Question

What is the classical economics position on (a) wages, (b) prices, and (c) interest rates?

Short answer

Classical economics posits that (a) wages are determined by the productive contribution of a worker, (b) prices are decided by the forces of supply and demand, and (c) interest rates are influenced by the balance between the demand and supply of loanable funds.

Step-by-step solution

Classical View on Wages

According to classical economic theory, wages—the price of labor—are derived from the productive contribution of a worker. Therefore, the wage of a labour should be equal to the value added by the last unit of labour employed. This principle is known as the marginal productivity theory of wages.

Classical View on Prices

In classical economics, prices are determined by the invisible forces of supply and demand without any intervention. The interaction between buyers and sellers in a competitive market leads to an equilibrium output and price. This principle is known as the law of supply and demand.

Classical View on Interest Rates

The classical theory of interest rates, also known as the loanable funds theory, suggests that interest rates are determined by the supply and demand for money. Interest rates rise when the demand for loanable funds exceeds the supply and fall when the supply of loanable funds exceeds the demand.

Key concepts

Marginal Productivity Theory

The marginal productivity theory hinges on the idea that wages reflect a worker's productive contribution to the company. Imagine every worker in a company as an essential cog in a machine.
Each worker's value is derived from the additional output created by the last worker hired.
This means that as long as an additional worker contributes more value than their cost, it makes sense to hire them. But the moment their contribution is less than their wage, hiring them becomes unprofitable. This principle ensures that wages are aligned with productivity levels in a competitive marketplace.
This approach emphasizes efficiency and productivity. In a competitive market, businesses are motivated to pay wages that match the value of the work done, encouraging workers to maximize their productivity. By understanding these dynamics, workers and employers can better navigate the job market.

Law of Supply and Demand

The law of supply and demand is a fundamental principle in economics that explains how the price and quantity of goods are determined in a market. Imagine a bustling market with sellers offering apples and buyers looking to purchase them.
The price of apples depends on how many apples are available (supply) and how many apples people want (demand). If sellers have lots of apples and not many buyers are interested, the price tends to go down. Conversely, if apples are scarce and coveted by many, the price goes up.

• **Equilibrium:** This is the point where the quantity of apples sellers want to sell equals the quantity buyers want to purchase.
• **Price Adjustment:** Prices rise or fall to bring supply and demand into balance.

The interaction of supply and demand guides markets toward equilibrium, where resources are allocated efficiently without excesses or shortages. Understanding this concept helps in predicting market outcomes and making informed economic decisions.

Loanable Funds Theory

The loanable funds theory explains how interest rates are determined by the interaction of borrowers and lenders in the financial market. Think of the financial market as a large pool filled with 'loanable funds'.
Borrowers need funds for various investments, while lenders are willing to provide these funds, hoping to earn interest.
Just like in any market, there are forces of demand and supply at play.

• **Demand for Loanable Funds:** This is driven by entities looking to invest and is influenced by the potential for return on investment.
• **Supply of Loanable Funds:** This comes from savings by individuals and institutions, influenced by the interest rate as a reward for saving.

When demand for funds is high and supply is relatively low, interest rates rise to balance out the spending and saving behavior of the economy. Conversely, if there is a surplus of savings, interest rates tend to drop. This theory helps to comprehend how monetary policies and economic conditions can affect the cost of borrowing and overall economic growth.