The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Output and Employment

  • J. A. Kregel
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_1583

Abstract

Within his broader analysis of the ‘nature and causes of the wealth of nations’, Adam Smith (1776) identified the primary determinants of the growth of national output as labour productivity (given by the state of technology as determined by the division of labour), and the proportion of the total working population ‘productively’ employed (in modern language, producing outputs directed to the support of capital accumulation). For Smith, and other classical economists, the problem was not that commodities might remain unsold or labour unemployed, but the composition of output and employment required for capital accumulation: a high proportion of ‘unproductive’ labour would slow the pace of technological change by reducing the expansion of the market and thus the division of labour. When capital accumulation fell below the growth of population unemployment increased and wages would fall below subsistence, reducing population growth. The distribution of income between rent and profits was a key determinant of the composition of output: landowners expenditure on services or luxury goods being unproductive.

Within his broader analysis of the ‘nature and causes of the wealth of nations’, Adam Smith (1776) identified the primary determinants of the growth of national output as labour productivity (given by the state of technology as determined by the division of labour), and the proportion of the total working population ‘productively’ employed (in modern language, producing outputs directed to the support of capital accumulation). For Smith, and other classical economists, the problem was not that commodities might remain unsold or labour unemployed, but the composition of output and employment required for capital accumulation: a high proportion of ‘unproductive’ labour would slow the pace of technological change by reducing the expansion of the market and thus the division of labour. When capital accumulation fell below the growth of population unemployment increased and wages would fall below subsistence, reducing population growth. The distribution of income between rent and profits was a key determinant of the composition of output: landowners expenditure on services or luxury goods being unproductive.

But whatever the rate of capital accumulation it was argued that a ‘glut of commodities in the aggregate’ was impossible, since ‘there cannot be an aggregate supply without an equal aggregate demand’ (James Mill, Mill 1844, p. 238). If individuals must produce in order to purchase commodities, and do not want ‘money but in order to lay it out, either in articles of productive, or articles of unproductive consumption’ (p. 233–4) then since ‘the demand and supply of every individual are always equal to one another, the demand and supply of all the individuals in the nation, taken aggregately, must be equal’ (p. 232). Although it was always possible for ‘miscalculation’ to produce ‘superabundance or defect’ (p. 241) of commodities in particular markets, they would cancel in the aggregate. Mill’s argument that what was true of an individual’s output and employment was a fortiori true of the aggregate of all actions represented in the economy as a whole also formed the basis of Say’s Law, and dominates modern discussion of the ‘microfoundations of macroeconomics’.

Neoclassical theory did not challenge this method of approach, but shifted emphasis from the growth-maximizing composition of output and employment to analysis of individual utility and profit maximizing allocation of given resources to alternative uses. The existence of excess supply or demand in any market represented misallocation of resources and an unexploited possibility to increase total profit or utility by substitution in production or consumption until marginal utility or profit generated by the marginal purchase was equal for each commodity produced or purchased. Thus Lionel Robbins’s famous definition of economics as ‘the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’ (1935, p. 16). The theory thus took as given the size of available output that Smith and Ricardo had tried to explain, and analysed what they had taken for granted, the decisions determining the allocation of expenditure across various commodities.

Since labour was also a scarce ‘means’ owned by the individual its allocation could be analysed relative to a market equilibrium wage rate which assured employment for all those willing and able to work at that wage. The profit-seeking individual acting in the market would thus insure movements in relative prices guaranteeing that excess supplies of commodities or labour were only temporary, arising from imperfections or frictions in the adjustment of competitive price.

In his Theory of Unemployment (1933) Pigou used the presumption that what was true of the individual market was true of the economy as a whole, to extend the analysis to the aggregate level (cf. Roncaglia and Tonveronachi 1985): if Q is aggregate real output and N the level of employment, then (1) Q = f(N) [f ′ > 0, f ′ > 0] given the technology embodied in existing equipment. Given the money stock M, and income velocity of circulation (1/k), the Cambridge version of the quantity theory equation of exchange determines nominal income, Y : (2) M = k(Y) = k(pQ). The division of Y into real output and the general price level, p, as well as the level of employment, is then given by the money wage w, and competitive profit maximization: (3) w/p = f(Q), The level of aggregate real output and employment are inversely related to the real wage: employment could be increased either by reducing money wages given the money supply or increasing the money supply, given money wages. Frictions in the market adjustment process might temporarily keep money wages too high or the money stock and prices too low to produce equilibrium in the aggregate output and labour market.

Keynes (1936) directly questioned this extension of the analysis of a single market to the aggregate economy because it failed to capture the interdependence of output and expenditures, or of supply and demand, at the aggregate level. Keynes pointed out that the expansion of employment and output that Pigou’s theory presumed to follow from a reduction in money wages rested on the implicit assumption ‘that aggregate demand depends on the quantity of money multiplied by the income velocity of money’ (1936, p. 258) so that assuming a given stock of money was equivalent to the assumption that the aggregate effective demand is fixed. … whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate effective demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money-wages will … be accompanied by the same aggregate effective demand as before … which is not reduced in full proportion to the reduction in money wages (ibid., pp. 259–60).

Keynes noted that this crucial assumption had probably been overlooked because of an unwarranted extension of the argument that the horizontal average revenue curve of the competitive firm is unaffected by changes in its level of output. But if demand is exogenously given for each firm, it is exogenous for the sum of all firms. Keynes argued that if the ‘theory is not allowed to extend by analogy its conclusion in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have’ (ibid., p. 260). The answer to this question involved the precise relationship between changes in money wages and prices, wage and non-wage real incomes and consumption and investment expenditures which the theory did not provide: what was needed was a theory of the determinants of aggregate demand.

Keynes’s ‘principle of effective demand’ sought to provide an explicit explanation of aggregate demand in terms of the combination of the propensity to consume setting consumption expenditure, and liquidity preference and the money supply setting the rate of interest together with the efficiency of capital determining investment expenditure, the multiplier converting the two types of expenditure into aggregate income. In his theory equilibria might occur in which labour willing and able to work at going wages in competitive markets could not find employment, while lower wages would only reduce income and consumption expenditure in like or greater proportion. Instead of a unique stable equilibrium at full employment output, Keynes’s analysis suggests the possibility of equilibria at any level of output and employment.

Keynes thus replaced both the quantity theory and what he called the ‘second classical postulate’ that labour could determine its real wage by altering its money supply price. Although profit maximization would assure the equality represented by equation (3) above, it would no longer be the relation which determined Q, nor would the quantity equation (2) determine Y.

The analysis also implicitly rejects the central proposition of Pigou’s theory that flexible real wages determined in the labour market produce an automatic tendency to full employment output in all markets. This recognition that ‘other things’ will influence the real wage and thus the behaviour of all markets represents a criticism of Marshall’s partial equilibrium analysis, but it also questions the automatic tendency to full employment output in a fully interdependent general equilibrium analysis, for in the absence of a Walrasian ‘auctioneer’ providing perfect, costless information, no single agent can predict the behaviour of the system as a whole without knowledge of the consequences of his actions on the behaviour of others. Without an explicit analysis of aggregate demand neither the partial equilibrium of a single market, nor a general equilibrium of all markets simultaneously, can provide the assurance that changes in wages and prices will not produce a more than offsetting change in aggregate demand. In opposition to Mill, individual or market equilibrium can only be understood relative to aggregate equilibrium; since aggregate equilibrium can occur at any level of output and employment there can be no automatic tendency to any unique level of production in individual markets.

See Also

Bibliography

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Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • J. A. Kregel
    • 1
  1. 1.