Principle of Effective Demand

1- Concept and Meaning
The principle of effective demand is the beginning point of Keynesian Theory of Employment. In a capitalist economy, the level of employment depends upon the level of effective demand. The higher the level of effective demand, the greater will be the level of employment and vice versa. It shows that the level of unemployment is the outcome of deficiency of effective demand. Hence, the level of employment in an capitalist economy can be raised by increasing the level of effective demand.

According to Keynes, effective demand is the balancing point between aggregate demand and aggregate supply at a level of employment. There are different levels of aggregate demand and aggregate supply at various levels of employment but there is a level of employment at witch aggregate demand and aggregate supply are equal. This point of equality is the point of effective demand. In other words, effective demand is the point of equality between aggregate demand price and aggregate supply price.

It implies that effective demand is the point of equality between AD and AS at a level of employment. Hence, it determines the level of employment in an economy in the short-run. That is why, the higher the level of effective demand, the greater will be the level of employment and vice versa and unemployment is the outcome of deficiency of effective demand. The basic remedy  to lessen the unemployment is to raise the level of effective demand in the economy.

2- Determination of Effective Demand

Effective demand is determined by the interaction between aggregate demand price (ADP) and aggregate supply price (ASP). These two determinants play important role which are explained as follows.

2.1- Aggregate demand price (ADP)

The aggregate demand price is the amount of money or proceeds which the entrepreneurs actually expect to receive from the sale of output produced by a number of men employed. In other words it refers to the expected revenue from the sale of output produced at a particular level of employment. The statement showing various aggregate demand prices at different level of employment is called the aggregate demand price schedule or aggregate demand function. It is as shown in table -1.

2.2- Aggregate supply price (ASP)

Aggregate supply is the total cost of production incurred for employing a certain given number of labor which the entrepreneurs must cover by selling the output produced by that given number of labor. In other words, it refers to the proceeds necessary from the sale of output at a particular level of employment. The statement showing various aggregate supply prices at different level of employment is called the aggregate supply price schedule or aggregate supply function. It is also as shown in table -1.

Table-1
Aggregate Demand Schedule		Aggregate Supply Schedule
Employment	ADP	Employment	ASP
5  Million	100 Billion	5  Million	90 Billion
10    "	120    "	10    "	100     "
15    "	128    "	15    "	11o      "
20   "	130    "	20   "	130     "
25    "	135    "	25    "	140     "
25    "	140    "	25    "	15o      "

Table-1 shows that with the increase in level of employment, both aggregate demand price and aggregate supply price are increasing. It means both are the increasing functions of level of employment. In the table it is seen that at employment 20 million, aggregate demand and aggregate supply prices are equal. It is the point of effective demand. The point of effective demand determines the level of employment.

The determination of effective demand has been illustrated in the diagram as;

In the figure, ADP & ASP are aggregate demand and aggregate supply functions or curves. These curves intersect each other at point E. This point of intersection is the point of effective demand where 20 millions of workers are employed. At this point entrepreneurs' expectations of profits are maximized. At any point other than this, the entrepreneurs will either incur losses or earn supernormal profits. At the employment of 10 million workers, the revenue expected is more than revenue necessary by AB as shown in the diagram. It indicates that employing more workers till 20 million is profitable where expected revenue and required-revenue or cost are equal at point E.

It is however not profitable to employ workers beyond 20 million to 25 because proceeds necessary is more than proceeds expected by CD. Thus, E the point of effective demand determines the actual level of employment in the economy which is the under-employment equilibrium. 

Of the two determinants, aggregate demand function or price plays important role in determining the level of employment in the economy. It is because; aggregate demand function or price depends on consumption function and investment function. According to Keynes, the cause of unemployment is the fall in either consumption expenditure or investment expenditure or both. So the level of employment can be raised by increasing either consumption expenditure or investment expenditure or both. The aggregate supply function is given because it depends on the technology and availability of raw materials which do not change in the short run.

In the above diagram, E is the point of effective demand which determines ON level of employment. If ONf is the full employment level for the economy, it requires raising the point of effective demand which is only possible by raising aggregate demand curve to AD1 where it intersects AS curve at E1. This is the new point of effective demand which provides an optimum level of employment ONf to the economy. If the demand curve raised beyond this point the economy will face inflation because the existing resources are fully employed and their supply can not be increased in the short run.

3- Importance of Effective Demand

The importance of effective demand has been explained as follows. 

3.1- Determinant of employment 

Effective demand determines the level of employment in an economy. An increase in effective demand causes a rise in level of employment and a decline in effective demand decreases the level of employment. Thus unemployment is caused by deficiency of effective demand and unemployment can be removed by raising the effective demand. The effective demand can be raised by increasing consumption expenditure and investment expenditure. So the principle of effective demand points out the causes and remedy of unemployment in the economy. 

3.2- Highlighting the role of investment 

The principle of effective demand highlights the role of investment in determining the level of employment in the economy. When income increases consumption expenditure also increases but by less than the increase in income. In such a situation, there is a widening gap between income and expenditure which leads to a fall in level of employment. This gap can be fulfilled by increasing investment to achieve full employment. Thus, principle of effective demand highlights the role of investment to maintain full employment. 

3.3- Rejection of classical view 

The principle of effective demand is also important in rejection of classical view of employment. The classical view is that supply creates its own demand and full employment equilibrium is a normal situation in the economy. The principle of effective demand approves that underemployment equilibrium is a normal situation and full employment equilibrium is accidental because in a capitalist economy total income is not spent on goods and services. As a result the existence of full employment is not possible and underemployment equilibrium is normal. 

3.4- The paradox of poverty 

When income increases, consumption also increases but less than proportionately. It causes a deficiency in effective demand and a rise in unemployment. In a poor community, the marginal propensity to consume is high so the gap between income and consumption is small and all resources can be employed by filling the gap with small investment expenditure. In a rich community the gap between income and expenditure is large due to low marginal propensity to consume. Therefore, it requires large investment expenditure to fill the gap but due to inadequacy of investment demand to fill the gap, there emerges inadequacy of effective demand resulting widespread unemployment.

4- Repudiation of Say’s Law and Full Employment Theory

The principle of effective demand repudiates Say’s law of market that supply creates its own demand and the full employment is a normal situation in the economy. The principle of effective demand points out underemployment equilibrium is a normal situation and full employment is accidental. In a capitalist economy supply fails to create its own demand because the total income is not spent on consumption of goods and services. As a result, there is not a possibility of full employment and the point of effective demand at any time represents underemployment equilibrium. 

The Pigou’s view that full employment can be achieved by a wage-cut policy is also repudiated by the principle of effective demand. A money wage-cut will bring a reduction in expenditure on goods and services leading to a fall in effective demand. Consequently level of employment also falls. Thus principle of effective demand repudiates Say’s law and classical theory of full employment equilibrium.