Unit – 3

Theory of Employment

Say’s Law of Market

Say’s law is the foundation of classical theory of employment. Say’s law, named after the French Economist J.B. Say, is a classical economic proposition that the production of aggregated output creates sufficient aggregate demand to purchase all of the output produced. In other words, Say’s law states that supply creates its own demand and over production is impossible. In Say’s words, “It is production which creates market for goods for selling each at the same time buying and more of production, more of creating demand for other goods”. Every producer finds a buyer.Every supply of output creates equivalent demand for output so that there can never be a problem of general over production. Thus, Say’s law denies the possibility of deficiency of aggregate demand.

Assumptions of Say’s Law

a)Free Market Economy

b)No government intervention

c)Flexibility in internal prices

d)Long run phenomenon

Classical theory of Employment

The classical theory of employment was developed by the combined contribution of classical economist like Adam Smith, J. B Say, J. S. Mill, David Ricardo etc.

The theory is based on the assumption of full employment of labour and other resources of the economy. Full employment refers the situation when all the people who are willing to work at the existing wage rate will get work. Thus, full employment doesn’t mean achieving zero unemployment. Zero unemployment is impossible in any real economy.

Assumption of classical theory of employment

a)This theory assumed that closed capitalist economy.

b)Full employment level

c)Money acts as medium of exchange

d)There is the existence of perfect competition in the market

e)There is existence of wage price flexibility

  1. Say’s law of market:

Same as before (not assumption)

  1. Money market:

Irving Fisher states that total value of output is equal to total expenditure on final goods and services. According to Fisher the long run rate of goods and services remains constant at full employment level. Similarly, (V and V) velocity of money and velocity of bank money also remains constant. Thus, price level (p) is determined by the supply of money (M and M). There is direct relationship between money supply and price level. Hence, PT = MV + MV

  1. Labour market:

Flexibility in wage rate assures labour equilibrium with full employment. Real wage rate is determined by market forces i.e. demand and supply of labour market. Demand for labour is negative function of real wage rate whereas supply of labour is positive function of real wage rate. Real wage rate is determined and the level where demand and supply of labour are equal. This level also represents level of full employment.

  1. Product market (Production function):

According to classical economist total output is decreasing function of the number of workers employed. It is due to the operation of law of diminishing returns but at the full employment level of output remains stable.

The classical theory of employment can be shown with the help of following figures:

y = f(N, K,T)

In figure A, DD represents demand for labour curve and SS represents supply. It intersect at point E i.e. equilibrium.

In figure B, y = fcurve indicates total production function. It slopes upward to the right and bends to the x-axis and after a point it becomes horizontal.

In figure C, two horizontal curve representing MV and M1V1 at corresponding level of price. It slopes downward to the x-axis.

Thus, it indicates that total output increases at a decreasing rate initially and reaches at its maximum and constant at full employment ON. At full employment level, corresponding output is OY.

Unemployment

Unemployment in reality is taken in sense of involuntary unemployment. Involuntary unemployment refers to a situation when people are willing to work at the prevailing wage rate. But they are unable to find the work.

Types of unemployment

  1. Cyclical unemployment
  2. Frictional unemployment
  3. Structural unemployment
  4. Open unemployment
  5. Disguish unemployment
  6. Educated unemployment

  1. Cyclical unemployment:

It is associated with the downsizing and depression phases of business cycle. During the downsizing and depression phase of business cycle income fall then aggregate demand also falls and output fall giving rise to widespread unemployment. It is caused by deficiency in aggregate demand.

  1. Fictional unemployment:

Frictional unemployment exists when there is lack of adjustment between demand and supply of labour force. People leave job for many reason and they take time to find new jobs because of lack of knowledge and mobility on part of the labour. This gives rise to temporary unemployment of those workers who are moving between jobs. Unemployment caused by movements of people from one job to another.

  1. Structural unemployment:

Unemployment in Nepal is basically structural in nature, which refers to a situation when a large number of persons do not get work because of limited job opportunities available. This is known as structural unemployment.

  1. Open unemployment:

Open unemployment refers to a situation when there are some workers who have absolutely no work to de. They are willing to work at the present wage rate but they are forced to remain unemployment in the absence of work.

  1. Disguish unemployment:

It refers to a situation when a person is apparently employment, but in fact is unemployed. It is not open for everyone to see. It remains canceled or hidden. This type of unemployment prevails mostly in villages.

  1. Educated unemployment:

It refers to the unemployment among the educated. Some of these people may be unemployed in the sense of open unemployment i.e. they are not doing any work whatever.

Keynesian theory of employment (Principle of effective demand)

British economist J. M Keynes in 1930s developed macro economics as a field of economic analysis, different from micro-economics. Keynes propounded the theory of employment, which is also known as principle of effective demands. According to this theory unemployment arises due to the deficiency of effective demand and method to control unemployment is to raise effective demand. According to Keynes the level of employment in short run will depend on aggregate effective demand for goods and services in the country. Greater the aggregate demand greater will be the volume of employment and vice-versa. Total employment depends on total demand and unemployment is the result of a deficiency of total demand. Effective demand represents total money spends on consumption and investment.

Assumptions:

  1. There is the existence of closed economy.
  2. There is operation of law of diminishing returns.
  3. Perfect competition market exists in the society.
  4. Less than full employment equilibrium is possible in short run time period.
  5. Labour supply in the economy is positively related to money wages.

Aggregate Demand Price / Function (ADP)

When the entrepreneur provides employment to the labour, they produce goods and services. The entrepreneur receives certain fixed amount of money from the sale of that product. Hence, the aggregate demand price refers to the receipt which all the entrepreneurs taken together expect from of the sale of the output. In brief, ADP means the expected price or income when certain volume of employment is given. The expected receipts are different to different level of employment. A schedule of receipts expected from the sale of output from various amount of employment is called aggregate demand function.

Aggregate Supply Price (ASP)

The entrepreneur should bear certain production cost when he gives employment to a fixed number of labour. Hence, he should get at least a minimum amount from the sale of output while giving employment. Therefore, ASP refers to the amount of money that the entrepreneur taken together must receive from the sale of output as given level of employment. In brief, ASP is the production cost of total output at a given level of employment.

The aggregate supply price is different at different level of employment. A schedule of minimum amount of receipts required to induce various quantity of employment is called aggregate supply function.

Determination of Equilibrium Level of Employment

The equilibrium level of employment can be determined by the interaction of aggregate demand function and aggregate supply function as shown in the following figure:

Figure:

In the figure x-axis represents level of unemployment and y-axis represents receipts and cost. E point is initial equilibrium where aggregate demand function (AD) intersects with aggregate supply function (AS). Any other level of employment will reduce the profit and the economy will not be in equilibrium. At ON, level of employment, aggregate supply function is greater than aggregate demand function which reflects less. E1 represents new equilibrium which is obtained in the case to achieve full employment.

Unit – 4

Theory of Multiplier

The concept of multiplier is one of the important components of Keynesiantheory of employment. This theory was propounded by a popular economist F.A. Khan in 1931. Later on J.M Keynes developed and redefined this theory. Hence, where K = multiplier.

= Change in income

= Change in investment

Multiplier is the ratio between change in income with change in investment at particular period of time. In other words, it tells us how many times income increases as a result of increase in investment.

Relationship between multiplier and MPC (Marginal Propensity to Consume)

Let a two sector economy, economy is in equilibrium as follows: Y = C + I ------(i)

When investment increases them,

Y + = C + + I + ------(ii)

Subtract the eqn (i) from (ii)

= + ------(iii)

Or, =

Or, - =

Or, =

Or,

Substituting the value,

Or, K = ------(iv)

K =

This equation shows that the multiplier and marginal propensity to consume have direct relationship. When MPC increases, multiplier also increases and vice versa. This positive relationship can be shown by the help of following table.

MPC / Multiplier K =
0 / 1
0.25 / 1.33
0.50 / 2
0.75 / 4
-1 /

Assumption of multiplier effect

  1. The original propensity to consume remains constant during the period of multiplier process.
  2. There is closed economy.
  3. There are no changes in prices.
  4. Consumption is function of current income
  5. There are no time lags in multiplier process.
  6. Consumer goods are available in response to effective demand for them.

Forward working multiplier can be shown with the help of following figure:

Figure:

In the given figure, x-axis represent income and y-axis represent saving / investment. Initial equilibrium is E1, at point E1 the equilibrium income is OY. Now there is an increase in the investment () which leads to an increase in the aggregate expenditure. Thus, this cause income to increase ().

Reverse working multiplier

Figure:

In the given figure x-axis and y-axis represents income and saving / investment respectively. Initial equilibrium is E1. At this point income level is OY1. Now there is decrease in investment () which leads to decrease in the aggregate expenditure. Thus, this cause income also decrease by ().

Leakage of multiplier

  1. Saving
  2. Undistributed profit
  3. Taxation
  4. Inflation
  5. Hoarding of cash balance
  1. Saving:

It is the most important cause for the leakage of multiplier process. Since the marginal propensity to consume is less than one, the whole increment in income is not spent on consumption. A part of it is saved which prefer out of the income stream and the increase in income in the next round decline. Thus, the higher the marginal propensity to save, the smaller the size of the income stream and vice versa.

  1. Undistributed profit:

If profits acquiring to Joint Stock Company are not distributed to the shareholders in the form of dividend but are kept in the reserve fund, it is a leakage from the income stream. If companies tend to reduce the income and hence, further expenditure on consumption goods thereby weakening the multiplier process.

  1. Taxation:

It is also important factor in weakening the multiplier process. Progressive taxes have the effect of lowering the disposable income of tax payers and reducing their consumption expenditure. Thus, increased taxation reduces the income stream and lowers the size of multiplier.

  1. Inflation:

When there is a raise in the price of consumption goods, a good part of the increased money expenditure out of the increased income will be dissipated on higher prices instead of promoting consumption, income and employment.

  1. Hoarding of cash balance:

This type of leakage will be greater if business prospectuses are bad and smaller. When business prospectus are good. Whenever new created money income is hoarded, it cannot reappear as income in the next round and the multiplier effect will be arrested.

The principle of acceleration

The principle of acceleration was developed by J. M Clark in 1917. Later on Hicks, Samulson and Harrod etc redefined this theory. The principle of acceleration is based on the fact that the demand for capital goods is derived from the demand for consumer goods. In other words, acceleration is the ratio between induced investment and initial change in consumption. Symbolically

V =

When, V = acceleration

= change in induced investment

= change in consumption

Hicks has broadly explained the concept of acceleration as the ratio of induced investment to change in income or output. Thus,

Acceleration (V) =

Acceleration principle can be explained by the following mathematical expression:

Igt = V (Yt – Yt-1) + R ------(i)

Where, Igt = gross investment at time period ‘t’

V = acceleration

Yt = income at time period ‘t’

Yt-1 = previous year income

R = replacement or depreciation

Or, Igt = V . + R

After deducting depreciation from gross investment we get net investment. Hence,

Int = V------(i)

Where, Int = net investment at time period ‘t’

=V.

Or, V = which is the regd equation.

Assumption

  1. Capital output ratio remains constant
  2. There is permanent change in consumption demand
  3. There should be no excess capacity in the capital goods
  4. Technology remains constant
  5. There is absence of time lag

Criticism of principle of acceleration

  1. The assumption of a fixed technical coefficient and replacement demand is not valid at least in short run changes in demand.
  2. The acceleration principle does not operate in those situations in which there exist most unused plant capacity that enables business to increase output of goods without increasing capital.
  3. The acceleration principle assumes a constant incremental capital output ratio but in dynamic world the cause of fixed ICOR are rare.
  4. It ignores the effect of price change which has a great role important.
  5. It only studies the effect of changes in consumption but ignores the effect of an autonomous investment.
  6. According to Prof. Tinbergn, this principle does not posses practical importance.

Importance of acceleration theory

Despite of some criticism, this theory occupies a significant place in macro economics analysis:

  1. It helps to understand the process of income generation more clearly and comprehensively.
  2. It also explains why the fluctuation in income and employment occur so violently.
  3. It demonstrates that capital goods industries fluctuate more than the consumer good industries.
  4. It is more useful in explaining the upper turning point of the business cycle because what is responsible for a fall in the induced investment is not any absolute fall in the demand for consumer goods but only a decline in its rate of increase.
  5. Harrod had used the coefficient of acceleration in the growth to show that the economic growth in the economy depends upon the size of acceleration, higher the size of acceleration higher the growth rate and vice versa.

Concept of super multiplier

The concept of super multiplier was developed by J. R Hicks in 1950. Super multiplier refers interaction between acceleration and multiplier. It shows the effect on equilibrium income, output and employment.

Ks = where, Ks = super multiplier

Super multiplier can be explained with the following mathematical expression. Let the economy is in equilibrium.

Y = C + I

Or, Y = C + Ii + Ia ------(i)

When investment increase leads to increase in income and consumption.

Or, Y + = C + + Ii + + Ia + ------(ii)

Subtract the eqn (i) from eqn (ii)

= + +

Or, = .+ .+

Or, - .- .=

Or, =

Substituting the values on eqn:

(1 – b – y) =

Or,

Or, Ks = which is our regd eqn.

The concept of super multiplier can be shown with the help of following figure:

Figure:

Consumption function:

In economics, consumption means the amount spent of consumption at a given level of income. There is direct relationship between income and consumption. The consumption varies with income. The propensity to consume or consumption functions shows the relation between income and consumptions. In short the propensity to consume shows how the consumption expenditure varies with change in income. Hence,

C = f( Yd) where Yd= disposable income

Consumption function can also be written as linear equations.

C = a + bYd

Where, a = autonomous consumption or Y=intercept

b = marginal propensity to consume

d = disposal income

This can be shown with the help of following table:

Income ($) / Consumption ($) / Saving ($)
0 / 20 / -20
60 / 70 / -10
120 / 120 / 0
180 / 170 / 10
240 / 220 / 20
300 / 270 / 30
360 / 320 / 40

This can be shown with the help of following figure:

Figure:

In the above figure, x-axis and y-axis represents the income level and consumption saving respectively. Here, OC is autonomous consumption and OS is autonomous saving. When income increases consumption also increased and reached at the equilibrium point E. E point shows that consumption is equal to income or zero level of saving. When income increases consumption also increases. The increasing rate of income is greater than the increasing role of consumption

Propensity to consume has two aspects:

  1. Average propensity to consume (APC)
  2. Marginal propensity to consume (MPC)
  1. Average propensity to consume (APC):

It shows the ratio of aggregate consumption expenditure to aggregate income. In other words, APC is the ratio of consumption and income. Hence,

APC =

  1. Marginal propensity to consume (MPC):

MPC shows the ratio of change in consumption and change in income. Hence,

MPC =

Distinction between APC and MPC has been shown from the following figures.

Figures:

Properties of MPC:

  1. Value of MPC is always positive and less than unity i.e. 0 < MPC < 1. It implies that consumption expenditure increases at less proportion than income.
  2. The short run MPC is stable. It is because of psychological and institutional factors.
  3. MPC of the poor is higher / greater than the rich one.

The relationship between APC and MPC

  1. APC means the ratio of total consumption to total income i.e. APC = and MPC is the ratio of change in consumption to change in income i.e. MPC = .
  2. If consumption functions be liner with positive expenditure at 0 income level. Its equation is C = a + by and APC is falling while MPC is constant. And APC is always greater than MPC.

Figure: