A Puzzle about Say’s Law

This is 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).

Does 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” – mean the total factor payments received before the sale of a given volume (or value) of output?

Or are “total factor payments” assumed to include the profit that flows to owners of capital after sales, so that “total factor payments” consists of the following:

(1) all factor payments to labour (wages);

(2) all factor payments to sellers of durable and non-durable, non-labour factor inputs;

(3) all factor payments to owners of goods rented (e.g., land or property rent).

(4) all profits from ownership of real capital.*

* another issue is: are money loans and interest on money loans a further cost of production?

In other words, the question is: how did the Classical economists define profit and is it included in Say’s law?

If proposition (1) means total factor payments received before the sale of a given volume (or value) of output, then, with many prices set above costs of production to allow profit, it cannot be true that total factor payments are necessary to purchase that total volume of output – unless the aggregate value of losses on goods sold (where prices are below costs of production) equals the aggregate value of profits.

If that is so (as some interpret Say’s law), this is just a grossly unrealistic general equilibrium theory, where the economy is assumed to have a tendency to rapid adjustment:

“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, in modern economies, most prices are set as a mark-up on total unit costs and are generally not adjusted to clear markets: that is, mark-up prices do not fluctuate around costs of production, but will generally be set above total unit costs. The price adjustment required in Say’s law does not normally happen.

The issue is also interesting because, in Classical economics, the “equilibrium price” (or natural price) is assumed to be the cost of production price (however this is defined), towards which all prices gravitate.

But, if a real world price is really a cost of production price, then the normal “equilibrium prices” of Say’s law would mean owners of capital get no profits.

In short, are total factor payments received for producing a given volume of output defined as (1) ex ante (before actual sales) alone or (2) ex ante and ex post payments (before and after the actual sales of those products)?

In either case, we have the following observations:

(1) if total factor payments are ex ante and ex post payments (before and after the actual sales), then Say’s law includes profits as a factor payment, and requires either (i) total equilibrium in product markets or (ii) a grossly unrealistic tendency to general equilibrium in the real world where aggregate value of losses on products sold equals the aggregate value of profits, or

(2) if total factor payments are ex ante payments (before sales) alone, then there is no reason why total factor payments should be necessary to purchase the aggregate volume of output if most industries earn profits by charging prices above costs of production, unless, once again, one assumes a grossly unrealistic tendency to general equilibrium in the real world where aggregate value of losses equals the aggregate value of profits.

Of course, this is before we get to the obvious points

(1) that people save money income,

(2) that there are different marginal propensities to consume,

(3) that we have an endogenous money system that generates new credit money and new spending in addition to total factor payments received, and

(4) that people spent money income on (i) second hand, real assets and (ii) financial assets on secondary markets, as well as newly produced commodities,

so there is no logically necessary nor empirical reason to think Say’s law would ever hold in the real world.

Further Reading
“The Myth of Say’s Law,” October 7, 2010.

“Say’s Law Presupposes Aggregate Demand as a Meaningful Concept,” May 28, 2011.

“Say Repudiated Say’s Law,” December 1, 2011.

“Jean Baptiste Say on Failures of Aggregate Demand,” December 1, 2011.

“Say’s Law: An Overview and Bibliography,” April 13, 2013.

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

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