Says Law of Market

Ratna Rajya Laxmi Campus (T.U)

By Bashu Dev Dhungel

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 Developed by French economist J.B. Say (1767-1832).
 It summarized as “Supply creates its own demand”
 This principle is easily seen to be true in a barter economy,
although its application was not supported to be limited to that
circumstances.
 Say’s expressed that “ people work not for its own sake (Indeed,
work is unpleasant), but only to obtain goods and services that
yields satisfactions.
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 In an economy that practices division for labour and exchange,
one obtains most of these goods and services not directly by his
own efforts; rather he produces goods in which his efficiency is
relatively the greatest and exchange the surplus above his own
use for the products of others.
 The very acts of production therefore constitutes the demand for
other goods: a demand equivalent to the value of the surplus
goods each man produces.
 Thus , there is no problem of overproduction.
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 Each man production (supply) constitutes his demand
for other goods, and hence the aggregate demand
must in some sense equal the aggregate supply.
 The total output may be limited by the fact that, at
some point, for each individual, the satisfaction of a
little more leisure will outweigh the sacrifice of a
little more goods that might have been obtained,
but such unemployment will be voluntary, not
involuntary.
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 Say’s law implies is that any increment of output will
generate an equivalent increase in income and in
spending.
 Thus, income and product can always be at a “full
employment” level. If they should be at lower level,
with some resources unwillingly idle, additional
production will generate an equivalent amount of
additional income, which will all be expended in the
purchases of the additional product.
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 No one will be content at less than full employment,
additional production will take place until the full
employment level is reached.
 Hence, general overproduction and general
unemployment are logical impossibilities.

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 Assumption of Say’s Law of Market

 Free-enterprise economy.
 Perfect competition exists in the commodity as well as factor
market.
 Optimum allocation of resources.
 Size of market has no limits.
 Savings are automatically converted into investment etc.
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 Applicability of Say’s Law of Market
• Say’s Law is application on both

• Barter economy: where goods are traded among goods.

• Money economy: As money acts as medium of exchange,

goods are exchanged with money.

• Two conditions need to be fulfilled in money economy for

the applicability of Say’s Law of Market:

• Aggregate Cost = Aggregate Income

Aggregate Income= Aggregate Expenditure

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Implication of Say’s Law of Market
• Free enterprise economy automatically attains
equilibrium at full employment in long run.

• There is no possibility of general unemployment and

general overproduction.

• Since supply always creates its own demand, there is no

need for government intervention.

• It validates Quantity Theory of Money.

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• In other words, changes in the supply of money
has no effect on the real economy’s process of
equilibrium at full employment.(money only acts
as medium of exchange).

• Flexibility in interest rate creates equality

between savings and investment.

• Wage flexibility creates full employment in the

labor market.
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 Quantity Theory of Money
 Quantity theory of money states that there is direct and proportionate relationship
between general price level and total money supply.
 It is expressed as MV + M’V’ = PT, where
 M= Quantity of Money Supply,
 V= Velocity of Money ( number of times unit of money changes hands in buying
goods and it is assumed to be constant)
 P= General Price Level
 T= Volume of transactions
 MV= money supply and
 PT= money spending
 The increase and decrease in money supply will produce a proportionate rise and fall
in the general price level.
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 Different forms of Quantity Theory of Money
• MV = PtT , where Pt = The average price level of all transactions
• It can be expressed as
• M = lPY
• where, M = Quantity of money in circulation
• V= Velocity of money
• P = Average price level of final output
• Y = Physical volume of final output
• l = transactions demand expressed as a fraction of money income
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Wages, prices, Employment, and Production
• Developed by the combined contribution of
classical economists such as Adam Smith, J.S.
Mill, A.C. Pigou, J.B. Say, David Ricardo etc.
• This theory is based on the assumption of full
employment.
• Full employment indicates the situation where
involuntary unemployment will be zero.
• If there is not the situation of full employment,
there is always a tendency towards full
employment.
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• The situation of unemployment is short-run
phenomenon and disappears in long run through
the automatic adjustment mechanism of the
economy.

• Full employment does not mean achieving zero

unemployment, it stands for 94 to 95%
employment rather than 100% employment.

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Assumption of Classical Theory of Employment

1. Perfect competition prevails in all industries

2. That each industries is vertically integrated: it hires only

labour and products final output, no intermediate goods

3. Given stock of capital goods and natural resources.

4. Maximization of profits

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• Actually, classical price theory, implies that the volume
of employment and output is determined in the first
instance not by the level but by the internal structure of
prices.

• The producer’s output and employment decisions

depends on a relationship between his costs and prices
buyers will pay for his output.

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• Purely competitive industry, maximize the profit
at which price equals to marginal cost.

I.e. P = MC …….(1)

Each seller’s output will be carried to the point

where his (rising) marginal cost equals to the given
price.

• Here labour is only variable inputs.

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• Marginal cost-the addition to total cost for an additional
unit of output-is equal to the wage rate divided by
marginal physical product of labour.

• I.e. MC = …….(2)

• Similarly output carried to the point where P = MC,

under this assumption , input carried to the point where
the wage equals to value of marginal product of labour.

• Then W = P*MPL …….(3)

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• Where P is the price per unit of output, W the wage per
unit of input, MC marginal cost of output, and MPL the
physical marginal product per unit of labour.

• The product P* MPL is the value of the marginal

product.

• We can rearrange the equation (3)

• MPL = ……..(4)

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• Equation (4) states that output is carried to the point where
the marginal products equals the real wages, i.e. money
wages deflated by the price level of output.

• These formulation indicates, it is the relationship of wages

to price that determines hiring and output, not the absolute
level of either one.

• Thus, both prices and wages should rise or fall in the same
proportion, there would be no incentive for the firm to hire
few or more workers or to produce a different output.
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• Since, total output is the some of output in all firms, i.e. same
rule applied in aggregate sense whatever applied in individual
firm.

• Short Run Production Function

• For the determination of equilibrium level of output and

employment we need to consider short run production function
that is characterized by diminishing returns.

• There is operation of law of diminishing returns.

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• Total output is a decreasing function of number of workers
employed.

• After full employment level, output level remains

constant.

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Real Wage rate
SL

W/P2 A B
E
W/p1

N Level of Employment
Output

Y= f(N)

O N l
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Labor Market Equilibrium
• Labor market is said to be in equilibrium when demand
for labor is just equal to the supply of labor.

• Flexibility in wage rate creates equilibrium between

demand and supply of labor in full employment.

• Demand for labor is a negative function of real wage

and supply of labor is positive function of real wage.

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• Unemployment in the economy can be solved by decreasing
wage rate.

• Unemployment is the result of rigidity of wage structure and

interference in the automatic working of the labor market.
• Product Market Equilibrium
• Product market is said to be in equilibrium when
there is equality between savings and investment.
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• It is attained through flexibility in interest rate.

• Saving is positive function of rate of interest and

Investment is negative function of rate of interest.

• Equilibrium level of interest is determined at the point

where saving is equal to investment.

• If S>I, interest rate falls which discourage saving and

encourage investment such that S =I.

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 General Functional Representation of Classical Model
1. Y = f(N),

2. = and = Real wage rate = MPL

3. N= f(), and f’ >0

4. M= lPY , where Y= Output, N= Employment,

W= Money wage rate, P = Price level,

M= Quantity of Money in circulation and l= fraction of

money income that needs to be held in cash balances to
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satisfy the transactions demand for money

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• Equation 1 represents aggregate production function of
the economy.

• As employment increases output increase but at

diminishing rate.

• Equation 2 expresses profit maximization condition i.e.

the real wage equals the marginal product of labor.

• Equation 3 represents the supply of labor

• Equation 4 represents the quantity theory of money

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Graphical Presentation of Classical Model

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• Figure A represents short run production function
characterized by diminishing returns .

• For each level of input (labor), there is corresponding output.

• Figure B shows the labor market equilibrium i.e. intersection

of demand curve for labor and supply curve for labor.

• The demand curve or the marginal product of labor is the

slope of production function on fig A

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• Note: Any change in slope of the production function curve
will alter the marginal product curve.

• The intersection between two curves in figure B determines

the point of full employment N 0 and the equilibrium real

wage=( W/P) 0 .

• If the real wage were somehow maintained higher than that

which corresponds to the intersection of the two curves,
there would be excess supply of labor over demand for labor.
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• If the real wage rate were lower than corresponds to the
intersection , the condition would be shortage of labor.
• The former condition results in a rapid decline in the
money wage and the latter condition results in rapid rise
in the money wage.
• Stability of the money wage is obvious condition of
equilibrium .
• Therefore, equilibrium requires a real wage of (W/P) 0

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• Fig C shows that how equilibrium price level is
attained .
• The diagonal line lPY ( slope= 1/l) shows the amount of
money required for each level of money income
• If the actual stock of money income is shown by the
vertical line marked by M 0 then money income can not
exceed (PY) 0 .
• Corresponding to equilibrium output Y0, we determine
equilibrium price P0.

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• Part D determines equilibrium nominal wage.

• Equilibrium real wage (W/P) as obtained from part A is

shown by a diagonal line.

• Any real wage is the ratio of price to money wage ,

therefore, corresponding to each real wage are
numerous possible combination of P and W, all of which
fall on a straight line through the origin whose slope
measures the real wage.
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• Given the equilibrium real wage and
equilibrium price , there is only one money
wage consistent with both of these.
• Therefore equilibrium money wage =W0

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Effect of Increase in MS in Classical Model

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• An increase in the quantity of money permits an increase
in the product of P and Y as shown in figure C.

• The previous output Y0 could now sell at a higher price P1.

• If the money wage did not rise, this would induce

employers to try to increase output, bidding against each
other for workers .

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• Since no more workers are to be hired, the money
wage must rise far enough to eliminate the excess
demand ( The gap between demand and supply at
the new price and the old wage is shown in figure
B)

• There will be excess demand until the real wage

is restored by a proportionate rise in money wage

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• The result of increase in quantity of money
is to raise money wage and price in equal
proportion leaving output, real wage and
employment unaffected.

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Assignment

 What would be the effect on output, real wage

and employment with the decrease in quantity of
money in classical model?
 Explain the dichotomy between real sector and
monetary sector in classical model.
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Effect of Technological Progress in Classical Model

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• The change is production function leads to change in
marginal product of labor.

• The new production function Y’ gives an new marginal

product curve MPL’.

• The equilibrium real wage is increased from (W/P) 0 to

(W/P) 1 .

• The equilibrium volume of employment increases from

N0to N1.
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• Output is enlarged to Y1 both because of higher
production function and larger employment.

• If M and l are unchanged, the larger output can be sold

at a lower price P1 .

• Compute what would be the new nominal wage and new

real wage. Will it increases or decreases?

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• With the drop in price, money wage also decreases.

• Depending upon the slope of various functions, the new

money wage might be lower than the change in price
level ( the fall in price level is more than fall in money
wage)

• Consequently, Real wage increases, output increases,

price level declines, nominal wage falls.
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 Assignment

 What would be the effect on real wage,

employment and output level with the increase in
supply of labor?

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Effect of Wage Rigidity in Classical Model

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• Initially , equilibrium money wage W0, consistent with full
employment

• Money wage = W0.

• Let us assume there is a break down of wage flexibility

assumption

• i.e. wage is artificially fixed at W1 (higher than W0), what

would be the effect on Price, Employment, Output and Real
Wage (W/P)?
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• In the first place, price must rise, at least somewhat.

• For if prices did not rise, the real wage would be higher than
before and employers would produce less and smaller output
with no increase in price would be inconsistent with a
constant M and l. Hence, prices must rise.

• Second, we can see that prices could not possibly rise as did
wages.

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• For if price rose in the same proportion the real wage
would be unchanged , employers would want to produce
as much as before, but for them to sell the same quantity
at higher price is also inconsistent with a constant M and
l.

• The new PY must be the same as before, therefore, price

must rise and output must fall.

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 Classical Model with Saving and Investment
• Saving is positive function of rate of interest

• Investment is negative function of rate of interest.

• Equilibrium level of interest is determined at the point where

saving is equal to investment.

• If S>I, interest rate falls which discourage saving and

encourage investment such that S =I.

• Product/Goods market is said to be in equilibrium when there

is equality between savings and investment.
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• It is attained through flexibility in interest rate. a
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 S
Interest rate
R E
I
S,I
O S=I

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 Conclusion

 Only the real variables have impact on output and

employment determination.

 Increase or decrease in money supply do not affect the

real sectors of the economy. It only affects nominal
wage and price level.

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Thank You

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