Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1

What is Say's Law?

French economist Jean-Baptiste Say (1767–1832) introduced what is now famously known as “Say’s Law” in his work, A Treatise on Political Economy in 1803. Say’s law asserts that the production of goods/services creates an equivalent amount of demand for other products.

Say wrote:

“It is worthwhile to remark that 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. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products.”

Note: It was Keynes who summarized Say’s law as “Supply creates its own demand”. Say never said this himself. Supporters of Say’s Law contend that this characterisation by Keynes is an over-simplification and does not capture Say’s full argument. While I believe Keynes’ statement captures the essence of Say’s law, I do agree that it's important to understand the context in which Say developed this belief. We’ll get to this soon.

Getting back to what Say said.... he submitted that his law implied that a general glut (a general, economy-wide excess of supply over demand) was impossible. If one good was in excess supply, another must be in excess demand. "The superabundance of goods of one description arises from the deficiency of goods of another description," he wrote.

Say also believed that money received from the sale of products would not be “hoarded” and would be fully spent on the purchase of other goods/services. He thought of money simply as a medium facilitating the exchange of one good for another. Thus, he rejected the idea that it could be held on to or “hoarded” causing demand to be lower than supply.

Context required for understanding Say’s Law

Ludwig von Mises’ article Lord Keynes and Say's Law, first published in The Freeman in October 1950, does a good job of laying down the context one needs to understand the intent behind Say’s law. Those interested in reading this article first hand should click on the link above and read it on the Mises Institute website.

Ludwig von Mises (1881-1973) was a leading economist of the Austrian school. His writings have greatly influenced the American libertarian movement.

In his article, Mises points out that Say’s law was designed (by Say) as a refutation of the misplaced beliefs held by the merchant class long before economics developed into a recognized discipline. In those times, whenever there was downturn in business, merchants blamed it on: 1) a scarcity of money, and 2) general overproduction.

Say was focused on refuting the claim that recessions were caused by general overproduction.

Mises goes on to explain Say’s thought process. Say believed that some goods would be in excess supply while others would be in short supply. The reason that some goods were in excess supply was because producers had erroneously overestimated the demand for them. Goods in excess demand belonged to producers who had correctly estimated the quantum of demand for their products. Thus, the merchants’ explanation that overproduction caused a downturn in their business was incorrect; it was their inability to correctly estimate demand and meet it at the cheapest price.

Also, according to Say, this situation would automatically start correcting, as prices for goods would adjust to bring about a balance between demand and supply (prices for goods in excess demand would rise, prices for goods in excess supply would fall). Say assumed that markets were perfectly competitive with free, unrestricted flow of labour and capital.

Hence, per Say, there could never be a “general overproduction” of all goods, and it was the specific intent of Say’s law to expose the fallacy of this age-old belief.

Now, lets move to another extremely important contextual point. Say’s belief that the supply of goods created a demand equal to the value of those goods rested on the assumption that that all income received from the sale of goods and services was spend on the purchase of other goods and services, and none of it was “hoarded”. To him “hoarding” did not make any sense since he considered money simply a medium of exchange for goods.

In A History of Economic Thought (1967), William J Barber writes:

“Because a deficiency in aggregate demand allegedly could never exist, Say's Law ruled out the possibility of 'general over-production'. This conclusion rested on an important, though implicit, assumption: that all income was spent and none hoarded. For Say and most writers in the classical tradition, the basic premise was too self-evident to call for detailed argument. As they viewed the world, there was no reason why anyone should ever wish to hoard. After all, no intelligent man (as opposed to the exceptional case of the misguided miser) would accumulate idle balances when he could increase his income by lending the same funds at interest. This attitude was held with the force of dogma by the orthodox classical mind, a phenomenon not unrelated to its antipathy toward the mercantilist attitude that hoarding on a national basis was socially beneficial.”

Note: Mercantilism was a pre-Classical school of economic thought that encouraged government intervention, accumulation of monetary reserves and the restriction of domestic consumption.

Appreciating the “Classical” ideas of J.B. Say, Adam Smith (widely regarded as the father of Classical economics) and other thinkers becomes much easier when seen against the backdrop of the economic thought preceding and/or prevailing at their time.

Now that we have context, I’m going to move on to the criticism of Say’s law by Keynes and others before him in my next post Say’s Law: Context, Criticism and Keynes’s Refutation - Part 2.