Tuesday, December 11, 2012

A Note on Prices and Say’s Law

In neoclassical theory, the equilibrium price is the price in a particular commodity market that equates the demand for that commodity with the supply, so that the market is cleared. It can be understood as a market-clearing price.

By contrast, in Classical economics, the equilibrium price (or natural price) is derived from costs of production (wages, other factor inputs, rent, and profits). That is, factor inputs are capital goods (where the return is profit), labour (the return is wages), land (rent) or raw materials (cost of purchase).

Now let us turn to how later Classical economists defined or formulated Say’s law, according to Thomas Sowell (1994: 39–41):
(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).
I have pointed out before that many modern studies have concluded that it was the Classical economists Adam Smith and James Mill who had a major role in developing Say’s law, in terms of the propositions listed above, not necessarily Jean-Baptiste Say himself.

Indeed Thweatt (1979: 92–93) and Baumol (2003: 46) conclude that Adam Smith was in fact the father of Say’s law in Classical economics, and that James Mill was the first to express it properly in 1808.

What is the significance of this?

It is as follows: propositions (1) and (4) above seem to me to show the influence of the Classical price theory: the notion that the equilibrium price (or natural price) is derived from costs of production, and indeed that prices are normally or generally equal to the costs of production.

For how else it is possible to argue, as in proposition (1), that the “total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output”? If this is supposed to mean the total factor payments received before the sale of a given volume (or value) of output, there is a problem.

That Say’s law does think in terms of Classical equilibrium price is confirmed by the way that sectoral imbalances are allowed and explained by the theory:
“There could be, Say argued, a temporary glut of some commodities, but this would result from the fact that market equilibrium had not been attained. Some prices would be too low and others too high, relative to their respective long-run equilibrium prices or costs of production. In this case, there would be a glut of those commodities whose prices were too high and simultaneously a shortage of those commodities whose prices were too low. The gluts and shortages would exactly cancel out in the aggregate.” (Hunt and Lautzenheiser 2011: 137).
But already before we get to other critiques of Say’s law, it is vulnerable to the observation that this is not how prices are formed in the real world: in many markets for newly produced goods and services, especially in industrial markets, prices are administered or set by corporations and businesses, according to normal production costs plus a profit markup. Because of the profit markup, there is some degree of stability of profits that results from price administration (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012).

But once the profit markup is factored into real world prices, the Classical price theory falls apart: prices in the real world are seldom the Classical equilibrium prices derived from costs of production, but the prices for many commodities exceed the costs of production. In the aggregate, the sale price of the aggregate supply of commodities will be well above the costs of production, and so the idea that the “total factor payments received for producing a given volume ... of output are necessarily sufficient to purchase that volume ... of output” before actual purchase is false. It is also false to say that in “real terms, supply equals demand ex ante [= before the event],” if by this one means that aggregate costs of production including wages or purchases of factor inputs will equal the aggregate cost of the output when purchased. The latter – the aggregate cost of the output when purchased – will exceed the total factor payments before sale.

Of course, if one wants to define Say’s law as the idea that the income from aggregate sales plus factor payments is sufficient to purchase that output in a given period, perhaps one can evade this criticism, but the point is there seems to be ambiguity about how Say’s law is defined.

Are total factor payments received for producing a given volume of output defined as ex ante or ex post payments, i.e., before or after the actual sales of those products?


BIBLIOGRAPHY

Baumol, W. J. 2003. “Retrospectives: Say’s Law,” in S. Kates (ed.), Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Edward Elgar Pub, Cheltenham; Northampton, Mass. 39–49.

Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.

Hunt E. K. and Mark Lautzenheiser. 2011. History of Economic Thought: A Critical Perspective (3rd edn.). M.E. Sharpe, Armonk, N.Y.

Melmiès, J. 2012. “Price Rigidity,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.

Mill, James. 1808. Commerce Defended. An Answer to the Arguments by which Mr. Spence, Mr. Cobbett, and Others, have Attempted to Prove that Commerce is not a Source of National Wealth. C. and R. Baldwin, London.

Sowell, T. 1994. Classical Economics Reconsidered. Princeton University Press, Princeton, N.J.

Thweatt, W. O. 1979. “Early Formulators of Say’s Law,” Quarterly Review of Economics and Business 19: 79–96.

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