Classical view on unemployment, Managerial Economics

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The classical economists as we observed in Unit 1 of this course, were of the view that full employment prevailed  in  the  economy  all the time. This was consistent with the view that whatever amount of labour was supplied  got demanded  by  firms. A  basic  assumption  in  the classical framework was  the flexibility in wage rate and prices. Thus the gap between supply of and demand for labour got wiped out through adjustments in wage rate. 

304_classical view of unemployment.png

Fig. : Equilibrium  Level of Employment 

In Fig.  we measure real wage  rate (w) on y-axis and quantity of labour (L) on x-axis. The equilibrium wage rate  reached  through interaction of supply of  labour (L,)  and demand for labour (Ld)  is W*  and quantity of labour employed is L*, which represents full employment. 

The  aggregate  supply curve according to classical economists is a vertical straight line at the full employment output level. At  the equilibrium wage rate everyone seeking employment gets engaged. If  the wage rate  is above w (see Fig.) there is excess supply of labour compared to  its demand.  In  their efforts to get  employed  some  of  the currently unemployed workers will be willing to work at a wage lower than the prevailing one and in the process will bring down the wage rate till it reaches w*. On the other hand, when wage rate  is below w* there will  be  excess demand compared to supply. Due to shortage of labour firms will compete with each other and will be willing to pay higher wage, as a result of which wage rate will increase. Remember that classical economists were concerned with real wage  in the economy, which  is W defined as the  ratio of nominal wage (W)  to price  level (P)  such that  w =  -. P Thus flexibility in real wage assured that a rise in price level is accompanied by a proportionate rise in nominal wage.  In  fact  the dichotomy between real  and monetary sectors of the economy, as envisaged in classical model, ensures such proportional changes. The classical economists did not rule out the possibility of decrease in nominal  wage  rate. Nonetheless, it  was  always  in  response  to decrease in money supply and price level. In  theory, the classical model  appears to have a  sound  base. When  compared with  reality, however, it does  not  explain the obvious  phenomenon  of unemployment in the economy. As we will see below, there is much rigidity  in the economy, which does not allow smooth and instantaneous changes in wage rate. Moreover, some amount of frictional unemployment  is always present  in an  economy as workers switch over from one job  to another. The neoclassical economists recognized the limitations of classical model and made amendments to the classical position of zero unemployment. They assumed that the economy in normal times  has  certain minimum  unemployment  called 'natural rate of unemployment'.  

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