Classical Theory of Income

& Employment
Lecture 5
 Learning Objectives.
1. What are the basic assumptions of Classical Model?
2. How do the Goods/output market function in Classical
Model?
3. How do the Labor/employment market function in
Classical Model?
4. How do both Markets arrive at equilibrium
simultaneously?
 1st Goal: Assumption of Classical Model
1. A closed private economy exists, where there is no government intervention and no
foreign trade exists.
2. It is based on a short run model where population, capital, technology and
organizational knowledge remains the same.
3. Supply of money is fixed i.e. Ms =Md.
4. Labor is homogenous in nature. There is no possibility of unemployment in the
economy.
5. There is a perfect competition in all markets of the economy. i.e. prices, wages and
interest rates are flexible.
6. Total expenditure in the economy is Y = C + I where as total output of the economy is
Y = C + S.
7. The production of a firm is dependent on its labor whereas capital is held constant
i.e. Y = f(L) K.
8. Saving and investment both are functions of interest rate. i.e. S =f(i) & I = f (i).
However, saving has direct and investment has an indirect relation with interest rate.
2nd Goal: Output or Goods Market in Classical Model
• Goods market are also terms as the Real Sector or Product Sector of the
economy.
• According to classical model, Aggregate production function is given by:
Y = f(L) K

Y = National Income
L = Labor
K = Capital

Graph in book pg-28

Real output is increasing at a decreasing rate. i.e. MPL ↓ with L↑
Output or Goods Market in Classical Model
3rdGoal: Labor Market or Real employment in
Classical Model
• We know from the assumption of classical model that, Labor is homogenous in nature
and there is no possibility of unemployment in the economy.
• If labor is welling to accept the wages equal to the value of its marginal product, there
cannot be unemployment.
VMP = MP * P = W
VMP = Value of Marginal Product
MP = Marginal Product
P = Price of Product
W = MP. P → W/P = MP
Firm will employ units of labor till the MP of labor = its wage rate (W/P). It is also called
as the profit-maximization condition for the firm.
In the presence of perfect competition, wages are determined by the forces of demand
and supply. i.e. if wages are flexible there cannot be unemployment.
Aggregate Demand and Supply for labor
4th Goal: Equilibrium in both Output and Labor market
Review
• We have learned about
• The classical economic models and its various assumptions.
• The classical output model.
• The classical employment model.
• The combined equilibrium in classical models.
THANK YOU