Say’s Law of Market– Explained !

Read this article to learn about the Say’s Law of market in economics.

Introduction:

An important element of classical economics is Say’s Law of Markets, after J.B. Say, a French economist who first stated the law in a systematic form.

Briefly stated, this law means that ‘supply always creates its own demand.’ In other words, according to J.B. Say, there cannot be general over­production or general unemployment on account of the excess of supply over demand because whatever is supplied or produced is automatically exchanged for money.

In an exchange economy whatever is produced represents the demand for another product because whatever is produced is easily sold.

Whenever additional production takes place in the economy, necessary purchasing power is also generated at the same time to absorb the additional supply; hence, there is no scope of supply exceeding demand and causing unemployment. This law was the basis of their assumption of full employment in the economy which rested on the plea that income is spent automatically at a rate which will always keep the resources fully employed.

Savings, according to classical are just another form of spending; all income, they believed, is partly spent on consumption and partly on investment. There is no ground to fear a break in the flow of income stream in the economy. Hence there cannot be any general over-production or unemployment.

The classical economists always assumed a state of employment in the economy. The normal situation in an economy, according to them was full employment equilibrium. Less than full employment, they believed, was an abnormal situation. Classical always held that there are no lapses from full employment equilibrium and even if there are any, there is always a tendency to return to full employment. This belief of the classical economists was based on the views of a French economist, J.B. Say (1767-1832).

J.B. Say made popular the ideas of Adam Smith in France and on the European continent. His law of markets which Galbraith described as having had the status of an article of faith with classical economists for over a hundred years is the formal expression of the idea that widespread and involuntary unemployment because of general over-production is impossible. In other words, there cannot be any involuntary unemployment because of a deficiency of effective demand or total demand.

In his analysis of the market mechanism, J.B. Say noted down: “…a product is no sooner created, than it from that instant, affords a market for other products to the full extent of its value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest the value should vanish 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 the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent for other products.”

Briefly stated, it means that “supply creates its own demand”. He asserted that there cannot be any general over-production or general unemployment in the economy as whatever is produced is automatically consumed. In other words, every producer who brings goods lo the market does so only to exchange them for other goods.

Say believed that people did not work for its own sake but to obtain other goods and services that go to satisfy their wants. To be employed simply meant to work in a field or to start a shop and to sell one’s own product in the market. The organisation of the economy was simple under which people spent on tools and consumer goods. Saving and investment were not separate processes.

The producer sold his product and not his labour. Products were exchanged for products. Ricardo expressed Say’s Law of Markets in the following words: “No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity which may be useful to him, or which contributes to future production. By producing, then tie necessarily becomes either the consumer of his own goods or the purchaser and consumer of the goods of some other person. Productions are always bought by productions; money is only the medium by which the exchange is effected.”

Say believed that during the process of production necessary purchasing power is generated which absorbs the additional supply, for example, when a new car is manufactured, necessary purchasing power is simultaneously generated in the form of wages, profits etc. so that the car is used. Hence there is no possibility of the aggregate demand becoming deficient.

“Say’s Law, in a very broad way, is description of a free exchange economy. So conceived, it illuminates the truth that the main source of demand is the How of factor incomes generated from the process of production itself. A new productive process, by paying out income to its employed factors, generates demand at the same time that it adds to supply.” Say, no doubt, admitted that supply of a particular commodity may exceed its demand temporarily on account of the wrong calculations of businessmen, but general over­production and hence general unemployment is impossible.

He admitted that specific commodities might be overproduced but a general glut in the sense of a general depression was unthinkable, for the very process of production created the required effective demand necessary to absorb total output. If, however, due to some mistake, over-production comes to exist in respect of a particular industry, it will be corrected automatically when businessmen suffer losses and switch over from the production of goods they cannot sell to the production of goods they can sell. Say was supported in his view by Ricardo and Mill for they also held the view that a general glut of the market could not occur.

Assumptions:

The orthodox statement as enunciated above is based, more or less, on the following assumptions:

(i) That the free enterprise system based on price mechanism provides a place for growing population and an increase in capital.

(ii) In an expanding economy new firms and workers find their way into the productive process, not by displacing others but by offering their own products in exchange.

(iii) The extent of the market is not limited i.e., incapable of expansion. The extent of the market is as big as the volume of products offered in exchange.

(iv) No necessity on the part of the government to intervene in business matters so that the attainment of automatic adjustment is facilitated.

(v) Flexibility of interest rates and long period were considered essential for its successful working.

J.S. Mill has supported Say’s Law and regarded it as extremely important. The older formation of Say’s law by David Ricardo and James Mill was cast in terms of a society that has become mostly a matter of the past—a society in which producers were self-employed either as peasant, proprietors, craftsmen, or as individual proprietors.

Mill took note of the depressed state of the market accompanying a crisis. At such times “…everyone dislikes to part with ready money, and many are anxious to procure it at any sacrifice.” Depression, Mill said, is “a glut of commodities or a dearth of money. It is a temporary derangement of markets caused by contraction of credit.”

Such periodic depressions, Mill felt, do not go to contradict Say’s law. Such maladjustments or disturbances do not prove that there are not powerful hidden forces tending to restore full employment equilibrium. Marshall in his Principles (1890), strongly supported Mill’s views. Lack of confidence, Marshall felt, was the chief cause of depression. When confidence is shaken, though men have the power to purchase, they may not choose to use it. American orthodox economist, F.M. Taylor, in his Principles (1921) endorsed Say’s law. Business depressions, in his opinion, do not disprove Say’s law.

He expressed the view that in the short-run the smooth and automatic process of exchange of products may be broken by temporary disturbances but these do not invalidate the efficacy of fundamental forces (which Say’s law sought to illuminate) tending automatically towards full employment.

Pigovian Formulation of Say’s Law:

Say’s Law of Markets, as enunciated above, was put by Pigou in a different form. According to Prof. Pigou, there cannot be any general unemployment in the labour market, if the labour is just prepared to accept a wage according to its marginal productivity. In a free enterprise economy where there is free, perfect and thorough-going competition, if the labourers just accept low wages, unemployment would vanish completely (except seasonal and frictional unemployment).

It is important to note that Pigovian formulation of Say’s Law ran in terms of the tendency of the economy, under thorough-going competition, to provide full employment in labour market. According to classical school, basic determinant of the volume of employment at any given time is the level of wages. In a free market economy with “thorough-going competition” the free working of the market forces of supply of labour and demand for labour go to determine the market wage rate, completely ruling out the possibility of unemployment.

If, however, there is unemployment, i.e. if the supply of labour exceeds the demand for labour at any given time, the market wage rates would fall till the supply is equal to demand and full employment equilibrium is restored. Classicals, therefore, held the view that if unemployment persisted for a long time, it must be ascribed to wage rigidity on account of the imperfections of labour market.

Such conditions did prevail, according to Prof. Pigou, before the First World War and as a result there did not exist unemployment except in a temporary form after the War, however, circumstances have changed and certain new forces have arisen to weaken the competitive forces in the labour market, for example, minimum wage, laws, collective bargaining, growth of trade unions, unemployment insurance, arrangements between workers and employers, group pressures and government intervention.

These factors have gone a long way to make the labour markets imperfect and hence the chances of unemployment have multiplied. Therefore, reduction in wage rates cannot solve unemployment. Pigou never made a direct attack on Say’s law not because he had doubts about its fundamental nature but because the orthodox formulation of Say’s law did not suit the society in which he happened to live.’

Implications of Say’s Law:

1. According to Say’s Law of markets there is automatic adjustment in the economy as whatever is produced is consumed. In other words, every output brings along with it the necessary purchasing power in circulation which will lead to its sale, so that there is no over-production. Hence, there is no necessity on the part of the government to intervene in business matters as that will come in conflict with the automatic adjustment mechanism of Say’s Law of Markets.

2. Since supply creates its own demand, hence general unemployment and over-production are impossible.

3. Again according to Say’s Law of Markets as long as there are unemployed resources in the economy it is profitable to employ them because they can pay their own way. In other words, when the unemployed resources are used, they lead to more production so as to cover their own costs.

4. Another important implication is the mechanism of flexibility in the rate of interest, which brings about equality between savings and investment. To classicals, saving is another form of spending. Therefore, whatever is saved is necessarily invested. Hence, there is no possibility of the deficiency of aggregate demand and the mechanism through which it is maintained is the rate of interest.

5. Further implication of Say’s Law of Markets flows from the Pigovian formulation, i.e., wage rate is the mechanism which helps to bring automatic adjustment, i.e., a lowering of the wage rate will lead to full employment under free and perfect competition. The government should, as far as possible, ensure a free market and there should be absolutely no regulation of wage rates.

6. Because goods are exchanged for goods, money acts as a veil and has no independent role to play. Money is only a medium of exchange to facilitate transactions.

Say’s Law in Barter and Money Economies:

In a barter economy, where a person gets no money but only goods. Say’s Law always holds good. In barter economy, people produce goods either with a view to consuming themselves or to trade them for some other goods required by them; in the process, they definitely create in aggregate the demand for goods which is always equal to aggregate supply of goods produced by them. The price ratios are such as would clear the market of goods. If the price of one good is higher to that of another good, resources would shift from the production of low-priced goods to the production of high-priced goods.

As a result, the price of the first good will rise on account of decreased supply, while of the other goods would tend to fall due to increased supply. In this way price equalization process starts till the equilibrium price comes to prevail in the market—which in a barter economy ensures that all goods are either consumed or exchanged at some positive price.

Say’s Law was developed and applied to a society in which producers were self-employed like individual proprietors, artisans, peasant farmers, master craftsmen etc. who either raised the products on their farms or manufactured them in their workshops. In this early 19th century set up, saving was investment and not a separate or distinct process as it is today.

As stated by Mill, Say’s Law is expressed in barter terms. But the classical economists believed that the principle was equally valid if money were introduced into the analysis. In a monetary economy Say’s Law is interpreted to mean that money income will automatically and continuously be spent at the same rate at which it is being generated through an act of production. If this is true, then money makes no difference and supply will continue to create demand.

A long line of classical economists believed that although Say’s Law was originally set forth for a barter economy (i.e., to supply one good in barter is unavoidable to demand another) yet the law was equally true in a money economy. It is true that one’s excess production in a money economy is exchanged in the market for money and not for other goods, it may still be argued that the purpose of production is not to get money as such, but to get money with which to buy the products of others. The introduction of money, made no difference because money was only a medium of exchange. Only a miser will need money for its own sake than for what it will buy.

Thus, according to the proponents of Say’s Law, it holds true both under barter economy as well as under money-economy. The law states that income received is always spent on consumption and investment. It other words, money is never hoarded. The money or expenditure stream (MV) remains neutral. In a barter economy, every seller is essentially a buyer. If they sell their produce for money, the money will promptly be spent against other goods.

Money is merely a convenient medium of exchange avoiding the leakages of barter and nothing more. Thus, the law though framed in terms of a barter economy held true for an economy using money also. Money economy behaved in the same way as barter economy, because rational individuals will not hold idle money. In this sense, there is indeed an identity of selling and buying under barter economy and even under money economy.

In his excessive zeal for establishing the practical importance of his thesis, Say expressed himself time and again, as if indeed, the total monetary value of all commodities supplied would have to equal the monetary value of all commodities demanded not only in equilibrium but ‘always and necessarily’. This is logically wrong if he actually meant it.

Is Say’s Law Still Valid?

From the points enumerated above, it is clear beyond doubt that whatever force Say’s Law had during barter economy, it certainly does hold true of modern conditions. It has been completely given up by modern economists in their theoretical and practical work on money and business cycles. Under barter economy where production was primarily for consumption i.e., whatever was produced was exchanged for goods and services. Say’s Law had some meaning. But today, when the production is based on future expectations and anticipations of demand, it has little validity, as there is bound to be some over-production, resulting in some type of glut in the market.

Viewed, however, as a broad generalization in micro context, Say’s Law presents in a greater measure a picture of the exchange economy, wherein new firms and workers find their way into the productive process by offering their own products in exchange. In J.A. Schumpeter’s view, Say never presented the law in the form in which we find it today. What he actually meant was that a good deal of production is always meant to be consumed and the rest which is saved is likely to be invested generally.

This law is not as meaningless as some assume, under the influence of Keynes. Say’s Law is still held to be valid. In principle, the economy would always absorb all the commodities, it. was capable of producing. The periodic unemployment associated with the trade cycle was an aberration, a consequence of the unbalanced structure of production caused by too rapid an expansion of the capital goods industries.

Say’s Law forms a good argument against the pessimism of those who see a general increase in production leading to a slump. For example, many fear expansion of production in the underdeveloped countries. They apprehend that the world will be flooded with products but they forget and overlook the fact that this greater production automatically leads to a greater money income which provided that it is spent in the right way, creates the market for greater flow of goods, this does not mean that disturbances cannot occur, but these are anything but a necessary consequence of the expansion of productive capacity. Supply does, in fact, tend to create its own demand.

Even today, we know that the law is true to the extent production creates its own demand via payment to the factors of production and their resulting consumption. The very fact that there cannot be any stable equilibrium in the economy unless Y = C + I shows the validity of Say’s Law even under modern conditions and manifests its inherent accuracy. In other words, the sum of expenditures on consumption and investment demand must be high enough as to be equal to income generated (supply). Hence, in a sense Y = C + I, is nothing but an elaboration and application of Say’s Law in the long run. In their fondness for the law, people gave misleading and conflicting interpretations.

In this connection, J.A. Schumpeter remarks:

“Most people misunderstood it, some of them liking, others disliking what it was they made of it. And a discussion that reflects little credit on all parties concerned dragged on to this day when people, armed with superior technique, still keep chewing the same old cud each of them opposing his own misunderstanding of the law to the misunderstanding of the other fellow, all of them contributing to make a bogey of it.” Prof. Hansen remarks, “History of thought illustrates again and again how a great living principle, tossed about on the sea of controversy is likely to lose its vitality. Too often it may be applied, as a tool of analysis to highly complex problems for which it is unsuited. Misleading conclusions inevitably emerge. This is what happened to Say’s Law.”