Determination of Effective Demand

Interpretation

• From 0 to 3 million workers, AD is greater than AS, so entrepreneurs earn extra profits and have an incentive to increase employment.
• At 4 million workers, AD equals AS; entrepreneurs’ expectations are exactly realised, so this is the equilibrium level of employment determined by effective demand.
• At 5 and 6 million workers, AD is less than AS; expected receipts are not enough to cover costs, so employment is reduced back towards 4 million workers.

• On the X‑axis we measure employment and on the Y‑axis we measure costs/receipts (Rs. crores).
• The upward‑sloping AD curve shows the aggregate demand price (expected sale proceeds) for different employment levels, while the AS curve shows the aggregate supply price (minimum proceeds needed) for the same employment levels.
• The two curves intersect at point E. This point E is the point of effective demand and determines the equilibrium employment level ON.
• At a lower employment level ON₁, expected receipts (segment AB) are greater than minimum receipts, so entrepreneurs gain extra profit and will increase employment.
• At a higher level ON₂, expected receipts N₂D₂ are less than the minimum required N₂S₂, so firms incur losses and will reduce employment.
• Therefore, only at point E (ON workers employed) are entrepreneurs satisfied, and this employment level actually prevails in the economy.

• The equilibrium level of employment determined by effective demand need not be a full‑employment level.
• In the diagram, point E is the point of effective demand where AD and AS intersect, but the corresponding employment ON₁ is less than full employment.
• Full‑employment level of labour is ON₂, so segment N₁N₂ on the employment axis represents unemployed workers (underemployment).

Moving towards full employment

• To reach full employment, aggregate demand must increase.
• When aggregate demand rises, the AD curve shifts upward (say from AD to AD′′).
• The new intersection of the higher AD curve with the AS curve is at E₂, which corresponds to full‑employment level ON₂.
• Thus, by increasing aggregate demand (for example, through higher consumption, investment, or government spending), the economy can move from an underemployment equilibrium to full employment.

Over‑full employment equilibrium

• If aggregate demand increases beyond the full‑employment level, the new intersection E₂ lies to the right of the full‑employment output.
• In this case, employment cannot increase further because all resources are already fully employed.
• The excess demand mainly leads to rising prices (inflation) rather than more jobs, so E₂ is called an over‑full employment equilibrium.

• In a recession, households and firms cut their spending, so aggregate demand is low.
• Even though many workers are unemployed and willing to work, firms do not find it profitable to hire them because expected receipts are below costs.
• The economy can therefore get stuck at an underemployment equilibrium, where AD = AS but employment is below the full‑employment level.

• Effective demand is determined at the point where Aggregate Demand (AD) equals Aggregate Supply (AS).
• This point decides the equilibrium level of income and employment in the economy.
• Entrepreneurs expand employment as long as AD > AS and reduce it when AS > AD.
• Effective demand may or may not correspond to full employment; it can exist even at underemployment or lead to inflation if demand rises beyond full employment.