The Theory of Employment and Unemployment

Classical and Keynesian theories of employment and unemployment start from a common framework. There is a single composite good, output, produced under conditions of diminishing returns to each scarce factor of production and constant returns to scale. The conditions governing production are described by a production function, and the demand for labor is derived from this function. The supply of labor is based on individual decisions to give up other activities - loosely described as leisure - and allocate time to labor. These relations yield a negatively sloped aggregate demand curve for labor relating offers of employment and the relative price of labor, or real wage, and a positively sloped supply curve of labor. The intersection of the two curves determines the market clearing real wage and the equilibrium level of employment. Unemployment can be defined as the difference between the amount of employment demanded and supplied at each real wage or as the difference between actual and equilibrium employment. Both definitions are in use currently.