Say’s law of the market is a very famous classical theory of employment. It is said that Say’s law of market and the quantity theory of money are the two building blocks of the complete classical theory of income determination. Say’s law of market explains the supply side of an economy while the quantity theory of money explains the demand side of an economy.
Statement of Say’s Law of Market
According to Say’s Law of Market, the economy is capable of producing and purchasing the full employment output. Saying in the dictum: “Supply creates its own demand.” Just by producing goods and services, the economy automatically generates the income necessary to buy those full employment output. National income accounting provides somewhat sensible support to Say’s Law of Market. Because in national income accounting, we often observe output equals income.
Assumption of Say’s Law of Market
- There is always full employment in an economy.
- Wages and prices are flexible.
- There is perfect competition in the markets.
- Saving and investment are functions of interest rate and, at any time, saving always equals investment.
- There is no government intervention i.e. laissez-faire economy.
- Assumption of the long run.
- People use money only for transaction purposes.
Based on these assumptions, there are main two mechanisms that assure the Say’s Law of Market.
Supply Side Mechanism
According to classical economists, the economy operates in full employment. Full employment refers to the full use of available resources in an economy. Therefore, there is no unemployment in the economy. According to classical economists, there is no involuntary unemployment in the economy. If any unemployment, it is voluntary or frictional unemployment. All this unemployment are short-run phenomenon. However, in the long run, all this unemployment disappears and the economy is capable of producing a full employment level of output(why?).
The reason is that widespread unemployment will bring the wage rate down, which happens due to free competition among unemployed labor in the labor market to get a job that makes laborers ready to work at a lower wage rate. Then after prices of products fall due to a decrease in production cost (in terms of wage rate fall), demand for products increases, and the surplus of labor will disappear as buyers of labor buy more labor time. Consequently, the assumption of flexible wages and prices allows an economy to produce at the full employment level.
Demand Side Mechanism
The classical model also predicts that the economy is capable of purchasing the full-employment output. Because as the production of goods and services takes place, the income necessary to purchase those goods and services will automatically be created in the form of wages, rents, interest payments, and profit. So, the economy or its agents purchases all goods and services.
But, what if people save too much of their income? As people save more, this will lower interest rates. Eventually, this will induce households to save less and businesses to invest more until saving equals investment. That means all savings are spent through investment by equalizing savings to investment. In this way, all the income is spent to purchase full employment output in the classical system.
To sum up, Say’s law of the market states that an economy has an automatic adjustment mechanism. And, no government intervention is required to solve any economic problem. Supply is the only prime mover of an economy. Therefore, we should keep on supplying goods and services. The economy automatically creates a market for the products. No one should worry about the overproduction in an economy.