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Classical economics is a school of economic thought whose major developers include William Petty, Adam Smith, David Ricardo, and John Stuart Mill. It is seen by many as the first modern school of economic thought.
It tended to stress the benefits of trade, an analysis organized around the natural price of commodities, and either the cost of production theory of value or the labor theory of value.
It was largely displaced by marginalist schools of thought (such as the Austrian School) who saw value to derive from the marginal utility that consumers found in a good rather than the cost of the inputs that made up the product. Ironically, considering the attachment of many classical economists to the free market, the largest school of economic thought that still adheres to classical forms is the Marxist school. This may be due to the fact that Karl Marx died before marginalist theories were widely accepted.
= Classical Model = In the Classical Model, the individual is assumed to be the basic unit of analysis and these individuals, both workers and employers, will make choices that reflect their unique tastes, objectives, and preferences. It is assumed that individuals' wants typically exceed their ability to satisfy them (hense scarcity of goods and time). It is further assumed that individuals will eventually experence diminishing marginal utility. Finally, wages and prices are assumed not to be sticky (they move up and down freely). The classical model assumes that traditional supply and demand analysis is the best approach to understanding the labor market. The functions that follow are aggregate functions that can be thought of as the summation of all the individual participants in the market.
= Aggregate Supply - Labor Market =
Some notation:
Labor Demand
The consumers of the labor market are firms. The demand for labor services is a derived demand, derived from the supply and demand for the firm's products in the goods market. It is assumed that a firms' objective is to maximize profit given the demand for its products, and given the production technology that is available to it. Let be price level of commodities
Let be nominal wage
Let be real wage (w/p)
Let be profit of firms
Let be labor demand
Let be the firms output of commodities that it will supply to the goods market.
Output function
Let us specify this output (commodity supply) function as the complex variable:
It is an increasing concave function with respect to LD because of the Diminishing Marginal Product of Labor. Note that in this simplified model, labour is the only factor of production. If we were analysing the goods market, this simplification could cause problems, but because we are looking at the labor market, this simplification is worthwhile.
Some notation:
Firms' profit function
Generally a firm's profit is calculated as:
profit = revenue - cost
In nominal terms the profit function is:
In real terms this becomes:
Firms' optimal (profit maximizing) condition
In an attempt to achieve an optimal situation, firms can maximize profits with this Maximized profit function:
When functions are given, Labor Demand (LD) can be derived from this equation.
Labor Supply
The suppliers of the labor market are households. A household can be thought of as the summation of all the individuals within the households. Each household offers an amount of labour services to the market. The supply of labor can be thought of as the summation of the labor services offered by all the households. The amount of service that each household offers depends on the consumption requirements of the household, and the individuals relative preference for consumption verses free time.Let U be total utility
Let YD be commodity demand (consumption)
Let LS be labor supply (hours worked)
Let D(LS) be disutility from working, an increasing convex function with respect to LS.
Households' consumption constraint
Consumption constraint = profit income + wage incomeHouseholds' utility function
total utility = utility from consumption - disutility from work
substitute consumption:
