Classical theory assignment help

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Classical theory
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History / system before classical theory
mercantilism

• The beliefs of this system was
• Wealth of nation is measured in terms of precious
  metals
• There Is need of government to direct the
  development of capitalist system.

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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
  increased
• To ensure that market existed for all goods
• To encourage the consumption

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Main features of classical theory

• 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
  economy.
• Government has no role to play. Rather it was
  supposed to have harmful impact.

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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.

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Production function
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• 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
  decreasing rate.
• 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.

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Marginal productivity
It is the addition to total output by additional
labor. 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 falling. Initially it falls
but remain positive. But afterwards it become
negative.
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How the level of employment is determined
It is determined by labor demand and labor
supply. LABOR DEMAND 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 the price. MC
P Mc is the cost of producing extra unit. Thus
equal to money wage/ MPn
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It should equate to price. Thus P W/ MPn w/p
MPn This equation gives the labor demand curve
Real wage
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Labor supply

• 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
  leisure.
• CONSTRUCTION OF LABOR CURVE

REAL WAGE2gt REAL WAGE1
24 REAL WAGE2
24 REAL WAGE1
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• 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.

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Intersection of both the curves determine the
equilibrium real wage rate and employment level.
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Equilibrium level of output
N
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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. Graphically, Increase in
prices leads to rise in labor demand , shifting
the Nd rightwards. Also, the real wages falls
thus shifting the labor supply backwards.
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Real wage
Labor supply
Labor demand
labor
Money wage
Ls (3 P1)
Ls ( 2P1)
Ls( P1)
Nd 3 P1
Nd 2 P1
Nd P1
labor
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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
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Determination of output, labor and wages
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