It’s no secret that economies cyclically expand and contract, but the big question is why this happens. There are 2 competing answers, with one focusing on demand and the other on supply. The former more or less underpins the Keynesian theory of macroeconomics, but that’s a topic for another article. Today, we’re going to focus on the latter creed and take a look at the phenomenon known as Say’s Law.
The theory
In his “A Treatise on Political Economy,” classical economist Jean-Baptiste Say wrote the following:
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…As each of us can only purchase the productions of others with his own productions – as the value we can buy is equal to the value we can produce, the more men can produce, the more they will purchase.
In other words, the ability to purchase something depends on the ability to produce and sell something. To have the means to buy (aka money), you must have first sold something. Since demand is predicated off of your means to buy, and since those means to buy come from production, it follows that the demand for goods comes from the supply of goods. Production creates income, which in turn creates demand.
The gist of the concept can be modelled like so:
Yes, it’s an awfully simple representation of the infinitely complex economy, but it hits home the point nonetheless. Say then drew 2 additional points. Firstly, money is a medium for exchange. It bridges the processes of production and consumption and ultimately acts as the facilitator between trade. At the end of the day, the only value being transferred is that of the goods and services produced and consumed; that value is simply “represented” through money.
Secondly, and perhaps more importantly, a general glut (an excess of supply relative to demand) isn’t possible because an excess supply of one good implies the shortage of another elsewhere. Think about how “supply creating its own demand” would apply here; this overproduction must come from somewhere, namely, the overconsumption of other goods that fuel the overproduction.
Hence, there isn’t any “general glut" but rather, a shift in demand from one good (which is now overconsumed) to another (which is now overproduced). Eventually, according to Say, these market imbalances will correct themselves through an equilibration mechanism inherent to the price system. Someone may open up business in the underproduced industry, or firms may cut back their production in the overproduced area.
These 2 points actually tie in with one another, as some may ask if gluts and shortages cancel out across the economy, then how would this work if there’s excess demand for money? That is, if people are hoarding cash and not spending it, wouldn’t this create an excess supply for all goods (because now nobody is spending anything, so by definition there’s “too much” supply relative to the demand)?
Say’s counter was that there’s no reason to hoard money. Remember, money is a medium for trade, it allows for exchange to take place between buyers and sellers. Therefore, the only reason to have money in the first place would be to spend it on goods and services. In Say’s own words: “money is a veil.”
So, what can be concluded from here? A few things:
Production is not indicative of supply as much as it is of producers’ demand for goods. Why do people produce in the first place? Above all, to fulfill their own needs. Thus, producers increasing production suggests an increase in their demand, as production is simply the means for them to eventually satisfy that demand.
A greater number and variety of producers is economically beneficial, the more prosperous it will be. Not only will overall supply increase, but the income from which consumers purchase goods and services will also grow (remember, production creates income).
The success of a producer or industry benefits others. How? Because that successful producer or industry can now purchase the output of other producers or industries, becoming their biggest customers in a sense.
Encouraging consumption harms the economy. Production creates the wealth that allows people to accumulate goods and services. So if everyone were to continuously consume without producing, there would be little wealth left in no time.
Say’s Law in contemporary economics
While instrumental in discrediting mercantilist economics (a school of thought that sought to maximize exports and minimize imports, and saw money as the source of wealth), Say’s Law came under scrutiny during the Great Depression after decades of achieving mainstream status. The quarter of unemployed Americans should’ve been in high demand according to Say’s Law, but they weren’t and the worst economic catastrophe in history raged on.
Say’s Law couldn’t explain this, and so in came John Maynard Keynes, the most influential economist of the 20th century. Keynes asserted that Say’s emphasis on supply and production was misguided, and instead focused on demand as the key variable behind economic activity. He theorized that demand depends on how willing consumers and businesses are to consume and invest, not on the amount of production.
This framework seemed to hold water far better than Say’s in the context of the Great Depression, and so a new orthodoxy was ushered in. Most economists nowadays pay little attention to Say’s Law on the grounds that it’s an overly-simplistic theory with one too many holes in its reasoning.
Keynes saw the Great Depression was enough to refute Say’s Law as it was, in his view, a recession induced by a lack of adequate demand. Regardless, Keynes saw Say assuming the following conditions in his theory:
A barter economy (direct exchange of goods and services without a common medium of exchange such as money)
Flexible prices (prices rapidly adjusting upwards or downwards)
A laissez-faire, free-market economy
Keynes treated money as more than a medium of exchange. Because money also stored value, he reasoned that its ability to create economic bubbles (and, in turn, economic depressions) shouldn’t be ignored and disproves Say’s money-neutrality (the idea that money is simply a medium of exchange). Secondly, Keynes argued that prices are not flexible but “sticky” and cannot quickly respond to market demand.
Keynesian economist Paul Krugman takes issue with the role of money in Say’s Law in particular. He, like Keynes, argues that the idea that people don’t hoard money simply isn’t true. People curb spending and even sell goods or services without immediately spending the income all the time. This makes sense when considering how households may respond to tight economic conditions – people try to increase savings and decrease debts. In this case, supply (income) won’t equal demand (spending).
On the note of where money fits into everything, some classical economists argued that money hoarding would always be balanced by spending. In other words, every dollar amount saved would equal every dollar amount invested. But Keynes pointed out that the decision to hoard money and invest it are made by different people and thus for different reasons with different incentives at play. As such, it’s extremely unlikely that the hoarding and investing of money will match, and it’s not like saving necessarily stimulates investment.
Keynesian and neoclassical economics, the dominant schools of thought nowadays, advocate for economic policies that directly contrast the implications of Say’s Law. Keynes argued that people tend to hoard money during economic contractions and so governments must step in to stimulate demand, whereas Say felt that if a government were to jumpstart an economy (keep in mind that he was generally against this), it should target supply and production, for those areas generate income and hence, demand.
Econ IRL
Climate change is undoubtedly one of, if not the biggest issue of this era, and people generally seem to recognize the problem. There’s recently been a whole movement of firms and households voluntarily reducing their carbon emissions, with some companies even going as far as to offer consumers the option to compensate their consumption’s carbon emissions (i.e. for flights). This market so to speak increased by 100% in 3 years. What does it reveal about how people value environmental protection?
That’s the fundamental question of this week’s paper. Through a field experiment with 250,000 consumers, the authors offered visitors of a grocery delivery service to offset carbon emissions by buying carbon offsets. To determine the consumers’ willingness to pay, the authors have the service vary between subsidizing the price of the offset and matching the offset’s impact on carbon mitigation.
The results appear to vary on the information presented to the consumer. By presenting salient information, their average willingness to pay increases from 0 to 16 EUR per total CO2. Why might this be? After administering 2 surveys the authors find that:
When the quantity of carbon compensated by the offset is increased, consumers don’t realize that the offset is more effective.
When the price of the offset is decreased, consumers think the offset is less effective.
In both cases, however, when presented with information, consumers believe the opposite of what they had previously thought.
‘Till next time,
SoBasically