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History / system before
classical theory :
The beliefs of this system was:
Wealth of nation is measured in terms of precious
There Is need of government to direct the
development of capitalist system.
What are the measures taken :
Increased exports and decreased imports to
increase foreign currency.
Increase export subsidy and import duties
Export of gold was prohibited.
ROLE OF GOVERNMENT
To make the country self sufficient so that
imports can be reduced and exports can be
To ensure that market existed for all goods
To encourage the consumption
Main features of classical
Free market economy should operate as it
brings equilibrium on its own.
Equilibrium exist only at full employment
level. There is no involuntary unemployment
Wealth of the nation should be measured in
real terms like output.
Output is determined by labor, fixed capital
and fixed technology.
Money has no intrinsic value. It act only as a
means of exchange. Hence, increase in money
supply will not change any real factor in the
Government has no role to play. Rather it was
How output is determined
Output is a function of labor and capital.
In short run, capital is assumed to be constant.
So, the level of employment determines the
level of output.
level of employment is determined by the
demand and supply factors.
It is assumed that output can be increased by
additional worker at the same rate at low level
of employment. this is shown by straight line
and termed as constant returns to scale
As more labor are hired with same level of
capital, additional output by each worker
starts falling. This makes production function
flatter. This tells that output is rising but at
Then we have negative returns to scale as the
output starts falling. That is the additional
worker reduce the total output. Firm will
never operate on that part.
It is the addition to total output by additional
MPn= change in output/ change in labor.
slope of production function indicates
marginal productivity of labor.
As more and more labors are hired, MPn starts
Initially it falls but remain positive. But
afterwards it become negative.
How the level of employment
It is determined by labor demand and labor
Labor is demanded by the firms which employ
that level of labor that maximize their profit.
In the perfect competition, profit is maximized
at a level where the marginal cost is equal to
MC = P
Mc is the cost of producing extra unit. Thus
equal to money wage/ MPn
It should equate to price. Thus
P = W/ MPn
w/p = MPn
This equation gives the labor demand curve
Labor is supplied by individual in the economy who try to
maximize their real income i.e. the amount of consumption
and leisure. There is a trade of between these two goods. As
income will rise by increasing labor hour and reducing the
CONSTRUCTION OF LABOR CURVE
24 * REAL WAGE1
24 * REAL WAGE2
REAL WAGE2> REAL WAGE1
WAGE RATE measures the opportunity cost of leisure. Higher
the wage rate, higher the opportunity cost. So, labor supply
will increase with the increase in real wage rate.
Intersection of both the curves determine the
equilibrium real wage rate and employment
Aggregate supply curve
This curve establish a relationship between price and quantity.
In an economy if price rises, the firm will try to increase the
output. But as we know the supply of labor is constant. Every
firm will try to hire more worker , they will increase money
wage so as to bid workers away from other firms. Firms which
cannot increase the wages lose their workers. This process will
continue till money rise in equal proportion to prices.
Increase in prices leads to rise in labor demand , shifting the
Nd rightwards. Also, the real wages falls thus shifting the labor
wage Labor supply
Ls (3 P1)
Ls ( 2P1)
Nd* 2 P1
Nd* 3 P1
Aggregate demand curve
it has been derived from Fischer equation
Money demand= k p.y
where k= 1/v
money demand= money supply
Ms= k P.Y
P= Ms/ kY