Say’s Law of Markets – Notes

An early 19th century French Economist, J.B. Say, states that “supply creates its own demand.” The logic behind this law is that supply of goods itself generates sufficient income to generate a demand equal to the supply of goods. This is how supply creates its own demand.

In its original form, the law is applicable to a barter economy where goods are ultimately sold for goods. Therefore, whatever is produced is ultimately consumed in the economy.

This law can be explained in the context of both a barter system and a monetized economy.

Barter economy where goods are ultimately sold for goods. people tend to specialize in the production of goods or services which they can produce relatively more efficiently.

When they offer their produce in barter for other goods, they create demand for other goods. For example, a farmer offers his surplus produce (say, wheat) to the weaver in exchange for cloth. Thus, the farmer creates demand for cloth. The weaver who is in need of wheat produces surplus cloth which creates demand for wheat. Thus, production of wheat creates demand for wheat.

Therefore, whatever is produced is ultimately consumed in the economy.  Every good brought to the market creates a demand for some other goods.

Say’s law applies equally well to the monetized economy. Money is used as medium of exchange in an monetized economy.

Income generated from the process of production itself. When producers obtain the various inputs (land, labour and capital and entrepreneurship) to be used in the process of production, they generate the necessary income in the form of rent, wages, interest and profits. They spend their money income on the goods they produce. Thus, supply creates its own demand.

Whole income is not spent on consumption but a part of it is saved which is automatically invested for further production.  when investment equals saving at full-employment level of output, supply goes on creating its own demand to maintain full employment. If there is any divergence between saving and investment, the equality is maintained through the mechanism of the rate of interest.

Assumptions of the Say’s Law of Market-

  • There is a laissez-faire capitalist economy without government
  • Interference.
  • There is perfect competition in labour and product markets.
  • People are motivated by self-interest. The producers want to maximize their profits and the households want to maximize their economic well- being.
  •  The law is based on this proposition that there is automatic and self-adjusting mechanism in different markets.
  • It is a closed economy without foreign trade.
  • The quantity of money is given and money is only the medium of exchange.
  • Labour is homogeneous.
  • There is the existence of full employment.

Two Major points of Say’s Law –

1.) There is neither Overproduction nor Underproduction- Say’s law states that, in a capitalist economy, total supply always equals total demand and there cannot be ‘general underproduction’ or ‘general overproduction. There might be short-term imbalances in the demand and supply of some goods and services caused by the exogeneous factor. This short-term imbalance between demand and supply is corrected and equilibrium restored in a capitalist economy by the market forces. If demand exceeds supply, then there is underproduction, Excess demand leads to rise in prices, it will encourage supply and supply will equal to demand. Similarly, when there is overproduction, because of excess supply. It will decrease the price which results in decrease in supply and increase in demand. This process of demand-and-supply adjustment restores the equilibrium. Thus, in the long run, a market economy will always be in equilibrium. It  can be described as follows.

Value of Total Production = Cost of Production

Cost of Production = Wages + Rent + Profit + Interest

Wages + Rent + Profits + Interest = Factor Incomes

Factor Incomes = Total Expenditure

Total Expenditure = Value of Total Production

Total Demand = Total Supply

2.) There is no unemployment in the economy- There cannot be general overproduction and the problem of unemployment in the economy. If there is general overproduction and unemployment in the economy, wages decrease. Decrease in wage rates makes employment of labour more profitable. This results in increase in demand for labour and unemployment disappears. The problem of unemployment arises in the economy in the short run. In the long run, the economy will automatically tend toward full employment when the demand and supply of goods become equal. In classical view, total production is always sufficient to maintain the economy at the level of full employment in a free market economy.

Criticism of Say’s Law- J.M. Keynes criticized Say’s law of markets on the following basis:

1.Supply does not create its Demand

Say’s law assumes that supply creates its own demand. But in real, demand does not increase as much as production increases. According to Keynes, all income earned by the factor owners would not be spent in buying products which they helped to produce. A part of the earned income is saved and is not automatically invested because saving and investment are distinct functions. When all earned income is not spent on consumption goods and a portion of it is saved, it creates deficiency in aggregate demand. This leads to general overproduction and unemployment. Instead of he argued that it was demand that created supply. When aggregate demand rises, to meet that demand, firms produce more and employ more people.

2. Underemployment Equilibrium

Keynes regarded full employment as a unrealistic situation. The general situation in a capitalist economy is underemployment because the economy does not function according to Say’s law, and supply always exceeds its demand. We find millions of workers are prepared to work at the current wage rate, and even below it, but they do not find work.

3. Self-adjustment not Possible

Keynes pointed out that the capitalist system is not automatic and self-adjusting. There are two principal classes, the rich and the poor. The rich possess much wealth but they do not spend the whole of it on consumption. The poor have lack money to purchase consumption goods. Thus, there is general deficiency of aggregate demand in relation to aggregate supply which leads to overproduction and unemployment in the economy. Keynes, therefore, advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures. The state may directly invest to raise the level of economic activity or to supplement private investment. It may pass legislation recognising trade unions, fixing minimum wages and providing relief to workers through social security measures.

4.Money not Neutral

Say’s law of markets is based on a barter system and ignores the role of money in the system. Say believes that money does not affect the economic activities of the markets and  is only the medium of exchange. On the other hand, Keynes has given due importance to money. Money is held for income and business motives. Individuals hold money for unforeseen contingencies while businessmen keep cash in reserve for future activities.

5. Long-Run Analysis Unrealistic

The classical economists believed in the long-run full employment equilibrium through a self-adjusting process. Keynes was in the favour of  short-run as he believed that “In the long-run we are all dead”.

Thus Say’s law is unrealistic and is incapable of solving the present day economic problems of the capitalist world.

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