The term classical economics was applied to a school of economic thought that began with Adam Smith's writing of the Wealth of Nations in 1776.  Interestingly enough, the creator of the term was Marx, and it was further perpetuated by John Maynard Keynes in his General Theory.  The classical school of economic thought was the dominant school of thought until the time of the great depression.

Some of the most famous economists of the classical school include Adam Smith, David Ricardo, W. Jevons, Jean-Baptiste Say, John Stuart Mill, Professor Pigou, and Alfred Marshall.

The Classical School's Labor Market

Classical Theory: The Classicals argued that the aggregate labor market determines total employment, and can be summarized by 2 postulates (as proposed by Keynes)

Postulate 1:

Wage = MPL (marginal product of labor)

Assumptions:

• we are talking about the real wage

• everyone receives the MPL as their wage – this is a necessary assumption for profit maximization

• finally we assume diminishing returns to a fixed factor, in this case, capital is fixed in the long run

We see that the second derivative is negative (the curve is downward sloping).  There are several possible causes of this:

1. The first and most prominent reason is that diseconomies of scale set in

2. The second could be a skill argument (you are forced to hire less and less productive workers, as the pool of available workers shrinks.)

3. Long run fixed capital argument – represents fixed plant equipment

We assume one productive sector making both an output and a consumption good.  This means that the real wage is same for both producers and consumers.  An example would be people eating robots (basically eating that which they produce).

Here we can see that demand is downward sloping – this is a consequence of profit maximization. This leads us to our second postulate:

Postulate 2:

Uwage = MDUwork (surrendered leisure time or marginal disutility of work) 

If we have voluntary contracting in the economy (no forced labor), max employment is the intersection, L*.

Max employment therefore yields max output.  At wages below L*, we have a shortage and the level of labor and output is less, as determined by the supply curve.  At wages above L*, we have a surplus and labor/output are determined by the demand curve.

Two types of classical unemployment:

1. Frictional – between jobs
2. Voluntary – people not actively seeking jobs

During the great depression, Pigou and Marshall claimed that the real wage was too high.  Workers needed to accept a lower wage – they are in effect claiming some sort of sticky wage.  This however requires workers to be acting irrationally.

Keynes' attack on the Classical School's labor market

What else could have caused lower levels of unemployment? Keynes argued:

1. A drop in prices
2. Could have institutionalization – labor unions

These two causes rule out the category of involuntary unemployment.  Keynes also challenges the irrationality of a refusal to accept money-wage cuts. He makes a relative wage argument.

Money-wage decreases – relative process in sectors.  This means that it is enacted in a piecemeal fashion, showing its relative nature. 

Real wage decreases – changes aggregate when price increases, and is thus accepted more easily when it comes in the form of rising prices.

- fights the claim that wage = MDUlabor  

Keynes goes further and makes a second objection:

This dealt with money wage deductions:

W – drop prices: 
P – prices may fall – aggregate demand model comes into play

Purchases are streams of nominal cash outlays, when cash outlays drop, prices may drop as well. You can likewise tell a story where decreasing prices leads to decreasing wages.  This in turn leads to further declines in prices.  Thus, Keynes argues that it is difficult to make the connection between the money-wage and real wage that the classical school makes.

Keynes therefore makes the following assumption.  To restore full employment requires lowering the real wage.  In other words, real wage movements are anti-cyclical.  Current day economics has not proven this relationship.  In fact, a relationship with real wage movements have been shown to be a-cyclical or nonexistent.

Under these set of assumptions, the most acceptable way to enact a real wage decrease for workers is through inflation.

The classical school is unambiguous in nature.  They argue that there is really only one variable that determines employment and that is the real wage.  L^s and L^d are locked down given a set of assumptions.

Keynes makes a distinction:

Wage goods (or consumer goods) vs. Capital goods (or investment goods).

Employers – care about their relationship
Workers – care about the wage goods  

In a two sector analysis: P_W, P_K

Employers in wage goods sector w/P_W – (Can be thought of as a Consumer Price Index)
Employers in capital goods sector w/P_K

Workers in turn deflate money wages by prices w/P_W (This is also the real wage for workers)

In other words, this is telling us that there is another set of goods and prices.  This means, in Keynes’ mind that it is in fact possible for the market to clear in different places, based on variations in capital goods prices.  

An example of another factor would be the changing of interest rates
- this in turn effects the cost of borrowing funds

The labor curve therefore must not be locked down, it must be allowed to shift.  In fact, the distribution and level of wealth can help to determine L* as well.

Keynes view of full employment is not associated with clearing of the labor market.  Clearing of the aggregate labor market is not a sufficient condition for unemployment.

1. Classical Theory

2. Workers respond in a positive performance way to rising wages (they become more productive when they are paid more)

3. Upward sloping demand, downward sloping supply – target income, if wages rise, people may stop working once they get a certain level of income

4. Add back downward sloping demand

 Even if we restrict the possible labor markets to one variable, the w/p, we can see that there are four possible outcomes.

Keynes – general theory – pg 15.   If in the event of ­ Wage goods (consumer price inflation) Þ Real Wages ¯ then both aggregate supply and aggregate demand for labor ­.

Using Keynes specific quote we can argue for the existence of involuntary unemployment:

            Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.

In the above instance, if there were to be a rise in the price level (drop in real wages) from W1 to W2, then the volume of employment N, would move from A to C (in both cases it is constrained by the amount of labor supplied at the existing real wage).  Consistent with Keynes definition is the fact that at C, the “aggregate demand,” which at point B is N_B, is greater than the “existing volume of unemployment,” which at the original point A, was N_A.  

All along, Keynes makes the argument that workers will accept declines in the real wage, but not in the money wage – this goes back to our argument of the relative argument (piecemeal fashion of nominal wage cuts).

We can then move on the other cases.

What if the real wage is too high?

Here, a drop in real wages shows no signs of involuntary unemployment, as the employment falls from N₁ to N₂.  This case is unlikely though, because this assumes an upward sloping demand curve.

When we look at the case where there is an upward sloping demand curve (efficiency wage theorem) and a downward sloping demand curve (could happen if people have a target income).

Here, we can see that even though there is even excess demand for labor and involuntary unemployment. 

We can look at one more case, where both labor supply and labor demand are downward sloping.

Was there involuntary unemployment in this case? Yes, employers will demand more than the initial level of unemployment, and at the same time, supply will increase.  In this graph, at points above the market clearing position, you can get involuntary unemployment, in fact, even at the market clearing position you get involuntary unemployment.  This means that at every point on this curve you can get involuntary unemployment.

What if we switch the positions of labor demand and labor supply?

It doesn’t matter which way they cross, if they are downward sloping, every position has involuntary unemployment.

Now, if we look at Keynes’ definition of unemployment found on page 26 of his general theory, we can see a different and clearer definition of involuntary unemployment.

Speaking of full employment Keynes says:

            An alternative, though equivalent, criterion is that at which we have now arrived, namely a situation is that in which aggregate employment is inelastic in response to an increase in effective demand for its output.

In the first definition, we were talking about price levels.  Here, we look at employment from the perspective of demand; increasing demand leads to increasing employment.  Keynes sees both these definitions as equivalent because he is assuming that increasing aggregate demand will necessarily cause a decrease in the real wage.  If we can ignore this mechanism, we have a different definition.

Keynes comes closer to this definition in his later works.  In correspondence in August, 1936, Keynes wrote that full employment is merely the limiting case in which supply of employment is no longer elastic.  Full employment is only possible when elasticity of supply reaches zero.

Keynes argues that when you reach a level of full employment, increasing demand only leads to rising price levels.

Keynes’ notion of involuntary unemployment;

1. Less than full employment

2. An elastic response of employment and output to an aggregate demand increase.

3. A position below the pure inflation barrier (this is the point where increasing aggregate demand leads to nothing but increases in the price level.)

One reason Keynes thinks the way he does is that he has an arbitrage theory of pricing.

The Classical School Continued

Here, the N^D curve is pinned down by a fixed capital stock.

The classical school has models for savings and investment as well. 
We will assume r is interest rates, I is investment, and S is savings.

The Classicals then argue:

Quantity Theory Relationship (Income Version)

- The quantity of money times the velocity of its circulation is equal to the real income

Money Supply * Velocity = Price Level * Output (income)

MV = PY c
MV(r*) = PY*

So the quantity of money only changes the price level because the velocity of circulation is fixed via the rate of interest. M ® P ® w. Where w is the wage rate.

All the important action in the economy is in the labor market. There is no story for aggregate demand; even interest rates have no effect on demand.  This is why it can be called a “real wage economy”, because the wage doesn’t adjust for these things.

Synoptic View:

Classical School

a) All unemployment can be largely construed as voluntary and fits into three categories:

1)      Frictional – time lag between jobs

2)      Search – idea is that workers may quit existing job to try to find another

3)      Money-wage stickiness –real-wage is too high because money-wages don’t adjust and this goes back to the notion that workers refuse to accept money-wage cuts.

b) The Economic System is self-adjusting to full employment.  Classical view that forces or mechanisms exist to restore a position of full employment.  If you didn’t have any interference or government intervention, you would have a tendency to move to full employment (they would still admit there could be lags or leaks in the system).

c) Money is neutral – if we increase the quantity of money, it only influences the general level of prices.  It will have no effect on relative prices.  It will have no effect on the real output and employment of the economy.

d) The interest rate functions to clear the loanable funds market.  Interest rates should bring savings and investment in conjunction with one another, but it does not affect the real output of the economy.

e) Savings drive economic growth.  Income that is not spent for consumption purposes is savings (That which is left over from the expenditure screen of consumers).  Savings would then go to capital accumulation.

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