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Unit 3: Theories of Income, Output and Employment: Classical Theory

Figure 3.1 Notes

Assuming a closed economy and no government, households and firms interact in the labour,
product and capital markets. Households supply labour to firms that use that labour to produce
goods and services. Firms compensate workers by paying wages. Households use their income
to purchase goods and services firms produce. Households also save and their savings finance
firms' investments. Households earn interest and dividend in return.

Simultaneous Equilibrium in Markets

Since all markets are interrelated, what happens in one market will have impact in other markets.
Assuming free enterprise and free price mechanism automatic adjustment in overall price level,
wage rates and interest rates lead to simultaneous equilibrium in all the markets. To know how
it happens, let us first study how the equilibrium is reached in the individual markets.

Caselet Geo-classical Economics

enry George was an American classical economist, but was also very critical of
much of classical thought and presented alternative theories. His major work
Hwas Progress and Poverty, written in 1879. Thus he and his Georgist followers
form a school of their own, which I call "geo-classical," the term "geo" standing for both
George and for land. It has elements in common with both the Physiocrat and the classical
school. But George rejected the classical notion of Malthus that population will tend to
outrun production, and he also argued against the classical "wages fund" theory that
wages are paid from some fixed amount of capital fund.
Instead, George theorized that wages are set at the margin of production, where the best
free land is available, and production of better land, after paying wages and capital yields,
constitutes land rent. Land rent is increased and wages lowered by land speculation,
which pushes the margin to less productive land. The remedy for the resulting poverty is
the collection of land rent for public revenue and the abolition of the taxation of labor and
capital. This will not only increase the margin to more productive land, but also remove
the stifling effects of taxing and restricting labor. George also advocated free trade just as
the classicals and physiocrats did.

Contd...

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