Wednesday, 4 June 2014

Does Supply Create Its Own Demand?

Many a policy during recent years have been aimed at making things easier for producers. The rationale has been that if producers can create more goods (or make the same goods with less money) then they will have to hire more people, thus boosting employment, consumption and growth. This understanding is based on what has been commonly known as Say's law, which states that "the mere circumstance of creation of one product immediately opens a vent for other products".

Unfortunately, this "law" does not always hold. In fact, at times it appears to be nothing more than a misunderstanding of how the world works and how businessmen think and operate. Let us consider the following example: Company X creates 100 units of good Y which it sells to the public. Demand is good so that there are no excess goods at the end of the day. However, Company X is not the only company in town; there are dozens of others which produce all kinds of goods, some substitutes of good Y, some complementary and some which are completely irrelevant.

One terrible day, some shock (say a financial breakdown) causes demand for all goods to drop by 20%. Given that firms employed as much workers as it was enough to meet demand and earn them a profit, they now begin to lay off people, until they once again meet demand, with a lower cost. For simplicity, let us suppose that there are no frictions in the economy and this correction happens very fast. Obviously, letting workers go will mean a further deterioration of demand, but we will ignore this for now and just assume that there has been a drop of just 20%. 

An additional option would be to cut workers' salaries by 20%. Yet, this is unlikely to happen because some workers would remain idle and not be fully used during their employment hours. Having them all work less is a bit unrealistic, thus a combination of wage reductions and less employment appears to be more likely. Now let's say that the government, instead of doing anything else, subsidizes part of the firm's expenses, making the good less expensive. What does this mean: basically instead of earning €1 euro per item, it now earns €2. Surely, the company's profits rise spectacularly. But does it mean that it helps the economy? Not really.

The issue here is that firms, unlike what many people people believe, hire only when they are trying to meet demand and not when profits are rising. Unless dropping the price by €1 means that there is a surge in demand for their goods enough to hire extra workers, then nothing will occur in the economy. As some goods are price inelastic then we know that reducing prices will not change their demand by much. In addition, the economy's reduced income means that people are more likely to hold off purchases, even if they can afford it, a form of buffer against worst days in the future.

What is more, even if a lower price increases demand, there appears to be a problem similar to what we know as the paradox of thrift or the prisoner's dilemma: what is good for the individual (here the firm) is not necessarily good for the economy as a whole. For instance, the first firm which will hire new workers must be certain that the demand for its goods will be sufficient to cover wages. Yet, only a very small part of those wages will be allocated to the good the worker is producing (think of it this way: an ice cream maker will not just consume ice cream). This, in its turn, benefits the other firms in the economy by much more: by incurring no expenses, they see demand for their products marginally increased. 

It is more than obvious that if a firm starts hiring then others will most likely follow, even though there is a "first mover disadvantage". The disadvantage is mitigated only if demand is persistent and large enough to cover the wages and leave room for profit. This means that Say's law most likely holds if there increased demand for goods. The magic word here is demand: even in Say's world, it takes demand to create supply not vice versa. To what avail are we to fill the market with trillions of goods if nobody wants to purchase them? Nevertheless, this is very hard to know in advance (given the lower income and reduced trust in the economy) and in addition, the cost is high: unless direct subsidies are employed then the effect of other measures such as reduced red tape or other bureaucratic hurdles is infinitesimal.

Then the big question arises: why should we subsidize firms to create cheaper goods, when we know that the outcome is uncertain, or even if the outcome is favourable, the shift will probably take very long? More so, why shouldn't we just target the demand side, which creates more growth faster and tackles issues such as poverty and unemployment much faster, while in addition it is cheaper? If we let ideological barriers such as thinking that assisting the demand side is "Keynesian/Minskian" and the supply side "Liberal/Free Market/Friedmanite", we just reach the conclusion that we are enforcing the same thing through different ways. The only problem lies in choosing wisely which way suits us better.

P.S. This article strictly refers to established firms.l Start-ups usually do create their own demand for their (new) goods, but they are not usually the ones to receive government aid as they are either at infancy level or non-existent during those times. In addition, their "new" demand lies heavily on whether the public has enough funds to purchase innovative goods, something which brings us back to original demand. Assisting in the creation of start-ups (when times are good but especially when times are bad) while simultaneously boosting demand could in fact work wonders for an economy.

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