Classical Theory of Employment (Say’s Law): Assumptions, Equation & Criticisms

In this article we will discuss about:- 1. Introduction to Say’s Law of Markets 2. Assumptions of Say’s Law 3. Say’s Law in Barter and Money Economies 4. Pigovian Formulation 5. Implications 6. Criticisms.

Introduction to Say’s Law of Markets:

Say’s law of markets is the central pillar of the whole classical theory. J.B. Say (1764-1832), a French economist, introduced a law of markets in his book Traite d’economic politique. According to this law, “Supply creates its own demand.” J. B. Say believed that every producer who brings goods to the market does so only to exchange them for other goods. In other words, whatever is produced is automatically consumed and thus there cannot be any general over-production or general unemployment in the economy.

Say’s law provides a significant insight into the functioning of the free-exchange economy. It shows how employment of factors of production pays in its own way. When a factor production (say labour) is employed, it results in the production of commodities on the one hand and generates income (in the form of payment to the factor of production) on the other. The income received is spent in the market on the purchase of goods.

Thus, the employment of a factor of production pays in its own way, because it increases income by an amount equal (in equilibrium conditions) to the amount taken out of the income stream by way of selling its products. In the words of Hansen, “The employment of hitherto unused resources, by adding to the circular flow of income and output, pays in its own way.”

Say’s law was also supported by Ricardo and J.S. Mill. According to J.S. Mill, “Consumption co-exists with production. Production is the cause of demand. It never furnishes supply without furnishing demand, both at the same time and to an equal extent.” In the words of Ricardo, “Productions are always bought by productions; money is only the medium by which the exchange is effected.”

Some other definitions of Say’s law are as follows. According to Mc Connell, “The very act of producing goods generates an amount of income exactly equal to the value of goods produced. That is the production of any output would automatically provide the wherewithal to take that output off the market.”

Similarly, according to Gardner Ackley, “The very act of production constitutes the demand for other goods. The aggregate demand must in some sense equal the aggregate supply.” In the words of Hansen, “A new productive process, by paying out income to its employed factors, generates demand at the same time that it adds to supply.”

In short, Say’s law of markets maintains that- (a) aggregate demand always equals aggregate supply; (b) every additional supply creates an equivalent amount of additional demand; and (c) there can be no general over-production or general unemployment’

Assumptions of Say’s Law:

Say’s law of markets is based on the following assumptions:

(i) There is free economy where perfect competition prevails both in the commodity market and in the factor market.

(ii) Free market economy and its price mechanism provides scope for growing population and an increase in capital.

(iii) There is optimum allocation of resources.

(iv) Commodity prices and factor prices are determined by the market forces of demand and supply and are in perfect equilibrium.

(v) Flexibility of wages, interest rate and prices are essential for automatic adjustment in the economic system.

(vi) There is no government intervention in the automatic working of the free-market economy.

(vii) The extent of the market is not limited.

(viii) Money is veil. It acts as a medium of exchange to facilitate transactions only.

(ix) The circular flow of money continues without any leakages.

(x) The equilibrium process of the economy is perceived from the long run point of view.

Say’s Law in Barter and Money Economies:

Say’s law applies both in a barter economy as well as in a money economy:

I. Say’s Law in a Barter Economy:

In a barter economy, Say’s law, which states that supply creates its own demand, is simple truth; it is merely a tautology. In such an economy, goods are produced either for sell-consumption or for direct exchange to get some other goods.

Every seller is essentially a buyer. Whenever a person produces a good greater than his personal requirement, the surplus production is brought to the market to get some other goods in exchange. Similar is the case with other producers. Thus, in a barter economy products exchange against products and supply creates its own demand.

Again, in a barter economy, every person is self-employed and there is no involuntary unemployment. The production is on small scale. The producer himself acts both as a saver and an investor. Whatever he saves in and for the expansion of his own business. Thus, saving is investment and not a distinct and separate process.

II. Say’s Law in Money Economy:

Say’s law, though framed in terms of barter economy, also holds in a money economy where money is used as a medium of exchange. In a money economy, products are sold in the market and money is collected in exchange for them. This money is further spent to purchase some other products.

Money acts merely as a convenient medium of exchange, making the transactions more easy and quick; in other words, money is a veil or is neutral. Money economy basically behaves in the same way as barter economy because money does not play any active role to influence the real sector of the economy.

The validity of Say’s law in a money economy depends upon two conditions:

(i) The production of goods and services creates in aggregate an amount of money income equal to the cost of production of goods and services produced. Or, aggregate cost = aggregate income.

(ii) The whole of aggregate income received is spent to purchase goods and services. Or, aggregate income = aggregate expenditure.

Figure 4 illustrates Say’s law in a money economy in terms of identity between aggregate demand and aggregate supply, or between aggregate expenditure and aggregate income. AD = AS line is 45° line indicating equality between aggregate demand and aggregate supply at all points.

At point M, aggregate demand, OA is equal to aggregate supply, OB. Movement to point N shows that as aggregate supply increases (to OB₁), aggregate demand also increases (to OA₁) to become equal to aggregate supply. Thus, again, at point N, OA₁ = OB₁. Since aggregate demand and aggregate supply are identical (i.e., always equal), general over-production or general unemployment is an impossibility.

Pigovian Formulation of Say’s Law:

Modern version of Say’s law has been provided by Pigou. The older formulation of the law was in terms of a society in which the workers are self-employed. In such a society, the workers sell their products, and not their labour; the products exchange against products; and thus supply creates its own demand. In the modern money economy, on the contrary, the employers are different from the employees.

The employment is found in the labour market in which the employers may refuse to employ the workers. Pigou constructed the classical theory (and Say’s law) to make it applicable in the labour market. It was particularly the Pigovian version that Keynes attacked in General Theory. Pigou was of the view that under free competition there is always a tendency in the economy to provide full employment in the labour market.

Pigovian formulation of Say’s law concentrates on two things:

(a) The demand for labour function (i.e., the marginal product curve); and (b) the money wage rate. According to Pigou, “With perfectly free competition …. there will always be at work a strong tendency for wage fate to be so related to demand that everybody is employed.” Pigou’s position has been restate by Hansen in the following words- “Whatever the state of demand, there will always be, via wage adjustment, a tendency towards full employment.”

Pigou used the following equation to explain his view point:

It is clear from this equation that, given q and Y, employment (N) can always increase by reducing wage rate (W). Under perfect competition, wage rate (W) will so adjust itself that the number of workers employed (N) becomes equal to the total number of workers available at full employment.

In Figure-5, the curve YD is the demand for labour curve (or the marginal product curve of labour), showing a functional relation between employment and wages. Its negative slope indicates that as employment increases, the marginal productivity of labour decreases; thus, more employment is possible only at the reduced wage rate.

At OW wage rate, ON is the number of workers employed. If more workers (i.e., ON₁) are to be employed, the wage rate should fall (to OW₁).

Thus, according to Pigou, given the state of demand for labour (i.e., given the marginal product curve), employment can always be increased by reducing money wages. The mechanism through which wage reduction leads to full employment is as follows- Reduction in wages leads to reduction in production costs; as a result, prices fall and the demand for products, and hence for labour, increases, consequently, employment will increase.

This analysis leads to the following conclusions:

(i) The cause of unemployment is the labourers themselves who refuse to accept lower wages.

(ii) There is always a tendency, through appropriate wage adjustments, towards full employment in the labour market.

Implications of Say’s Law:

Say’s law has the following implications:

I. Automatic Adjustment:

Economic system has build-in-flexibility. There is automatic adjustment in the economy because whatever is produced is consumed. Flexibility of wages, interest rates and prices brings automatic adjustment.

Automatic adjustment leads to full employment equilibrium in the economy in the long run. Thus, there is no need for the government to intervene in the business matters because it will come in conflict with automatic adjustment mechanism.

II. Impossibility of General Over-Production:

Since supply creates its own demand, there cannot arise a deficiency of aggregate demand. Hence general over-production is impossible.

III. Impossibility of General Unemployment:

Since general over- production is impossible, there can be no general unemployment. Even if there is some unemployment somewhere, it will be temporary and will automatically disappear in the due course of time.

IV. Employment of Unused Resources:

Employment of unused resources pays its own way. It enlarges the income stream by an amount equivalent to the amount taken out of the income stream through the sale of its products. Thus, it generates demand at the same time that it adds to supply.

V. Flexibility of Interest Rate:

Rate of interest is the equilibrating force between saving and investment. Flexibility of interest rate brings about equality between saving and investment, and thus ensures the purchase of the whole output at full employment level.

VI. Flexibility of Wage Rate:

Flexibility of wage rate ensures full employment in the labour market. Lowering of wage rate removes unemployment in the economy.

VIII. Money is Veil:

Money is veil. It acts only as a medium of exchange and has no independent role to play.

IX. Production More Important:

Production is more important than consumption. As Say himself remarked, “It is the aim of good government to stimulate production; of bad government to encourage consumption.”

X. Saving is Virtue:

Saving is socially useful. Since all savings are automatically invested, increase in saving leads to increase in production; demand is automatically created.

Criticisms of Say’s Law:

Say’s law has been criticised by a number of economists, like Malthus, Sismondi, Hobson, Aftalion, J.M. Clark, Karl Marx, D.H. Robertson and Keynes. However, it was Keynes who repudiated the law from its very foundation and rejected it completely on the ground that aggregate demand need not be equal to aggregate supply at full employment.

According to P.M. Sweezy, “Histonans fifty years from now may record that Keynes’ greatest achievement was the liberation of Anglo-American economics from tyrannical dogma (Say’s law).”

The main points of criticism of Say’s law are as follows:

i. Deficiency of Aggregate Demand:

Say’s law is based upon the assumption that so much total demand is created as would generate adequate market for total output. Keynes has revealed the fallacy of this belief by dividing the aggregate demand into consumption demand and investment demand, and by pointing out that the determinants of consumption and investment are not inter- connected.

The factors which determine consumption are quite different from the factors which determine investment; the former are psychological factors depending upon income, while the latter are technological factors depending upon marginal efficiency of capital.

When income increases, consumption also increases, but by less than the increase in income. This creates a gap between income and consumption, which in no case is automatically filled by investment. Hence there arises deficiency of aggregate demand.

ii. Possibility of General Over-Production:

According to Say’s law whatever is earned is spent on consumption and investment. Income is spent automatically at a rate that will keep all productive resources of the economy fully employed and there will be no general over-production.

Keynes, on the other hand, pointed out that income is not automatically spent on consumption goods and investment goods. There may arise deficiency of aggregate demand which causes over-production.

iii. Criticism of Pigovian Version:

Keynes’ attack was more severe and broad-based on Pigovian formulation of Say’s law. According to Pigou, reduction in money wage, through its downward effect on cost of production and prices, tends to increase employment. Keynes pointed out that wages are a double- edged weapon.

They are not only the costs of production, but also form the incomes of the labourers. A reduction in wages, if, on the one hand, produces favourable effect on employment through reduction in costs and prices, also, on the other hand, reduces income, which; in turn, decreases aggregate demand and hence employment.

Keynes’ argument is explained through Figure-6. With YD demand for labour (or marginal product) curve, Pigou argues that a reduction in wage rate (from OW to OW₁) will lead to increase in employment (from ON to ON₁).

But, according to Keynes, if a cut in wage rate causes income to fall proportionately, then the demand for labour curve will shift leftward from YD to Y’D’ and the volume of employment will remain unchanged at ON.

Keynes also criticised Pigou’s argument on practical grounds. In modern times, it is practically difficult to reduce money wages for the following reasons:

(a) The workers, due to money illusion, often oppose a reduction in money wages,

(b) The trade unions, which have become an integral part of modern industrial system, would certainly resist a wage-cut policy,

(c) In a welfare state, there is legislation regarding minimum wages and unemployment insurance, which makes wages inflexible downwards.

iv. Under-Employment Equilibrium:

Say’s law implies that equilibrium in the economy is attained only at full employment level. But, Keynes, on the other hand, has shown that the economy can be in equilibrium at less-than- full employment level. In fact, the condition of under- employment is more near to reality in a capitalist economy.

v. Empirical Evidence against Say’s Law:

The Great Depression of 1930 has proved Say’s law wrong. It was during this depression that there was huge piling up of stocks in the factories; there was widespread unemployment; and, the employers faced with lack of aggregate demand. In such conditions. Say’s law stood practically discredited.

vi. Fallacy of Aggregation:

The main fallacy in Say’s law is that the partial equilibrium analysis, which was relevant only to an individual firm or industry, has been extended to the economy as a whole. It is too much for Say’s law to assume that the micro economic principles can be applied to macro-economic considerations. For example, it is wrong to assume that more saving, which is a virtue for an individual, also brings prosperity for the economy.

vii. Lack of Automatic Adjustment:

Keynes refuses to accept the classical view that economic system is a self-adjusting system. He has shown glaring discrepancies in demand and supply of commodities, saving and investment, and demand and supply of labour.

viii. Government Intervention:

The economy does not automatically reach full employment level and there may be unemployment due to deficiency of aggregate demand. Thus, government has to intervene to increase expenditure in the economy.

ix. Saving-Investment Equality:

Keynes rejected the view that the equality between saving and investment is brought about through flexibility of rate of interest. According to him, income, and not interest rate, is the equilibrating force between saving and investment.

x. Role of Money:

Say and other classical economists believed that money acts only as a medium of exchange. According to Keynes, money functions not only as a medium of exchange, but also as a store of value. Keynes assigns money an active role in the determination of income, output and employment.

xi. Unrealistic Assumptions:

Say’s law is based upon many unrealistic assumptions:

(i) It presumes the existence of free and perfect competition which is far from reality.

(ii) It is stated as a long run tendency, but, according to Keynes, “In the long run, we are all dead.”

(iii) It presents a static picture of the world by assuming a state of full employment.

(iv) It is not practical and provides no solution to the actual problems of the economy.

Conclusion:

It is by now clear that whatever validity Say’s law has in a barter economy, it has no practical relevance in the modern world as a tool of economic analysis. According to A.H. Hansen, “History of thought illustrates again and again how a great living principle, tossed about on the sea of controversy is likely to lose its vitality.

Too often it may be applied, as tool of analysis to highly complex problems for which it is unsuited. Misleading conclusions inevitably emerge. This is what happened to Say’s law.”