Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill.
Classical economists claimed that free markets regulate themselves, when free of any intervention. Adam Smith referred to a so-called invisible hand, which will move markets towards their natural equilibrium, without requiring any outside intervention.
Assumptions of Classical Approach
- There is existence of full employment without inflation
- There is a laissez faire capitalist economy without government interference
- It is a closed economy without foreign trade
- There is a perfect competition in labour and product markets
- Total Output of the economy is divided between consumption and investment expenditure
- The quantity of money is given and money is only the medium of exchange
- Wages and Prices are perfectly flexible
- Constant Technology
- Equality between saving and investment
Say’s Law of Market: According to Say’s Law “Supply creates its own demand”, i.e., the very act of producing goods and services generates an amount of income equal to the value of the goods produced. Say’s Law can be easily understood under barter system where people produced (supply) goods to demand other equivalent goods. So, demand must be the same as supply. Say’s Law is equally applicable in a modern economy. The circular flow of income model suggests this sort of relationship. For instance, the income created from producing goods would be just sufficient to demand the goods produced.
Saving-Investment Equality: There is a serious omission in Say’s Law. If the recipients of income in this simple model save a portion of their income, consumption expenditure will fall short of total output and supply would no longer create its own demand. Consequently there would be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is saved by households will be invested by firms. That is, investment would occur to fill any consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national income and employment will remain unaffected.
Wage Flexibility: The classical economists also believed that a decline in product demand would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary unemployment was logical impossibility in the classical model.
Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
- According to Keynes saving is a function of national income and is not affected by changes in the rate of Thus, saving-investment equality through adjustment in interest rate is ruled out. So Say’s Law will no longer hold.
- The labour market is far from perfect because of the existence of trade unions and government intervention in imposing minimum wages laws. Thus, wages are unlikely to be Wages are more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall in production as well as a fall in employment.
- Keynes also argued that even if wages and prices were flexible a free enterprise economy would not always be able to achieve automatic full employment.