Monday, December 13, 2010

Notes from General Theory - Chapter 1 and 2

There is nothing in Chapter 1.

Chapter 2: Classical theory depends on three crucial assumptions:

a) Real wage is equal to the marginal disutility of existing employment,
b) There is no such thing as involuntary unemployment in the strict sense
c) Supply creates its own demand in that aggregate demand price is equal to aggregate supply price for all levels of output and employment.

Classical theory of employment depends on two fundamental postulates:
a) Wage is equal to the marginal product of labor, i.e. wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit. This gives us the demand schedule for employment.

b) The utility of wage when a given volume of labor is employed is equal to the marginal disutility of that volume of employment, i.e real wage of an employed person is that which is just sufficient to induce the volume of labor actually employed to be forthcoming. Disutility covers every reason why men would withhold their labor rather than accept a wage. This gives us the supply schedule for employment.

Equilibrium happens where the utility of the marginal product balances the disutility of the marginal employment.


There can be only two forms of unemployment in the classical theory:
a) Frictional unemployment: due to various factors like time lags between job findings etc
b) Voluntary unemployment: refusal of work due to legislation or social practices.

Keynes postulated there can be a third form of unemployment, viz involuntary unemployment.

So, there can be only four means of increasing employment, which Professor Pigou described in his Theory of Unemployment:
a) Decreasing frictional unemployment, through improvement in organization or foresight.
b) Decrease in marginal disutility of labor
c) Increase in marginal physical productivity of labor in the wage-goods industries
d) An increase in the prices of non-wage goods compared with the prices of wage goods, associated with a shift in the expenditure of non-wage earners from wage-goods to non-wage goods. Didn't get this.


Why does unemployment exist? Classical theory argues that full employment could always be reached by making real wages sufficiently low. Keynes disputes that, for two reasons.

a)  Labor focuses on money wages, not real wages. If inflation were to increase prices, that is equivalent to a reduction in real wages. But labor does not strike because of this, unless the inflation is gargantuan. So supply of labor is not a function only of real wages, which is what classical theory assumes.

b) Look around during Depression years in 1932. Can it really be argued that unemployment exists because labor is unwilling to work at a low wage?  


Also, classical theory assumes that a fall in money wages is accompanies by a fall in real wages. In a short period of time, that is not true. A fall in money wages might very well be accompanies by a rise in real wages, and vice versa. One can argue that nominal wages will fall only during a pronounced deflation, during which real wages might actually rise. And conversely, nominal wages track inflation with a lag, so real wages might actually fall during a boom.


Classical theory assumes that there is a collective bargaining that labor does to bring its real wages in line with the marginal disutility of employment. Keynes argues that something like this doesn't exist at all. Employment and real wages are determined in ways other than the demand-supply curve of labor.  


The struggle on nominal wages primarily affects the distribution of aggregate real wage between different labor groups, and not its average amount per unit of employment, which depends on different set of forces. The effect of combination on the part of a group of workers is to protect their real relative wage. The general level of real wages depends on other forces of the economic system. Didn't get this.


Involuntary employment: Men are involuntary unemployed if in the event of a small rise in the price of wage-goods relative to the money wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. i.e. if marginal profitability were to increase and entrepreneurs were to hire labor, there is labor available. 


So the second postulate - that real wage is equal to marginal disutility of employment - corresponds to absence of involuntary unemployment.  Classical theory is the theory of distribution under conditions of full employment.

Axiom of parallels: Demand price of output as a whole is equal to its supply price. Didn't get this. 

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