Left: Jean-Baptiste Say (5 January 1787 – 15 November 1832), Wikimedia Commons 
Right: John Maynard Keynes (5 June 1883 – 21 April 1946), Wikimedia Commons / National Portrait Gallery

At the very heart of the argument between neoclassical economists and Keynesians is the dispute over which economic law best reflects reality: Say’s Law of Markets or Keynes Law. Much of the discord between dirigistes and neoliberals (aka conservatives or classical liberals) would evaporate if this argument could be settled to general satisfaction. At its core the argument is about what changes affect market supply-demand balances the most: changes in supply or demand.

How Markets Work

The most fundamental problem any economy must solve,  so basic that it is often called The Economic Problem or sometimes the basic or central economic problem, is to match the supply of economic goods (including services) with the demands of consumers. Any statement of the problem takes as given that economic goods are scarce in the sense there is not enough to supply everyone’s desires. To solve the problem requires some way for the economy to decide what to produce, how much to produce, and how to allocate what is produced to consumers. No matter what type of economy, whether capitalist or socialist, it must solve this problem.

The two most basic economic laws that deal with The Economic Problem are the law of supply and demand and the law of marginal utility. In any situation where  the economy is in equilibrium, i.e. the  quantity of goods produced is determined by the price, and the quantity bought  by the consumer is also determined by the price, the economy’s solution to The Economic Problem is uniquely determined by the law of supply and demand, graphically displayed below.

For any particular good, consumers will buy a quantity of the good that depends on its price. As the price increases, the amount of the good consumers will buy will decrease. The green demand curve labeled D in the plot gives that quantity as a function of price. On the other hand, as price increases a supplier will naturally be willing to produce more of the good in order to earn a larger profit. This fact is represented by the supply curve S. In a free-market unencumbered by government controls, market forces will quickly push the good’s price to the equilibrium market price where the two curves intersect. The supplier will set the price as high as he can, but if he sets it too high at some price P_H above the equilibrium market price, the quantity consumers are willing to buy will be less than the amount produced. The difference between the quantity produced and the quantity bought is the surplus shown in the model graph. To set the price too high causes the producer to suffer losses; in the short-term he has unproductively used capital to produce the excess product that he could otherwise have used productively for something else. Also, he would then have to spend extra to warehouse the excess, hopefully to be sold in the future. In reaction, the producer will reduce the amount and price of what he produces until the surplus is sold. The effect is to push the quantity and price of the good back to the market equilibrium point.

If by chance the supplier were to produce too little of the good at a price P_L below the market equilibrium price, the quantity desired by consumers at that price will be greater that what was actually produced. The good will be quickly sold out, with the difference between consumers’ desires and what the producer makes being the shortage represented in the plot above. The producer will then discover he did not make the profit he could have, so he increases the quantity he supplies as well as the price at which he sells it. The effect again is to push the quantity and price toward the market equilibrium point.

There are actually two different kinds of equilibrium at play here. One is the market equilibrium at which the supply and demand curves intersect. The second is an equilibrium of the economy where the supply and demand curves do not change with time. If the economy is not in equilibrium with one or both of the curves changing, the shift of the curves is determined by the law of marginal utility. In an environment where either the supply or demand curve shifts, the market price is determined by the price of the last good sold. In 1870 Carl Menger, Leon Walras, and William Stanley Jevons independently noted that as the supply of a good  increases, the price of the last good sold (also known as the marginal utility) decreases. This is because the supply of a good becomes increasingly less useful as the consumer’s need is fulfilled. Once a consumer has no more need for the good, he will not pay anything for it.

Suppose that the demand curve is initially given by D₁ as shown in the figure below. We then suppose that for some reason that the supply of the good increases to an extent that the market is partially saturated with the good.

Then the consumers would buy a smaller number of the good at the same price as before the change. This means the demand curve would be shifted to the left to some new demand curve D₂ as shown in the figure. If for some reason the supply curve does not change, i.e. the suppliers have some inertia in changing their behavior, the new equilibrium price point where the two curves intersect will be at a point where both the price and the quantity sold will be smaller. After a while, however, the producers may decide they can maximize their profits at a lower price by producing the same number of goods as they were capable of before. If that happens the supply curve will also shift to the left until the intersection with D₂ is at a new equilibrium point where the quantity bought and sold is the original quantity with the equilibrium market price decreasing even further. This kind of behavior is often observed in markets when new technology and/or sources of supply are discovered that increases available supply at the same or lower cost.

The law of marginal utility can also act in reverse to cause prices to increase with so-called “supply shocks”, such as the oil crises of the 1970s when OPEC restricted oil output. With supplies of a good decreasing, the price at which a supplier

would sell a given quantity of the good would increase to reflect the increasing scarcity and cost to the supplier of the good. This would cause the the supply curve to shift to the right. If the demand does not react, the new market equilibrium point would be at a lower quantity with a higher price. However, if the need for a given quantity of good is inelastic, consumers could also force the demand curve to the right to obtain a market equilibrium at the same quantity at an even higher price.

The combination of the law of supply and demand working in tandem with the law of marginal utility in a free-market is often referred to as Adam Smith’s Invisible Hand. In his original statement of this metaphor in his classic 1776 book An Inquiry Into The Nature and Causes of the Wealth of Nations, Adam Smith wrote about producers seeking the greatest profits possible.

As every individual, therefore, endeavours as much as he can, both to employ his capital in the support of domestic industry, and so to direct that industry that its produce maybe of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. … and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.  Wealth of Nations, Book IV, Chapter II

The emphasis in this quote is mine.

Are Market Balances More Sensitive to Demand Than To Supply?

With this background we are finally ready to look at the very heart of the fundamental disagreement between the Keynesians and neoclassical economists. Say’s law of markets was propounded by Jean-Baptiste Say in 1803 in his book A Treatise on Political Economy. His original statement of it was as follows:

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.  A Treatise on Political Economy, Book I, Chapter XV

Another way of stating it that eliminates a possible misunderstanding is the following:

The production of an economic good or service increases aggregate demand by exactly the amount spent to buy raw materials, intermediate products, and labor used to produce the product.

When the producer employs workers and buys materials, he puts demands on the economy. The money exchanged for these things passes to the suppliers, who can then use it to make their own demands on the economy. One must be very careful about how Say’s law is formulated, because it can easily be put (and often is) in a form that is obviously not true. Keynesians are most guilty of this, as was Keynes himself. In Chapter 2, Section VI of The General Theory of Employment, Interest and Money, Keynes writes

From the time of Say and Ricardo the classical economists have taught that supply creates its own demand.

The emphasis here is mine. This formulation is obviously false since the mere fact that a businessman creates a good does not ensure that anyone will want to buy it. Instead, what Say says in his Treatise is production (i.e. supply) must necessarily precede demand, because no one can demand any economic good without first producing something of at least equal economic value. The fruits of your labor are represented by the money you receive as a wage or salary, so that when you pay for a good with your money, you are essentially trading a part of what you have produced for what the supplier of the good you are buying has produced. In the words of the economist and economic historian Mark Skousen,

To buy, one must first sell. In other words, production is the cause of consumption, and increased output leads to higher consumer spending.

Any businessman (at least among those who are successful and survive in business) will look at an opportunity to invest in a good’s production very carefully before proceeding. Therefore, at least some businessmen will produce something that others will buy. The production of those particular goods will satisfy even Keynes’ bastardized version of Say’s Law. However, what about the business failures that do not produce something others will buy? Do they create demand? Indeed, they do, but the demand they create is not sustainable. In producing the goods not salable in quantities allowing economic survival, producers pay their workers wages and pay for any raw materials and intermediate goods needed for production. Their workers and suppliers receive a short-term flow of capital from the unsuccessful producer until that producer goes out of business. These workers and suppliers then have added means to make their own economic demands on the economy. Should the producer be successful in marketing his good, then the created demand is long-term and sustainable. In those particular cases, supply does indeed create its own demand.

From Keynes’ misunderstanding of Say’s Law came his believe that Say’s view of the economy could not explain the business cycle. If every supply of a good created its own demand, then everything produced would be sold and there would never be a recession, let alone a depression. Moreover, Say’s law of markets can be cast in the form that overall, aggregate demand is derived from production and supply. Note this formulation does not imply that production of every good produces its own supply. However, Keynes reasoned, if this formulation is false, then what is the true relationship between supply and demand? We know they (price times quantity) must equal each other at market equilibrium from the law of supply and demand. Which is the chicken and which the egg? Keynes then assumed the inverse of Say’s law, which can be characterized as Keynes’ law: aggregate supply is derived from economic demand.

The neoclassical retort to Keynes’ law is: Oh, really? How can you consume something before it is produced? Without production and supply, economic demand is meaningless because there is nothing that can be demanded! Since production must precede consumption, it follows the most fruitful path for government during hard economic times is to do everything in its power to encourage businesses’ supply of goods, not to encourage aggregate demand. If supply of goods is encouraged and produced, aggregate demand will arise automatically through the flow of money to the workers and suppliers. How can government stimulate production in every part of the economy equally? Cuts in taxes and pruning of economic regulations come immediately to mind.

This kind of approach to handling recessions/depressions makes sense in another way. Keynesian stimulus programs through fiscal policy generally take the form of government making large purchases of goods or services in the hope of stimulating aggregate demand by the flow of money from government to individuals and businesses. What this means is that government takes on the task of allocating a large part of the country’s economic resources during the hard times. Yet, as discussed in How Is the Weather Like a Country’s Economy?, any economy is a chaotic system. This means the economy remains stable and healthy only through the establishment of local microeconomic supply-demand balances between pairs of suppliers and consumers. Either the suppliers or the consumers can be individuals or groups of people such as companies. The government can not hope to set up the hundreds of millions or billions of supply-demand balances of a healthy economy through a much smaller number of very large purchases. Inevitably, through sheer lack of knowledge of everything the economy wants or needs, the government will move capital away from where it is actually needed to where it is not. Do this a little and the economy stagnates. Do it somewhat more and the economy is thrown deeper into recession. Do it a lot more and the economy will dive into the abyss of depression. Government would achieve much better results by stimulating the entire economy equally through cuts in taxes, especially on businesses, and substantial pruning of economic regulations.

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