A Brief Review of the Classical Laws of Economics and Why They Still Matter

Recently, I suggested that the members of the Biden Administration needed to take a remedial course in basic economics. Fundamental to the understanding of that subject are the four classical laws of economics, which are (mostly) not at all hard to understand. Yet, the Biden administration is struggling greatly to comprehend their implications.

As a public service for the Biden Administration and for progressives in general, these laws are briefly summarized below. In addition, we need to look at how progressives often run afoul of these laws to make matters much worse. This second task will be taken up in a following post.

The Law of Supply and Demand and Adam Smith’s Invisible Hand

The American Revolution was not the only world-shaking event that occurred in 1776. In that very same year, a Scottish moral philosopher called Adam Smith published a book entitled An Inquiry into the Nature and Causes of the Wealth of Nations. It is more commonly known as The Wealth of Nations. In it, Smith argued for the superiority, both moral and efficacious, of free-market capitalism over the then reigning doctrine of mercantilism. In Book I, Chapter VII, titled Of the Natural and Market Price of Commodities, Smith explained his idea of the Law of Supply and Demand.

However, the language of that chapter is a bit turgid, especially falling on modern ears. The more usual way that a modern reader learns about Supply and Demand is graphically through Alfred Marshall’s supply and demand curves. These curves for some arbitrary good or service, say bread loaves, will look somewhat like the diagram below.

The supply curve is labeled S in the graph while the demand curve is labeled D. The vertical axis gives the number of goods (in our case the number of bread loaves) either sold (in the case of the supply curve) or bought (in the case of the demand curve). The horizontal axis gives the price at which the good is bought and sold. Of course, each buyer and each seller of the good would buy or sell slightly different amounts at a given price, due to different valuations and preferences. The curves in the graphical model above would be best fits to the scattered data.

The law of supply says that the number of goods that producers are willing to produce and sell increases with the price. The demand curve D, on the other hand, shows that the number of goods the consumers are willing to buy decreases with price. The reasons for these behaviors should be obvious. A buyer wants to buy at the smallest price possible, while the seller wants to sell at the greatest price possible. At the point where the two curves intersect, called the equilibrium market price, both buyer and seller are willing to buy or sell the same quantity of the good at a price both will accept.

At a price P_L below the market equilibrium price, more product would be demanded by consumers than supplied, and there would be a shortage of the good. At a price P_H above the market equilibrium price, the producer would supply far more of the good than the market demanded. There would then be an inefficient surplus of the good.

One of the most famous quotes from Adam Smith’s Wealth of Nations is the following.

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

The Wealth of Nations, Book I, Chapter II

Later on, he writes

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. 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 may be 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. By preferring the support of domestic to that of foreign industry, he intends only his own security; 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.

The Wealth of Nations, Book IV, Chapter II

The emphasis in this last quote is mine. As we will discover, each of the four classical economic laws forms a part of Adam Smith’s Invisible Hand. Individuals and organizations of inviduals are guided by this Invisible Hand to choices of what to produce and what not to produce, how much should be produced, and at what price.

J. B. Say’s Law of Markets

The next classical law we shall scrutinize would not be recognized at all by any self-respecting Keynesian as an economic law. Propounded by Jean-Baptiste Say in 1803 in his book A Treatise on Political Economy, Say’s Law of Markets asserts

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.

J.B. Say, A Treatise on Political Economy

A modern statement of the law of markets is this:

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

That is, an increased supply of a particular good creates demand for the goods and services needed to produce it. If, in addition, the increased supply of that good is something needed and desired in the market, then the additional demand becomes self-sustaining. The increased production of the good is supported by the market’s demand for it itself.

This observation that the stimulation of the supply-side of the economy will itself increase economic demand is considered heretical by American progressives. The Keynesian economics of John Maynard Keynes has morphed into a faith that any required economic stimulation must be provided by the state. This will be discussed later in the next post.

Menger’s Law of Marginal Utility

Carl Menger’s law of marginal utility is a fusion of two parts. The first is the idea that it is the utility or usefulness of something that gives it its value. As the utility of any particular thing varies with each individual, its value is something that has a large subjective component.

The second part of the law of marginal utility was supplied by the founders of the marginal utility revolution in 1870: Carl Menger, Leon Walras, and William Stanley Jevons. They 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 more of the good, he will not pay anything for it. This view of marginal utility presupposes the utility theory of value.

How does the law of marginal utility relate to Marshal’s supply and demand curves? 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 increase available supply at the same or lower cost.

Ricardo’s Law of Comparative Advantage

Possibly the most controversial of the classical economic laws is Ricardo’s Law of Comparative Advantage. It is also the hardest to understand. It is the most important justification for international trade. The discoverer of the law, David Ricardo, published his thoughts on economics, including what is now called the law of comparative advantage, in 1817.

Ricardo was a highly successful British stockbroker and market speculator before he became a political economist. As a beneficiary of free markets, he was greatly influenced by Adam Smith’s Wealth of Nations. The Wealth of Nations was written primarily as an attack on mercantilism, which was the reigning economic philosophy in Europe from the 16th to the late 18th century. Mercantilism held that the wealth of a nation was increased by accumulating monetary reserves (particularly in the form of gold). They advocated establishing a positive balance of trade, where they sold more goods to other nations than those nations sold to them, thereby bringing in the desired monetary reserves. As a part of this policy, mercantilists advocated high tariffs on imported goods to discourage the loss of money from buying other nations’ goods. Other mercantilist policies to discourage imports and encourage exports included banning the export of gold and silver,  requiring the use of their own nation’s ships to export goods, subsidizing exports, and forbidding their colonies from trading with other nations.

In contradistinction, Adam Smith thought the source of the wealth of a nation consisted primarily in its capacity to produce economic goods. The economic goods themselves were wealth. Money was only a claim check for a portion of that wealth. Therefore, if a nation aspired to be wealthy, it should encourage the increase of the country’s capacity to produce goods. But the supply of goods must be balanced by their consumption, i.e. their economic demand, for the supply of wealth to be stable. If imports are discouraged or banned, foreign nations will not have the means to buy the country’s exports. Fundamentally, the real driver of wealth production in foreign trade is the exchange of one country’s goods for the goods of another nation. If a mercantilist encouraged exports and discouraged imports, then ironically he would actually be making his country poorer! He would be sending wealth out of the country without allowing a matching import of wealth.

When Ricardo read The Wealth of Nations, he was most especially impressed with Smith’s criticisms of mercantilist barriers against free trade between nations. His law of comparative advantage was a statement about what goods should be traded.

The concept of comparative advantage in producing and trading a good is a subtle one. It is made difficult by differences in valuations in two different countries with different currencies and different preferences. (Remember from the law of marginal utility that valuations are at least partially subjective!)

However, we must first distinguish between absolute advantage and comparative advantage. If country A can produce a good at less cost than another country B (compared using monetary exchange rates), then country A has an absolute advantage in producing the good. Then it makes sense for A to export the good to B, assuming B does not have a comparative advantage.

To determine if one country or the other has a comparative advantage, equilibrium market prices for the good must exist in each country. Suppose you take the ratio of country A’s cost of producing a good to the value (i.e. its price) in country B’s market. This gives country A’s cost of production in terms of how much country B values the good. Call this ratio the country’s cost per B exchange value for the good. Country B can similarly calculate its cost per A exchange value for the same good. If country B has a smaller cost per A exchange value than country A’s cost per B exchange value, then country B has a comparative advantage over the country A in producing the good.

Ricardo’s law of comparative advantage can now be formulated as follows:

If one country has a comparative advantage over another country with some good, then even if that other country has an absolute advantage, it is advantageous to both countries for the country with the comparative advantage to export the good to the other country.

What happens is this: The country with the comparative advantage (country B) can sell more of the good to the other country (country A) than it could have sold in its own domestic markets without losing other opportunities. This is because country A values the good more than country B compared to its cost in B, and country B can produce it at less cost compared to its value in A. That is what the cost per value ratio tells us.

The utility of the law of comparative advantage is in determining an international division of labor. It helps determine which country produces what in a way that maximizes wealth production among the involved nations. Just as a division of labor in a domestic market maximizes that country’s potential for producing wealth, doing the same internationally does the same for the world. In fact, comparative advantage does more than that by allowing a country to do what it does best — allowing the other country to do what it does best — to maximize the total production of the world. This is explained in an entertaining fashion in the video below.

The sections above show the four major mechanisms by which free-market capitalist economies are governed. Under their free operation uninterrupted by government interventions, the four classical laws can insure the highest possible economic growth, the largest possible percapita GDP, and the most equal distribution of the GDP. Those formidable claims are justified by large amounts of empirical data, as demonstrated in the post How Much Human Freedom Can We Find in the World?

In my next post, we will see how progressive Democrats do not understand almost all of this. They are then driven by economic illiteracy to make the human condition much, much worse.

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