How supply can create its own demand

By S.C.

This week “The Economist explains” is given over to economics. Today’s is the third in a series of six explainers on seminal ideas.

IN THE depths of the Great Depression, more than a quarter of America’s workers could not find employment. There was not enough demand for the goods and services they could supply. Today America’s workforce can produce more than 17 times as much, but unemployment is under 5%. Somehow demand, so inadequate in the 1930s, is sufficient to match a massively increased supply of goods and services eight decades later. This happy outcome would have surprised some economists of the 1930s, who worried about a “secular” (ie, persistent) stagnation of demand. But it would have been no surprise at all to an older generation of economists, led by Jean-Baptiste Say. His best-known work, “A Treatise on Political Economy”, ran to six editions between 1803 and 1841. It contained much of what became known as Say’s law, the notion that supply creates its own demand.

Say and his intellectual allies pointed out that people would not go to all the trouble of producing a good or service, unless they intended to obtain something of equal value in return. So each addition to supply is accompanied by an intended addition to demand. Moreover, the act of production creates an additional item of value for which other things can be exchanged. In this way, production creates a fresh “outlet” for existing products (and 17 times as much production creates 17 times as many outlets). In the course of making new goods, an entrepreneur will pay wages to his workers, rent to his landlord, interest to his creditors, invoices to his suppliers and any residual profits to himself. These payments will at least equal the amount the entrepreneur can get for selling his product. The payments will therefore add as much to spendable income as the recipients’ joint enterprise has added to supply.

Proponents of Say’s law acknowledged that entrepreneurs might miscalculate, producing more than enough of some goods. But an economy could not produce more than enough of goods in general. If capital, labour and other productive capacity has been devoted to oversupplying one kind of product, these resources must have been denied to other, more lucrative endeavours. Therefore if one item suffers from excess supply, it is likely that another will suffer from excess demand. The obvious solution is to change the mix of production, rather than to reduce its level.

There were at least two flaws to Say’s view of the economy. If an entrepreneur cannot sell as many goods as intended, he (and eventually everyone he employs or patronises) will not have the wherewithal to buy as much either. Although they may intend to demand more (and would do so, if their energies were better employed) they may have no way to put that demand into effect. Second, people may hoard the money they earn from supplying goods and services, holding it as an asset, rather than spending it on other things. An excess demand for money can therefore coexist with an excess supply of everything else. That, indeed, is one explanation for the Great Depression. Nonetheless, over the long run Say’s law is largely true. And by increasing the supply of money to meet any excess demand for it, modern central banks can try to make it true in the short run too.

Read the full brief on Say’s law

Previously in this series
Monday: Why do firms exist?
Tuesday: How people became the central focus of economics