The Principle of Effective Demand

An entrepreneur has 2 kinds of expenses based on employment:

1. The Factor Cost

These are his payments for the factors of production, exclusive of other entrepreneurs.

This is the income of his workers.

2. His payments to suppliers

The “user cost” is the cost of using his own equipment.

Output - factor cost = profit or entrepreneur's income

Gross Income = Factor Cost + Profit

Gross income is the revenue from a sale.

The aggregate supply price of the output of a given amount of employment is the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment.[3]

The income* which the entrepreneurs expect to receive from the sale determines:

• the factor cost per unit of employment
• the amount of employment

Entrepreneurs will try to adjust the amount of employment to maximise profits.

The Aggregate Supply Curve is:

Aggregate_Supply_Price = φ(Number_of_Workers)	

• Aggregate_Supply_Price is the aggregate supply price of a product from employing N men

Gross Income is the proceeds which entrepreneurs expect from the employment of N men

The Aggregate Demand Curve is:

Gross_Income = f(Number_of_Workers)	

For every number of workers, the expected income is greater than the aggregate supply price.

• If Gross_Income is greater than Aggregate_Supply_Price , the entrepreneurs will:
  • increase employment beyond the current number
  • raise costs by competing with one another for those workers up to where the number of workers which the Aggregate Selling Price has become equal to Gross Income .

Thus, the volume of employment is where the aggregate demand function intersects with the aggregate supply function.

• At this point, the entrepreneurs’ expectation of profits will be maximised.

The effective demand is the value of Gross Income at this point.

This is the substance of the General Theory of Employment.

The Classical Doctrine

The classical doctrine is “Supply creates its own Demand”

• f(Number of Workers) and φ(Number of Workers) are equal for all values of Number of Workers, i.e. for all levels of output and employment
• when there is an increase in Aggregate Selling Price( = f(Number of Workers)) corresponding to an increase in Number of workers, Gross Income ( =f(Number of workers)) necessarily increases by the same amount as the Aggregate Selling Price.

The Classical theory assumes that the aggregate demand price always accommodates itself to the aggregate supply price.*

In this way, no matter how many workers are employed, the gross income is equal to the aggregate supply price which corresponds to that number of workers.

It means that:

• effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible. *
• the amount of employment is indeterminate except until it hits the level of slave-wages.

This means that competition between entrepreneurs would always increase employment up where there is full employment and the supply of output as a whole becomes inelastic [because there there are no more additional workers]. At this point, a further increase in effective demand will no longer lead to any increase in output.

An alternative, equivalent, criterion is a situation where aggregate employment is inelastic per increase in the effective demand.

Say’s law says that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output.

• It means that there is no obstacle to full employment*.

We assume that the money-wage and other factor costs are constant per unit of labour employed.

But this simplification is solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money-wages, etc., are liable to change.

The General Theory

When employment increases, aggregate real income is increased. This increases aggregate consumption, but not by so much as income.

Hence, employers would make a loss if all of the increased employment were devoted to satisfying the increased demand for immediate consumption.

A high level of investment is needed to sustain the target employment

Thus, to justify any given amount of employment, the current investment must be enough to absorb the excess of total output over what the society chooses to consume when employment is at that given level.

Unless this investment is there, the receipts of the entrepreneurs will be less than what is needed to induce them to offer the given amount of employment.

The amount of current investment dictates:

• the society’s propensity to consume
• the equilibrium level of employment (the employment level wherein employers do not expand or contract employment)

The amount of current investment will depend, in turn, on “the inducement to invest”. This inducement depends on the relation between:

• the schedule of the marginal efficiency of capital, and
• the rates of interest on loans

Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium. This is because any other level will lead to inequality between:

• the aggregate supply price of output as a whole and
• its aggregate demand price

This level cannot be greater than full employment, i.e. the real wage cannot be less than the marginal disutility of labour. But there is no reason to expect it to be equal to full employment.

Exception

The effective demand associated with full employment is a special case.

• It is only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship corresponds to classical assumptions. It is in a sense an optimum relationship.

But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.