Unit VIII: Theory of Employment - Applied Economics - BCA Notes (Pokhara University)

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Wednesday, July 17, 2019

Unit VIII: Theory of Employment - Applied Economics

Introduction:

According to classicists, there will always be full employment in a free-enterprise capitalist economy because of the operation of Say’s Law and wage-price flexibility. This classical theory came under severe attack during the Great Depression years of the 1930s at the hands of J. M. Keynes. He rejected the notion of full employment and instead suggested full employment as a special case and not a general case. Full employment is a temporary phenomenon and astrological coincidence.
Theories of Employment, Meaning of Effective Demand, Aggregate Supply (AS), Aggregate Demand (AD), Principle of Effective demand, Equilibrium Level of Employment,

He claimed his theory to be ‘general’, i.e., applicable at any point in time. That is why he christened his epoch-making book: The General Theory of Employment, Interest and Money (1936). Thus, Keynes’ theory is “general”. In this book, he not only criticized classical macroeconomics but also presented a ‘new’ theory of income and employment. He is often described by economists as a revolutionary one in the sense that it was Keynes who salvaged the capitalist economy from destruction in the 1930s. Critics, however, label him as a ‘conservative revolutionary’.

Keynes’ theory of employment is a demand-deficient theory. This means that Keynes visualized employment/unemploy­ment from the demand side of the model. His theory is, thus, known as a demand-oriented approach, as opposed to the classical supply-side model. According to Keynes, the volume of employment in a country depends on the level of effective demand of people for goods and services. Unemployment is attributed to the deficiency of effective demand.

It is to be kept in mind that Keynes’ theory is a short-run theory when population, labour force, technology, etc., do not change. Once Keynes remarked that since “in the long run we are all dead”, it is of no use to present a long-run theory. In view of this, one can ar­gue that the volume of employment depends on the level of national income/output. Higher (lower) the level of national output higher (lower) is the volume of employment. Thus, Keynesian theory of employment deter­mination is also the theory of income deter­mination.

Meaning of Effective Demand:

Keynes’ theory of employment is based on the princi­ple of effective demand. In other words, the level of employment in a capitalist economy de­pends on the level of effective demand. Thus, unemployment is attributed to the deficiency of effective demand and to cure it requires the increasing of the level of effective demand.
Theories of Employment, Meaning of Effective Demand, Aggregate Supply (AS), Aggregate Demand (AD), Principle of Effective demand, Equilibrium Level of Employment,

By ‘effective’ demand, Keynes meant the total demand for goods and services in an economy at various levels of employment. Total demand for goods and services by the people is the sum total of all demand meant for consumption and investment. In other words, the sum of consumption expenditures and investment expenditures constitute effec­tive demand in a two-sector economy.

In or­der to meet such demand, people are em­ployed to produce all kinds of goods, both consumption goods and investment goods. However, to complete our discussion on ef­fective demand, we need another component of effective demand, the component of gov­ernment expenditure. 

Thus, effective demand may be defined as the total of all expenditures, i.e. C + I +G Where,
C stands for consumption expen­diture,
I stands for investment expen­diture, and
G stands for government expen­diture.

Here we ignore government expenditure as a component of effective demand. According to Keynes, the level of employment is determined by the effective demand which, in turn, is determined by aggregate demand function or aggregate demand price and aggregate supply function or aggregate supply price. In Keynes’ words; “The value of D (Aggregate Demand) at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply function, will be called the effective demand.”

Assumption:

The principle of effective demand is based on the following assumptions:
1. There is the existence of a closed economy, ignoring the effect of foreign trade.
2. There is the operation of the law of diminishing returns.
3. Perfect competition exists in the market.
4. He assumes that labour has a money illusion. It means that a worker feels better when his wages double even when prices also double, thus leaving his real wage unchanged.
5. The government is assumed to have no part play either as taxer or a spender, i.e. the fiscal operations of the government are not explicitly recognized.
6. Less than full employment, equilibrium is possible in a short period.

Aggregate Supply (AS):

Employers hire and purchase various inputs and raw materi­als to produce goods. Thus, production in­volves cost. If sales revenue from the sale of output produced exceeds the cost of production at a given level of employment and output, the entrepreneur would be induced to employ more labour and other inputs to produce more.
Theories of Employment, Meaning of Effective Demand, Aggregate Supply (AS), Aggregate Demand (AD), Principle of Effective demand, Equilibrium Level of Employment,
At any given level of employment of labour, aggregate supply price is the total amount of money that all entrepreneurs in the economy expect to receive from the sale of output produced by a given number of labourers employed. For each particular level of employment, there is an aggregate supply price. Here, by ‘price’ we mean the amount of money received from the sale of output, i.e., sales proceeds.

Thus, aggregate supply price refers to the proceeds from the sale of output at each level of employment and there are dif­ferent aggregate supply prices for different levels of employment. If this information is expressed in a tabular form, we obtain “ag­gregate supply price schedule” or aggregate supply function. The aggregate supply func­tion is a schedule of the minimum amounts of proceeds required to induce varying quanti­ties of employment. Simply, it shows various aggregate supply prices at different levels of employment. Plotting this information graphi­cally, we obtain the aggregate supply curve.

According to Keynes, the aggregate supply function is an increasing function of the level of employment. Aggregate supply (AS) curve slopes upward from left to right because the volume of employment increases with the increase in sale proceeds. But there is a limit to increase output level. This is called full employment level of output beyond which output cannot be increased, it is because of full employment that AS curve becomes vertical or perfectly inelastic. This means that the level of employment cannot exceed full employ­ment (LF) level even by increasing aggregate supply price. This is shown in Figure below.

Aggregate Demand (AD):

Aggregate demand or aggregate demand price is the amount of money or price which all entrepreneurs expect to receive from the sale of output produced by many labours employed. Or it refers to the expected revenue from the sale of output at a particular level of employment. Each level of employment is associated with a particular aggregate supply price and there are different aggregate demand prices for different levels of employment.
Theories of Employment, Meaning of Effective Demand, Aggregate Supply (AS), Aggregate Demand (AD), Principle of Effective demand, Equilibrium Level of Employment,
Like the aggregate supply schedule, the aggregate demand schedule shows the aggregate demand price for each possible level of employment. Plotting the aggregate demand schedule we obtain aggregate demand curve as there is a positive relationship between the level of employment and aggregate demand price, i.e., expected sales receipts. This is shown in Figure below. It rises from left to right.

Equilibrium Level of Employment (The Point of Effective Demand):

The level of employment in an economy is determined at that point where the aggregate supply price equals the aggregate demand price. In other words, the intersection of the aggregate supply function with the aggregate demand function determines the volume of income and employment in an economy.

It is, thus, clear that so long as expected sales receipts of the entrepreneur (i.e. aggregate demand schedule) exceed costs (i.e. aggregate supply schedule), the level of employment should be increasing and the process will continue until expected receipts equal costs or aggregate demand curve intersects aggregate supply curve.

Note that the AS curve starts from the ori­gin. If aggregate receipts (i.e. GNP) are zero, entrepreneurs would not hire workers. Like­wise, AD curve also starts from the origin. The equilibrium level of employment is deter­mined by the intersection of the AS and AD curves. This is the point of effective demand point E in Figure below. Corresponding to this point, OLE workers are employed. At the OLlevel of employment, expected receipts exceed nec­essary costs by the amount RC. Entrepreneurs will now go on hiring more labour till OLlevel of employment is reached.

At this level of employment, entrepreneurs’ expectations of profits are maximized. Employment beyond OLE is unprofitable because costs exceed rev­enue. Thus, actual employment (OLE) falls short of full employment (OLF). The Keynesian system shows two kinds of equilibrium actual employment equilibrium determined by AD and AS curves and underemployment equi­librium.
Theories of Employment, Meaning of Effective Demand, Aggregate Supply (AS), Aggregate Demand (AD), Principle of Effective demand, Equilibrium Level of Employment,

Keynes made a little emphasis to the aggre­gate supply function since its determinants (such as technology, supply or availability of raw materials, etc.) do not change in the short run. Keynes was examining the possibility of unemployment in a capitalistic economy against the backdrop of Great Depression of the 1930s.

After diagnosing the problem, Keynes recommended policy prescription so as to create more employment in the economy. Indeed, for curing unemployment problem, he did not subscribe to the classical ideas, the supply-oriented policies. Keynes attached great importance to demand stimulating poli­cies to cure unemployment. In other words, Keynes paid emphasis on the aggregate de­mand function. That is why Keynes’ theory is known as a ‘theory of aggregate demand’.

The figure above shows the situation of equilibrium at less than full employment level. Actual equilibrium, OLE, is short of full employment equilibrium, OLE. Thus, the distance OLF to OLE measures unemployment. This is called involuntary unemployment, a situation at which people are willing to work but do not find jobs.

This unemployment, according to Keynes, is due to the deficiency of aggregate demand. This unemployment can be removed by stimu­lating aggregate demand. Aggregate demand is the sum total of consumption and invest­ment demand or expenditures in the economy. By raising consumption expenditure, the level of employment can be raised.

But there is a limit to consumption expenditure. So what is needed is the raising of (private) investment demand. Anyway, an increase in consump­tion demand and investment demand will raise the level of employment in the economy. The point of effective demand has been changed because of the shifting of AD curve from AD to AD1 New effective demand is now given by E1 Corresponding to this point, the equilibrium level of employment is OLF, the level of full employment.

Thus, in Keynes’ theory, unemployment is due to the deficiency of effective demand. Only by stimulating effective demand can a higher level of employment be achieved. However, Keynes goes on arguing that equi­librium level of employment will not neces­sarily be at full employment.

A capitalist economy will always experience underem­ployment equilibrium, an equilibrium situation less than full employment. Full employ­ment, according to Keynes, can never be achieved. In Keynes’ scheme of things, both consumption and investment cannot be raised enough to employ more workforce. Therefore, he recommends the government to come forward and take appropriate action to cure the unemploy­ment problem.

This means that aggregate de­mand is now the sum total of all consumption, investment and government expenditures. It is because of the multiplier effect of both pri­vate investment expenditure and government expenditure, that there will be larger income, output and employment. But equilibrium in the economy will be established at less than full employment situation because of (i) wage rigidity, (ii) interest inelasticity of investment, and (iii) liquidity trap.

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