Lecture Notes: Classical Economic Theory - Mr. Ryan

Introduction

• Important theory in economics to discuss today.
• Review of previous concepts is necessary for understanding.

Key Concepts to Review

1. Market Equilibrium

• Definition:
  • In both markets (product and factor), there exists a supply and demand.
• Axes:
  • Horizontal: Quantity
  • Vertical: Price
• Equilibrium Price & Quantity:
  • Equilibrium Price: Price at which quantity demanded equals quantity supplied.
  • Equilibrium Quantity: Quantity where buyers and sellers agree.

2. Surplus and Shortage

• Surplus:
  • Occurs when price is above equilibrium price.
  • Quantity supplied > Quantity demanded.
  • Results in excess goods: sellers lower prices to reduce surplus.
• Shortage:
  • Occurs when price is below equilibrium price.
  • Quantity demanded > Quantity supplied.
  • Leads to buyers bidding prices up, driving them toward equilibrium.

3. Labor Market Dynamics

• Wages:
  • Price in the labor market is termed wages.
• Effects of Low Wages:
  • Low wages lead to a shortage of labor (demand > supply).
  • Businesses offer higher wages to attract workers.
• Effects of High Wages:
  • High wages lead to a surplus of labor (supply > demand).
  • Workers may bid down wages to secure employment.

Aggregate Market Review

• Production Costs:
  • Lower production costs = increased short-run aggregate supply (shift right).
  • Higher production costs = decreased short-run aggregate supply (shift left).
• Wages and GDP Relationship:
  • When wages decrease, real GDP increases.
  • When wages increase, real GDP decreases.

Classical Economic Theory Overview

Key Assumptions of Classical Economic Theory

1. Self-Correcting Economy:

   • The economy adjusts itself without intervention.
   • Gaps (inflationary or recessionary) are temporary.
   • Laissez-faire approach: do nothing and let the economy correct itself.

2. Inadequate Demand:

   • Low demand won't cause the economy to collapse.
   • "Say's Law": Supply creates its own demand.
   • Production leads to income generation, which drives demand.

3. Flexible Wage Rates:

   • Wages can adjust up or down based on market conditions.
   • Flexibility is necessary for the labor market to function effectively.
   • Psychological resistance from workers against wage cuts complicates this assumption.

Closing Economic Gaps

Closing a Recessionary Gap

• Definition:
  • Real GDP < Natural GDP (indicates underutilization of resources, high unemployment).
• Market Dynamics:
  • Surplus of labor: wages are too high.
  • Wages will decrease due to excess supply, increasing demand for labor.
  • Lower wages decrease production costs, increasing short-run aggregate supply.
  • Result: Real GDP moves toward natural GDP.

Closing an Inflationary Gap

• Definition:
  • Real GDP > Natural GDP (indicates overutilization of resources, low unemployment).
• Market Dynamics:
  • Shortage of labor: wages are too low.
  • Businesses raise wages to attract workers, leading to increased production costs.
  • Higher costs decrease short-run aggregate supply.
  • Result: Real GDP moves back to natural GDP.

Conclusion

• Government intervention is not needed according to classical economic theory.
• Importance of understanding assumptions, processes for closing economic gaps.
• Evidence both for and against classical economic theory exists.