Say’s Law of Market

■ An early 19th century French Economist, J.B. Say, enunciated the

proposition that “supply creates its own demand.” Therefore, there
cannot be general overproduction and the problem of unemployment
in the economy. On the other hand, if there is general overproduction
in the economy, then some labourers may be asked to leave their
jobs. There may be the problem of unemployment in the economy for
sometime
■ It is production which creates markets for goods. 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. Nothing is more
favourable to the demand of one product, than the supply of
another.”This definition explains the following important facts about
the law.
■ Production Creates Market (Demand) for Goods:When producers obtain the
various inputs to be used in the production process, they generate the necessay
income. For example, producers give wages to labourers for producing goods.
The labourers will purchase the goods from the market for their own use. This, in
turn, causes the demand for goods produced.
■ Barter System as its Basis: In its original form, the law is applicable to a barter
economy where goods are ultimately sold for goods. Therefore, whatever is
produced is ultimately consumed in the economy
■ General Overproduction Impossible: If the production process is continued under
normal conditions, then there will be no difficulty for the producers to sell their
products in the market. According to Say, work being unpleasant, no person will
work to make a product unless he wants to exchange it for some other product
which he desires.
■ Saving-Investment Equality:Income accruing to the factor owners in
the form of rent, wages and interest is not spent on consumption but
some proportion out of it is saved which is automatically invested for
further production
■ Rate of Interest as a Determinant Factor : Say’s law of markets
regards the rate of interest as a determinant factor in maintaining the
equality between saving and investment. If there is any divergence
between the two, the equality is maintained through the mechanism
of the rate of interest. If at any given time investment exceeds saving,
the rate of interest will rise.
Loanable Funds theory of Rate of
Interest
■ According to this theory, rate of interest is determined by the demand
for and supply of loanable funds. In this regard this theory is more
realistic and broader than the classical theory of interest.
■ Loanable funds theory differs from the classical theory in the
explanation of demand for loanable funds.
■ According to this theory demand for loanable funds arises for the
following three purposes viz.; Investment, hoarding and dissaving
■ Investment (I): The main source of demand for loanable funds is the
demand for investment. Investment refers to the expenditure for the
purchase of making of new capital goods including inventories. The
price of obtaining such funds for the purpose of these investments
depends on the rate of interest
■ Hoarding (H): The demand for loanable funds is also made up by
those people who want to hoard it as idle cash balances to satisfy
their desire for liquidity. The demand for loanable funds for hoarding
purpose is a decreasing function of the rate of interest
■ Dissaving (DS): Dissaving’s is opposite to an act of savings. This
demand comes from the people at that time when they want to spend
beyond their current income. Like hoarding it is also a decreasing
function of interest rate.
Supply of Loanable Funds:

■ Savings (S): Savings constitute the most important source of the

supply of loanable funds. Savings is the difference between the
income and expenditure. Since, income is assumed to remain
unchanged, so the amount of savings varies with the rate of interest.
Individuals as well as business firms will save more at a higher rate of
interest and vice-versa.
■ Dishoarding (DH): Dishoarding is another important source of the
supply of loanable funds. Generally, individuals may dishoard money
from the past hoardings at a higher rate of interest. Thus, at a higher
interest rate, idle cash balances of the past become the active
balances at present and become available for investment. If the rate
of interest is low dishoarding would be negligible.
■ Disinvestment (DI): Disinvestment occurs when the existing stock of
capital is allowed to wear out without being replaced by new capital
equipment. Disinvestment will be high when the present interest rate
provides better returns in comparison to present earnings. Thus, high
rate of interest leads to higher disinvestment and so on.
■ Bank Money (BM): Banking system constitutes another source of the
supply of loanable funds. The banks advance loans to the
businessmen through the process of credit creation. The money
created by the banks adds to the supply of loanable funds.
Determination of Rate of
Interest:
■ According to loanable funds theory, equilibrium rate of interest is that
which brings equality between the demand for and supply of loanable
funds. In other words, equilibrium interest rate is determined at a
point where the demand for loanable funds curve intersects the
supply curve of loanable funds
■ The rate of interest is determined at the point of intersection of the
two curves—the supply of loanable funds curve (SL) and the demand
for loanable funds curve, DL. Fig. 4 shows that the equilibrium rate of
interest is EM; at this rate, the demand for loanable funds is equal to
the supply of loanable funds i.e. OM
The Classical theory of
Employment.
■ The classical economists believed in the existence of full employment
in the economy. To them, full employment was a normal situation and
any deviation from this regarded as something abnormal.
■ Unemployment results from the rigidity in the wage structure and
interference in the working of free market system in the form of trade
union legislation, minimum wage legislation etc. Full employment
exists “when everybody who at the running rate of wages wishes to
be employed.”
Wage Price Flexibility:

■ The classical economists believed that there was always full employment in the
economy. In case of unemployment, a general cut in money wages would take the
economy to the full employment level. This argument is based on the assumption
that there is a direct and proportional relation between money wages and real
wages.
■ When money wages are reduced, they lead to reduction in cost of production and
consequently to the lower prices of products. When prices fall, demand for
products will increase and sales will be pushed up. Increased sales will necessitate
the employment of more labour and ultimately full employment will be attained.
■ Pigou explains the entire proposition in the equation: N = qY/W. In this equation, N
is the number of workers employed, q is the fraction of income earned as wages, Y
is the national income and W is the money wage rate. N can be increased by a
reduction in W
Classical dichotomy

■ In macroeconomics, the classical dichotomy is the idea, attributed to

classical and pre-Keynesian economics, that real and nominal
variables can be analyzed separately. To be precise, an economy
exhibits the classical dichotomy if real variables such as output and
real interest rates can be completely analyzed without considering
what is happening to their nominal counterparts, the money value of
output and the interest rate
■ In particular, this means that real GDP and other real variables can be
determined without knowing the level of the nominal money supply or
the rate of inflation. An economy exhibits the classical dichotomy if
money is neutral, affecting only the price level, not real variables
■ In the strict sense, money is not neutral in the short-run, that is,
classical dichotomy does not hold, since agents tend to respond to
changes in prices and in the quantity of money through changing their
supply decisions. However, money should be neutral in the long run,
and the classical dichotomy should be restored in the long-run, since
there was no relationship between prices and real macroeconomic
performance at the data level
■ In the long-run, owing to the dichotomy, money is not assumed to be
an effective instrument in controlling macroeconomic performance,
while in the short-run there is a trade-off between prices and output
(or unemployment), but, owing to rational expectations, government
cannot exploit it in order to build a systematic countercyclical
economic policy
The Classical Theory of Income
And Employment
■ Determination of income and employment is important part of
macroeconomics. In Capitalist economies( free market economies )
two theories of income and employment
■ In economics terminology, full employment signifies the market
condition where the demand for labor is equivalent to the supply of
labor at prevailing wage rate . Demand for labour (DL)= Supply of
Labour (SL) Therefore, full employment is the employment level at
which every individual who desires to work at the prevalent wage rate
gets work . If DL<SL Unemployment but rare
phenomenon Wage rate will change to make DL=SL
■ Full employment is achieved But full employment does not mean zero
unemployment . Even at full employment there may exist some
unemployment Full employment mean absence of involuntary unemployment
■ Voluntary unemployment :: Voluntary unemployment when a worker decides
to leave a job because it is no longer financially fulfilling. Workers are not
willing to work at prevailing wage rate.
■ Frictional unemployment :people between the jobs occurs when workers leave
their old jobs but haven’t yet found new ones. Refers to workers who are in
between jobs Frictional unemployment also occurs when students are looking
for first job Frictional unemployment is short-term and a natural part of the job
search process.
■ Structural Unemployment: Structural unemployment exists when shifts occur in
the economy that creates a mismatch between the skills workers have and the
skills needed by employers. Every worker is different; every job has its special
characteristics and requirements. Unemployment that results from a mismatch
between worker qualifications and the characteristics employers require is
called structural unemployment. Even if the number of employees firms
demand equals the number of workers available, people whose qualifications
do not satisfy what firms are seeking will find themselves without work.
■ Cyclical Unemployment/Demand deficient unemployment:Cyclical
unemployment is caused by the contraction phase of the business cycle. That’s
when the demand for goods and services falls dramatically. Cyclical
unemployment creates more unemployment. The laid-off workers have less
money to buy the goods and services they need. That further lowers demand.
■ Seasonal Unemployment:seasonal unemployment as another type of
unemployment. As its name suggests, seasonal unemployment results
from regular changes in the season. Workers affected by seasonal
unemployment include resort workers, ski instructors, and ice cream
vendors etc
Classical Theory Of Income, Output And
Employment Is Based On The Following
Assumptions
■ Rational human being motivated by self interest
■ There is a normal situation of full employment.
■ There is a laissez faire capitalist economy without foreign trade. No
interference of Govt. Automatic adjustment
■ There is perfect competition in labour, money and product market .
E.g. In labour market labour is homogeneous. Under conditions of
perfect completion, flexibility of wages tends to establish full
employment. Reduction in wages can increase employment
Determination of income and
employment
■ In any Capitalist economies( free market economies ) Level of output
depends on level employment And level of employment(full
employment ) determined in labor market where Demand for labor
=supply of labor
■ DL = SL level of income /output = f( labour, capital ,technology )
f(N, K, T ) in short run All other factors are constant labor is the only
variable factor. So production depends on labour(employment ) level
of income = f(employment )
■ Full employment is a situation in which all those who are able to and
want to work at the existing rate of wage get work without any undue
difficulty.”
■ Firms are the buyer of labour service labour services are used
because of its productivity
■ Under Perfect Competition to maximize profit labour is used upto the
point where
■ Wage rate = labor’s productivity W =MRPL ( MRPL=MPPL X MR )
■ As more more labor is used ttheir productivity declines so more
labour will be demanded when real wage is low