Saturday, August 08, 2009

The Logic of Say's Law

Say's law has come under discussion, so I will now explain what it means and what it doesn't mean and why it is true.

Say's law in essence means that there can never be deficient aggregate demand, something which also means that there can't be general overproduction. The reason for that is we always have unfulfilled desires, and thus always want more goods and services. That is essentially always true, and is if anything even more true during recessions when people are compelled to cut back on their purchases because of lower income. The only possible context where this would not be the case would be in some hypothetical world where everyone already has what they want, either because of super abundance or the spread of some anti materialist philosophy. But in that case it wouldn't really be a problem, so even then aggregate demand wouldn't be deficient.

This however, does not mean that there can't be any economic crisis, of course. While aggregate demand can't be too low, demand for certain products are often too low. And when there is a significant mismatch between the structure of production (supply) and the structure of demand, then recessions or depression will be the result. But that does not in any way contradict Say's law.

Keynesians often retort that during deep slumps all industries suffer problems (Actually, this is not strictly true, there are some goods and services that boom during recessions and depressions). Doesn't this prove that aggregate demand is deficient? No, this is in fact the result of inadequate supply of goods that people want. Inadequate supply is another way of describing falling income resulting from the overproduction in selected cyclical industries (which is to say capital goods and consumer durables). That means that the workers and capitalists in those industries don’t produce anything which workers and capitalists in relative non cyclical industries want. It is a decline in aggregate supply (income) which causes a decline in aggregate demand.

Some critics have further argued that Say's law assumes no hoarding, or at least no increase in hoarding, and that if people decide to increase hoarding of money, then Say's law will not hold. But what hoarding means is in effect that people want higher real cash balances, which in turn is a desire for higher future demand for goods. That means that there is a relative overproduction of current consumer goods and a relative underproduction of investment goods that will enable that higher future demand for goods. The relative overproduction is in turn a sign that prices are too high and need to come down. People still want these things, but at current prices, they provide less value than future goods, meaning that prices must come down in order to raise real cash balances that way and begin the adjustment process. But again, this is simply another example of a mismatch between the structure of supply and the structure of demand in accordance with Say's law.


Blogger Yancey Ward said...

I have often thought that the resistance to Say's Law was rooted in the same passion that weds one to the labor theory of value- people would rather fix the value of their own production without the interferring input of the people that have to trade for it.

8:56 PM  
Blogger happyjuggler0 said...

The way I think about it is that workers are suppliers. (I'm mainly leaving out non-human capital to make it easier for readers to understand).

If they stop working because they are laid off, then they stop supplying. No supply, no trade. This hurts the suppliers they traded with.

Using the concept of misdirected investment, one can see that people who worked in a "misdirected industry" (e.g. building houses during a housing bubble) will eventually get laid off. But while they are working, they are getting paid, and trading their pay for things like cars, restaurant meals, etc.

But once they get laid off, they cut back on purchases of things they don't actually need right now (such as cars and restaurant meals), until they can find another job.

So there are three main effects of misdirected investment on GDP.

First, there is the wasted wealth and labor that went into such misdirected investment. Once this stops, GDP takes a hit from that industry coming to a screeching halt.

Second, there is the GDP hit from laid off workers of suppliers to the misdirected industry, such as lumber suppliers, pipe suppliers etc.

Third, there is the GDP hit from industries (such as auto workers and restaurant employees) that had traded their supply with the laid off workers supply in the first two categories.

The third GDP hit doesn't really qualify has misdirected investment (or not in the same manner anyway), since once those people who used to work in the misdirected industry (and its suppliers) get new jobs, then they can then start trading their supply with their old trading partners' supplies, which will then recreate the old useful employment in auto manufacturing and restaurants.

So to come out of a downturn/recession/depression, we need for workers (and capital) to be redeployed somewhere where they are employed in an economically profitable business. This takes time.

The key phrase in the last paragraph is "economically profitable". Government programs that waste resources rarely, if ever, produce such an economic profit, and thus won't solve the problem at hand. Building a bridge to nowhere that almost no one will use, or destroying old cars that had a couple of years use left in them (via the broken window fallacy) doesn't qualify as "economically profitable".

What is necessary is new supply that people want to trade their own supply for. Government borrowing and spending doesn't solve this problem because they misidentify the problem as not enough demand, when in reality it is not enough desired supply.

And as you say, at any rate demand is limitless. It is supply that is limited. And it is creating supply that voluntarily trades with someone else's supply that can be properly identified as "supply creating its own demand".

9:41 PM  
Blogger happyjuggler0 said...

By the way, another problem with Keynesians is that they think in terms of aggregates and homogeneous agents. This causes them to say really ignorant things like "businesses won't invest in creating new supply because the economy has too much overcapacity, therefore government has to create demand".

The economy may, and does, have too much capacity in industries that received too much misdirected investment, but this is a far cry from saying that there is too much capacity in all industries. In fact, it can make economic sense for a low cost business to invest in new capacity in an industry which has too much high cost capacity.

In each and every recession there are businesses that are investing in new capacity and hiring new workers, and they aren't stupid for doing so. That is a concept that is easily missed when one thinks in terms of aggregates, or in terms of homogeneous agents.

9:49 PM  
Blogger The Arthurian said...

Stefan, I have another question. You write: "Say's law in essence means that there can never be deficient aggregate demand.... The reason for that is we always have unfulfilled desires, and thus always want more.... That is essentially always true, and is if anything even more true during recessions when people are compelled to cut back...."

I am trying to understand your definition of aggregate demand. It seems to be the sum of effective demand or effectual demand as defined by Keynes and Adam Smith, plus some unfulfillable wish list of additional demand. I assume that as usual I am misunderstanding something you have said.

By the way effective demand (for Keynes) is the demand that calls forth supply; and similarly for Adam Smith....

Happy: Your graphic is nifty!

9:47 PM  
Blogger stefankarlsson said...

"Arthurian": I may have expressed myself in a way which will appear confusing. What I meant was that deficient aggregate demand can't cause a recession, the reason for this is that demand is determined by what we want and since we can't have all that we want (especially during recessions/depressions!), the underlying cause is that we lack the ability to supply something that the potential producers of what we want also wants, and that the crisis therefore is based on the mismatch between the structure of demand and the structure of supply.

In a praxeological sense, one could perhaps then have that wider definition of "aggregate demand". In a statistical sense, unfulfilled desires are clearly not measurable, so any statistical measure can only include actual purchases.

9:43 PM  

Post a Comment

<< Home