Labour economics seeks to understand the functioning and dynamics of the market for labour.

Labour markets function through the interaction of workers and employers. Labour economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attempts to understand the resulting pattern of wages, employment, and income. In economics, labour is a measure of the work done by human beings. It is conventionally contrasted with such other factors of production as land and capital. There are theories which have developed a concept called human capital (referring to the skills that workers possess, not necessarily their actual work), although there are also counter posing macro-economic system theories that think human capital is a contradiction in terms.

Compensation and measurement

Wage is a basic compensation for paid labour, and the compensation for labour per period of time is referred to as the wage rate. Other frequently used terms include:
y y y y y

wage = payment per unit of time (typically an hour) earnings = payment accrued over a period (typically a week, a month, or a year) total compensation = earnings + other benefits for labour income = total compensation + unearned income economic rent = total compensation - opportunity cost

Economists measure labour in terms of hours worked, total wages, or efficiency.

y

total cost = fixed cost + variable cost

[edit] Demand for labour and wage determination

Main article: Labor demand

Labour demand is a derived demand; that is, hiring labour is not desired for its own sake but rather because it aids in producing output, which contributes to an employer's revenue and hence profits. The demand for an additional amount of labour depends on the Marginal Revenue Product (MRP) and the marginal cost (MC) of the worker. The MRP is calculated by multiplying the price of the end product or service by the Marginal Physical Product of the worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker since doing so

will increase profit. The firm only employs however up to the point where MRP=MC, and not beyond, in economic theory. Wage differences exist, particularly in mixed and fully/partly flexible labour markets. For example, the wages of a doctor and a port cleaner, both employed by the NHS, differ greatly. But why? There are many factors concerning this issue. This includes the MRP (see above) of the worker. A doctor's MRP is far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than that of becoming a port cleaner. For example to become a doctor takes a lot of education and training which is costly, and only those who are socially and intellectually advantaged can succeed in such a demanding profession. The port cleaner however requires minimal training. The supply of doctors therefore would be much more inelastic than the supply of port cleaners. The demand would also be inelastic as there is a high demand for doctors, so the NHS will pay higher wage rates to attract the profession. The MRP of the worker is affected by other inputs to production with which the worker can work (e.g. machinery), often aggregated under the term "capital". It is typical in economic models for greater availability of capital for a firm to increase the MRP of the worker, all else equal. The education and training noted in the last paragraph are counted as "human capital". Since the amount of physical capital affects MRP, and since financial capital flows can affect the amount of physical capital available, MRP and thus wages can be affected by financial capital flows within and between countries, and the degree of capital mobility within and between countries.[1]

[edit] Two ways of analysing labour markets

There are two sides to labour economics. Labour economics can generally be seen as the application of microeconomic or macroeconomic techniques to the labour market. Microeconomic techniques study the role of individuals and individual firms in the labour market. Macroeconomic techniques look at the interrelations between the labour market, the goods market, the money market, and the foreign trade market. It looks at how these interactions influence macro variables such as employment levels, participation rates, aggregate income and Gross Domestic Product.

[edit] The macroeconomics of labour markets

The labour force is defined as the number of individuals age 16 and over, excluding those in the military, who are either employed or actively looking for work. The participation rate is the number of people in the labour force divided by the size of the adult civilian noninstitutional population (or by the population of working age that is not institutionalised). The nonlabour force includes those who are not looking for work, those who are institutionalised such as in prisons or psychiatric wards, stay-at home spouses, children, and those serving in the military. The unemployment level is defined as the labour force minus the number of people currently employed. The unemployment rate is defined as the level of unemployment divided by the labour force. The employment rate is defined as the number of people currently employed

divided by the adult population (or by the population of working age). In these statistics, selfemployed people are counted as employed. Variables like employment level, unemployment level, labour force, and unfilled vacancies are called stock variables because they measure a quantity at a point in time. They can be contrasted with flow variables which measure a quantity over a duration of time. Changes in the labour force are due to flow variables such as natural population growth, net immigration, new entrants, and retirements from the labour force. Changes in unemployment depend on: inflows made up of non-employed people starting to look for jobs and of employed people who lose their jobs and look for new ones; and outflows of people who find new employment and of people who stop looking for employment. When looking at the overall macroeconomy, several types of unemployment have been identified, including:
y

Frictional unemployment This reflects the fact that it takes time for people to find and settle into new jobs. If 12 individuals each take one month before they start a new job, the aggregate unemployment statistics will record this as a single unemployed worker. Technological advancement often reduces frictional unemployment, for example: internet search engines have reduced the cost and time associated with locating employment. Structural unemployment This reflects a mismatch between the skills and other attributes of the labour force and those demanded by employers. If 4 workers each take six months off to retrain before they start a new job, the aggregate unemployment statistics will record this as two unemployed workers. Rapid industry changes of a technical and/or economic nature will usually increase levels of structural unemployment, for example: widespread implementation of new machinery or software will require future employees to be trained in this area before seeking employment. The process of globalisation has contributed to structural changes in labour, some domestic industries such as textile manufacturing have expanded to cope with global demand, whilst other industries such as agricultural products have contracted due to greater competition from international producers. Natural rate of unemployment This is the summation of frictional and structural unemployment, that excludes cyclical contributions of unemployment e.g. recession's. It is the lowest rate of unemployment that a stable economy can expect to achieve, seeing as some frictional and structural unemployment is inevitable. Economists do not agree on the natural rate, with estimates ranging from 1% to 5%, or on its meaning some associate it with "nonaccelerating inflation". The estimated rate varies from country to country and from time to time. Demand deficient unemployment In Keynesian economics, any level of unemployment beyond the natural rate is most likely due to insufficient demand in the overall economy. During a recession, aggregate expenditure is deficient causing the underutilisation of inputs (including labour). Aggregate expenditure (AE) can be increased, according to Keynes, by increasing consumption spending (C), increasing investment spending (I), increasing government spending (G), or increasing the net of exports minus imports (X M). {AE = C + I + G + (X M)}

[edit] Neoclassical microeconomics of labour markets

Neo-classical economists view the labour market as similar to other markets in that the forces of supply and demand jointly determine price (in this case the wage rate) and quantity (in this case the number of people employed).

However, the labour market differs from other markets (like the markets for goods or the money market) in several ways. Perhaps the most important of these differences is the function of supply and demand in setting price and quantity. In markets for goods, if the price is high there is a tendency in the long run for more goods to be produced until the demand is satisfied. With labour, overall supply cannot effectively be manufactured because people have a limited amount of time in the day, and people are not manufactured. The labour market also acts as a non-clearing market.[citation needed] Whereas most markets have a point of equilibrium without excess surplus or demand, the labour market is expected to have a persistent level of unemployment. Contrasting the labour market to other markets also reveals persistent compensating differentials among similar workers.[citation needed] The competitive assumption leads to clear conclusions workers earn their marginal product of labour.[citation needed]
[edit] Neoclassical microeconomic model See also: Labour supply Supply

An advertisement for labour from Sabah and Sarawak, seen in Jalan Petaling, Kuala Lumpur.

Households are suppliers of labour. In microeconomics theory, people are assumed to be rational and seeking to maximize their utility function. In this labour market model, their utility function is determined by the choice between income and leisure. However, they are constrained by the waking hours available to them. Let w denote hourly wage. Let k denote total waking hours. Let L denote working hours. Let denote other incomes or benefits. Let A denote leisure hours.

The utility function and budget constraint can be expressed as following:

max U(w L + , A) such that L + A k.

This can be shown in a graph that illustrates the trade-off between allocating your time between leisure activities and income generating activities. The linear constraint line indicates that there are only 24 hours in a day, and individuals must choose how much of this time to allocate to leisure activities and how much to working. (If multiple days are being considered the maximum number of hours that could be allocated towards leisure or work is about 16 due to the necessity of sleep) This allocation decision is informed by the curved indifference curve labelled IC. The curve indicates the combinations of leisure and work that will give the individual a specific level of utility. The point where the highest indifference curve is just tangent to the constraint line (point A), illustrates the short-run equilibrium for this supplier of labour services.

The Income/Leisure trade-off in the short run

If the preference for consumption is measured by the value of income obtained, rather than work hours, this diagram can be used to show a variety of interesting effects. This is because the slope of the budget constraint becomes the wage rate. The point of optimization (point A) reflects the equivalency between the wage rate and the marginal rate of substitution, leisure for income (the slope of the indifference curve). Because the marginal rate of substitution, leisure for income, is also the ratio of the marginal utility of leisure (MUL) to the marginal utility of income (MUY), one can conclude:

Effects of a wage increase

If wages increase, this individual's constraint line pivots up from X,Y1 to X,Y2. He/she can now purchase more goods and services. His/her utility will increase from point A on IC1 to point B on IC2. To understand what effect this might have on the decision of how many hours to work, you must look at the income effect and substitution effect. The wage increase shown in the previous diagram can be decompiled into two separate effects. The pure income effect is shown as the movement from point A to point C in the next diagram. Consumption increases from YA to YC and assuming leisure is a normal good leisure time increases from XA to XC (employment time decreases by the same amount; XA to XC).

The Income and Substitution effects of a wage increase

But that is only part of the picture. As the wage rate rises, the worker will substitute work hours for leisure hours, that is, will work more hours to take advantage of the higher wage rate, or in other words substitute away from leisure because of its higher opportunity cost. This substitution effect is represented by the shift from point C to point B. The net impact of these two effects is shown by the shift from point A to point B. The relative magnitude of the two effects depends on the circumstances. In some cases the substitution effect is greater than the income effect (in which case more time will be allocated to working), but in other cases the income effect will be greater than the substitution effect (in which case less time is allocated to working). The intuition behind this latter case is that the worker has reached the point where his marginal utility of leisure outweighs his marginal utility of income. To put it in less formal (and less accurate) terms: there is no point in earning more money if you don't have the time to spend it.

The Labour Supply curve

If the substitution effect is greater than the income effect, the labour supply curve (diagram to the left) will slope upwards to the right, as it does at point E for example. This individual will continue to increase his supply of labour services as the wage rate increases up to point F where he is working HF hours (each period of time). Beyond this point he will start to reduce the amount of labour hours he supplies (for example at point G he has reduced his work hours to HG). Where the supply curve is sloping upwards to the right (positive wage elasticity of labour supply), the substitution effect is greater than the income effect. Where it slopes upwards to the left (negative elasticity), the income effect is greater than the substitution effect. The direction of slope may change more than once for some individuals, and the labour supply curve is likely to be different for different individuals. Other variables that affect this decision include taxation, welfare, and work environment.
[edit] Neoclassical microeconomic model See also: Labor demand Demand

This article has examined the labour supply curve which illustrates at every wage rate the maximum quantity of hours a worker will be willing to supply to the economy per period of time. Economists also need to know the maximum quantity of hours an employer will demand at every wage rate. To understand the quantity of hours demanded per period of time it is necessary to look at product production. That is, labour demand is a derived demand: it is derived from the output levels in the goods market. A firm's labour demand is based on its marginal physical product of labour (MPL). This is defined as the additional output (or physical product) that results from an increase of one unit of labour (or from an infinitesimally small increase in labour). If you are not familiar with these concepts, you might want to look at production theory basics before continuing with this article.

The Marginal Physical Product of Labour

In most industries, and over the relevant range of outputs, the marginal physical product of labour is declining. That is, as more and more units of labour are employed, their additional output begins to decline. This is reflected by the slope of the MPPL curve in the diagram to the right. If the marginal physical product of labour is multiplied by the value of the output that it produces, we obtain the Value of marginal physical product of labour:
MPPL * PQ = VMPPL

The value of marginal physical product of labour (VMPPL) is the value of the additional output produced by an additional unit of labour. This is illustrated in the diagram by the VMPPL curve that is above the MPPL. In competitive industries, the VMPPL is in identity with the marginal revenue product of labour (MRPL). This is because in competitive markets price is equal to marginal revenue, and marginal revenue product is defined as the marginal physical product times the marginal revenue from the output (MRP = MPP * MR).

A Firm's Labour Demand in the Short Run

The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. In competitive markets, a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginal resource cost of labour (W = SL = MFCL). In imperfect markets, the diagram would have to be adjusted because MFCL would then be equal to the wage rate divided by marginal costs. Because optimum resource allocation requires that marginal factor costs equal marginal revenue product, this firm would demand L units of labour as shown in the diagram.
[edit] Neoclassical microeconomic model Equilibrium

The demand for labour of this firm can be summed with the demand for labour of all other firms in the economy to obtain the aggregate demand for labour. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtain the aggregate supply of labour. These supply and demand curves can be analysed in the same way as any other industry demand and supply curves to determine equilibrium wage and employment levels.

[edit] Information approaches

In the classical model it is assumed that both sides know how much work effort and marginal product the employee contributes.[citation needed] In many real-life situations this is far from the case. The firm does not necessarily know how hard a worker is working or how productive they are. This provides an incentive for workers to shirk from providing their full effort since it is difficult for the employer to identify the hardworking and the shirking employees, there is no incentive to work hard and productivity falls overall.[citation needed] One solution used recently (stock options) grants employees the chance to benefit directly from the firm's success. However, this solution has attracted criticism as executives with large stock

option packages have been suspected of acting to over-inflate share values to the detriment of the long-run welfare of the firm. Another aspect of uncertainty results from the firm's imperfect knowledge about worker ability. If a firm is unsure about a worker's ability, it pays a wage assuming that the worker's ability is the average of similar workers. This wage undercompenstates high ability workers and may drive them away from the labour market. Such phenomenon is called adverse selection and can sometimes lead to market collapse. There are many ways to overcome adverse selection in labour market. One important mechanism is called signalling, pioneered by Michael Spence. In his classical paper on job signalling, Spence showed that even if education does not increase productivity, high ability workers may still acquire it just to signal their abilities. Employers can then use education as a signal to infer worker ability and pay higher wages to better educated workers.

Keynesians - Introduction Keynesian economists are, not surprisingly, so named because they are advocates of the work of John Maynard Keynes (if only all economics was that easy!). Much of his work took place at the time of the Great Depression in the 1930s, and perhaps his best known work was the 'General Theory of Employment, Interest & Money' which was published in 1936. In this section we look more generally at the work of Keynesian economists. Follow the links below or at the foot of the page to find out more detail about what they believed in and the policies they proposed. * * * * * Beliefs Theories AS & AD Policies Virtual Economy policies

Keynesians - Beliefs

Keynes didn't agree with the Classical conomists!! In fact the easiest way to look at Keynesian theory is to see the arguments he gave for Classical theory being wrong. In essence Keynes argued that markets would not automatically lead to full-employment equilibrium, but in fact the economy could settle in equilibrium at any level of unemployment. This meant that Classical policies of non-intervention would not work. The economy would need prodding if it was to head in the right direction, and this meant active intervention by the government to manage the level of demand. Follow the links in the navigation bar at the foot of the page or in the side panel to find out more detail on the sort of policies this may involve. Keynesian beliefs can be illustrated in terms of the circular flow of income. If there was disequilibrium between leakages and injections, then classical economists believed that prices would adjust to restore the equilibrium. Keynes, however, believed that the level of output (in other words National Income) would adjust. Say, for example, that there was for some reason an increase in injections (perhaps an increase in government expenditure). This would mean an imbalance between leakages and injections. As a result of the extra aggregate demand firms would employ more people. This would mean more income in the economy some of which would be spent and some saved (or paid in tax). The extra spending would prompt the firms in the economy to produce even more, which leads to even more employment and therefore even more income. This process would go on, and on, and on, and on until it stopped! It would eventually stop because each time income increased, the level of leakages (savings, tax and imports) also increased. Once leakages and injections were equal again, equilibrium was restored. This process is called the Multiplier effect.

Keynesians - Theories Keynes argued that relying on markets to get to full employment was not a good idea. He believed that the economy could settle at any equilibrium and that
there would not be automatic changes in markets to correct this situation. The main Keynesian theories used to justify this view were: * * * * The labour market The market for loanable funds (money market) The Multiplier Keynesian inflation theory

Monetarist

The labour market Keynes didn't have the same confidence in the labour market as Classical economists. He argued that wages would be 'sticky downwards'. In other words workers would not be happy about taking wage cuts and would resist this. This would mean that wages would not necessarily fall enough to clear the market and unemployment would linger. We can see this in the diagram below:

[The labour market]

When the demand for labour falls from D1 to D2 (maybe due to the onset of a recession), the wage rate should fall, so that the market clears. However, Keynes argued that because wages were sticky downwards, this would not happen and unemployment of ab would persist. This unemployment he termed demand deficient unemployment.
The market for loanable funds (money market) Classical economists were of the view that savings would need to be increased to provide more funds for investment. Keynes disputed this assumption - once again because he had less faith in markets as the economics 'miracle cure'. He argued that any increase in savings would mean that people spent less. This would mean a decrease in aggregate demand. This would just make things worse and firms would be even less inclined to invest because they would find the demand

for their products decreasing. He felt that investment depended much more on business expectations. The Multiplier Any increase in aggregate demand in the economy would result, according to Keynes, in an even bigger increase in National Income. This process came about because any increase in demand would lead to more people being employed. If more people were employed, then they would spend the extra earnings. This in turn led to even more spending, which led to even more employment which led to even more income which then led to even more spending which then led to ................. The length of time this process went on for would depend on how much of the extra income was spent each time. If the initial recipients of the extra income saved it all, then the process would stop very quickly as no-one else would get their hands on the extra income. However, if they spent it all the knock-on effects of the extra spending would carry on for some time. Therefore the higher the level of leakages, the lower the Multiplier would be. The precise formula for calculating the multiplier is: Multiplier = 1 ------------------------------------------------1 - Marginal propensity to consume

Keynesian view of inflation The key to the classical view of inflation was the Quantity Theory of Money . This theory revolved around the Fisher Equation of Exchange :

MV = PT where: M is V is P is T is

the the the the

amount of money in circulation velocity of circulation of that money average price level and number of transactions taking place

Keynes once again rejected this theory (you may be getting the idea that he didn't agree much with classical economics!!). He argued that increases in the money supply would not inevitably lead to increases in inflation. Increasing M may instead lead to a decrease in V. In other words the average speed of circulation of money would fall because there was more of it about. Alternatively, the increase in M may lead to an increased in T (number of transactions), because as we have seen Keynes disputes the assumption that the economy will find its own equilibrium. It may be in a position where there is

insufficient demand for full-employment equilibrium , and in that case increasing the money supply will fund extra demand and move the economy closer to full employment. Keynesians tend to argue that inflation is more likely to be cost-push inflation or from excess levels of demand. This is usually termed demand-pull inflation

Keynesians - AS & AD Keynes didn't distinguish between the short-run and the long-run as Classical economists tend to. He argued that the economy could settle at any equilibrium level of income at any time, and it was the government job to use appropriate policies to ensure that this equilibrium was a good one for the economy. This can be illustrated on an aggregate supply and demand diagram:

[Aggregate supply and demand]

The economy could settle at any of the 4 equilibria shown (Q1 - Q4). Clearly Q1 is not a very desirable equilibrium as the level of output is very low and there would be high levels of unemployment. Nevertheless this situation could, according to Keynes, persist in the long-term unless the government did something to stimulate the economy. This something would have to be some sort of reflationary policy, which boosted the level of aggregate demand (see the next section on policies for more details on the type of policies that could be used). As aggregate demand grows so does the level of output, but as the economy nears full employment the dark spectre of inflation emerges - in other words the price level starts to increase! This inflation is due to

an excess level of demand and so is called demand-pull inflation. At the same time there will be increased pressure on the labour market as nearly everyone has a job, and so wages will begin to rise as firms have to offer more to get the people they want. This in turn will cause costs to increase, and result in cost-push inflation.

Keynesians - Policies The other sections about Keynesians show that they believe that the economy can settle at any equilibrium. This means that they recommend that the government gets actively involved in the economy to manage the level of demand. You will then be stunned to learn that these policies are known as demand-management policies. Demand management means adjusting the level of demand to try to ensure that the economy arrives at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary gap) then the government will need to reflate the economy. If there is an excess of demand, such as in a boom, then the government will need to deflate the economy. Reflationary policies Reflationary policies to boost the level of economic activity might include: * Increasing the level of government expenditure * Cutting taxation (either direct or indirect) to encourage spending * Cutting interest rates to encourage saving * Allowing some money supply growth The first two policies would be considered expansionary fiscal policies, while the second two are expansionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Reflationary policies]
The reflationary policies have boosted the level of output from Q1 to Q2. The impact on the price level has been small, though if demand increased any more it may well be inflationary. Deflationary policies Deflationary policies to dampen down the level of economic activity might include: * Reducing the level of government expenditure * Increasing taxation (either direct or indirect) to discourage spending * Increasing interest rates to discourage saving * Reducing money supply growth The first two policies would be considered contractionary fiscal policies, while the second two are contractionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Deflationary policies]
The initial level of aggregate demand was inflationary - prices were increasing rapidly. However, the deflationary policies have reduced demand to AD2 and thus reduced the level of inflation.

The Classical Theory

The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. The classical doctrinethat the economy is always at or near the natural level of real GDPis based on two firmly held beliefs: Say's Law and the belief that prices, wages, and interest rates are flexible.

. According to Say's Law, when an economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real GDP. The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest. While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will be saved. Income that is saved is not used to purchase consumption goods and services, implying that the demand for these goods and services will be less than the supply. If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and reduce the number of resources that they employ. When employment of the economy's resources falls below the full employment level, the equilibrium level of real GDP also falls below its natural level. Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is that the funds from aggregate saving are eventually borrowed and turned into investment expenditures, which are a component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP.

Consider, however, what happens when the funds from aggregate saving exceed the needs of all borrowers in the economy. In this situation, real GDP will fall below its natural level because investment expenditures will be less than the level of aggregate saving. This situation is illustrated in Figure 1 .

Figure 1Classical theory of interest rate adjustment in the money market

Aggregate saving, represented by the curve S, is an upward-sloping function of the interest rate; as the interest rate rises, the economy tends to save more. Aggregate investment, represented by the curve I, is a downward-sloping function of the interest rate; as the interest rate rises, the cost of borrowing increases and investment expenditures decline. Initially, aggregate saving and investment are equivalent at the interest rate, i. If aggregate saving were to increase, causing the S curve to shift to the right to S , then at the same interest rate i, a gap emerges between investment and savings. Aggregate investment will be lower than aggregate saving, implying that equilibrium real GDP will be below its natural level. Flexible interest rates, wages, and prices. Classical economists believe that under these circumstances, the interest rate will fall, causing investors to demand more of the available savings. In fact, the interest rate will fall far enoughfrom i to i in Figure 1 to make the supply of funds from aggregate saving equal to the demand for funds by all investors. Hence, an increase in savings will lead to an increase in investment expenditures through a reduction of the interest rate, and the economy will always return to the natural level of real GDP. The flexibility of the interest rate as well as other prices is the self-adjusting mechanism of the classical theory that ensures that real GDP is always at its natural level. The flexibility of the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the time and thus prevents real GDP from falling below its natural level. Similarly, flexibility of the wage rate keeps the labor market, or the market for workers, in equilibrium all the time. If the supply of workers exceeds firms' demand for workers, then wages paid to workers will fall so as to ensure that the work force is fully employed. Classical economists believe that any unemployment that occurs in the labor market or in other resource markets should be considered voluntary unemployment. Voluntarily unemployed workers are

unemployed because they refuse to accept lower wages. If they would only accept lower wages, firms would be eager to employ them. Graphical illustration of the classical theory as it relates to a decrease in aggregate demand. Figure 2 considers a decrease in aggregate demand from AD1 to AD2.

Figure 2Classical theory of output and price level adjustment during a recession

The immediate, short-run effect is that the economy moves down along the SAS curve labeled SAS1, causing the equilibrium price level to fall from P1 to P2, and equilibrium real GDP to fall below its natural level of Y1 to Y2. If real GDP falls below its natural level, the economy's workers and resources are not being fully employed. When there are unemployed resources, the classical theory predicts that the wages paid to these resources will fall. With the fall in wages, suppliers will be able to supply more goods at lower cost, causing the SAS curve to shift to the right from SAS1 to SAS2. The end result is that the equilibrium price level falls to P3, but the economy returns to the natural level of real GDP.