What Is Walras's Law?
Walras's law is an economic theory, which states that the existence of excess supply in one market must be matched by excess demand in another market so that both factors are balanced out. Walras's law asserts that an examined market must be in equilibrium if all other markets are in equilibrium. Keynesian economics, by contrast, assumes that one market can be out of balance without a "matching" imbalance elsewhere.
- Walras's law implies that, for any excess demand oversupply for a single good, a corresponding excess supply over demand exists for at least one other good, which is the state of market equilibrium.
- Walras's law is based on equilibrium theory, which states that all markets must be "cleared" of any excess supply and demand to be in equilibrium.
- Keynesian economic theory stands in contrast to Walras's law, by stating one market can be in imbalance without another market being out of balance.
- Walras's law works on the principle of the invisible hand; where there is excess demand, the invisible hand will raise prices, and where there is excess supply, the invisible hand will decrease prices, until equilibrium is reached.
- Critics claim that it is difficult to quantify utility, which influences demand, making Walras's law difficult to formulate as a mathematical equation.
Understanding Walras's Law
Walras's law is named after French economist Léon Walras (1834 - 1910), who created general equilibrium theory and founded the Lausanne School of economics. Walras's famous insights can be found in the book Elements of Pure Economics, published in 1874. Walras, along with William Jevons and Carl Menger, were considered founding fathers of neoclassical economics.
Walras's law assumes that the invisible hand is at work to settle markets into equilibrium. Where there is excess demand, the invisible hand will raise prices; where there is excess supply, the hand will lower prices for consumers to drive markets into a state of balance.
Producers, for their part, will respond rationally to changes in interest rates. If rates rise they will reduce production and if they fall they will invest more in manufacturing facilities. Walras predicated all of these theoretical dynamics upon the assumptions that consumers pursue self-interests and that firms try to maximize profits.
Limitations of Walras's Law
In practice, observations have not matched Walras's theory in many cases. Even if "all other markets" were in equilibrium, an excess of supply or demand in an observed market meant that it was not in equilibrium. Walras's law looks at markets as a whole rather than individually.
Economists who studied and built on Walras's law hypothesized that the challenge of quantifying units of so-called "utility," a subjective concept, made it difficult to formulate the law in mathematical equations, which Walras sought to do. Measuring utility for each individual, not to mention aggregating across a population to form a utility function, was not a practical exercise, critics of Walras's law argued. According to them, if this could not be done, the law would not hold, because utility influences demand.