DEFINITION of Say's Law Of Markets

Say's law of markets is a classical economic theory that says that production is the source of demand. According to Say's law, the ability to demand something is financed by supplying a different good.

Say's Law Of Markets

Say’s law of markets, developed in 1803 by French classical economist and journalist, Jean-Baptiste Say, was influential because it deals with how a society creates wealth and the nature of economic activity. To have the means to buy, you first have to have something to sell, Say reasoned. So, the source of demand is production, not money. Supply creates in other words, creates its own demand.

The law of markets ran counter to the mercantilist view that money is the source of wealth. It supports the view that governments should not interfere with the free market and should adopt laissez-faire economics. Say's law still lives on in modern neoclassical economic models which assume that all markets clear.

Say’s law has also influenced supply-side economists, who believe in tax breaks for business and other policies intended to spur production, and Austrian economists who believe Say’s law would hold if interfering governments and monetary policy did not distort the economy, create booms and busts and cause misallocations of capital.

Implications of Say’s Law of Markets

One of the burning issues of Say’s day was the question whether a free economy could experience a depression as a result of overproduction, or excess demand. Say’s law says that a supply glut cannot be the cause of such downturns, because macroeconomic activity tends towards stability and the economy should always be close to full employment. Because the supply of one type of good constitutes the demand for other, different goods, aggregate demand is not only equal to, but identical to, aggregate supply. To boost the economy, the focus should be on increasing production rather than demand.

The Keynesian Challenge to Classical Economics

The Great Depression appeared to prove that economies could experience crises that market forces could not correct – as there was an abundance of manufacturing capacity, but not enough demand. British economist John Maynard Keynes challenged Say’s law in his seminal book, "General Theory of Employment, Interest and Money."

Keynesian economics argues that governments do need to intervene to stimulate demand – through expansionary fiscal policy and money printing — because structural rigidities in the economy can lead to unemployed resources. Banks businesses and consumers hoard cash in hard times and during liquidity traps, as we witnessed during the global financial crisis.