Classical, or 'real wage' unemployment

Economists identify several types of unemployment, including classical, structural and demand deficient unemployment.

Classical unemployment (or real wage unemployment) relates to the effect of a sustained increase in real wages above the free market equilibrium wage rate.

Classical unemployment may arise when free markets are prevented from establishing a market clearing equilibrium, including the following circumstances:

  1. Trade unions bargaining for wage increases in above of market equilibrium.
  2. Governments setting minimum wages.
  3. General deflation, with falling prices but where wages do not adjust downwards (they are 'sticky').

An increase in real wages will affect both the demand for, and supply of labour.

Classical unemployment diagram

An increase in real wages (at W1) will cause the demand for labour to contract (a to b) and the supply to extend (a to c). This is the Classical theory of unemployment - if real wages rise above the market rate, fewer will be employed, though more will look for work.

Video on classical unemployment

A minimum wage would cause Classical unemployment if set above the market rate.

Elasticity of demand

The extent of Classical unemployment depends upon the elasticity of demand for labour, and on the elasticity of supply of labour. With a more elastic supply of labour (as with S1) as a result of lower skills or fewer barriers to entry, the impact of higher wages is significant in encouraging low skilled workers to join the labour market, hence increasing Classical unemployment. [Classical unemployment is now b to e.]

Classical unemployment and elasticity

Also, if demand for labour is elastic, (as with D1) perhaps due to the ease with which capital can be substituted for labour, the contraction of demand may have a significant effect on the amount of surplus labour created. [Classical unemployment is now c to f.]

If both demand for labour and the supply of labour is elastic, then there is a large potential increase in Classical unemployment.

Criticisms

Critics of this theory suggest that if we follow the logic then it can be argued that reducing unemployment can be successfully achieved by reducing wages back to the theoretical market clearing rate.

However, there are at least two objections to this:

  • Firstly, reducing wage rates maybe be difficult to achieve in practice
  • Secondly, reducing wages is likely to lead to falling spending, and a reduction in economic activity, with less employment (rather than more!)

Other criticisms include:

Free markets do not always arrive at the socially optimal level of employment and wages, such as where monopsonists are free to set low wages and employment, or where imperfect information exists in the labour market.

Finally, market forces do not necessarily operate in the public sector, where wages are set by government or government controlled pay-settlement organisations. In other words there is not an equivalent free market equilibrium wage rate against which to make a comparison.

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