The classical view of the labour market

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Classical economists assumed the labor market was similar to the goods market in that price would adjust to ensure that quantity demanded equaled quantity supplied. When demand would increase, the price of labor (the wage rate) would also increase. This would increase quantity supplied (the number of workers or hours worked) and quantity demanded of labor. Conversely, a decrease in the demand for labor would depress wages and the units of labor supplied would decrease. This view is illustrated in the following figure:

Con..

Con..
The labor demand curve illustrated in the preceding figure shows the amount of labor that firms want to employ at different wage rates. Like other demand curves, it slopes downward, meaning that at higher wage rates, firms will want to employ fewer workers. The labor supply curve shows the amount of labor that households are willing to supply at different wage rates. Its upward slope shows that households are willing to supply more labor at higher wage rates. In other words, at higher wage rates, people that were formerly not in the labor force will be lured into working by higher wages. Conversely, at low wage rates, more people will choose not to participate in the labor force. In the classical view of the labor market, all unemployment is voluntary. When the economy goes into a recession and the demand for labor falls, the wage rate will decline and people will opt out of the labor force.

The Market for Labor

Suppose we have the following information about the market for labor: Demand for labor: w = 10 - 2L Supply of labor: w = 1 + 3L where L = hundreds of thousands of hours per week w = real wage in dollars per hour, base year dollars. Solving for the equilibrium real wage and level of employment, we get: Demand = Supply 10 - 2L = 1 + 3L 9 = 5L Equilibrium L = 1.8 Equlibrium w = $5.40 We can see this equilibrium in Figure 1:

The Market for Labor FIGURE 1

The Market for Labor FIGURE 1 (con)

According to this equilibrium, at a real wage of $5.40 per hour, employment is 180,000 hours of labor per week. The demand for labor depends on the hiring rule used by profit maximizing firms. In the simplest case, the perfectly competitive case, firms hire labor until the real wage equals the marginal physical product of labor: Hiring rule: w = MPP where MPP = [change in output/change in units of labor] w = the real wage = W/P or the money wage divided by the price level. Also, we assume that, in the short run, the marginal physical product of labor is positive but decreaseing. Therefore, as a firm hires more labor, each additional unit of labor hired generates a smaller increase in output .than the unit of labor hired before it. The supply of labor is determined by the willingness and ability of individuals to offer their efforts to the market. Increases in the real wage will create a higher quantity of labor supplied; higher real wages mean that the opportunity cost of not working has risen. But, the supply curve will shift if other factors, such as the labor force participation rate, change. Changes in the labor force participation rate can come about due to changes in social attitudes, changes in the working age population, changes in expectations about future income, etc. Once equilibrium is reached, as in the example above, there is no reason for the market to move from that equilibrium unless either the demand for labor or the supply of labor shifts. Let the Figure 2 below depict the market for labor in the economy.

Figure 2

Figure 2 (con)
At point E, we have the equilibrium real wage w(E), and the equilibrium level of employment L(E). At the wage w(E), firms are hiring labor so that the Marginal Physical Product of labor is equal to the real wage. There is no reason for this equilibrium to change unless either the demand or the supply curve of labor shifts. Let's assume that L(E) is the level of employment that generates the long-run equilibrium level of real GDP, or the Potential real GDP. Therefore, in Figure 3 below, point E, the long-run equilibrium, has a real wage of w(E) and employment of L(E).

Figure 3

Figure 3
Now, suppose impovements in our education system make labor of all kinds more productive. At every value of the real wage, the marginal physical product of labor increases. This shifts the demand curve for labor out to the right, as seen in Figure 4. This means that at the current real wage, w(E), employers are willing and able to hire more labor than L(E). There is an excess demand for labor at w(E), so the real wage will be bid up to w(G), and employment will rise to L(G).

Figure 4

 But, this change in the equilibrium real wage, due to educational improvement, means that the ability of the economy to produce goods has improved. If the education change is permanent, then both the shortrun aggregate supply curve and the long-run aggregate supply curve will shift to the right, as shown in Figure 5. The permanent improvement in the productivity of labor, brought about by educational improvement, has lead to an increase in Potential real GDP, even though the real wage is higher than w(E). The increased productivity of labor has lead to a positive supply shock. The new short-run equilibrium will be point F. If aggregate demand is held constant, following neutral policies, then the new long-run equilibrium will be at point G. The real wage would be w(G), as in Figure 4. Potential real GDP will be higher, due to the increased employment we see in Figure 4, L(G). The increase in employment from L(E) to L(G) has lead to the increase in Potential real GDP.

Figure 5

Pigous Theory:
1. According to Professor Pigou, the unemployment 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 classical theory, there could be small amounts of frictional unemployment attendant on changing from one job to another but there could not be involuntary unemployment for a long period. According to Professor Pigou, if people were unemployed, wages would fall until all seeking employment were in fact employed. Involuntary unemployment which was found at times of depression was because of the fact that wages were kept too high by the actions of labour unions and governments. Therefore, Professor Pigou advocated that a general cut in money wages at a time of depression would increase employment. According to Pigou, perfectly elastic wage policy would abolish fluctuations of employment and would ensure full employment. The of the economy as described by the classical theory is depicted as follows:

Criticism of Classical Theory:

Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to aggregate supply. Employment in a country cannot be increased by cutting general wages. There is no direct relationship between wages and employment. Interest rate adjustments cannot solve savings-investment problem. Classical economists have made the economy completely self-adjusting and self-reliant. An economy is not so self-adjusting and government intervention is unobvious. Classical economists have made the wages and prices so much flexible. In practical, wages and prices are not so flexible. It will create chaos in the economy. Money is not a mere medium of exchange. It has an essential role in the economy. The classical theory has failed to explain the occurrence of trade cycles.