The classical general equilibrium model aims to describe the economy by aggregating the behavior of individuals and firms. Note that the classical
general equilibrium
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ov ...
model is unrelated to
classical economics, and was instead developed within
neoclassical economics
Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good ...
beginning in the late 19th century.
In the 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 (hence scarcity of
goods
In economics, goods are items that satisfy human wants
and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not ...
and time). It is further assumed that individuals will eventually experience diminishing marginal utility. Finally,
wages
A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', '' prevailing wage'', and ''yearly bonuses,'' and remuner ...
and
prices
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...
are assumed to be elastic (they move up and down freely). The classical model assumes that traditional
supply and demand
In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labo ...
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 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 firm's objective is to maximize
profit
Profit may refer to:
Business and law
* Profit (accounting), the difference between the purchase price and the costs of bringing to market
* Profit (economics), normal profit and economic profit
* Profit (real property), a nonpossessory inter ...
given the demand for its products, and given the production technology that is available to it.
Some notation:
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:
:
It is an increasing concave function with respect to L
D 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.
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 (L
D) can be derived from this equation.
Labour supply
The suppliers of the labor market are
household
A household consists of two or more persons who live in the same dwelling. It may be of a single family or another type of person group. The household is the basic unit of analysis in many social, microeconomic and government models, and is im ...
s. A household can be thought of as the summation of all the individuals within the household. Each household offers an amount of labour services to the market. The supply of labour can be thought of as the summation of the labour 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.
Some notation:
Let U be total utility
Let Y
D be commodity demand (consumption)
Let L
S be labor supply (hours worked)
Let D(L
S) be disutility from working, an increasing convex function with respect to L
S.
Households' consumption constraint
Consumption constraint = profit income + wage income
Households' utility function
total utility = utility from consumption - disutility from work
substitute consumption:
Households' optimal condition
Maximized utility function:
When functions are given, Labor Supply (L
S) can be derived from this equation.
Aggregate demand
Y = C + I + G
whereby Y is output, C is consumption, I is investment and G is government spending
Monetary market
MV=PY(Fisher's Equation of Exchange)
References
{{Reflist
Economics models
Utility