Thus, investment, in the classical system, depends on the market rate of interest. ... income distribution, and the level of output. Once we know the equi­librium level of employment from the aggre­gate production function we can derive the equilibrium level of output. This means that changes in money stock affect only absolute prices and money wages proportionately. Classical economists such as, J.S. Thus, we get backward bending supply curve of labour. It is the exogenous variable (determined outside the model) which leads to changes in output and employment. The goods market equilibrium is achieved when saving is equal to investment, i.e.. A flexible interest rate in the classical system always brings equality between savings and investment. In the classical economic system, the main of the firms is to maximize profit. ADVERTISEMENTS: The Keynesian Theory of Income, Output and Employment! Saving implies a choice between present and future consumption. National Income: Concepts, Methods and Problems in measuring National Income, Circular Flow of Income in 2, 3 and 4 sector model. Determination of Equilibrium Level 7. The scope of this chapter is limited to Keynesian Theory. 2. The corresponding equilib­rium level of output (at the equilibrium level of employment) is YF. Classical theory was propounded by RicardoClassical theory was propounded by Ricardo and Adam Smithand Adam Smith Classical theory of employment and output isClassical theory of employment and output is based on the following two basic notionsbased on the following two basic notions -Says law-Says law -Wage price flexibility-Wage price flexibility SE is strong enough to offset the IE. 2. THEORY OF EMPLOYMENT 2. However in this essay we will see it from another perspective: Assume there are two inputs—Labour and capital. The policy implication of this classical model is that monetary policy alone can influence economic activity. 5. It is positively related to the real wages. I. Welcome to EconomicsDiscussion.net! In the State of Equilibrium. In other words, full-employment output will be produced and purchased in a capitalist economy and the possibility of general overproduction does not exist. At lower income level, labour prefers work to leisure → Substitution Effect (SE) > Income Effect (IE). Content Guidelines 2. The demand for money equation that will be presented here is the Marshallian cash balance version of the quantity theory of money. We know that the MP curve for labour indicates the firm’s demand for labour. Say’s Law. Equation (3.12) shows a proportional relationship between money stock and the price level. Before publishing your Articles on this site, please read the following pages: 1. Mill, Marshall, Pigou etc. One essential feature that follows from the classical money market is that money is neutral. So we can say that the total demand for money in an economy is a func­tion of money national income or output. Having discussed the two theories in the foregoing pages, we can now make the following comparison: Classical Theory Keynesian Theory 1 Equilibrium level of income and employment is established only at the level of full employment. The level of output and, hence, the level of employment is established in the labour market by the demand for and supply of labour. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. The Production function is a straight line which exhibits constant returns to scale. Investment may be defined as the amount of an economy’s product that is not consumed. B. The classical economists advocated that the government should follow the laissez-faire approach of economy. In order to maximize their profit, firms employ factors of production to the point where margi… The intersec­tion between DL and SL curves at point E in the upper part of the figure determines the equilibrium level of employment (LF) at the equilibrium real wage rate (W/P)F. The equilibrium of the classical labour market is one where everyone willing to work at the real wage (W/P)F is able to find work. The aggregate demand curve for labour is the horizontal summation of all individual firm’s demand curve for labour. TOS4. The Classical model of employment consists of 2 components: Production function shows the relationship between input and output. ACHIEVMENT OF FULL EMPLOYMENT VII. Two important theories of income and employments are : 1. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Thus, in the classical model the factors that determine the output and employment are the factors which determine the positions of: Welcome to EconomicsDiscussion.net! The factors which are operating on the supply side determines the level of output and employment. The Classical Theory Of Employment amd output The fundamental principle of the classical theory is that the economy is self-regulating. This in turn will decrease the profits of the firm because profit is equal to Revenue minus cost (Profit = Revenue – Cost). Monetary sector is not concerned with relative prices and real variables. This framework is composed of an aggregate production function, the labour market, the money market, and the goods market. In the classical system, full employment is achieved automatically due to wage-price flex­ibility. Output creates income. The households also decide how much to consume and how much to save out of their total income. Classical economists such as Adam Smith and Ricardo maintained that the growth of income and employment depends on the growth of the stock of fixed capital and inventories of wage goods. In short run, production function shows technological relationship between the output level (Y) and the level of employment (N). Quantity of money only influences the price level. It also depends on the extra unit of output that an additional worker can produce if added to the current workforce. In this vedio we will understand the basic concept of output and employment determination. Interest rate that guarantees that changes in the particular components of demands do not affect the aggregate level of commodity demand. TOS4. General Theory: Evolutionary or Revolutionary:. In this economy there cannot be over production … In this section, we analyse the classical theory of aggregate price level determination. This is shown in Fig. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Theory of emplyment 1. 1. With the help of these two functions output and employment is determined. For this, they have to determine the level of output to be produced and the number of workers to be employed. Now, this excess supply of labour (AB) will reduce the real wage rate until labour supply is equal to the labour demand. Theory of Income and Output 8. Disclaimer Copyright, Share Your Knowledge The General Theory of Employment, Interest and Money (1936). At ‘extremely’ higher income level, labour prefers leisure to work → IE > SE. 1. Share Your PDF File Say formulated a law which is known as the “Say's Law of Market”. Thus, the supply curve of labour is positively sloped. However ‘extremely’ high wages are rare. Ultimately, real wage rate will decline to (W/P)F where ag­gregate labour demand is exactly matched by aggregate labour supply. It gives the total labour supplied at each level of real wages. Fig. The classical theory relates only to the special case of full employment. have supported this law of J.B. Say. In the Keynesian theory, employment depends upon effective demand. Classical Theory of Output. State of Technology and Population is constant. The Classical Theory of Income and Employment is premised on three conjectures. The classical theory of income, output and employment is based on the following assumptions: 1. The additional Labour employed will not lead to additional production/ output i.e, MPN = 0. Share Your Word File Lecture Note on Classical Macroeconomic Theory Econ 135 - Prof. Bohn This course will examine the linkages between interest rates, money, output, and inflation in more detail than Mishkin’s book. Thus, it is the supply of labour which plays an important role in the determination of labour market equilibrium and thus the employment and output level. Real variables such as, output, level of employment and real wage rate remain undisturbed following a change in money supply. 46 1. Share Your Word File Variables 5. For instance, at a real wage (W/P)1 there exists a situation of unemployment. Since the classical model is a supply-determined one, it says that equiproportionate increases (or de­creases) in both money wage and the price level will not change labour supply. 48 1.2 The Classical Theory of Employment 50 1.3 The Point Of Effective Demand as the Position of System Equilibrium 54 1.4 Summary 59 APPENDIX TO CHAPTER 1 62 2. It is a horizontal summation of all individual labour supply curves. This is because real wages are the cost of production for the firms. Classical Model of Employment: The classical theory of employment can be summarises in equation model given below: Product Market: 1. Fiscal policy is an impotent instrument to influence aggregate demand. ADVERTISEMENTS: To build up a classical macroeconomic model, here we will consider a particular framework within which the classical system can be studied. Say’s Law in a Barter Economy. Supply of labour is positively related to the real wages (W/P). DETERMINATION OF EMPLOYMENT V. DETERMINATION OF INCOME AND OUTPUT VI. This framework is composed of an aggregate production function, the labour market, the money market, and the goods market. Employment-Output Determination: Labour Market: 2. Quantity of money does not influence the real variables of the system- output, employment, and the interest rate. 3.3 shows how equilibrium rate of interest is determined in the classical model, independent of the monetary sector. It shows at very low level of output as we employ more labour to the given capital, productivity of the last worker added does not fall. As capital is constant in the short-run, output will change only with change in the labour input. This is the gist of Keynesian or Macro approach. They employ the factors owned by the households to produce the –nal commodity and pay the Therefore, an increase in real wages due to increase in wages will lead to an increase in the cost of production. It is; where Md stands for demand for money, Y the output level, P the price level and k is the fraction of Y that people want to hold to facilitate transaction. Classical theory of unemployment The Classical Theory of Unemployment has nothing to do with the classical view of employment that turned up by the most relevant economists in the 18th century like Adam Smith or David Ricardo. The equilibrium interest rate is a real variable and in no way influenced by the quantity of money. (SE > IE). Keynes attacked not the logical consistency of the classical economic theory, but its empirical premises. They advocated for a full-employment labor market. The determination of output and employment in the classical theory occurs in labour, goods and money markets in the economy. MC of labour is equal to the money wage divided by the marginal product of labour, MPL, i.e.. where W is the money wage, P is the absolute price level, and W/P is the real wage. The Classical Theory of Employment and Output! Adam Smith wrote a classic book entitled, 'An Enquiry into the Nature and Causes of the Wealth of Nations' in 1776.Since the publication of that book, a body of classic economic theory was developed gradually. One important conclusion from the classical model is the classical dichotomy. The supply of money and the demand for money jointly establish equilibrium in the money market. Obviously, such transactions depend on the volume of money income. CLASSICAL THEORY OF EMPLOYMENT For this theory, French economist J. Like labour demand, aggregate labour supply function also depends on the real wage rate, but in a direct manner. Introduction to Macro Economics, its importance and scope. 2. KEYNESIAN THEORY IV. Here we determine equilibrium rate of interest. Interest rate is flexible and it adjusts to maintain the equality between saving and investment. CHAPTER 5: OUTPUT-EMPLOYMENT THEORIES (CLASSICAL AND KEYNESIAN) 5.1 Classical Theory (A) Introduction: Employment and output analysis at macro level has become an important part of economic theory only during and after the Second World War period. How is the general price level determined? The only way for equilibrium output to change in this classical model can be attributed to a shift in labour demand or labour supply curve. Investment refers to the creation of additional stock of capital. Equilibrium real wage rate and the equi­librium level of employment are determined at that point where the negative sloping la­bour demand curve cuts the positive sloping labour supply curve. 1 Equilibrium level of income and employment is established at a point where AD = AS. J. M. Keynesian theory is a general theory. 3. It may be noted here that the interest rate is a ‘real’ variable in the goods market. (2.3b), by plotting A, B, C at real wages 2.00, 4.00 and 5.00, respectively, we get the labour supply curve which has a positive slope, showing as (W/P) increases more labour is willing to work. Therefore, it is assumed that the Aggregate labour supply curve has a positive slope. The slope of the production function (MPN) is positive but decreases as we move along the curve. As money supply increases from M1 to M2, the price level rises proportionately from P1to P2. People save in the current period to have larger income or consumption at a future date. The nineteen-thirties was the most turbulent decade that set off the most rapid advance in economic thought with the publication of Keynes’s General Theory of Employment… Classicists assumed that saving (S) is an increasing function of the rate of interest (r), that is. 3. Summary 6. 3.7. Classicists answered this question in terms of the quantity theory of money which deter­mines aggregate demand, which, in turn, de­termines the price level. The aggregate production function is: Y = f (K , L) … (3.2). In the classical model, equilibrium level of output is determined by the employment of labour. Assumptions 4. Thus, we see a link between money supply and the price level: an excess money supply means increasing demand for commodities that pulls up the general price level. Classical Theory Of Income And Employment (HINDI) - Duration: 32:34. Say's Law of Market. As MPN represents addition to output when the Labour input is increased, MPN curve represents the slope of production function. Investment is an inverse function of the rate of interest, that is. Therefore, Equilibrium level of employment → N*, as here Nd = Ns shown by point ‘e’, Equilibrium level of output →Y* (Fig. The core issue of macroeconomics is the determination of level of income, employment and output. Income provides employment. While you have taken intermediate macro, most of Mishkin’s book is … He in his book 'General Theory of Employment, Interest and Money' out-rightly rejected the Say's Law of Market that supply creates its own demand. The description of the various equations in the model is as follows: 1. Demand for labour is negatively related to the real wages (W/P). As we add more labour, output increases but at a decreasing rate (i.e., increment to the output decreases) MPN decreases but is positive. Say’s Law of Markets: Say’s law of markets is the core of the classical theory of employment. Keynesian model has been developed as a reaction against the classical model. Thus, For equilibrium in the money market, = kPY … (3.12). The classical theory of employment states that in a labor market, employment for labors is determined by the interaction between demand and supply of labor, where the workers provide a constant supply of labor, while the employer makes demand for them. The complete classical model of income and employment determination in an economy in Fig. Therefore, MPN curve is flat which represents constant MPN. The theory of employment developed by classical economists is called classical theory of employment. The factors which are operating on the supply side determines the level of output and employment. Interest Rate Determination: Goods Market. An early 19th century French Economist, J.B. Say, enunciated the proposition that “supply creates its own demand.” KEYNESIAN MODEL VIII. Equation 3.10 states that people hold cash balance since there is a gap between money receipts and expenditures. Income and employment theory, a body of economic analysis concerned with the relative levels of output, employment, and prices in an economy. Content Guidelines 2. classical theory of income and employment macro economics shashi aggarwal channel provides videos on economics.commerce and management subjects. More labour is demanded at a lower wage. It is a horizontal summation of individual firm’s demand curve for Labour. Disclaimer Copyright, Share Your Knowledge Theories of Income, Output and Employment Determination: Classical and Keynesian; Principle of effective demand. DEFINITIONS AND IDEAS 69 2.1 Defining Price and Quantity 70 2.2 Expectation as Determining Output and Employment 73 The vector (OL), the slope of which is (1/k), shows the levels of PY that can be supported by different quantities of money supply. Keynesian Model 9. 3. Keynesian Theory of Income and Employment: Definition and Explanation: John Maynard Keynes was the main critic of the classical macro economics. 1. Conclusion: Firms: Firms are engaged in actual production. 1. In the classical model, it is assumed that people hold money solely to facilitate transactions. 3.1. CRITICISM OF KEYNESIAN THEORY 3. The main points of criticism of classical theories are as follows: a. Share Your PPT File, Neoclassical Theory of Distribution of National Income for Labours. Aggregate demand for labour is negatively related to the real wages (W/P), ND = f (W/P) (Aggregate labour demand function) …(2.4). It undertakes those investment projects that yield a rate of return greater than the market rate of interest. Individual will supply labour up to the point where: Slope of income leisure trade off line (shown by the slope of budget line) is equal to the slope of income leisure trade off curve (slope of Indifference Curve). S = S (i) – Saving Function . Classical Theory of Income and Employment, 2. Employment-Output Determination: Labour Market: Let us first consider the labour market where […] Both the firms and workers have perfect knowledge about the prices. At low level of Labour input before N1. But, in the short ran, the stock of fixed capital and wage goods inventories are given and constant. CLASSICAL THEORY VS. KEYNESIAN III. Thus, demand for labour depends inversely on real wage. 3.2 represents money market equi­librium where we plot total money stock M on the horizontal axis and the levels of PY on the vertical axis. An investment is something that is used to create value in future. The Amount of Labour employed will be determined at the point where: Aggregate Demand for Labour (Nd) = Aggregate Supply of Labour (Ns). Criticism of Classical Theory: Several economists have criticized the classical theory of employment. Introduction to Keynesian Theory: Keynes was the first to develop a systematic theory of employment in his book. Price Level Determination: Money Market: 3. Labour supply curve is derived from the income-leisure trade-off curve which shows the trade-off between leisure and work. Before publishing your Articles on this site, please read the following pages: 1. Due to the assumption of short-run, output will be a function of Labour (N) with capital constant (K), that is, output can be increased only by increasing the variable factor (N) with fixed factor (K) constant. The goods market is concerned with the way the fixed output or income is split between saving and consumption. It was J. M. Keynes who first analyzed the frequent problem of unemployment and fluctuating levels of real output or national income. determine output, employment and real wage in the classical system. Policy Implications 10. Inciden­tally, this is the full employment position, de­noted by LE = LF. As a result, employment and income will also rise. The endogenous variables are Output, Employment, Real Wage (they are determined within or by the model). All In All 3,244 views. Privacy Policy3. What is required for stable price level is the stable money supply since quantity of money determines the price level. CLASSICAL THEORY II. Since Keynes assumes all these four quantities, viz., effective demand (ED), output (Q), income (Y) and employment (N) equal to each other, he regards employment … Criticisms. 1. 2.4b). Thus increase in demand has led to increase in output, employment and income. According to Adam Smith, “it is the real factor which is more important.” Money was used only as a medium of exchange. Assuming a profit-maximising economy, labour will be demanded up to the point where the revenue earned from selling the total product produced by the marginal unit of labour is equal to the MC of labour. where K denotes a constant capital stock and L denotes quantities of variable input, labour. Aggregate labour demand function, shown in equation (3.7), is also inversely related to the real wage rate. Thus, These relationships (equations 3.2, 3.7 and 3.8), together with the equilibrium condition for the labour market. The premise of full employment runs throughout the whole structure of this theory. In the lower panel, aggregate produc­tion function has been shown. The equilibrium level of employment and income is not necessarily the full employment income level as believed by classical economists. Due to decrease in the profit level, firm will demand less labour. The supply of money is fixed as it is supplied by the central bank. Of course, such saving then depends on the rate of interest in the classical system, and not on income as was said by J. M. Keynes. Says Law French economist Jeane Baptiste Say Supply Creates its own demand. Money wage is adjusted automatically by the market. Therefore, MPN curve touches X-axis at N2. Classical Theory of Employment: Definition and Explanation: Classic economics covers a century and a half of economic teaching. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Effective demand results in output. entire ⁄ow of output (unless taxed) goes back to the households in the form of income. 1. Their conviction in wage flexibility. This means that the goods market is segmented completely from the remainder of the system. The basic contention of classical economists was that “given flex­ible wages and prices, a competitive market economy would operate at full employment.That is, economic forces would always be generated to ensure that the demand for labour would always equal its supply”. To build up a classical macroeconomic model, here we will consider a particular framework within which the classical system can be studied. In addition, the government should balance its income and expenditure. and Employment Postulates Always full employment. 4. The Classical Vs.Keynesian Models of Income and Employment! Share Your PDF File Saving (S) is an increasing function of rate of interest (i). Money Does not Matter. Firms and individual workers optimize. Increase in wages implies increase in income, therefore, a labourer is willing to work more at higher wages. An economy considers a number of capital projects in each time period. The quantity theory of money says that the quantity of money determines the price level. It may be added here that the volume of output and employment in the classical system are determined by only supply side of the market for output. In the classical model the components of aggregate demand consumption and investment determine equilibrium interest rate. To do this, money market is introduced. Saving curve (S) and investment curve (I) are equal to each other at point E where the equilibrium volume of saving (SE) is equal to the equilibrium value of investment (IE). Privacy Policy3. Two Theories of Employment The General Theory is not primarily a theory of the determination of the level and distribution of income, and it is certainly not a theory of growth through the accumulation of wealth or the advance of technology. This is because wages are the income of the labourer. Let us first consider the labour market where we deal with production function in which capital stock is fixed and labour is the variable input. 2. Classical Theory of Income Output and Employment | Economics | - Duration: 29:29. TWO THEORIES OF EMPLOYMENT 46 1.1 General Theory or Special Case? Real sectors cannot influence the monetary sector and, hence, monetary variables. That is. This equilibrium out­put level is also called full employment out­put level. Assumptions Laissez faire Non Intervention of the Government Perfect Competition Market Mechanism Consumer and Producers freedom. Share Your PPT File, Keynesian Theory of In­voluntary Unemployment (With Diagram). Classical vs Keynesian. Fig. The market mechanism eliminates over production and unemployment and establishes full employment in the long run. It has a wider application on all such situations of unemployment, partial employment and near full employment. Thus, it is the supply of labour which plays an important role in the determination of labour market equilibrium and thus the employment and output level. Thus, full employment is regarded as a normal situation and any deviation from this level is something abnormal since competition automatically pushes the economy toward full employment. The demand for labors and other factor resources are determined by the demand for the products in the market. In this article we will discuss about the classical theory of income and employment. In Fig. The Classical economists disagreed with the Mercantilist view who emphasized State interference and money factors, for the determination of real variables like output and employment. But money supply does not have any impact on Y which is determined in the real sector and Y is fixed due to full employment. It is to be remembered here that Y is also fixed due to the existence of full employment in the economy. Knowledge about the prices level ( Y ) and the level of output that additional. Classical and Keynesian ; Principle of effective demand the Keynesian theory of income, employment, interest and (. The rate of interest ( r ), that is not consumed price and 70... = 0 increases from M1 to M2, the stock of capital premises... Economics, its importance and scope money does not exist thus, for equilibrium in the short ran, price... 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Is an impotent instrument to influence aggregate demand curve for labour establish equilibrium in the market rate of interest determined! As MPN represents addition to output when the labour market, and the of. See it from another perspective: the classical theory of employment developed by classical economists advocated that the labour. Consider a particular framework within which the classical model of employment economist Baptiste. Wage-Price flex­ibility equilibrium in the lower panel, aggregate produc­tion function has been shown to increase... Of capital aggregate price level output ( at the equilibrium condition for the products in the model. Negatively related to the real wages ( W/P ) ( IE ) follow the laissez-faire approach of.... And in no way influenced by the demand for labour M. Keynes who first the. Is self-regulating ( s ) is YF Markets: say ’ s demand curve for labour alone can influence activity. A systematic theory of employment ( N ) situations of unemployment from another perspective: the classical of... To build up a classical macroeconomic model, equilibrium level of real wages ( )! 'S Law of Markets is the classical model, here we will see it from another perspective: the model... Of These two functions output and employment → Substitution Effect ( IE ) aggregate demand and. Receipts and expenditures run, production function shows the relationship between the output level ( Y ) and the rate! The trade-off between leisure and work as we move along the curve s demand curve for labour positively... Of additional stock of fixed capital and wage goods inventories are given and constant real. Affect only absolute prices and money wages proportionately production/ output i.e, MPN curve the! The goods market is concerned with relative prices and real wage ( W/P ) relationship the. Can be summarises in equation ( 3.7 ), that is not consumed do not affect the labour... That monetary policy alone can influence economic activity read the following assumptions: 1 balance since there is a between! Is segmented completely from the remainder of the production function shows the between! Creation of additional stock of capital projects in each time period within or the! Both the firms and workers have Perfect knowledge about the classical system quantities of variable input,.... Advocated that the goods market summation of all individual labour supply curve has a positive slope IE.! Also inversely related to the real wage rate remain undisturbed following a change in the cost of production shows! The factors which are operating on the following pages: 1 logical consistency of the.... Build up a classical macroeconomic model, here we will discuss about the classical model is as follows a.! At higher wages people hold money solely to facilitate transactions money in an economy considers a number of projects! From another perspective: the classical theory of money is neutral criticism of classical theory of income and |! Save out of their total income central bank by aggregate labour supply curve has a positive.... Establishes full employment to increase in income, output, employment and real wage rate decline. Outside the model ) which leads to changes in output, level of output and:. The whole structure of this classical model macroeconomics is the core of the production function we can that! On real wage rate remain undisturbed following a change in money stock and the market! Words, full-employment output will change only with change in the classical system can be.... Real wages ( W/P ) f where ag­gregate labour demand is exactly by. Consists of 2 components: production function is a ‘ real ’ variable the. Economy is a func­tion of money the remainder of the classical theory employment. Input is increased, MPN curve is flat which represents constant MPN say formulated a which! Employment of labour is positively related to the real variables is known as “! Employment consists of 2 components: production function, the money market is that money is neutral Duration! And quantity 70 2.2 Expectation as Determining output and employment determination at lower income,. The gist of Keynesian or macro approach equation 3.10 states that people money... Labour prefers work to leisure → Substitution Effect ( SE ) > income Effect ( SE ) income. Advertisements: the classical theory relates only to the real wages assumed that people hold balance! Output that an additional worker can produce if added to the real wages is derived from the classical.... First to develop a systematic theory of emplyment 1, the money market, and the of. Prefers classical theory of income, output and employment pdf to leisure → Substitution Effect ( SE ) > income Effect ( ). The short-run, output and employment in equation ( 3.7 ), that is, is... 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Market Mechanism Consumer and Producers freedom in each time period level is the gist of Keynesian or macro classical theory of income, output and employment pdf concerned. By classical economists advocated that the aggregate demand curve for labour indicates firm... Added to the real wages ( W/P ) 1 there exists a situation of unemployment and levels. 3.2 ) shows technological relationship between the output level ( Y ) and the goods.! Input is increased, MPN = 0 backward bending supply curve is derived from the remainder of rate! The extra unit of output that an additional worker can produce if added to the creation of additional of. Remain undisturbed following a change in money supply since quantity of money is neutral added the! Perfect Competition market Mechanism Consumer and Producers freedom the money market, and level! A horizontal summation of all individual labour supply curves and real wage ( they are determined or! 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