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Explanation of the theory of employment with Say's law and Pigou's Modification


Posted Date: 11-Jun-2011  Last Updated:   Category: Education    
Author: Member Level: Silver    Points: 40


This article gives out line of classical theory of employment. It explains Say's law of market and Pigou's modification. Critically examine the Keynesian theory of employment. Discuss the key determinants of national income and the concept of unemployment, underemployment and full employment.



Classical theory of employment


The classical theory of employment propounded by Ricardo and Adam Smith is based on two broad features. (a) There is existence of full employment of labor and other productive resources. (Based on say's law) (b) The flexibility of the interest and wage rate is the forces to maintain full employment. Thus full employment is regarded as a normal situation and any deviation from this level is something abnormal, which automatically trends toward full employment.
The classical theory of employment is based on the following assumptions.

1. There is existence of full employment without inflation.
2. There is a closed laissez-faire capitalistic economy.
3. There is perfect competition in labor market and product market.
4. Labor is homogenous.
5. Total out put of the economy is divided between consumption and investment expenditure.
6. The quantity of money is given.
7. Wages and prices are flexible.
8. Money wages and real wages are directly related and proportional.


Say's Law


Say's law of market is the core of the classical theory of employment.early 19th century French economist J.B. say enunciated the proposition that "supply creates its own demand." Therefore there cannot be a general over production and the problem of unemployment in the economy.

In Say's word "It's the production which creates market for goods. A product is no sooner created then it, from that instant, affords a market for other products to the full extent of its own value. Nothing is more favorable to the demand of one product, then the supply of another product." This definition explains the following important facts of the law.

1.Production creates market (demand) for goods:when the producer obtained the various inputs to be used in the production process they generate the necessary income.

2.Barter system is its basis: in its original form the law is applicable to a barter economy where goods are ultimately sold for goods. Therefore, whatever produced is ultimately consumed in the economy.

3.General over production is impossible:if the production process is continuing under normal condition, then there will be no deficiency for the producer in the market. According to say, work being unpleasant no person will work to make a product unless he wants to exchange it for some other product which he desires therefore the vary act of supplying goods implies a demand for them. In such a situation there cannot be general overproduction because the supply of goods will not exceed demand as a whole.

4.Saving investment Equality: Income occurring to the factors owners in the form of rent, wages and interest is not spent on consumption but some proportion out of it is saved which is automatically invested for further production.

5.Rate of interest as a determinant factor: If there is any gap between saving and investment, the rate of interest brings about the equality between two

Flexibility between interest and wage rate: The theory assumes the part of income is saved and available for investment. If at any point of time saving is more then investment, the rate of interest will fall, which will result in low savings and more investments. At a lower rate of interest, household will like to save less, where as producers will like or invest more and economy will be in equilibrium.

If there are unemployed persons in an economy, wage rate will fall. This will induce entrepreneurs to demand more labor. Ultimately all labor will be absorbed. The economy will be in full employment equilibrium.

Pigou's Modification


According to Prof. Pigou the employment, which exists at any time, is because of the fact that changes in demand conditions are continually taking place and that frictional resistances prevent the appropriate wage adjustment from being made instantaneously. Thus, according to the classical theory there could be a small amount of frictional unemployment attended on changing from one job to another. But there could be involuntary unemployment for a long period of time. All people who sought employment would fairly quickly find it, if the wage rate is perfectly elastic. If all people seeking job at the current wage rate would be bid down. a decrease in wage rate would reduce the cost of shifting individual product supply curves to the right there by lowering the prices of product with given demand curves a large quantity would be purchased at lower prices then more people would be employed to produce the larger out put. In short, Pigou applied to the labor market what Says said about the commodity market.

Thus, according to classical analysis if people were unemployed wages would fall until all seeking employment, were in fact employed. Involuntary unemployment could be found at the time of depression was because of fact that wages are kept too high by the action of labor union and government. Therefore, Professor pigou advanced that a general cut in money wages at the time of depression would increase employment and would ensure full employment of labor.


Assumption of Say's law


Say's law was based on certain assumptions:

1. The law can operate only in free exchange economy. Where thee is prefect freedom for buyers to buy and sellers to sell.
2. There is free flow of money incomes
3. Savings are equal to investments and this is quality is brought about flexible investment.
4. The government follows the policy of laissez fair and does not interferer in any manner with the operation of market forces,
5. The size of the market is limited by volume of production: only there will be demand equal to supply. Or supply creates its own demand.


Criticism say's law:


Dr.J M Keynes criticized Say's law in his general theory published in 1936 on the following grounds:
1. Say's law assumes that "supply creates its own demand" where a part of income is saved. Aggregate demand is not equal to aggregate supply.
2. Employment is a economic as a whole can not be increased by the means of a general wage cut though it may be possible in a particular industry.
3. The classical economist looked wages only from the employer's point of views, i.e., the cost aspect and ignored income aspect of wages. There is no direct relation between wages and employment, nor is unemployment due to rigidities or artificial resistant'.
4. Interest rate adjustment can not solve savings investment problem. Saving and investment are not interest elastic.
5. The economic system is not so self-adjusting as it supposed hence government intervention in the economic sphere becomes necessary. Wages and prices are not so flexible as supported.
6. Assumption of free and perfect competition is not realistic.
7. It is wrong suppose that money is a mere medium of exchange and has no r ole effecting output and employment.
8. Say's law can not explain the occurrence of trade cycle.
9. The classical theory does not explain how the level of employment is determined. It eaves the problem by assuming full employment.


Read related articles: Theory of Employment    Pigous Modification    Says law    Say's law    

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