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Question
According to the classical theory of employment, how to wage reduction solve the problem of unemployment diagramatically explain.
Solution
The classical theory of employment assumes that the economy operates at the level of full employment without inflation in the long period. It also assumes that wages and prices of goods are flexible and a competitive market exists in the economy (laissez-faire economy). According to the classical theory of employment, full employment conditions can be achieved by cutting down the wage rate. Unemployment would be eliminated when wages are determined by the mechanism of the economy itself. The following figure shows the relationship between wage rate and employment:
In the figure, when the wage rate is OW, then the employment is ON. As the wage rate is reduced to OW1, then the employment has increased to ON1. Prof. Pigou has taken this theory as a base for developing the solution to the unemployment problem.
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