually employed to be forthcoming. Disutility must be taken to cover every kind of reason which might lead a man, or a body of men to withhold their labour rather than accept a wage which had to them a utility below a certain minimum.”

This postulate implies that workers’ demand is essentially for real wage and not for money wage and the relationship between the two is direct. The second postulate gives the supply schedule for various levels of employment forthcoming at different real wage rates, while the first postulate gives the demand schedule for employment.

Given the supply and demand functions, “The amount of employment is fixed at the point where the utility of the marginal product balances the disutility of the marginal employment.”

The two postulates would get simultaneously satisfied at the point of intersection of the demand schedule and the supply schedule for employment. The classical theorists would not admit the possibility of involuntary unemployment; the economy would be normally at the full employment equilibrium. There is either frictional unemployment or voluntary unemployment.

The short-run classical model can be presented diagrammatically through the following figure:

It is based on the following assumptions:

(i) The supply of labour is an increasing function of real wage rates, i.e., more labour will be offered for higher real wage rates.

(ii) The demand for labour is a decreasing function of real wage rates i.e., less labour will be hired for higher real wage rates and more at lower real wage rates.

(iii) There are no imperfections or institutional rigidities in the labour market, i.e. labour is perfectly mobile.

(iv) Aggregate demand (for goods and services) remains constant and no changes are anticipated.

(v) Population, tastes, technology, etc. are given.

The demand for labour:

A firm in a competitive industry will hire workers up to the point where the value of marginal product (marginal product multiplied by the price of output) just equals the cost of the factor. The demand for labour, therefore, may be written as: N_d= D (W/P); which states that the demand for labour is a function of the real wage rate. According to the law of Diminishing Marginal Returns, the marginal product of labour declines as more workers are hired. It follows that if the level of employment is to be increased, the real wage must fall. The demand for labour is, therefore, a decreasing function of the real wage rate.

The Supply of Labour:

The demand curve DI)’ in the figure shows this. Classicals assumed that a change in the quantity of labour supplied will take place only if the real wage changes. Consequently, the classical labour supply function may be written as: N_s = S (W/P). The supply curve SS’ in the figure shows this.

The Equilibrating Mechanism:

Given the supply and demand functions of labour, we can explain the equilibrating mechanism in the labour markets in the following steps :

(1) W/P, i.e. the average money wage deflated by price level is shown on the vertical axis, while the horizontal axis measures the various amounts of employment or N.

(2) DD curve represents the demand for labour indicating that more labour is hired at lower real wage rates, ON < ON₀; SS is the supply curve showing that more labour is offered at higher real wage rates ON being > 0N_o

(3) When the wage rate is (W/P₁) the system is in disequilibrium, so that workers bid down money wages relatively to prices to the level of W/P₀ eliminating unemployment to the extent of by NN₀. At the real wage rate (W/P₁) the quantity of labour demanded is ON, while workers offer ON’ units of labour.

It means there is excess supply of labour to the extent of AW. When more workers are willing to work at the going real wage rate than business is willing to hire, we have involuntary unemployment. Should the real wages fall to (W/P_Q), involuntary unemployment would disappear.

(4) (W/P_Q) is the equilibrium wage rate in the market where amount of labour demanded is equal to the amount of labour supplied and N₀ is the full employment level. Anybody unwilling to work at that wage rate is, therefore, considered voluntarily unemployed.

(5) Thus, demand for and supply of labour are so related to real wage rate that any discrepancy between the two will cause such a change in real wage rate that full employment is restored. In equilibrium, therefore, we have D (W/P) – S (W/P) = o and N = N₀.

This logic was applied to all types of labour markets. Hence, on the basis of above argument unemployment was considered incompatible with equilibrium. Such is the self-adjusting classical system of automatic full employment equilibrium.

It is, therefore, clear why during the pre-Keynesian era when classical theories held sway, employment problem was never taken so seriously. The state of full employment was considered as a normal feature of the free-enterprise economy any deviation from it being taken as frictional, temporary, and originating from the imperfections of the market.

From Particular to General Wage Cut:

During the Great Depression, Prof. A C. Pigou proposed the policy of general wage cutting. One finds it hard to agree with the classical reasoning that a general wage cut will remove unemployment, unless the wage cut is a particular wage cut in a single firm or industry. It may be true that wage cut in a single industry (say Toys industry) may increase employment if there is no fall in the demand for toys.

It cannot be presumed from this that the demand for the toys would not be affected at all if a general wage cut (as opposed to a particular wage cut in toy industry) is applied to the economy as a whole. If the wages of the workers employed in the toy industry only are reduced, there is no doubt that the cost of production of toys will also be reduced more than the fall in the demand for toys.

Thus, while the income of the workers employed in the toy industry has been reduced, the workers in other industries continue to enjoy the same purchasing power and with a fall in the prices of toys, the demand for toys will go up leading to more production and employment.

It may, however, be noticed that the wage cut proposed by the classicals is the general wage cut affecting the economy as a whole rather than a particular wage cut.

As such, if the general wage cut applied in the economy as a whole reduces purchasing power of the people (results in a fall in the effective demand) it is highly doubtful that the demand for toys would go up resulting in an increase of output and employment in the toy industry. This will happen only when the wage cut is a particular wage cut (in toy industry alone).

Keynes’ Criticism of Wage Cuts Policy:

Keynes strongly opposed the classical theory of automatic adjustment through flexible wage rates including the Pigovian formulation of Say’s Law on the ground that the same had become obsolete under modern conditions.

Keynes particularly rejected the thesis that unemployment would disappear if workers accept sufficiently low wages. He regarded wage cuts to remedy unemployment as unsound both from the theoretical and practical points of view. He considered such a step as highly anti- moral and anti-social.

From the practical viewpoint also he doubted the validity of such a step. In his view, collective bargaining by labour unions, unemployment insurance, minimum wage laws, etc. had come to stay. Keynes’ theory of employment does not depend upon flexibility of wage rates. He argued that employment depends upon effective demand and not on the wage bargains between employers and workers.

According to him, even if wage rates become flexible under thorough-going competition, unemployment could still exist. Keynes recognised that wages are a double-edged weapon. Reduced wages not only diminish the costs but they also reduce money incomes and purchasing power of these workers.

Classicals laid more stress on the cost aspect but Keynes emphasized the income aspect of wages. According to Keynes, wages arc a source of demand and when these are cut, general purchasing power also suffers. Total demand and total expenditure decline as a result of wage cuts. Hence, to him, this was no good method to achieve full employment.

Keynes’s Break with the Classicals:

Keynes rejected the classical theory of unemployment, which in his view held (i) that the wage bargains between workers and employers determine (real) wages, (ii) that the level of (real) wages thus arrived at determines the amount of employment. He agreed basically with the assumption of diminishing returns that an increase in employment can only occur to the accompaniment of a decline in the rate of real wages.

He differed with the Classical theory in his argument that there was no expedient by which labour as a whole could reduce its real wage to a given figure by making revised money bargains with the entrepreneurs.

However, the extent to which Keynes’ break with the classical view was less than complete was evident in his remark that “If our central control succeeds in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable; the classical theory comes into its own again from this point onwards.”

The volume of employment, according to Keynes is determined by effective demand. To him, unemployment is not due to the refusal of the workers to accept a wage corresponding to their marginal productivity but due to inadequate aggregate demand.

Demand determines employment and employment determines the marginal products and therefore wages. The manipulation of wage rates, Keynes thought, was not a sound way to increase employment. Manipulation of demand for labour is a far more effective policy.

Keynes vehemently opposed the classical theory of automatic adjustment because the same had become obsolete in the conditions of contemporary, capitalist world. Keynes particularly objected to the notion that unemployment would disappear if workers would just accept sufficiently low money wage rates.

According to him this classical reasoning turned out to be extremely disastrous both from the theoretical and practical points of view.

He contended that collective bargaining by trade unions, minimum wage laws, unemployment benefits, etc. have become an integral part of the modern advanced, democratic economics possessing increased productivity and technology. The classical theory of employment though quite logical and simple on account of strong basic postulates was unacceptable owing to the unrealistic nature of its assumptions.