Two Important Theories of Income and Employment | Micro Economics

Two important theories of income and employments are : 1. Classical Theory of Income and Employment, 2. Keynesian Theory of Income and Employment!

1. Classical Theory of Income and Employment:

The theory is ascribed to early Classical economists like Adam Smith, Ricardo, and Malthus and neo-classical like Marshall, Pigou and Robbins.

They believe that:

(i) An economy, as a whole, always functions at the level of full employment:

i.e., full employment of labour and other resources .Full employment level of output of goods and services is the largest output that the economy is capable of producing when all its resources are fully employed. Full employment is regarded as a normal situation, yet there could be a temporary unemployment.

If at all there is unemployment, it must be a temporary one and it will be cured automatically through free play of economic forces. Classical behave that aggregate supply would always be at full employment level which is based on two assumptions, namely Say’s Law of Market and Wage-price flexibility as explained below.

(ii) Supply creates its own demand:

Classical theory of employment is based on ‘Say’s Law of market’ which states that ‘supply creates its own demand’. This implies that supply creates a matching demand for it with the result that the whole of output is sold out. So, there is no deficiency in aggregate demand and hence no possibility of over-production and unemployment. Thus, equilibrium level of income and employment is established only at the level of full employment.

(iii) Flexible system of prices, interest rates and wages:

(a) Price mechanism automatically brings equilibrium between demand and supply in the market, (b) Flexibility of interest rates brings about equality between savings and investment, (c) Flexibility of wage rates brings about full employment equilibrium. As a result, the aggregate supply is always at full employment level of output.

2. Keynesian Theory of Income and Employment:

(a) Criticism against Classical Theory:

Keynes criticised the Classical theory stating that the assumptions on which the theory is based are wrong and impractical. For example, (i) In real world situation, an economy often does not function at the level of full employment; rather it generally functions at less than full employment level, (ii) Supply cannot create its equivalent demand on its own and, therefore, there is every possibility of general over-production and unemployment, (iii) Similarly, prices, wages and interest rates may not be flexible due to presence of monopolies and trade unions. The Great Depression of 1929-33 fully shattered the Classical myth of full employment. It was at such a crucial time that Keynes developed his alternative theory of income and employment as detailed in the following pages.

(b) Keynesian Theory:

With this background, Keynes, a British Economist, propounded his own theory and in 1936, brought out his famous book “General Theory of Income, Interest and Money” which brought about a revolution in economic thought. This led to the emergence of Macroeconomics as a separate branch of economics.

Salient points of his theory are:

(i) An economy can be in equilibrium even at less than full employment level:

Economic system does not ensure automatic equality between ‘aggregate demand’ and ‘aggregate supply at full employment’ as believed by Classical. He proved that an economy could be in equilibrium even at less than full employment level. This is the basic difference between Classical Theory and Keynesian Theory.

(ii) Demand creates its own supply:

Aggregate demand for goods and services directly determines the level of output, income and employment. If AD increases, level of output will go up by increasing emplo3mient of resources to meet increased demand and as a result income will also go up. Thus, demand creates its own supply.

(iii) Equilibrium level of income and employment is determined by aggregate demand and aggregate supply:

But this does not mean level of full employment. The equilibrium level of income maybe at below or above the level of full employment .In reality, an economy operates very often at less than full employment equilibrium. Since in the short run, aggregate supply does not change, it, therefore, changes in aggregate demand which brings about changes in income and employment.

This is the gist of Keynesian approach. The core issue of macroeconomics is the determination of level of income, employment and output. According to this theory, in an economy income and employment are in equilibrium at that level at which Aggregate Demand = Aggregate Supply.

Mind, Keynesian theory is supposed to apply under short run and perfect competition. Thus, in Keynesian framework, this determination depends mainly on the level of aggregate demand because during short run aggregate supply is constant with respect to given price. Let us, therefore, first of all clearly understand the concepts of aggregate demand and aggregate supply.