Say's Law
The equation of the previous section, that net borrowing must equal zero, indicates that various parts of the economy are connected, though it does not tell us a great deal about the connection. Another, more flexible way of illustrating the connection is to use an insight from general equilibrium theory. Key elements from this approach date from the early 19th century, where they appear as Say's Law. Though these ideas are named after French economist Jean Baptiste Say (1767-1832), they were developed by several economists in addition to Say.
When economists study the work of earlier economists, they often have disputes about what the earlier economists really meant. Thus there are shelves of books and articles about What Marx Really Meant, and the number about What Keynes Really Meant is also substantial. The dispute about What Say's Law Really Means is far smaller, but it has yielded a number of positions. A reason that these controversies can exist is that writers are sometimes ambiguous in what they say, and their positions can be interpreted in a number of ways. The following interpretation of Say's Law is not the only possible interpretation.
Although the popular expression of Say's Law is "Supply creates its own demand," this quotation does not appear in Say's writings nor in the writings of the other economists of his time. The "law" was developed at a time when economists had begun to notice that the economic system could be subject to "crises," periods that today we call recessions. They did not have the economic statistics that we now have to identify these periods, but traders and merchants were aware of them through increased bankruptcies, slower trade, an increase in beggars, and sometimes runs on banks.
The question of the nature of these crises, their causes, and their relationship to the economic system became a topic of debate. The major figure on one side of the debate was Thomas Malthus, better known for his theory of population. He argued that crises were a result of a "general glut" of goods. The production of goods could outrun the ability or desire of people to purchase these goods, and it was this oversupply or underconsumption that led to an economic crisis.
On the other side of the debate were David Ricardo, James and John Stuart Mill, and Say. Those ideas that are called Say's Law were developed by all of them in their attempt to show that the underconsumptionist thesis was wrong.
Say's Law can be illustrated with a three-person, three-commodity, barter economy. Let our three persons be Crusoe, who is a fisherman, Friday, who collects coconuts, and Saturday, who grows bananas. Crusoe will catch fish for two reasons, either because he wants to eat them himself, or because he wants to trade them for coconuts and bananas. Friday and Saturday also work either to consume their own output or to trade it. If initially each banana and coconut is worth one fish, Crusoe may plan to trade five fish for two coconuts and three bananas. (These numbers are made up and have no special significance.) In the table below these plans are shown with a positive number indicating that a person plans to supply a commodity to the marketplace and a negative number indicating that a person plans to demand a commodity from the marketplace. The numbers show what each wants to do at the existing set of prices, not necessarily what each actually does.
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Bananas |
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Summation |
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In a barter world, buying cannot be done unless one sells at the same time, and selling cannot be done unless one buys at the same time. In a world of barter, the only way one can finance purchases is by selling, and there is no reason to sell except to finance purchases. It is for this reason that Say's Law implies that a column should sum to zero. The act of supplying is also an act of demanding; supply creates its own demand.
The table contains the plans of Friday and Saturday in addition to Crusoe. Notice that adding each of their columns results in a total of zero. If, however, rows are added, there is no need to sum to zero, and the rows for fish and bananas do not sum to zero. A non-zero total here means that plans will not be realized (work out). The +2 in the fish row indicates that at the original prices there will be an oversupply or surplus of fish. The -2 in the banana row means that at the original prices there will be an overdemand or a shortage of bananas. To make the markets clear, the price of fish should fall and the price of bananas should rise. In turn, the new prices will affect future plans. Most economists (but certainly not all) have believed that, with repeated changes in prices and plans, eventually an equilibrium situation will be reached so that all rows will sum to zero--that quantity supplied will equal quantity demanded in each market.
The logic of the table implies that there can be no general glut or oversupply of goods, which was the point Say and others were arguing. It is possible for "gluts" of particular goods, but counterbalancing this is a shortage or undersupply of other goods. It is not possible, given the assumption that columns must sum to zero, for an oversupply (or underdemand) of all goods to exist. This conclusion won the debate in the early 19th century and remained unchallenged until the 20th century.
The logic of the table also implies that if all markets except one are balanced, then the last one also must balance. This conclusion was named after Leon Walras and has become known as Walras' Law. (Say's Law captured in a verbal and intuitive way the spirit of general equilibrium analysis.) Walras' Law says that if a system has n markets, and n-1 of them are in equilibrium, then the final nth market must also be in equilibrium. This conclusion is widely used in macroeconomics (because it says we can ignore a market), and we will appeal to it in later discussions to justify conclusions.
However, Say's Law has problems when we leave the world of barter.
Copyright Robert Schenk
