Say's law

In economics, Say’s Law or Say’s Law of Markets is an often misunderstood principle attributed to French businessman and economist Jean-Baptiste Say (1767-1832) stating that in a purely free market economy production, or supply, constitutes demand for what is produced.

Correctly interpreted, Say's Law maintains that commodities are produced simply as a means to acquire other commodities: consumption is the aim of production. Thus in a barter economy, commodities are produced for direct trade. In a non-barter economy, commodities are produced for indirect trade: They are first produced, then exchanged for a certain amount of money, and subsequently that money is exchanged for commodities desired by the producer. By implication, in order to obtain a desired commodity, one must first and necessarily produce a commodity which is itself desirable. Entrepreneurs who produce undesirable commodities, or instead produce desirable commodities but at unprofitable costs, will fail.

What's more, each desirable commodity produced will be exchanged for a commodity (or commodities) of equal desirability and value (or nearly so*). In essence then, one particular quantity of value is produced and exchanged for a second, commensurate quantity of value. This suggests the principle that, across the entire economy, production provides both the sufficient means and the sufficient ends to purchase itself. In other words, supply equals demand. (*Free market economic theory suggests that commodities cannot everywhere and at all times exchange for other commodities of exactly proportional value. If this were indeed the case, then entrepreneurial profit, hence capital accumulation and economic growth, would be impossible.)

Further, therefore, recession or depression in a purely free market economy - characterized by a systemic imbalance of supply and demand - can only result from suddenly massive and widespread entrepreneurial miscalculation regarding which commodities are desirable and which production methods are efficient. According to the Classical economists, including Say, and according to Austrian economists, such deep and wide entrepreneurial miscalculation is impossible in a purely free market economy; indeed, recession and depression are caused exclusively by government interferences and machinations.

Which is not to argue, these economists maintain, that entrepreneurial miscalculation on a much smaller scale is not possible in a purely free market economy. Due to real world uncertainty, entrepreneurial miscalculation occurs often, giving frequent rise to oversupply and undersupply in particular markets. When this occurs in a purely free market economy, however, relative prices promptly adjust the exchange ratios between and among commodities to correct the imbalances. Indeed, according to Austrians, resource scarcity and real world uncertainty ensure that a central characteristic of a purely free market economy is the ceaseless adjustment of exchange ratios, as entrepreneurs constantly seek to utilize the available resources to best satisfy the expressed demands of the market.

Thus, an important implication of Say's Law is that recessions do not occur because of inadequate demand or lack of money. According to Say's Law, the production of goods provides the means for the producers to purchase what is produced, and hence, demand will grow as supply grows. For this reason, prosperity can be increased by increasing production, not consumption. Another implication of Say's Law is that the creation of more money simply results in inflation; more money demanding the same quantity of goods does not create an increase in real demand.

Following John Maynard Keynes, modern Keynesian macroeconomists argue that Say's Law only applies when prices are fully flexible. In the short run, when prices are not flexible, a drop in aggregate demand can cause a recession.

Yet, per the analysis above, what is important to bear in mind regarding the Keynesian critique of Say's Law is that Keynesians fail to annunciate the distinction that the empirical fact of price inflexibility which is the nexus of their critique is data culled not from a purely free market economy, but instead from an historic and contemporary economy much more accurately described as being mercantilist. In effect, then, when Keynesians critique "free market economics" and "capitalism" they are actually doing no such thing. The Keynesian critique is instead one directed at a mercantilist economy, properly understood.

Say's formulation

James Mill restates Say's Law as "production of commodities creates, and is the one and universal cause which creates a market for the commodities produced". In Say's language, "products are paid for with products" (1803: p.153) or "a glut can take place only when there are too many means of production applied to one kind of product and not enough to another" (1803: p.178-9). Explaining his point at length, he wrote that:

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J.B. Say, 1803: p.138-9)

He also wrote:

It is not the abundance of money but the abundance of other products in general that facilitates sales... Money performs no more than the role of a conduit in this double exchange. When the exchanges have been completed, it will be found that one has paid for products with products.

Say argued against claims that business was suffering because people did not have enough money and more money should be printed. Say argued that the power to purchase could be increased only by more production. James Mill used Say's Law against those who sought to give economy a boost via unproductive consumption. Consumption destroys wealth, in contrast to production which is the source of economic growth. The demand for the product determines the price of the product, but not if it will be consumed.

It is important to note that Say himself never used many of the later short definitions of Say's Law and that Say's Law actually developed due to the work of many of his contemporaries and those who came after him. The work of James Mill, David Ricardo, John Stuart Mill, and others evolved into what is sometimes called "law of markets" which was the framework of macroeconomics from mid 1800s until the 1930s.

Recession and unemployment

According to Keynes (see more below), if Say's Law is correct, widespread involuntary unemployment (caused by inadequate demand) cannot occur. However, involuntary unemployment in classical economists in the context of Say's Law explains unemployment as arising from insufficient demand for labour. That is, supply had exceeded demand in some segments of the economy.

While in general, more is not produced than there could be demand for, some particular products are produced too much and consequently other products too little. This "disproportionality" in relation to the consumer preferences would lead to a producer not being able to sell the products at cost-covering prices, causing losses and the closing of several firms. Since demand is ultimately determined by supply, the reduction in supply of these isolated sectors of the economy will reduce the demand for products in the other sectors, causing a general reduction in output. Hence decreasing demand for labor.

Such economic losses and unemployment were seen as an intrinsic property of the capitalistic system. Division of labour leads to a situation where one always has to anticipate what others will be willing to buy, and this will lead to miscalculations. However this theory alone does not explain the existence of cyclical phenomena in the economy because these miscalculations would happen with constant frequency. Some economists developed a theory of business cycles that tries to explain the business cycle as a cluster of errors of anticipation of demand caused by the credit expansion.

The kind of unemployment that results is what modern macroeconomics calls "structural unemployment". It differs from Keynesian "cyclical unemployment" that arises due to inadequate aggregate demand.

Role of money

It is not easy to say what exactly Say's Law says about the role of money apart from the claim that recession is not caused by lack of money. One can read the second long quotation by Say (see above) as stating simply that money is completely neutral, although Say did not concern himself about the question. The central notion that Say had concerning money can be seen in the first long quotation above. If one has money, it is irrational to hoard it.

To Say, as with other Classical economists, it is quite possible for there to be a glut (excess supply, market surplus) for one product, and it co-exists with a shortage (excess demand) for others. But there is no "general glut" in Say's view, since the gluts and shortages cancel out for the economy as a whole. But what if the excess demand is for money, because people are hoarding it? This creates an excess supply for all products, a general glut. Say's answer is simple – there is no reason to engage in hoarding money. According to Say, the only reason to have money is to buy products. It would not be a mistake, in his view, to treat the economy as if it were a Barter economy. To quote Say from above:

Nor is [an individual] less anxious to dispose of the money he may get ... But the only way of getting rid of money is in the purchase of some product or other.

An alternative modern view that gives an equivalent result is that all money that is held is done so in financial institutions (markets), so that any increase in the holding of money increases the supply of loanable funds. Then, with full adjustment of interest rates, the increased supply of loanable funds leads to an increase in borrowing and spending. So any negative effects on demand that results from the holding of money is canceled out and Say's Law still applies.

In Keynesian terms, followers of Say's Law would argue that on the aggregate level, there is only a transactions demand for money. That is, there is no precautionary, finance, or speculative demand for money. Money is held for spending and increases in money supplies lead to increased spending.

Some classical economists did see that loss of confidence in business or collapse of credit will increase the demand for money which would cut down the demand for goods. This view was expressed both by Robert Torrens and John Stuart Mill. This would lead demand and supply to move out of phase and lead to an economic downturn in the same way as miscalculation in productions, as described by William H. Beveridge in 1909. However, in classical economics, there was no reason for such a collapse to persist. Persistent depressions, such as that of the 1930s, are impossible in a free market according to laissez-faire principles. The flexibility of markets under laissez faire allow prices, wages, and interest rates to adjust to abolish all excess supplies and demands; however, since all economies are a mixture of regulation and free market elements, laissez-faire principles (which require a free market environment) would not be able to adjust effectively to excess supply and demand.

Modern interpretations

A modern way of expressing Say's Law is that there can never be a general glut. Instead of there being an excess supply (glut or surplus) of goods in general, there may be an excess supply of one or more goods but only when balanced by an excess demand (shortage) of yet other goods. Thus, there may be a glut of labor ("cyclical" unemployment), but that is balanced by an excess demand for produced goods. Modern advocates of Say's Law see market forces as working quickly—via price adjustment—to abolish both gluts and shortages. The exception would be the case where the government or other non-market forces prevent price changes.

According to Keynes, the implication of Say's "law" is that a free-market economy is always at what the Keynesian economists call full employment. Thus, Say's Law is part of the general world-view of laissez-faire economics, i.e., that free markets can solve the economy's problems automatically. (Here the problems are recessions, stagnation, depression, and involuntary unemployment.) There is no need for any intervention by the government or the central bank—such as the U.S. Federal Reserve—to help the economy attain full employment. All that the central bank needs to be concerned with is the prevention of inflation.

In fact, some proponents of Say's Law argue that such intervention is always counterproductive. Consider Keynesian-type policies aimed at stimulating the economy. Increased government purchases of goods (or lowered taxes) merely "crowds out" the private sector's production and purchase of goods. Contradicting this view, Arthur Cecil Pigou—a self-proclaimed follower of Say's Law—wrote a letter in 1932 signed by five other economists (among them Keynes) calling for more public spending to alleviate high levels of unemployment.

Keynes vs. Say

Keynesian economics places central importance on demand, believing that on the macroeconomic level, the amount supplied is primarily determined by effective demand or aggregate demand. For example, without sufficient demand for the products of labor, the availability of jobs will be low; without enough jobs, working people will receive inadequate income, implying insufficient demand for products. Thus, an aggregate demand failure involves a vicious circle: if I supply more of my labor-time (in order to buy more goods), I may be frustrated because no-one is hiring — because there is no increase in the demand for their products until after I get a job and earn an income. (Of course, most get paid after working, which occurs after some of the product is sold.) Note also that unlike the Say's law story above, there are interactions between different markets (and their gluts and shortages) that go beyond the simple price mechanism, to limit the quantity of jobs supplied and the quantity of products demanded.

Keynesian economists also stress the role of money in negating Say's Law. (Most would accept Say's Law as applying in a non-monetary or barter economy.) Suppose someone decides to sell a product without immediately buying another good. This would involve hoarding, increases in one's holdings of money (say, in a savings account). At the same time that it causes an increased demand for money, this would cause a fall in the demand for goods and services (an undesired increase in inventories (unsold goods) and thus a fall in production, if prices are rigid). This general glut would in turn cause a fall in the availability of jobs and the ability of working people to buy products. This recessionary process would be cancelled if at the same time there were dishoarding, in which someone uses money in his hoard to buy more products than he or she sells. (This would be a desired accumulation of inventories.)

Some classical economists suggested that hoarding would always be balanced by dishoarding. (More generally, this is seen in terms of the equality of saving (abstention from purchase of goods) and investment in goods.) However, Keynes and others argued that hoarding decisions are made by different people and for different reasons than decisions to dishoard, so that hoarding and dishoarding are unlikely to be equal at all times.

Some have argued that financial markets and especially interest rates could adjust to keep hoarding and dishoarding equal, so that Say's Law could be maintained, or that prices could simply fall, to prevent a decrease in production. (See the discussion of "excess saving" under "Keynesian economics".) But Keynes argued that in order to play this role, interest rates would have to fall rapidly and that there were limits on how quickly and how low they could fall (as in the liquidity trap). To Keynes, in the short run, interest rates were determined more by the supply and demand for money than by saving and investment. Before interest rates could adjust sufficiently, excessive hoarding would cause the vicious circle of falling aggregate production (recession). The recession itself would lower incomes so that hoarding (and saving) and dishoarding (and real investment) could attain balance below full employment.

Worse, a recession would hurt private real investment – by hurting profitability and business confidence – in what is called the accelerator effect. This means that the balance between hoarding and dishoarding would be pushed even further below the full employment level of production.

Keynesians believe that this kind of vicious circle can be broken by stimulating the aggregate demand for products using various macroeconomic policies mentioned in the introduction above. Increases in the demand for products leads to increased supply (production) and an increased availability of jobs, and thus further increases in demand and in production. This cumulative causation is called the multiplier process.

Modern adherents

Economists such as Thomas Sowell (who wrote his doctoral dissertation on the idea) of the Chicago School have advocated Say's law. Arthur Laffer, the supply-sider, also adhered to the law, as does the Austrian School.

A number of economists articulate the related Treasury View, which states that fiscal stimulus cannot affect unemployment.

See also

• List of eponymous laws
• Fiscal policy
• Treasury View, a related critical view of fiscal policy

References

External links

• The Proceedings of the Friesian School: "Say's Law and Supply Side Economics"
• "Say's law: Were (are) the critics right?", by William L. Anderson
• Say's Law in Context, by Peter Anderson (2 July 2003)

Further reading

• Jean-Baptiste Say, 1803. "A Treatise on Political Economy, or the production, distribution and consumption of wealth", 1803 (Engl. transl.)
• Axel Leijonhufvud, 1968. On Keynesian Economics & the Economics of Keynes: A Study in Monetary Theory. Oxford University Press. ISBN 0-19-500948-7.
• Kates, Steven (1998). Say's Law and the Keynesian revolution: how macroeconomic theory lost its way. Edward Elgard Publishing Limited. ISBN 1858987482.