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

The classicists believed in the existence of full employment in the economy and a situation less Notes
than full employment was regarded as abnormal necessary to have a special theory of
employment. The classical analysis was based on Say's Law of Markets that "supply creates its
own demand." They thus ruled out the possibility of over production. The classical economics
was based on the laissez-faire policy of a self· adjusting economic system with no government
intervention. In this unit you will learn about the Classical Theory of Income, Output and
Employment.

3.1 Concepts Related to Classical Theory

The main concepts used in the classical model are:
Full Employment: An economy is said to be in full employment when its entire labour
force is gainfully employed. Labour force is that part of the population of the country
which is physically and mentally able and at the same time willing to work.
Nominal Wage vs. Real Wage: Nominal wage is what a worker receives in the form of
money. Real wage is what a worker can buy from the nominal wage.

Nominal wage w
Real wage = =
Price level p
Real Rate of Interest: Nominal rate of interest is the rate which the lender receives from
the borrower in money. Real rate of interest is rate accruing after adjustment of inflation.
(Rate of interest = ROI, ROI in figures)
Real ROI = Nominal ROI – rate of inflation

Value of Marginal Product of Labour (VMPL): VMPL equals MPL multiplied by the price
of the product (P) the labour produces.
VMP = MP × P = MP × AR
L L L
It is distinguished from 'Marginal Revenue Product of Labour (MRPL), which equals
MPL ×MR. Since in case of perfect competition in the product market MR=AR, VMP =MRP .
L L
Aggregate Demand and Aggregate Supply: Aggregate demand is the total value of final
goods and services that all sections of the economy taken together are planning to buy at
a given level of income during a period of time. Aggregate supply is the value of final
goods and services planned to be produced in an economy during a period.
Supply of Money: Money supply of a country is the stock of money on a specific day. This
is the sum of currency held outside banks and chequable deposits. This is the money which
can be directly used for transactions.

3.1.1 Say's Law

Say's law of market states that ' supply creates its own demand'. If goods are produced then there
will automatically be a market for them. This means that there cannot be a general
'overproduction' or 'glut' in an economy that is based on a market system of production and
exchange. Correspondingly, there cannot be a deficiency in aggregate demand.
Each person's production constitutes his or her demand for other goods; hence, for the entire
community, aggregate demand equals aggregate supply.

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