Say's Law of Markets - Notes
Say's Law of Markets
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.
Dr. Swati Gupta
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