Classical Theory: The

economy in the long run

Who are classical economists?
It was differently treated in the literature
Karl Marx treated Adam smith and Ricardo as classical economists.
Keynes treated all Pre- Depression economists as classical.
In modern literature new group is called neo-classical. Marshall and Pigou.
Postulates of Classical Macroeconomics
There is always full employment.
The economy is always in the state of equilibrium
Laissez-faire system ( no govt control)
Money has limited role in influencing output and employment
4 Questions of Macroeconomics
1. What determines a Nation’s Total Income?
2. Who gets income from production
3. Who buys the output of the economy.
4. What equilibrates the demand for and supply of goods and services?
 What determines a Nation’s Total
Income?
Total Income depends on two things.
1. Quantity of Inputs ( Factors of Production)
2. Its ability to turn Inputs to Output ( Production function)

Assumptions for Factors of Production :

Capital ( K) and Labour (L) are the factors of production (FOP).
It is given or fixed K K and LL
Full utilization of factor of production.
Production Function
Y = F(K, L)
It is having Constant returns to scale property i.e. zY = F(zK, zL).

Supply of Goods and Services in the country is given as

Y  F (K , L)
Say’s Law: the foundation of classical
macroeconomics
French economist Jean-Baptiste Say (1767–1832):
“ Supply creates its own demand” :
oPeople produce goods in which they are good at
oThis creates demand for other goods.
• Example: farmer offers his surplus to weaver to exchange for
cloth.
oThis Law works well in exchange economy
• (Production—Income to FOP--- Demand of goods)
2. How National Income is Distributed to
FOP?
•The distribution of National Income is determined by factor prices.
•Factor prices are the amount paid to the factors of production.

Factor Supply

Price

Factor Demand
Quantity of Factors

If we know the equilibrium price then we can easily find the answer
Decision facing firms.
How much labour to employ assuming there is perfect competition.
In perfect completion P is given by the market
Wage is fixed as supply of labour (L) is fixed

Profit = Revenue – costs ( K, L)

Profit = PF(K,L) – RK – WL Since Y= F(K,L)

So if we know the amount of K and L to be hired then we can maximize profit.

Decision facing firms.
How much labour to be hired?
Labours are hired based on their marginal productivity
MPL = F(K,L+1) – F(K,L)

profit = Revenue – Cost

For Maximization ∆profit = ∆Revenue - ∆Cost = 0
∆profit = P x MPL - W = 0
P x MPL = W
MPL = W/P ( real wage) ………….. For profit max firms hire labours at which MPL = real wage.
Similarly MPK = R/P ( real rental price)
Division of National Income
Economic profit = Y- MPL x L –MPLx K
Y = MPL x L + MPK x K + Economics profit
If factors are paid as per marginal product then entire output is exhausted if production function
has constant return to scale property and economic profits is zero.

Y = 𝐴𝐾 ∝ 𝐿1−∝
MPL = 1 −∝ 𝐴𝐾 ∝ 𝐿−∝
MPK = ∝ 𝐴𝐾 ∝−1 𝐿1−∝
Replace the values in Y = 1 −∝ 𝐴𝐾 ∝ 𝐿−∝ x L + ∝ 𝐴𝐾 ∝−1 𝐿1−∝ x K = 𝐴𝐾 ∝ 𝐿1−∝
Labour and capital share
MPL = 1 −∝ 𝐴𝐾 ∝ 𝐿−∝ whereas MPK = ∝ 𝐴𝐾 ∝−1 𝐿1−∝
1−∝ Y ∝𝑌
MPL = MPK =
𝐿 𝐾

Marginal productivity is proportional to average factor productivity . The ratio of labour income
to the capital income is ( 1-α) / α .

Conclusion: Factors share depends on parameter α not the amount of K, or L. it is estimated that
the share of income to labour is around 0.7 and the capital is 0.3.
Determining GDP

Output is determined by the fixed factor supplies and

the fixed state of technology:
Production function

Y  F (K , L)

Output (Y)
60
50
40

Marginal product of labour is diminishing 30

20
with an increase in employment. 10
0
0 1 2 3 4 5 6 7 8 9 10
Labor (L)
 MPL and the production function
F (K , L )
Marginal Product of Labor
MPL

MPL (units of output)

12
1
As more labor is 10
MPL
Y added, MPL  8

1 6
output 4
Slope of the production
MPL 2
function equals MPL
0
1 0 1 2 3 4 5 6 7 8 9 10
Labor (L)
L labor
 Exercise
L Y MPL
0 0 n.a.
1 10 10
Suppose W/P = 6. 2 19 9
3 27 8
If L = 3, should firm hire more or less
labor? Why? 4 34 7
5 40 6
If L = 7, should firm hire more or less 6 45 5
labor? Why?
7 49 4
8 52 3
9 54 2
10 55 1

CHAPTER 3 NATIONAL INCOME

 MPL and the demand for labor
Factor
price Each firm hires labor
up to the point where
MPL = W/P.
Real
wage

MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded

CHAPTER 3 NATIONAL INCOME

 The equilibrium real wage

Labor The real wage

Factor supply
price
adjusts to equate
labor demand with
supply.

equilibrium
real wage MPL,
Labor
demand
L Units of labor, L

CHAPTER 3 NATIONAL INCOME

 Similarly the equilibrium rental rate

Factor
price Supply of The real rental rate
capital adjusts to equate
demand for capital
with supply.

equilibrium
R/P MPK,
demand for
capital
K Units of capital, K

CHAPTER 3 NATIONAL INCOME

The Neoclassical Theory of Distribution
States that each factor input is paid its marginal
product is accepted by most economists

CHAPTER 3 NATIONAL INCOME

 How income is distributed:
W
total labor income = P L  MPL  L
R
total capital income = K  MPK  K
P
Euler’s Theorem: If production function has
constant returns to scale, then

Y  MPL  L  MPK  K

national labor capital

income income income
The ratio of labor income to total income in the U.S.

1
Labor’s
share 0.8
of total
income 0.6

0.4
Labor’s share of income
is approximately constant over time.
0.2 (Hence, capital’s share is, too.)

0
1960 1970 1980 1990 2000

Reading material: Declining Labour share of income ( See Blackboard)

What Determines Demand for goods and
service?
Demand Comes from

Demand for goods and services = C + I + G

Important conclusion
Output Per worker grew by 2.2 % real wage grew by 1.9% for 1960 -2010

With productivity growth by 2% ………….. 35 years real wage takes to grow double
Equilibrium in the Market for goods and
services
Y = C + I +G
Collapse of Classical economics
Market conditions were never close to perfect competition
There were supplies but no demand for long time….. Says law failed.
Long run disequilibrium