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Monday, September 17, 2012

Say's Law, the Dance Party and the Picnic

In the midst of my macro class today, I came up with two ideal types to help the class picture one economy in which Say's Law holds, and one in which it does not. Let's look at each.

First we imagine a class dance party. We stipulate that people are only allowed to enter the dance hall in pairs, and that they agree to dance with any available partner at any point they are in the hall, and then they all leave at the same time.

In that situation, no general glut is possible. Every person by entering the room is simultaneously supplying and demanding a dance partner, surely the proper way to understand Keynes's formulation of Say's Law as "supply creates its own demand." So long as there is an even number of people in the room, no one can overproduce a supply of dance partners. Say's Law holds.

The dance was such a success that we plan a class picnic. Everyone is going to make a small dish, the right size for a single meal, with the idea that everyone can take small portions of five or ten of the dishes and thus sample a wide variety of foods without overeating. But, independently, everyone privately thinks, "There will probably be others who forget to bring anything, and besides, I want to appear generous in the eyes of my classmates." So each person actually makes a dish large enough to provide five meals. Four-fifths of the food brought to the picnic winds up going uneaten.

We experienced a general glut at the picnic. The market still equilibrated, in a sense: We did not get what we intended, as we were not able to "sell" all of the food we produced. (We could understand the food as being exchanged for the admiration of one's classmates.) But we did get something for it: We got inventory. This is much like what Keynes claims happens during a typical recession: investment, instead of resulting in sales, results in the buildup of inventory.

Thus the validity of Say's Law is not a matter of pure economic logic. There is nothing illogical or contrary to economic reason about either of the above scenarios. The question is, "Is real economy X more like the dance party or the picnic?" We might also ask, "Is X sometimes like the dance party and sometimes like the picnic? If it is sometimes more like one and sometimes more like the other, why? If it is more like the picnic, but we could make it more like the dance party, should we? What would the costs of doing so be?"

Finally, it is interesting to note how the two scenarios above are both coordination problems, the first successfully solved, the second not.


22 comments:

  1. And of course even in the first example there are going to be search frictions, but we can do what we normally do and wave our hands fairly safely at them.

    I think the second example is good. It actually sounds more like Malthus's answer to me than Keynes. There's no price mechanism linking production to consumption, so a somewhat unexplained divorce between how much is brought and how much is eaten causes a general glut by virtue of arithmetic.

    Here's a Keynes example: you're dance, but without the rule that everyone has to dance with a partner.

    This is really what goes on in the macroeconomy, after all. There is no rule that every trade that can be made will be made. People's preferences vary and some people don't want to dance with other people.

    The Classical argument, according to Keynes (and we all know it's a bit of a straw man for heuristic purposes), says that there will be some sort of assortive matching and the less attractive dance partners will eventually settle for each other and everyone will go on dancing.

    But anyone who's been to a grade school dance knows that that's not true. There's always a contingent standing and not dancing - and they're not standing there because of search frictions. This doesn't even getting into the discouraged dancers who exit the dance hall and don't get counted in the Bureau of Labor Statistics' official undancing rate.

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    1. "I think the second example is good. It actually sounds more like Malthus's answer to me than Keynes."

      Yes, in fact, I drew it from my understanding of Malthus. It's interesting in that it shows money is not necessary for a general glut to occur.

      In your dance example, what role does money play, if any?

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    2. Well nothing specifically in the example. It relies on decision making by economic actors, just like Keynes.

      The common refutation of Say's Law is the monetary one from Malthus: excess demand for money. Insofar as we identify "excess demand for money" with "liquidity preference" there's a definite Malthusian flavor to Keynes's argument. But Keynes - I think - is making a much more fundamental point than that. The level of demand can be such that a general equilibrium is still not a full employment equilibrium. In my Keynes dance example everyone is dancing with someone if, by their own subjective assessments, they see a net benefit to dancing with them. That's hardly sufficient for guaranteeing everyone gets a dance.

      I think a lot of people mix up the ideas of labor market equilibrium and full employment. I don't think these are the same thing, but I'm a little weird in that sense - even Keynes often talked about them as if they were synonymous.

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  2. There will always be a possibility that the expectations of producers will be out of line with the reality of what actual buyers will do and lead to either an unplanned increase in inventory or output being sold at lower prices than anticipated by the producers. There seems no reason why this could not happen across the whole economy (for example due to a sudden drop in demand for all goods after production decisions have already been made).

    To my mind the interesting question is not whether this could happen (it seems that people who deny it are not paying attention to what is being described). If I'm nos mistaken Keynes actually describes a mechanism whereby there will always be a tendency for Say's law to reassert itself albeit at the expense of the economy operating at an equilibrium that may be considered to below optimum output levels.




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  3. There will always be a possibility that the expectations of producers will be out of line with the reality of what actual buyers will do and lead to either an unplanned increase in inventory or output being sold at lower prices than anticipated by the producers. There seems no reason why this could not happen across the whole economy (for example due to a sudden drop in demand for all goods after production decisions have already been made).

    To my mind the interesting question is not whether this could happen (it seems that people who deny it are not paying attention to what is being described). If I'm nos mistaken Keynes actually describes a mechanism whereby there will always be a tendency for Say's law to reassert itself albeit at the expense of the economy operating at an equilibrium that may be considered to below optimum output levels.




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  4. I like that example (pair) and it certainly does illustrate the coherency of a non-trivial kind of general glut. If that were where the economic analysis ended, I don't think there would be much disagreement.

    The disagreement comes when you follow up the picnic example with:

    ... "and therefore, people should be forced / manipulated into eating more than they really want to" (analogous to aggregate demand-boosting policies); or

    ... "and therefore, we should attenuate the signal of admiration so that people have to eat more of others' food in order to signal their desired admiration level" (analogous to trying to inflate away sticky prices); or

    ... "and this is a horrible tragedy we must avoid because of course the goal of a picnic is to maximize food consumption" (analogous to an implicit unquestionable assumption that an economic policy must maximize money-exchanges); or

    ... "so let's do whatever it takes to make this same quantity be the right amount of food next time" (analogous to policies that prevent liquidation of production found to be unsustainable in light of new realities).

    So I don't have trouble accepting the existence of picnic scenarios (or their broad-economy counterparts), but those who promote "general glut" explanations are always doing it to support one of the above non-sequiturs, hence why I'm always reaching for the proverbial revolver.

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  5. "It is worthwhile to remark that 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." - J.B. Say

    Wouldn't Say's Law hold in that the food had no value and therefore created its own demand? I'm confused why you hold that Keynes's interpretation was correct even though it seems Say is being clear that supply only constitutes demand when the former has value. That's why I thought Rothbard was right when he stated "Say's law is simple and almost truistic and self-evident".

    In addition:
    1) Aren't these still misallocations of resources rather than general gluts? If one person had produced, let's say, slinkies instead of food, then perhaps the market would have cleared. People would have grabbed slinkies and went home and enjoyed them.
    2) This "economy" is completely closed off. Perhaps they could have given the food to a charity nearby.
    3) There are no market prices. Without market prices, entrepreneurs cannot be realistically depended on to produce the right things that people actually desire. In order for this model to be proper, we'd have to say that they start off by first producing what they're going to sell while at the picnic (the reasoning for this involves #2. If you are going to stipulate that this is a closed economy, then literally everything must occur there or it is not really closed). There will have to be a bidding process for the factors of production toward the production of alternative consumer goods. This would certainly make the model more complicated, but that's precisely why it doesn't reflect what actually occurs in real life.

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    1. "Wouldn't Say's Law hold in that the food had no value and therefore created its own demand?"

      Leftovers are not valueless.

      "I'm confused why you hold that Keynes's interpretation was correct even though it seems Say is being clear that supply only constitutes demand when the former has value."

      Keynes knew that. Just measure supply in $ value and we get that auotmatically.

      That's why I thought Rothbard was right when he stated "Say's law is simple and almost truistic and self-evident"."

      You are aware that Say abandoned Says' Law?

      "Aren't these still misallocations of resources rather than general gluts?"

      These are little toy economies for illustrative purposes. We are imaging there is only one good.

      "There are no market prices."

      The model is meant to show whether a general glut is possible, which Say's Law denies. Of course, we can add money and prices, but that only makes matters worse for Say's Law, since money is precisely the thing people may wish to hold instead of goods.

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    2. "You are aware that Say abandoned Says' Law?"

      Yes, I was aware before making that post, thanks to a post you recently made on your blog, although I'm not sure how it is relevant to my arguments against your model.

      Regardless, Dr. Callahan, there seems like there's a lot of central planning in that model of the free market you've got there.

      In your model, however, the government has decided to:
      1) Shut off the economy from the rest of the world. No imports or exports!
      2) Put prohibition on all goods other than "food," for the sole reason of calling this a "general glut" rather than a misallocation and
      3) Eliminate all prices including prices for the factors of production. Are you sure you made up this model or did Bernanke tell it to you over a cup of tea after lowering interest rates to 0%? (this is only a joke, please don't interpret it as hostility haha)

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    3. "In your model, however, the government has decided to:
      "1) Shut off the economy from the rest of the world. No imports or exports!
      "2) Put prohibition on all goods other than "food," for the sole reason of calling this a "general glut" rather than a misallocation and
      "3) Eliminate all prices including prices for the factors of production. Are you sure you made up this model or did Bernanke tell it to you over a cup of tea after lowering interest rates to 0%? (this is only a joke, please don't interpret it as hostility haha)"

      Rubbish, rubbish, rubbish. There is no government in these models at all. We are IMAGINING a unrealistically simplified situation to conceptualize these things more easily. Go look at MIses's description of the ERE and see how far Mises takes this at times.

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    4. When constructing a model, there are a number of assumptions you make. When you make those assumptions, you have to be certain that even when those assumptions are gone, the model still applies to actions in the real world.

      So what I'm doing here is challenging you on the assumptions you're making. I realize it's a model, but I don't think this model applies to the real world. And here's why:

      1) I want to go back to what I said previously about Say's Law only applying to the supply of goods that have value. In a sense, the leftovers have no value to the individuals who don't want them. They are basically "bads". Technically, perhaps they have some value, but the costs required to take them home, etc. are so great that they overwhelm this value, but we can simplify and say these are bads, not goods. If an individual is offered a free item and does not accept it, it's essentially a bad. It has no value to him.
      2) The reason I brought up prices weren't for prices of exchange, but prices for the factors of production. If producers aren't bidding up the prices for the factors of production, how in the world are they supposed to know which are the goods consumers desire?
      3) Regardless of point #2, you don't even allow producers to change which goods they are selling to the consumer. In other words, as I pointed out in my previous post, the sole reason you have the ability to call this a general glut rather than a misallocation is because you have stated that only one good can be produced! Otherwise, my previous argument regarding individuals producing slinkies instead of food completely invalidates your entire model. In such a case, which is barely any more complex than the original model, Say's Law holds.

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    5. " When you make those assumptions, you have to be certain that even when those assumptions are gone, the model still applies to actions in the real world."

      No, you don't. You simply have to be aware they are assumptions, and not think they automatically hold in the real world. If you'll notice, I was concluding with questions: "The question is, e.g., "Is real economy X more like the dance party or the picnic?"

      Here I am ASKING if my model assumptions fit the real world. I consider that to be a subject for investigation. I do not HAVE to "be certain" my model applies.

      "Otherwise, my previous argument regarding individuals producing slinkies instead of food completely invalidates your entire model. In such a case, which is barely any more complex than the original model, Say's Law holds."

      You are mistaken about my model: there were many goods, all different types of foods. It is easy to generate even more complex models where general gluts occur: Malthus and Sismondi showed how to do this, and they (mostly Malthus) convinced Say.

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    6. Thanks, I actually had trouble understanding what Dr. Murphy was saying, but the link to your analogy clarified it for me.

      So basically Say's Law can be invalidated (not in the tautological sense but perhaps in a more meaningful sense?) if production is too great in comparison to leisure. Certainly something for me to think about more.

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    7. Yes!

      We could say: Say's Law always holds, if we take it to encompass leisure, money, and inventories as well as the sale of "ordinary" goods.

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  6. Yeah, I don't think I have a problem with these analogies, and my response would probably be like Silas'.

    But: Did you mean that only 1/5 of the food would be excess?

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  7. This post shows the ignorance that typically accompanies criticisms of Say's Law. Say's Law only applies to the economy as a whole, not to individual scenarios of dances or picnics.

    Say's Law, as Hazlitt's discussion of Keynes' understanding of it, or rather his misunderstanding of it has shown, contains the important provision that each of the various lines of production (dance classes, picnics, plus all other lines of production), are in coordination with each other, that is, what the classicals gave he misnomer "equilibrium".

    The example of a picnic in which there is too much food produced, does NOT represent a violation of Say's Law. This is because it represents an example of partial relative overproduction (and hence partial relative underproduction). Say's Law PROPERLY understood tells us that if there is some particular thing produced to which there is an insufficient demand, then this means that there is accompanying partial relative underproduction of something else that was not produced because the scarce resources went into that which was partially overproduced.

    Say's Law does not apply to picnics. It applies to the economy as a whole. The reason why it applies to the economy as a whole is because it is only in this sphere that the core foundation of Say's Law is found, which is the fact that the desire for wealth IN GENERAL is for all intents and purposes practically infinite. The desire for additional wealth always outstrips the ability to produce wealth. This is the foundation of Say's Law.

    So if there is ever a situation in which an instance of production was not met with a sufficient demand for it, then this doesn't prove that humans have a limited desire for additional wealth in general, and hence this does not prove that Say's Law is wrong. What it actually proves is that IF the scarce resources that went into the surplus food production INSTEAD went into something else that is desired, then there would not have been a partial relative overproduction and hence there would not have been a partial relative underproduction.

    Callahan's incorrect treatment of Say's Law is the same incorrect treatment that Keynes gave it. I suggest that Callahan read Hazlitt's chapter on Say's Law in his book "The Failure of the New Economics", so that he can learn how Keynes, and hence how Callahan himself, has misunderstood it.

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    1. "This post shows the ignorance that typically accompanies criticisms of Say's Law. Say's Law only applies to the economy as a whole, not to individual scenarios of dances or picnics."

      Always a good move to introduce yourself by insulting your host.

      In any case, this ignorance about Say's Law was apparently shared by Say himself, since he abandoned Say's Law by 1829. It is seemingly also shared by Thomas Sowell, who shows Malthus was basically correct in his book length treatment of Say's Law. (A brilliant economist writes an entire book on this law and still doesn't get it, while you grasped it by reading a few pages of Hazlitt!)

      "The example of a picnic in which there is too much food produced, does NOT represent a violation of Say's Law. This is because it represents an example of partial relative overproduction (and hence partial relative underproduction)."

      No, sorry, you misunderstood the models. These are closed economies only producing the good in question. Of course they are highly simplified: that's the point of a model!

      Since we are handing out reading suggestions, you might pick up Sowell's book.

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  8. Good morning, Dr. Callahan.

    I am not an economist, but I enjoy the subject and the discussion.

    I am confused about Say's Law, and I am hoping that you can clear-up my confusion, or, at least, part of it.

    Say stated that the supply of X would, after its sale, create demand for Y.

    Malthus and Sismondi stated that general gluts could occur. M and S did not define "general glut" to *necessarily* mean that the entire economy was glutted. They defined "general glut" to mean that a specific product or products could be glutted, with the possibility that the entire world of commodities could be overproduced.

    Initially Say disagreed with this. Then, after further reflection, he changed his mind.

    Why can't both things be true? In general, supply of X, upon its sale, will create a demand for Y.

    There will be times when X will be overproduced (for a number of reasons) and there will be a general glut as general glut is defined by M and S. (Isn't this what the Austrian Business Cycle Theory says will happen in a sector (typically the capital goods sector, I think) after the economy gets overheated?)

    Now, Say's statement, at bottom, is a description about supply (of X) and demand (of Y). The typical supply and demand ratio is about one thing: X. In the typical graph, the ratio can shift and slide. It is dynamic.

    Why can't Say's ratio also be dynamic? In a typical situation (no general glut), there is some ratio of X:Y. During the general glut, there is a different ratio of X to Y, but there is still a ratio. The different ratio is needed to clear X.

    Would you please tell me what I am missing in terms of my understanding?

    Thank you.

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    1. "Say stated that the supply of X would, after its sale, create demand for Y."

      No, this is not correct: the supply of the thing in and of itself represents the demand for other goods: none of this "after its sale." That's begging the very question Say was trying to address: how do we know all goods brought to market will be sold?

      I highly recommend Thomas Sowel''s quite readable book on this topic.

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  9. I had to laugh once I re-read my question: Basically, I was asking you to correct my understanding of Say's Law in a blog comment. Pretty near impossible, since you do not know me; you do not have any understanding of my grasp (or lack thereof) of Say's Law; and, Say's Law seems pretty slippery.

    Thank you for the book recommendation. It's on its way.

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    1. Excellent: it's a great book.

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