Classical Theory: The

economy in the long run

Who are classical economists?
It was differently treated in the literature
Karl Marx treated Adam smith and Ricardo as classical economists.
Keynes treated all Pre- Depression economists as classical.
In modern literature new group is called neo-classical. Marshall and Pigou.
Postulates of Classical Macroeconomics
There is always full employment.
The economy is always in the state of equilibrium
Laissez-faire system ( no govt control)
Money has limited role in influencing output and employment
Says Law: the foundation of classical
macroeconomics
supply creates its own demand : Says Law
People produce goods in which they are good at
This creates demand for other goods.
Example: farmer offers his surplus to weaver to exchange for cloth.
This Law works well in exchange economy
(ProductionIncome to FOP--- Demand of goods)
Classical theory of employment
Two components used to determine National Output and employment in the economy
Aggregate production function : Y=f(K,L)
Labour supply and demand functions.

Where K = capital: and L = labor:

The production function
denoted Y = F(K, L)
shows how much output (Y ) the economy can produce from
K units of capital and L units of labor
reflects the economys level of technology
exhibits constant returns to scale
 Assumptions of the model

1. Stock of Capital is Fixed

2. Labour if fixed
3. Technology is fixed or given.
4. Production function has constant returns to
scale.
The economys supplies of capital and labor are fixed
at
K K and LL
Determining GDP

Output is determined by the fixed factor supplies and

the fixed state of technology:
Production function

Y F (K , L)

Output (Y)
60
50
40

Marginal product of labour is diminishing 30

20
with an increase in employment. 10
0
0 1 2 3 4 5 6 7 8 9 10
Labor (L)
The distribution of national income
determined by factor prices,
the prices per unit that firms pay for the
factors of production

wage = price of L
rent = price of K
How factor prices are determined
Factor prices are determined by supply and demand in factor markets.
Recall: Supply of each factor is fixed.
What about demand?
Demand for labor
Assume markets are competitive:
each firm takes W, R, and P as given.
Basic idea:
A firm hires each unit of labor
if the cost does not exceed the benefit.
cost = real wage
benefit = marginal product of labor
 MPL and the production function
F (K , L )
Marginal Product of Labor
MPL

MPL (units of output)

12
1
As more labor is 10
MPL
Y added, MPL 8

1 6
output 4
Slope of the production
MPL 2
function equals MPL
0
1 0 1 2 3 4 5 6 7 8 9 10
Labor (L)
L labor
Demand for labour

Under perfect competition profit can be maximized by equating

MR = MC
MPL X P = W
MPL= W/P
MPL = real wage

Each firm hires labor up to the point where MPL = W/P

 Exercise
L Y MPL
0 0 n.a.
1 10 10
Suppose W/P = 6. 2 19 9
3 27 8
If L = 3, should firm hire more or less
labor? Why? 4 34 7
5 40 6
If L = 7, should firm hire more or less 6 45 5
labor? Why?
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 NATIONAL INCOME

 MPL and the demand for labor
Factor
price Each firm hires labor
up to the point where
MPL = W/P.
Real
wage

MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded

CHAPTER 3 NATIONAL INCOME

 The equilibrium real wage

Labor The real wage

Factor supply
price
adjusts to equate
labor demand with
supply.

equilibrium
real wage MPL,
Labor
demand
L Units of labor, L

CHAPTER 3 NATIONAL INCOME

 Similarly the equilibrium rental rate

Factor
price Supply of The real rental rate
capital adjusts to equate
demand for capital
with supply.

equilibrium
R/P MPK,
demand for
capital
K Units of capital, K

CHAPTER 3 NATIONAL INCOME

The Neoclassical Theory of Distribution
States that each factor input is paid its marginal
product is accepted by most economists

CHAPTER 3 NATIONAL INCOME

 How income is distributed:
W
total labor income = P L MPL L
R
total capital income = K MPK K
P
Eulers Theorem: If production function has
constant returns to scale, then

Y MPL L MPK K

national labor capital

income income income
The ratio of labor income to total income in the U.S.

1
Labors
share 0.8
of total
income 0.6

0.4
Labors share of income
is approximately constant over time.
0.2 (Hence, capitals share is, too.)

0
1960 1970 1980 1990 2000

Reading material: Declining Labour share of income ( See Blackboard)

Collapse of Classical economics
Market conditions were never close to perfect competition
There were supplies but no demand for long time.. Says law failed.
Long run disequilibrium