The Amount of Labour employed will be determined at the point where: Aggregate Demand for Labour (N^d) = Aggregate Supply of Labour (N^s)

(a) Demand for Labour:

Demand for labour is negatively related to the real wages (W/P). This is because real wages are the cost of production for the firms. Therefore, an increase in real wages due to increase in wages will lead to an increase in the cost of production. This in turn will decrease the profits of the firm because profit is equal to Revenue minus cost (Profit = Revenue – Cost). Due to decrease in the profit level, firm will demand less labour.

Aggregate Demand for Labour (N^d):

It is a horizontal summation of individual firm’s demand curve for Labour. Aggregate demand for labour is negatively related to the real wages (W/P)

N^D = f (W/P) (Aggregate labour demand function) …(2.4)

(b) Supply of Labour:

Supply of labour is positively related to the real wages (W/P). This is because wages are the income of the labourer. Increase in wages implies increase in income, therefore, a labourer is willing to work more at higher wages. Thus, the supply curve of labour is positively sloped.

Derivation of supply curve of labour:

Labour supply curve is derived from the income-leisure trade-off curve which shows the trade-off between leisure and work.

At lower income level, labour prefers work to leisure → Substitution Effect (SE) > Income Effect (IE) At ‘extremely’ higher income level, labour prefers leisure to work → IE > SE. Thus, we get backward bending supply curve of labour. However ‘extremely’ high wages are rare. Therefore, it is assumed that the Aggregate labour supply curve has a positive slope. SE is strong enough to offset the IE. (SE > IE)

Individual will supply labour up to the point where:

Slope of income leisure trade off line (shown by the slope of budget line) is equal to the slope of income leisure trade off curve (slope of Indifference Curve).

In Fig. (2.3b), by plotting A, B, C at real wages 2.00, 4.00 and 5.00, respectively, we get the labour supply curve which has a positive slope, showing as (W/P) increases more labour is willing to work. 

Aggregate Supply Curve of Labour (N^s):

It is a horizontal summation of all individual labour supply curves. It gives the total labour supplied at each level of real wages. It is positively related to the real wages.

Therefore, Equilibrium level of employment → N*, as here N^d = N^s shown by point ‘e’

Real wage → (W/P)* (Fig. 2.4a)

Equilibrium level of output →Y* (Fig. 2.4b)

Thus, Y* is the full employment level.

Determination of Income and Employment

The complete classical model of income and employment determination in an economy in Fig. 3.7. In panel (a) of this figure labour market equilibrium is shown wherein it will be seen that the intersection of demand for and supply of labour determines the real wage rate (W₀/P₀ ).

At this equilibrium real wage rate the amount of labour employed is N₁; and, as explained above, this is full employment level. As depicted in panel (b) of the figure this full employment level of labour N₁ produces Y₁ level of output (or income).

In panel (c) of Figure 3.7 we have drawn 45° line that is used to transfer the level of output on the vertical axis in panel (b) to the horizontal axis of panel (c). In panel (d) we have shown the determination of price level through intersection of the curves of aggregate demand for and aggregate supply of output, as explained by the quantity theory of money. In the classical theory, aggregate supply curve AS is a vertical straight line at full-employment level of output Y_F.

Thus, given constant velocity of money V, the quantity of money M₀ will determine the expenditure or aggregate demand equal to M₀V according to which aggregate demand curve (with flexible prices) is AD0. It will be seen from panel (d) of Fig. 3.7 that intersection of vertical aggregate supply curve AS at fully-employment level output Y_F and aggregate demand curve AD₀ determines the price level P₀. With price level at P0, the money wage rate is W₀ so that W₀/P₀ is the real wage rate as determined by the intersection of demand for and supply of labour [see panel (a) of Fig. 3.7].

Now, a relevant question is how this equilibrium level of real wage rate, prices, employment and output (income) will change following the increase in the quantity of money. Suppose the quantity of money increases from M₀ to M₁ with the given capital stock (as we are considering the short-run case) and the labour force being already fully employed, the output cannot increase. Therefore, as depicted in panel (d) following the increase in money supply to M₁, aggregate demand or expenditure will increase to M₁ V and thereby causing aggregate demand curve to shift to AD₁. As a result, price level rises from P₀ to P₁.

However, as explained above, with the given money wage rate W₀, the rise in price level from P₀ to P₁ will cause a fall in real wage rate. As will be seen from panel (a), with the rise in price level to P₁ real wage rate falls to W₀/P₁.

This will cause temporary disequilibrium in the labour market. At the lower real wage rate W₀/P₁, more labour is demanded than is supplied. Given the competition among the firms, this excess demand for labour will cause the money wage rate to rise to W₁ level so that the real wage is bid up to the original level W₁/P₁ = W₀/P₀.

Criticism of Classical Analysis

Classical school considered a frictionless society. Many obstacles like presence of trade unions, minimum wage legislation, industrial monopoly, imperfect situations etc., were completely ignored. The fact of the modern world is such that it is full of such artificial obstacles and, as such cannot accept classical ideas as policy prescriptions for its present problems. In the modern world none of the variables especially wages are flexible. There is continuous change in technology, tastes, labour supply and so on. Immobility of factors of production imperfect information on costs and their business conditions, Government interference etc. are the characteristic features of today?s economy. These conditions no doubt, invalidate certain results of classical theory. All the classical concepts were severely and vehemently criticized by Keynes for their inapplicability to macro economic problems and for their irrelevance in modern changed context. The criticism leveled against classical ideas will be discussed in detail in the next chapter before passing on to Keynesian theory of employment. So critical evaluation of classical ideas is postponed fro time being one fundamental mistake made by the classical school which invalidate majority of their contributions is that of application of micro principles to macro problems. They failed to integrate money market with value to real market. They failed to think about possibility of rigidities in economic system. They failed to visualize „artificial? hindrances in the smooth working of the market. They had too much reliance on the automatic and self adjusting characteristic of the economy. 

Thus contribution of classical school to the theory of employment and output, though great by itself is inapplicable, and irrelevant to modem economic problems. Keynes in his renowned book “General Theory” severely criticized the classical theory of employment. He criticized Say?s law, especially the views of Pigou that a general cut in wages, during depression and unemployment will restore full employment in the economy. As we have said above, according to Say?s law, every supply or production creates its own demand, as a result of which problems of over production and unemployment do not arise it is, of course true that supply?s creates demand for goods because the various factors which are employed in productive activity earn incomes from it, which are in turn spent on goods. For example, when factors of production are employed in production cloth then the incomes in the form of wages, rent interest and profits accrue to them which they spend on various goods. But from this it does not follows that the supply of production will create its entire demand. The incomes earned by the various factors of production are equal to the value of output produced, but this does not mean that the whole income received by the factors of production will be spent on goods and services. A part of the income is saved and the saved part does not necessarily create demand for goods and services, if entrepreneurs do not invest equal to the desired savings, then aggregate demand which consists of demand for consumer goods and capital goods, will not be enough to purchase available supply of output. Hence, if aggregate demand is not sufficient to purchase available supply, the producer would be unable to sell their whole output due to which their profits would decline and a result of which they would reduce their level of production giving rise to unemployment in the economy. In a given period, consumers spend a part of their income on consumption and the rest they save. Likewise, in a period, the entrepreneurs plan to spend on factories and machines, that is, they plan to invest. Aggregate demand is sum of consumption demand and investment demand. But in a free enterprise capitalist economy, the persons who save are often different from those who invest and further that the factors that determine savings are different from the factors which determine investment by the entrepreneurs.

People save to provide for their old age, to accumulate money for education and marriage of their children, but investment by entrepreneurs depends upon marginal efficiency of capital (that is, expected rate of profit), rate of interest, population growth and technological progress. We thus see that there is no such mechanism in a free enterprise economy which guarantees that investments made by the entrepreneurs are equal to the savings by the people. Desired savings by the people are generally not equal to the desired investment by entrepreneurs.

If the desired investment by entrepreneurs falls short of the amount of savings at fullemployment level of income, the equilibrium of the economy will be at less than full employment level and as a result of which unemployment will emerge in the economy. In this way, according to Keynes, there is no reason that sum of consumption expenditure and investment expenditure is necessarily equal to the value of output produced. In other words, there is no guarantee that aggregate demand will be equal to aggregates supply forthcoming at full employment level of resources. Hence, it is not necessary that the economy will be in equilibrium at the level of full employment. This invalidates Say?s Law, since according to Say?s Law over-production and unemployment cannot occur. Keynes also criticized Pigou?s view that a general cut in wages in times of depression will remove employment and that the full employment in the country will be achieved. According to Keynes, a general cut in wages will not bring about increase in employment because the reduction in wages will reduce the aggregate demand for goods. Keynes put forward the view that wages are not only the costs of production, they are also incomes of the workers which constitute the majority of the population of the country. As a result of a general cut in wages, the income of the workers will fall due to which aggregate demand will decline. As a result of decline in aggregate demand, level of production will have to be reduced and less labour will have to be employed than before. This will crate more unemployment rather than reducing it. No doubt, as a result of a general cut in wages, cost of production of industries will fall but with the fall in costs, “the demand for the products will not increase because due to the all –round cut in wages, purchasing power of the working class will decreases. Hence an all-round cut in wages will reduce the level of employment by reducing aggregate demand and will thus deepen the depression.

There is a fundamental difference between Keynes and Pigou in respect of the relationship between wages and employment. Pigou thought that level of employment in economy depends upon the level of money wages and therefore reduction in money wages will promote employment. On the other hand, Keynes thought that the level of employment depends upon the aggregate demand and the aggregate demand declines as a result of an all round cut in money wages. According to Keynes, even if the wage rates are perfectly flexible, the unemployment will prevail in the economy if the aggregate demand is deficient. Classical economists thought that a general cut in wages would reduce the cost of production of various industries but the y ignored the fact that a general cut in wages will also reduce the incomes of the people. In view of the fall in incomes and aggregate demand how will manufactures be able to sell their whole output? It is the sales of output that makes the wheel of trade, output and employment going. However, note that the classical theory is valid in the case of an individual industry. With the decline in wages, the cost of the industry will decrease and as a result the prices of its product would fall. The industry will be able to sell a larger amount of output at a lower price because it is not necessary that the goods produced by the industry are to be purchased by the workers employed in that industry whose wages have been reduced. But in the case of the economy as a whole, this is not valid because a general cut in wages will reduce the incomes of the working class and as a result enough demand will not be there for the output produced by the whole economy. This deficiency in demand will reduce the demand for workers as a result of which unemployment will spread among them. The fundamental flaw in Pigou?s analysis is that he applied partial equilibrium analysis, which is valid in the case of in individual industry, to the determination of income and employment in the whole economy.

The determination of the level of aggregate income and employment in the economy should be explained with the aid of general equilibrium analysis rather than with partial or particular equilibrium analysis of micro-economics. Because of the above-mentioned shortcomings of the classical theory, there was a need for development of new theory which could provide a correct explanation of the determination of income and employment in the economy. Capitalist economy cannot automatically attain a state of full employment. Keynes in his famous work “General Theory of Employment, interest and Money” not only criticized the classical theory but also propounded the new one which is still regarded as valid and correct.

Summary

Classical School believed in free enterprise economy or Capitalistic System, it assumed perfect competitions both in factor market and product market. There is no deviation from full employment. The economy experiences full employment permanently and even if there are occasional slips from full employment they can be corrected because of flexibility of prices, interest and wages. A cut in wage will restore full employment Workers are prepared to accept a reduction in wages. In the production field supply always creates its won demand. When additional goods are produced additional factors are employed, and these factors in turn spend the income creating an equivalent demand. Both capital for labour are function of real wage.

Since output is subject to the Law of Diminishing returns, more labour can be employed only at a lower wage. Because of increased number when marginal productivity falls, real wage must also fall to keep up the level employment. Money plays a very passive role. It is a more medium of exchange. The store of value function of money was completely ignored by the classical school. Money as such does not affect other variables in the system. When the quantity of money is doubled prices also are doubled. There is a direct and proportionate connection between money supply and price level. Classical school could not integrate money market with real market and as such these who markets remain loose and as two different compartments with no interlinkage. Savings and investment are always equal and this equality is brought by the flexible interest rate. There are no rigidities in the economic system. All variables are flexible in both directions. This ensures full employment in the economy.