Model Answer
0 min readIntroduction
Underemployment equilibrium refers to a situation where the economy is operating below its potential output, with a significant portion of the labor force either unemployed or working at less than their full capacity (e.g., part-time workers desiring full-time employment). This concept is central to Keynesian economics, developed in response to the Great Depression. Classical economics, preceding Keynes, largely assumed a self-correcting economy tending towards full employment. The fundamental difference lies in their perspectives on market mechanisms and the factors determining aggregate output and employment levels. This answer will delineate why underemployment equilibrium is a plausible outcome within the Keynesian framework, but not within the Classical one.
Classical Economics and Full Employment
Classical economists, like Adam Smith and David Ricardo, believed in Say’s Law – “supply creates its own demand.” This implies that the act of producing goods generates sufficient income to purchase those goods, preventing prolonged periods of overproduction or unemployment. Key tenets of Classical thought include:
- Wage and Price Flexibility: Wages and prices are assumed to be perfectly flexible, adjusting quickly to changes in supply and demand. If there is unemployment, wages will fall, making labor cheaper and increasing demand for it until full employment is restored.
- Rational Expectations: Individuals are assumed to have rational expectations, meaning they accurately anticipate future economic conditions.
- Limited Role of Government: Government intervention is seen as distorting the natural market forces and hindering the economy’s self-correcting mechanisms.
Therefore, in the Classical model, any deviation from full employment is considered temporary. Market forces will inevitably restore equilibrium at the full employment level of output. Underemployment equilibrium is not possible because wages and prices will adjust to eliminate any surplus labor.
Keynesian Economics and Underemployment Equilibrium
John Maynard Keynes challenged the Classical assumptions during the Great Depression. He argued that the economy could get stuck in a state of underemployment equilibrium due to several factors:
- Sticky Wages and Prices: Keynes argued that wages and prices are “sticky” – they do not adjust quickly to changes in demand. This stickiness can be due to factors like labor contracts, menu costs (the cost of changing prices), and psychological resistance to wage cuts.
- Insufficient Aggregate Demand: Keynes emphasized the importance of aggregate demand (AD) in determining the level of output and employment. If AD is insufficient, firms will reduce production and lay off workers, leading to unemployment.
- The Multiplier Effect: A decrease in investment or government spending can have a magnified negative impact on AD due to the multiplier effect.
- Animal Spirits: Keynes introduced the concept of “animal spirits” – psychological factors that influence investment decisions. Pessimistic expectations can lead to a decline in investment, even if interest rates are low.
In the Keynesian model, if AD is deficient, wages and prices will not fall sufficiently to restore full employment. This is because of wage stickiness and the fear of reduced profits. The economy can remain in a state of underemployment equilibrium, where there is involuntary unemployment – individuals are willing to work at the prevailing wage rate but cannot find jobs.
Comparative Analysis
The following table summarizes the key differences:
| Feature | Classical Economics | Keynesian Economics |
|---|---|---|
| Wage & Price Flexibility | Perfectly Flexible | Sticky |
| Role of Aggregate Demand | Supply-side driven (Say’s Law) | Demand-side driven |
| Expectations | Rational | Animal Spirits, Pessimism |
| Government Intervention | Minimal | Active (Fiscal & Monetary Policy) |
| Underemployment Equilibrium | Impossible | Possible |
Example: During the 2008-2009 financial crisis, despite significant monetary easing by central banks, unemployment rates remained high for an extended period. This illustrates the Keynesian concept of a liquidity trap and the stickiness of wages and prices, preventing a quick return to full employment. Conversely, Classical economists would argue that the crisis was a temporary disruption and that market forces would eventually restore equilibrium.
Conclusion
In conclusion, the possibility of underemployment equilibrium hinges on the fundamental assumptions about wage and price flexibility and the drivers of aggregate demand. Classical economics, with its emphasis on flexible markets and Say’s Law, precludes the existence of persistent underemployment. However, Keynesian economics, recognizing wage stickiness and the crucial role of AD, provides a framework where underemployment equilibrium is not only possible but also a likely outcome in situations of deficient demand. This difference in perspective has profound implications for the role of government intervention in stabilizing the economy.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.