ECON 378

Lecture Twelve - Say's Law

Sources:  Jean-Baptiste Say, A Treatise on Political Economy or the Production, Distribution and Consumption of Wealth (First published in 1803); Steve Horwitz, "Understanding Says Law of Markets," and John M. Keynes, The General Theory of Employment, Interest and Money.

Say was a French businessman and economist (1767–1832).

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: pp.138–9)

It has been interpreted as "Supply Creates its Own Demand" -- which really is not correct.

Basically he is saying that production must take place for someone to be able to demand something. When Bob produces a product or service, he gets paid for that work, and is then able to use that pay to demand other goods and services.

Remember:  Don't confuse wants with demand:

As Horwitz points out, "Say's Law has nothing to do with an equilibrium between aggregate supply and aggregate demand, but rather it describes the process by which supplies in general are turned into demands in general."

It is unfortunate that Say's law has been interpreted as being an equilibrium concept.   Because I don't believe that Say himself had any intension of that happening.

Keynes and Say's Law:

Keynes basically said that the law is "supply creates its own demand."  Or, (from the General Theory):

"that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product."

But it wasn't so much that Keynes disagreed with Say's law as that he said it was not practical under most conditions.  Chapter one of the General Theory:

"I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general.  The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which I was brought up and which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation, as it has for a hundred years past.  I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limited point of the possible positions of equilibrium.  Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience."

Modern day Keynesians, such as Paul Krugman, basically say that Say's law is wrong because (again - under certain circumstances) - people will hoard money -- and therefore, there will be an over-supply or over-production of goods and services.

This provides an explanation for recessions and depressions. 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.

This is a macro, equilibrium version of Say's Law. 

Austrians do not see any macro equilibrium -- individual markets can over-produce but the signals in markets will tell entrepreneurs that they need to redirect resources. 

So Austrians basically agree with the general meaning of Say's Law -- that an economy is driven by productivity, not demand - but have no equilibrium (most especially macro equilibrium) version of this theory.

Say's Law and its understanding is key to the idea that increasing spending without that spending "coming from" an increase in productivity will lead to false signals in the market -- booms and busts.  The busts "generally speaking" come from the fact that the increase in spending (aggregate demand) pulls resources into production (in particular industries) - pulling resources away from elsewhere.  The pie has not increased in order to generate this spending.  The boom takes place in these industries - but because there is not sufficient productivity generated to sustain this boom -- resources start to run out, so to speak, the false demand is over and the bust takes place.

So Say's Law is key to understanding the Austrian theory of the Business Cycle - our next topic.