B.A. LL.B. (Five Years) Sem 3 Economic Theory and Public Finance 2019 Dec (100 marks) Question Paper with Solutions

For full marks, cover: the statement of the law by J. B. Say, with his words, the short form "supply creates its own demand" and J. S. Mill's version; the reasoning behind it (goods buy goods, money as a medium, saving turned into investment by the rate of interest, flexible prices and wages), with a worked example; its assumptions; its implications for employment and policy; a critical examination, chiefly by Keynes; the element of truth that remains; a comparison table; and a conclusion.

A. The law stated

Jean-Baptiste Say, a French economist, set out the law of markets in A Treatise on Political Economy, first published in 1803. His central sentence was 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."

Keynes later put the classical teaching in a short form. "From the time of Say and Ricardo the classical economists have taught that supply creates its own demand". In plain words, the act of producing goods creates the income needed to buy them.

4. Prices and wages are flexible. If some goods are in excess, their prices fall until they are sold. If some workers are unemployed, wages fall until they are hired.

Worked example. An economy produces goods worth 1,000 crore rupees, so incomes of 1,000 crore are paid out as wages, rent, interest and profit. Households spend 900 crore and save 100 crore. In the classical view, the rate of interest falls until firms borrow the 100 crore and spend it on machines. Total spending is again 1,000 crore, equal to output. Nothing is left unsold, and no worker is left idle.

C. Assumptions

1. A free market economy with perfect competition.
2. No government interference in production or prices.
3. Money is neutral, a medium of exchange only.
4. Saving equals investment, brought about by the rate of interest.
5. Flexible prices, wages and interest rates.
6. A closed economy, with no foreign trade.
7. The long run, in which adjustments are complete.

D. Implications

The worked example again, in Keynes's terms. Suppose people always save a tenth of their income. At an income of 1,000 crore they save 100 crore, but firms, gloomy about sales, plan to invest only 60 crore. Spending is then 900 plus 60, or 960 crore, and goods worth 40 crore stay unsold. Firms cut output and jobs. Income keeps falling until saving shrinks to the 60 crore that firms wish to invest. With a saving ratio of one-tenth, that happens only when income has fallen to 600 crore. Supply did not create its own demand.

3. Wages and prices do not fall easily. Contracts, unions and custom keep money wages from falling. Even if they did fall, lower wages would reduce workers' spending and so demand.

4. Effective demand decides employment. Keynes showed that Say's law assumes away the very problem of unemployment. He wrote that "Say's law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment." In his theory, employment is fixed where aggregate demand equals aggregate supply, and that point can lie well below full employment.

G. Say and Keynes compared

Conclusion. Say's law holds that supply creates its own demand. Producing goods creates the income to buy them, and the rate of interest turns saving into investment. On this basis the classical economists concluded that general overproduction and lasting unemployment were impossible. Keynes showed that money can be hoarded, that saving and investment are equalised through income, and that demand can fall short of full-employment output. The law survives as a reminder of the supply side in the long run. It fails as a guide to unemployment in the short run.