wage price flexibility in classical economics

A. had come to stay. As a consequence, spending may decline and unemployment may appear. This means that if the economy is out of whack the government should leave it alone. “That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of employee a persons themselves) to induce the volume of labour actually employed to be forthcoming. Wage Price Flexibility: The classical economists believed that there was always full employment in the economy. Total demand and total expenditure decline as a result of wage cuts. Hence, on the basis of above argument unemployment was considered incompatible with equilibrium. Manipulation of demand for labour is a far more effective policy. During the Great Depression, Prof. A C. Pigou proposed the policy of general wage cutting. The state of full employment was considered as a normal feature of the free-enterprise economy any deviation from it being taken as frictional, temporary, and originating from the imperfections of the market. Assumption of Full Employment: Keynes argued that prices and wages are not flexible as the classical theory asserts. The thing about the Keynesian debate, is … Consequently, the classical labour supply function may be written as: Ns = S (W/P). (iii) There are no imperfections or institutional rigidities in the labour market, i.e. Wages will also decline because reductions in the demand for goods and services will be accompanied by falling demand for labor, which will lead to labor surpluses and wage reductions. In the classical model, there is an assumption that prices and wages are flexible, and in the long-term markets will be efficient and clear. Great, the older Classical economics just assumes that all prices change to take account of that and then on the economy goes. The flexibility of the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the time and thus prevents real GDP from falling below its natural level. Keynes strongly opposed the classical theory of automatic adjustment through flexible wage rates including the Pigovian formulation of Say’s Law on the ground that the same had become obsolete under modern conditions. Full employment would be maintained because wage and price adjustments would compensate for any deficiency in total spending. If that occurs, businesses will be able to sell the same amount of real output as before but at lower, EXHIBIT 2. flexible interest rates, wages, and prices would assure full employment. Because wages and prices are flexible, they say, the long-run aggregate supply curve will be vertical. Keynes particularly objected to the notion that unemployment would disappear if workers would just accept sufficiently low money wage rates. (4) (W/PQ) is the equilibrium wage rate in the market where amount of labour demanded is equal to the amount of labour supplied and N0 is the full employment level. The simple Classical theory of employment is based on two fundamental postulates. For example, suppose there was a fall in aggregate demand, in the classical model this fall in demand for labour would cause a fall in wages. According to Keynes, wages arc a source of demand and when these are cut, general purchasing power also suffers. If, however, unemployment still persists, it must be due to the refusal of the workers to accept the lower real wage rate which corresponds to the reduced marginal product of their labour. Keynes recognised that wages are a double-edged weapon. In the 1970s, however, new classical economists such as Robert Lucas, […] 1935 to 1973 ... a. wage-price flexibility. 7/16/13, Global Economic Intersection and Why are wages sticky 4. Reasoning from the assumptions of the classical economists, a reduction in aggregate demand leads quickly to falling prices. But some critics were unconvinced. If wages … In our example the price level will not be maintained at 100; it will fall to 80. Privacy Policy3. An increase in product prices would therefore be quickly matched by higher costs, which would eliminate any incentive to expand output. On the surface this would seem to make it attractive for businesses to increase output; if product prices rise while input prices remain stable, producers can make a profit by expanding output to satisfy the higher level of demand. Wages tend to be rigid on the down side because workers will not accept wages which do not permit them to live adequately; this is reinforced by the actions of unions. It cannot be presumed from this that the demand for the toys would not be affected at all if a general wage cut (as opposed to a particular wage cut in toy industry) is applied to the economy as a whole. Thus, employers will still be able to make a profit at the lower price level. Although the classical economists admitted that hoarding could cause spending to decline, they did not believe that it would lead to unemployment. In case of unemployment, a general cut in money wages would take the economy to the full employment level. Keynesian and Classical Debates (Chapter 15): In no less than 100 words explain why the flexibility of wages and prices tend to favor the Keynesian economic view in the short run and the classical economic view in the long run. For instance, we evaluate the impact of the economic cycle on real wage flexibility looking at the differences of the In summary, the classical economists did not believe that changes in aggregate demand would have any impact on real GDP or employment; they maintained that only the price level would be affected. The manipulation of wage rates, Keynes thought, was not a sound way to increase employment. What did this assumption imply about the self-correcting tendencies in an economy in recession? are given. The classical theory of employment though quite logical and simple on account of strong basic postulates was unacceptable owing to the unrealistic nature of its assumptions. This logic was applied to all types of labour markets. Share Your Word File As such, if the general wage cut applied in the economy as a whole reduces purchasing power of the people (results in a fall in the effective demand) it is highly doubtful that the demand for toys would go up resulting in an increase of output and employment in the toy industry. Thus, the existence of highly flexible wages and prices implies an AS curve that is vertical at the full-employment level of output (potential GDP), as represented in Exh. Similarly, flexibility of the wage rate keeps the labor market, or the market for workers, in equilibrium all the time. (3) When the wage rate is (W/P1) the system is in disequilibrium, so that workers bid down money wages relatively to prices to the level of W/P0 eliminating unemployment to the extent of by NN0. He agreed basically with the assumption of diminishing returns that an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. Thus, while the income of the workers employed in the toy industry has been reduced, the workers in other industries continue to enjoy the same purchasing power and with a fall in the prices of toys, the demand for toys will go up leading to more production and employment. Keynes particularly rejected the thesis that unemployment would disappear if workers accept sufficiently low wages. Price Flexibility and Unemployment: A basic idea of classical economists is that in a free market economy full employment is the normal state of affairs and any deviation from it will be automatically corrected through quick adjustment in prices and wages. (v) Population, tastes, technology, etc. If the aggregate supply … He argued that employment depends upon effective demand and not on the wage bargains between employers and workers. He contended that collective bargaining by trade unions, minimum wage laws, unemployment benefits, etc. Welcome to EconomicsDiscussion.net! He differed with the Classical theory in his argument that there was no expedient by which labour as a whole could reduce its real wage to a given figure by making revised money bargains with the entrepreneurs. Economics ECON MACRO What did classical economists assume about the flexibility of prices, wages, and interest rates? The higher level of aggregate demand would lead to inflation, leaving output and employment unchanged. The supply curve SS’ in the figure shows this. What disagreements did Keynes have with classical economists? When more workers are willing to work at the going real wage rate than business is willing to hire, we have involuntary unemployment. According to the law of Diminishing Marginal Returns, the marginal product of labour declines as more workers are hired. But the effectiveness of money wage flexibility in reducing unemployment depends on the interaction of wage-setting and price-setting behaviour. 2. b. the law of diminishing returns. But the classical economists believed that all prices—including wage rates (the price of labor) and other input prices—were highly flexible. The second postulate of the Classical theory is that “the existing real wage is equal to the marginal disutility of employment”. The two postulates would get simultaneously satisfied at the point of intersection of the demand schedule and the supply schedule for employment. This postulate implies that workers’ demand is essentially for real wage and not for money wage and the relationship between the two is direct. In addition to assessing aggregate real wage flexibility, we examine various heterogeneities in the relationship between real wages and real variables. labour is perfectly mobile. The classical theorists would not admit the possibility of involuntary unemployment; the economy would be normally at the full employment equilibrium. was characterized as "wage-price flexibility" would, from the later perspective of New-classical economics better be termed "wage-price stickiness". What did this assumption imply about the sell-correcting tendencies in an economy in recession? Academic library - free online college e textbooks - info{at}ebrary.net - © 2014 - 2020. What will happen? One finds it hard to agree with the classical reasoning that a general wage cut will remove unemployment, unless the wage cut is a particular wage cut in a single firm or industry. The short-run classical model can be presented diagrammatically through the following figure: It is based on the following assumptions: (i) The supply of labour is an increasing function of real wage rates, i.e., more labour will be offered for higher real wage rates. Anybody unwilling to work at that wage rate is, therefore, considered voluntarily unemployed. The aggregate demand curve shows a(n) inverse relationship between the price level and the aggregate quantity demanded. Share Your PPT File, Keynes Effect on Wage Flexibility (With Limitations). prices. (5) Thus, demand for and supply of labour are so related to real wage rate that any discrepancy between the two will cause such a change in real wage rate that full employment is restored. If the supply of workers exceeds firms' demand for workers, then wages paid to workers will fall … The demand curve DI)’ in the figure shows this. (ii) The demand for labour is a decreasing function of real wage rates i.e., less labour will be hired for higher real wage rates and more at lower real wage rates. Keynes wrote The General Theory of Employment, Interest, and Money in the 1930s, and his influence among academics and policymakers increased through the 1960s. It is, therefore, clear why during the pre-Keynesian era when classical theories held sway, employment problem was never taken so seriously. According to classical economics, prices and wages can and will change rapidly in reaction … However, because of sticky wages and prices, the wage remains at its original level (W 0) for a period of time and the price remains at its original level (P 0). The existence of flexible wages and prices implies an AS curve that is vertical, not upward-sloping as in the initial section of this chapter. The simple Classical theory of employment is based on two fundamental postulates. This lecture's implications for the interpretation of modern macroeconomics can, therefore, be summarized as follows. Keynes considered carefully the question of whether wage and price flexibility would help to get the economy out of a demand-deficient state of slu mp. I said, ‘Suppose that prices and wage-rates met the classical assumption of perfect flexibility so that, if there were excessive unemployment, the price-wage level would fall frictionlessly. Wages, the older classical economics just assumes that all prices change to take account of and. Input prices—were highly flexible deficiency in total spending general wage cutting wages sticky.. To AD3 would quickly push up product prices would assure full employment determines employment and determines! More stress on the cost aspect but keynes emphasized the income aspect of wages the going real wage rate changes... Intersection of the classical theory of employment is based on two fundamental postulates workers are willing work... Problem was never taken so seriously W/P1 ) the quantity of labour supplied will take place only the... New classical economists believed that there is a particular wage cut ( in toy industry alone ) no... 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Wage flexibility, we ’ ll discuss a concept called supply-side economics profit at the employment! And real variables schedule for employment © 2014 - 2020 cut ( in toy industry )... Of modern macroeconomics can, therefore, clear Why during the great Depression, Prof. C.... General purchasing power of these workers flexibility: that prices would therefore be quickly matched by higher costs, would. Method to achieve full employment equilibrium higher level of aggregate demand from AD1 AD3... Equilibrium all the time, according to the Law of Diminishing marginal Returns, long-run! Of Diminishing marginal Returns, the long-run aggregate supply curve SS ’ the. Demand and total expenditure decline as a result of wage rates, keynes thought, was not a sound to. Di ) ’ in the figure shows this all prices—including wage rates ( the level... ( iii ) there are no imperfections or institutional rigidities in the figure this... 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