Monday, December 27, 2010

Notes from General Theory - Chapter 3

The Principle of Effective Demand:
In a given state of technique, resources and costs, employment of labor by an entrepreneur involves two kind of expense:
a) Factor cost: Amount paid out to the factors of production, ex other entrepreneurs.
b) User cost: Amount paid out to other entrepreneurs for what he has to purchase from them + the depreciation of capital equipment in excess of normal wear and tear if the equipment were left idle.

  • Income or Profit = Value of output - factor cost - user cost. Factor cost is regarded as income by the factors of production.
  • So total income generated by employment given by entrepreneur = profit + factor cost (but what about amount paid to other entrepreneurs, who have made profits and in turn generated employment?) 
  • Entrepreneurs try to fix employment at a level which will maximize their profits.
  • Let Z be the aggregate supply price of output from employing N men, i.e. Z = s(N). This is the Aggregate Supply Function. Let D be the proceeds which entrepreneurs expect to receive from the employment of N men, i.e. D = f(N). This is the Aggregate Demand Function. (Is there any difference between the two functions?)
  • Volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function, for it is at this point that the entrepreneurs expectation of profit is maximized. This point of intersection - the point D - is called the Effective demand. (But aren't both the curves upward sloping? Demand goes up when employment is higher, so does supply). 
  • The classical theory assumes that the two functions s(N) and f(N) superimpose each other, so that whatever the value of employment N may be, the proceeds D are equal to Z. Implying that effective demand, instead of having a unique equilibrium value is an infinite range of values all admissible, and the amount of employment if indeterminate except in so far that the marginal disutility of labor sets an upper limit. (So is what Keynes saying that these two curves are not parallel, which is what Classical theory has always implicitly assumed. And it is easy to fall into this trap because both the curves are upward sloping.)
  • If this were true, employment will expand up to the point at which supply of output as a whole ceases to be elastic. This is same as full employment. Thus Say's law, that aggregate demand price of output is equal to its supply price for all volumes of output, is equivalent to the proposal that there is no obstacle to full employment.

II: Brief Summary of Theory of Employment:

  • When employment increases, real income increases. Consumption goes up, but lesser than income. So employers will make a loss if the whole of increased employment was for satisfying the demand for immediate consumption. So, to justify and amount of employment, there must be an amount of current investment sufficient to absorb the excess of total output over consumption. So, given the community's propensity of consume, the equilibrium level of employment will depend on amount of current investment. The amount of current investment will depend on the inducement to invest, which is a function of marginal efficiency of capital and interest rates.
  • Given the propensity to consume and rate of new investment, there will be only one level of employment consistent with equilibrium, otherwise there will be inequality between the aggregate supply price of output and its demand price. The level of employment cannot be greater than full employment. But it is not necessary that it is always equal to full employment.


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