What is Say’s Law?
Say’s Law is a theory developed by the French economist Jean-Baptiste Say in 1803, and has become one of the main assumptions in classical economics.
The law is often misinterpreted as “supply creates its own demand”, as quoted by John Maynard Keynes in The General Theory of Employment, Interest and Money (1936). More correctly, it states that the act of production will generate enough income for an equivalent amount of demand for other productions.
Imagine a situation where a firm produces a type of good. If the owner of the firm sells the good, this production creates wages for workers and income for the owner, which they can then use to buy other goods.
Implications of Say’s Law
- Supply will always equal demand. If production increases, wages will also increase, causing a rise in the demand for other goods and services. Production will then have to increase to match this extra demand. This self-correcting nature means that the economy will always operate at the full employment level as guided by the “invisible hand”.
- The law implies that production is the source of demand. Without production, there will be no consumption. Therefore to increase economic growth, the government should focus on increasing production rather than demand.
The theory came under criticism in the 1930s Great Depression, especially by John Maynard Keynes. This is because if Say’s Law is true, situations similar to that of the Great Depression – when aggregate demand fell below the productive capacity of the economy causing high unemployment and a prolonged recession – cannot exist. Keynes therefore argued the following points:
- Production does not always equal demand. In a recession, there can be insufficient demand for the goods that are produced. This is because people may hoard money, especially if they lack confidence or there’s a period of deflation. They will not spend all their income to consume or invest.
- Wages are not flexible. When there is a decrease in production, workers may resist a cut in wages and this results in unemployment as wages are now higher than the equilibrium.
Classical economics – This is a school of economic thought that believes free markets regulate themselves, and that the economy always moves towards full employment without the need for government intervention. Famous economists of this school of thought include Adam Smith, David Ricardo and Thomas Malthus.
Demand – The quantity of a good or service that people are willing and able to buy.
Full employment level – This is the maximum potential output for the economy where every unit of capital and labour is being utilised.
Invisible hand – An expression coined by the economist Adam Smith to show that when people acted selfishly and bought products that they wanted, society on the whole would be better off because only the goods and services that people wanted would be produced. Therefore when people act in their own self-interest they are actually acting in the most socially optimal way.
Supply – The quantity of a good or service offered for sale.