Theories of Employment and Income: One Mark Questions, Book Back Answers and Notes

About Theories of Employment and Income

Medium ~90 min study

Why do some economies have jobs for nearly everyone while others suffer long periods of unemployment? This unit sets out two very different answers. The classical economists said the market corrects itself: if there is unemployment, wages and prices fall until everyone who wants work finds it. Keynes, writing during the Great Depression of the 1930s, said this does not happen automatically and that an economy can settle at equilibrium with many people still out of work.

The classical case rests on flexible wages, prices and interest rates, and on Say's Law, which says supply creates its own demand. Keynes replaced this with the principle of effective demand. In his view, the level of employment depends on how much the community actually spends on consumption and investment, so low spending means low output and low employment, and the government may need to step in.

Expect MCQs on the types of unemployment, on what Say's Law does and does not assume, and on the meaning of \(ED = Y = C + I\). The ideas here lead straight into Unit 4, where consumption and investment are studied in detail.

What you'll learn

• Define full employment, involuntary unemployment and underemployment equilibrium.
• Distinguish the classical view based on flexible wages and prices from Keynes's demand-based view.
• State Say's Law of Markets, list its assumptions and explain the criticisms of it.
• Explain how effective demand determines the level of income and employment.
• Identify the types of unemployment found in developed countries and in India.
• Show the equilibrium of aggregate demand and aggregate supply functions with a diagram.

Before you start

• Demand, supply and market equilibrium from Class 11 Economics.
• National income aggregates and the circular flow from Units 1 and 2.
• Reading a simple graph with two intersecting curves.

Theories of Employment and Income explained

Classical and Keynesian Theories of Employment

Full Employment and Types of Unemployment

Full employment is a situation in which everyone who is able and willing to work at the prevailing wage rate gets a job. In other words, there is no involuntary unemployment. Even then some people will be between jobs, so full employment in practice allows for a small amount of frictional unemployment.

The textbook lists several types: seasonal, frictional, educated, technical, structural, disguised and cyclical unemployment. In developed countries the main problem is cyclical unemployment, which rises during a depression. In India the bigger problems are structural unemployment, caused by a slow rate of capital formation, and disguised unemployment in agriculture, where more people work on a farm than are needed and the marginal productivity of the extra workers is zero.

Classical Theory and Say's Law of Markets

The classical economists, including Adam Smith, David Ricardo, J.B. Say and A.C. Pigou, held that a free market economy tends towards full employment. Their theory rests on Say's Law of Markets: supply creates its own demand. When goods are produced, the factors of production earn an equal amount of income, and that income is spent on buying the goods. So there can be no general overproduction and no lasting general unemployment.

The theory assumes perfect competition, a laissez faire policy with no government interference, and full flexibility of wages, prices and the rate of interest. Any saving is brought back into spending by the interest rate, which adjusts until saving equals investment.

Keynes and Effective Demand

Keynes rejected the idea that the economy always returns to full employment. He argued that people save part of their income, that saving need not be matched by investment, and that wages and prices are not flexible in practice. As a result the economy can rest at an underemployment equilibrium.

The key idea is effective demand, the total spending on consumption and investment that actually takes place. Employment depends on it: \(ED = Y = C + I\). Effective demand equals national income and national output.

Aggregate Demand and Aggregate Supply Functions

The aggregate demand price is the total sale proceeds that entrepreneurs expect to receive from the output produced when a given number of workers are employed. The aggregate supply price is the minimum proceeds they must receive to make it worthwhile to employ that number of workers. Plotting these for different levels of employment gives the aggregate demand and aggregate supply functions. Where the two curves intersect, expected proceeds just equal the minimum required proceeds. This point is effective demand, and it fixes the actual level of employment and income, which may be below full employment.

Common mistakes to avoid

• Treating voluntary unemployment as involuntary. People who refuse work at the going wage are voluntarily unemployed and do not break full employment.
• Applying the classical full employment result to the short run. The classical economists said the market restores full employment in the long run; Keynes dealt with the short run and replied that in the long run we are all dead.
• Assuming Keynesian equilibrium is always at full employment. Keynes's point is that equilibrium can occur below it.
• Mixing up the adjusting variable. In classical theory the interest rate brings saving and investment into equality; in Keynes, changes in income do it.
• Calling disguised unemployment open unemployment. Disguised workers appear employed, but their marginal productivity is zero.

Test yourself on these with the practice test, then check the worked reasoning in the solved MCQs.

Frequently asked questions

What is the difference between classical and Keynesian theories of employment?

Classical economists believed that flexible wages, prices and interest rates automatically bring the economy to full employment, so the government need not interfere. Keynes argued that the economy can rest at underemployment equilibrium when effective demand is low, and that government spending may be needed to raise demand and employment.

How does Say's Law explain market self-correction?

Say's Law says supply creates its own demand. Producing goods creates wages, rent, interest and profit equal in value to the goods, and this income is spent on them. So, according to the classical economists, general overproduction and lasting unemployment cannot occur.

What does effective demand mean in Keynes's theory?

Effective demand is the total spending on consumption and investment that actually happens. It is found where the aggregate demand function meets the aggregate supply function, and it decides the level of output and employment. The textbook writes it as\(ED = Y = C + I\).

Why is disguised unemployment common in agriculture?

In rural India many family members work on a small plot of land because there are no other jobs. If some of them left, output would not fall, so the marginal productivity of these extra workers is zero. Population pressure on land and lack of non-farm work cause it.

How do the aggregate demand and aggregate supply functions fix employment?

The aggregate demand function shows the proceeds entrepreneurs expect at each level of employment; the aggregate supply function shows the minimum proceeds they need. Where the two meet, expectations and costs match, and that point of effective demand gives the equilibrium level of employment.

What are the criticisms of Say's Law?

People do not spend all their income; part is saved, and saving may not be invested, so demand can fall short of supply. Wages and prices are not fully flexible in the real world, and the Great Depression showed that general overproduction and mass unemployment can happen. Keynes also rejected the laissez faire assumption.

Can an economy be in equilibrium below full employment?

Yes. According to Keynes, if consumption and investment spending are low, effective demand is not enough to employ all willing workers. The economy can stay at that level, stable but with involuntary unemployment, unless something such as higher government spending raises demand.