Says Law of Market: Classical Macroeconomics8 min read


Learning Objectives

  • Say’s Law of Market: Meaning, Assumptions, and Implications
  • Say’s Law in Barter Economy
  • Say’s Law in Money Economy
  • Conclusion

Meaning

Says Law of Market is the core of the classical theory. Say’s law states that aggregate production necessarily creates an equal quantity of aggregate demand. The classical economist JB Say was the first economist to systematize the law of the market.

In simpler terms, “Supply creates its own demand” has been attributed to Say’s Law of Market.

The logic behind this law is that the supply of good itself generates sufficient income to generate a demand equal to the supply of the good. There cannot be any general overproduction or general unemployment in the economy as whatever is produced is automatically consumed.

In other words, every producer who brings goods to the market does so only to exchange them for other goods.

Assumptions

Some of the major assumptions of Say’s Law are as follows:

  • Perfect competition or Free Market Economy
  • Full employment
  • Wage – price flexibility
  • Money is only used as a medium of exchange
  • Money is barren or no asset demand for money
  • No money illusion
  • Neutrality of money

Implications

Major two implications of Say’s Law of Market are as follows:

  1. No general overproduction or underproduction

The primary notion of Say’s law is that aggregate supply or production necessarily creates an equal quantity of aggregate demand, that is, whatever is produced is automatically sold in the market through the mechanism of flexible price and wage.

However, in the short run, there might be an imbalance in demand and supply of goods and/or services, but market forces, in the long run, maintain this imbalance. Thus, in the long run, the market is always in equilibrium.

For example, keeping the aggregate demand in an economy constant, if production in an economy increases the price in an economy falls. According to the law of demand, as the price of a good fall, the demand for that good rises and vice-versa.

Hence, the demand for good rises and the market gets rid of overproduction.

  1. No unemployment under classical system

The classical economists believed that an economy is always in full employment and unemployment is a temporary phenomenon. Full employment is the condition where a person willing and able to work is ready to work at the prevailing wage rate get the work without due difficulty.

There cannot be general unemployment in the capitalist economy. Suppose the labor supply increases, the wage rate decreases, so it becomes profitable for employers or producers to hire more employees or workers.

Hence, they hire more employees at decreases wage rate and the unemployment disappears automatically. According to the classical economist, wage-price flexibility is the primary medium to keep the economy in the state of balance, nevertheless, classical economist did not rule out the existence of voluntary and frictional unemployment, which is the major flaw.

Any person who is not willing to work at the prevailing wage rate is not considered unemployed, and the frictional unemployment or search unemployment is the temporary phenomenon, which disappears in the long run.

Hence, an economy attains full employment in the long run.

Other implications of Say’s law

  1. Saving is virtue

Say’s Law of Market was developed in the 19th century, which was the time of the industrial revolution, and Europe was experiencing a boost in an economy with the increasing industrial revolution.

People used to invest whatever they save in their self-owned business. Thus, it is generally turned into investment. Hence, an increase in saving increases investment and increase in investment increases capital formation. Thus, saving is a virtue.

  1. Role of money

The classical economists believed that money has no role in an economy except for medium of exchange. Money merely serves as the medium of exchange.

The asset demand for money is zero means that people do not hold cash in excess of their transaction demand for money. Money is barren, so holding money is worthless. Money does not affect the production process.

The money has an impact on only monetary variables such as price level and money wage, but real variables are unaffected, which has been termed as “Classical dichotomy” by the classical economists.

  1. No government intervention

The classical economists’ verdict that there is no role of government in the market. The market is governed and controlled by the market forces, which is termed as “the invisible hand” by Adam Smith in his famous book “Wealth of nations”. The role of government is limited to the collection of taxation.

The other implication of Say’s law includes an emphasis on the supply side, flexibility of internal prices, and employment of unused resources.

Say’s Law in Barter Economy

The economic system where individuals exchange goods for goods, produce goods solely to consume by self or to exchange with other goods required for consumption. In a barter economy, no rational individual hoards the goods.

Features of Barter Economy

  • Exchange of goods with goods
  • People produce goods either to consume for themselves or to exchange with other goods
  • No role of money
  • Goods are never hoarded
  • Not in practice in today’s monetary world

In a barter economy, Say’s Law of Market unquestionably holds true. In an economy with the barter system, individuals receive no money but only goods in exchange for goods. People work either to produce the goods solely to the consumer these goods themselves or to exchange these for some other goods required for their own consumption. The individuals never hoard the goods.

Whether people consumer the goods produced by themselves or barter them with goods produced by others in the economy, they necessarily create the aggregate demand for goods that is equal to the aggregate supply of goods.

The price ratio between different goods would be determined by the supply of and demand for these goods and a set of equilibrium prices would always be reached which would clear the market. 

For example, in an economy, the production of rice is 1000 tons and the production of wheat is 20000 tons. Some individuals produce rice and some wheat. The produced rise either is consumed or is exchanged with wheat and similarly for wheat. The cost of production for both rice and wheat is equal.

Suppose 2000 tons of rice is consumed and remaining is exchanged with wheat and 4000 tons of wheat is consumed and remaining is exchanged. Thus, rice is available for exchange is 8000 tons and wheat available for exchange is 16000 tons.

Since the production of wheat is more than the production of rice. The wheat becomes cheaper. Since the economy has only two goods and the production of wheat is double the production of rice. The market clearing price ratio will be 2:1, that is, one ton of rice is exchanged for 2 tons of wheat.

Rice and wheat have the same cost of production; individuals shift their resources towards the production of rice because it is twice expensive to wheat. Thus, the production of rice increases and wheat production falls.

Hence, the price of rice falls. Thus, the price equalizing process would start in the economy and would continue until the equilibrium price of both goods is equal.

Rice (tons) Wheat (tons) Price ratio
Consumed Exchanged Total Consumed Exchanged Total
2000 8000 10000 4000 16000 20000 1:2
2000 10000 12000 4000 14000 18000 1:1.4
2000 12000 14000 4000 12000 12000 1.1

Source: A hypothetical table

Thus, the production of rice increases up to 14000 tons and wheat production falls up to 16000 tons and both goods have the same quantities to be exchanged; hence, their price ratio is 1.

Say’s Law in Money Economy

The money economy is an economic system where money acts as a medium of exchange, that is the price of goods are paid in terms of money.

Features of the Money economy

  • Money acts as a medium of exchange
  • Value of goods derived in terms of monetary price.
  • Money itself is barren, so no idle cash is held.
  • Money is neutral.

The Say’s Law of Market holds true in the money economy also. Money is neutral and money itself is barren; no rational person would hold idle cash balances in excess of his transactional requirement.

Money is never hoarded and can always be loaned at a positive price. According to classical economists, money only acts as a medium of exchange merely facilitating exchange that was cumbersome in the barter economy.

On the contrary, if an individual saves his or her income, then the economy has no objection on it. Classical economists assume saving as a virtue.

Since idle money is a loss as money itself is barren, the individuals either invest the saved income in his or her self-owned business or lends to a businessman or financial intermediaries in return of interest.

The financial intermediaries or businesspersons invest these funds in productive activities. Thus. The money will be always spent keeping the economy’s total spending equal to total income. Hence, saving is a virtue.  

The condition to hold the Say’s Law of the Market are:

  • The aggregate cost of production is equal to the aggregate factor income
  • Aggregate factor income equals to aggregate expenditure

Proof:

Value of Total production = Cost of production

Cost of production = Wage + Interest + Rent + Profit

Wage + Interest + Rent + Profit = Factor income

Factor income = Total expenditure

Total expenditure = Value of total production

Total demand = Total supply

Says Law of Market: Classical Macroeconomics Macroeconomics

Conclusion

Say’s Law of Money was formulated to apply in a society where individuals were self-employed or own their business or work on the farm. Their income is the proceeds from the sale of those produced goods and services. The proceeds were either spent on consumption or spent on the purchase of machinery and so on. In those days, investment and saving were not separate and distinct act. However, Say’s Law of Market is equally applicable to the money economy.

Suggested Readings:

Agarwal, Vinita. (2010). Macroeconomics: Theory and Policy. New Delhi: Pearson India

Shapiro, Edward. (1982). Macroeconomic Analysis. (5th Ed.). Boston: Thomson Learning

Vaish. MC. (2010). Macroeconomic Theory. (14th Ed.). New Delhi: Vikas Publishing House Pvt. Ltd.

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