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  • Does Supply Create Demand?

    Which comes first: supply or demand? This question has serious policy implications, especially as President Barack Obama proposes $447 billion in additional stimulus spending in order to try to spur job growth in America.

    “Demand-siders,” also known as Keynesians (after influential economist John Maynard Keynes), insist that short-run economic fluctuations are caused by shocks to the economy that leave aggregate demand—the total amount of money spent on goods and services in the economy—below full capacity. In their view, since less money is spent on goods and services, businesses must lay people off, which further reduces spending, resulting in more layoffs, causing even less spending, and so the cycle goes. The policy argument is that government must step in and spend—at a deficit—in order to prop up total demand.

    Another theory, however, first put forth by Jean Baptiste Say, an economist in the 19th century, articulates that supply creates demand. It became broadly known as “Say’s Law,” and has policy implications for “supply-siders.” Say’s Law stipulates that, since supply creates its own demand, overproduction—the creation of goods and services without an equal flow of demand for those goods and services—is impossible. This renders Keynesian policy useless at best and destructive at worst (since it interferes with normal free-market processes).

    So which theory is correct?

    In normal, meaning non-recessionary, times, with full employment and reasonably flexible wages, Say’s Law holds. To paraphrase Henry Hazlitt, supply creates its own demand, because at its most fundamental, supply is demand: “The supply of the thing they make is all that people have, in fact, to offer in exchange for the things they want.” In that sense, the supply of a farmer’s crops constitutes his ability to demand an automaker’s automobile.

    In bad times, however, excess supply is indeed possible. That’s why during recessions many businesses have unsold inventory: Supply and demand are out of equilibrium. So does this mean that Keynesians are correct—that, in bad times, government can prop up demand by deficit spending? Not quite.

    While the understanding of Say’s Law described thus far is imperfect, a broader understanding of it vindicates supply-siders and denies demand-siders.

    This slightly more sophisticated understanding of the law states that production creates demand. Say wrote: “It is production which opens a demand for products…Thus the mere circumstance of the creation of one product immediately opens a vent for other products.” In other words, the demand one has for goods and services comes from the income he or she produces.

    So what does this mean in terms of policy implications?

    It means that production ultimately drives both supply and demand. Recessions and booms therefore begin on the supply side, with shocks to productivity and labor supply. The key to stimulating an economy out of recession is to stimulate production, not aggregate demand.

    The way to encourage more production is to increase incentives for additional labor and investment. Taxes on income, corporate earnings, dividends and capital gains, among others, penalize production and are disincentives to additional work effort. Reducing those disincentives encourages people to take on additional work, resulting in more production in the economy, elevating both total supply and demand in tandem.

    Among politicians and academics, Keynesian philosophy is ubiquitously accepted. However, its repeated failures over the last few years have left Americans seeking an alternative explanation for what their common sense already tells them: No economy can spend its way to prosperity, whether it’s $447 billion or $845 billion.

    Posted in Economics [slideshow_deploy]

    6 Responses to Does Supply Create Demand?

    1. You may be correct to a point, but there is a huge theoretical piece of the puzzle missing, and that is the presence of monetary oversupply.

    2. @USAGeorge says:

      The bottom line test is always demonstrated in the results,demand side has been tried and found wanting for the circumstances. This does not mean that supply side is the answer,or that in itself is the correct answer by default. Whatever the choice of action to embrace next has to be rational,not political. Unless we consider supply side as the next step all we can do is repeat a failed action,that is something we can ill afford.

    3. Bobbie says:

      Innovation builds interest and creates demand. The freedom of Americans to innovate creates jobs. Supply and demand go hand in hand. Once government goes beyond their duty forcing itself into the free market of Americans, we're needlessly paying government expense and held accountable in compliance to government authority! No purpose! Freedom doesn't call for government! get government and their bad influence, intrusive and unconstitutional overreach OUT! Doesn't represent America(ns!)

    4. Economan says:

      I agree with your assessment David. Unfortunately for all of us the WH and Congress are ideologues who aren't concerned with the process but their re-election. They are relying on people's ignorance of economics and history.

    5. Tim says:

      David-

      You leave too much unaddressed here. Your example of "the supply of a farmer’s crops constitutes his ability to demand an automaker’s automobile" is true if we operate in a barter economy. Once you introduce money into an economy, all of a sudden you can have supply and demand for something that isn't a good or service — money. If everyone, in the aggregate, decides to demand more money, then everyone must therefore be choosing to demand less goods and services. And if everyone chooses to demand less goods and services (and more money), then whatever is produced (supply) is greater than what is consumed (demand); hence, supply does not create its own demand. In the short run, the net effect is that the economy supplies fewer (ie, produces less) goods and services to meet the fall in aggregate demand; after all, why produce more than what customers are willing to buy? Most of the time, this is why we see business cycle fluctuations. Your argument might be true in the long run, but I think you'll have a very tough time trying to prove this in the short run.

    6. Jack W. Paul says:

      Says law is incorrect. Demand is independent of supply. All you have to do is look at the Great Recession and its aftermath. When individuals are traumatized by lack of confidence, they won't consume or invest beyond a "subsistence" level. No matter how much is produced, much of it won't be purchased/consumed. The experiences of the past few years demonstrate the independence of demand, an independence that is masked in a buoyant economy. Supply-side palliatives won't work in the current fragile economic environment. We have a populace still wary of a tepid housing market. Moreover, we face global competition and a workforce that to a large extent is not trained for the information age. Severe budget cuts will have the impact of bringing about a deep recession, while reduced taxes for the wealthy will further exacerbate the income/wealth inequality that threatens to tear the fabric of society.

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