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8.4 Keynes’s Taxonomic Attack on Say’s Law

When Keynes became convinced that the vocabulary of orthodox economics

was not sufficient to explain why an economy might become mired in unemployment,

he developed an expanded classification and new definitions to

demonstrate that Say’s Law ‘is not the true law relating the aggregate demand

and supply functions … [and hence] there is a vitally important chapter of

economic theory which remains to be written and without which all discussions

concerning the volume of aggregate employment are futile’ (Keynes,

1936, p. 26).

Keynes’s General Theory is developed via an aggregate supply–aggregate

demand function analysis to achieve a point of effective demand (Keynes,

1936, pp. 25–6). The aggregate supply function (Z) relates entrepreneurs’

expected sales proceeds with the level of employment (N) entrepreneurs will

hire for any volume of expected sales receipts. This aggregate supply (Z)

function indicates that the higher entrepreneurs’ sales expectations, the more

workers they will hire. The aggregate demand function relates buyers’ desired

expenditure flows with any given level of employment (see Davidson, 1994).

Say’s Law specifies that all expenditure (aggregate demand) on the products

of industry is equal to the total costs of aggregate production (aggregate

supply) including gross profits. Letting D symbolize aggregate demand and Z

aggregate supply, if:

D = fd(N) (8.1)

and

Z = fz(N) (8.2)

then Say’s Law asserts that:

fd(N) = fz(N) (8.3)

‘for all values of N, i.e. for all values of output and employment’ (Keynes,

1936, pp. 25–6). In other words, in an economy subject to Say’s Law, all

costs of production are always recouped by the sale of output. There is never

a lack of effective demand. The aggregate demand and aggregate supply

curves coincide. In a Say’s Law economy, there is no obstacle to full employment.

The aggregate demand and supply functions will be coincident only if

money is neutral, everything is a good substitute for everything else (gross

substitution) and the future can be reliably predicted in terms of probabilities

(the ergodic axiom).

To challenge the applicability of Say’s Law to the real world in which we

live, Keynes had to develop a model where the aggregate demand and aggregate

supply functions, fd(N) and fz(N), were not coincident. Since Keynes

accepted the normal firm short-run flow-supply function developed in

Marshallian economics as the micro-basis for the aggregate supply function,

he could therefore differentiate his approach only via the concept of aggregate

demand. Keynes divided aggregate demand into two classes, that is,

D = D1 + D2 (8.4)

where:

D1 = f1(N) (8.5)

and

D2 f2(N) (8.6)

D1 represents all expenditures which ‘depend on the level of aggregate income

and, therefore, on the level of employment N’ (Keynes, 1936, p. 28).

D2, therefore, represents all other expenditures which are not related to income.

Even if D2 is related to aggregate income (that is, D2 = f2(N) so long as

f1(N) + f2(N) fz(N) for all values of N, then Say’s Law is not applicable.

Explicit recognition of the possibility of two classes of demand expenditures

must make Keynes’s analysis a more general theory than the orthodox

theory since the latter recognizes only a single demand class. Classical theory

is ‘a special case’ (Keynes, 1936, p. 8) where:

D2 = 0 (8.7)

and

D1 = f1(N) = fz(N) = Z (8.8)

for all values of N.

By proclaiming a ‘fundamental psychological law’ associated with ‘the

detailed facts of experience’ where the marginal propensity to consume was

always less than unity (Keynes, 1936, p. 96), by decree, Keynes declared that

f1(N) would never coincide with fz(N) in the real world, even if D2 = 0. Say’s

Law could not be applicable to ‘the facts of experience’.