Supply and Demand: What Comes First? Which is More Important? (Part 1 of 2)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff addresses a theoretical question that has divided economists for nearly a century and also divided CO readers two years ago in the comments section.

French Economist Jean-Baptiste Say (1767-1832)

A few years ago a rather heated debate broke out in CO Nation over a question that still divides economists today: What comes first, supply or demand? Production or consumption?

Some argued “Supply is more important. Demand is useless without something to demand.” (ie. production)

Others countered: “Demand is more important. No one will produce or supply anything if it’s not demanded first.”

So who is right?

The Economics Correspondent has been meaning to weigh in with economic theory and evidence for some time and figures now is as good a time as any.

But first off, the Correspondent would like to establish a critical definition: that of demand. 

Supply is a fairly easy concept. It’s goods and services produced by enterprises, be they large corporations down to a sole proprietor.

But in economics, demand is not only the wish to buy a product or service but also the means. 

Anyone can want the latest smartphone, but for “demand” to exist economists have to see consumers not only desire the new phone but also buy it.

In fact, economists talk in terms of the “supply side” and the “demand side,” and there are even “supply side” schools of economics that emphasize the greater importance of production—usually conservative or libertarian—and support government policies that encourage more supply such as lower taxes and fewer regulations.

Likewise there are “demand side” schools that emphasize the greater importance of consumption—usually liberal or socialist—and advocate government policies that encourage more spending such as greater taxation and redistribution to lower and middle classes (who spend a larger share of their income) and regulations that force wages up.

But more on those schools in a future column.

PRODUCTION MUST COME FIRST, BUT…

The Economics Correspondent will establish up front that he leans very heavily, albeit not completely, towards the supply and production side and will explain why, both in simple and more nuanced terms. Then he'll explain why demand-issues can still be important.

After reading, by all means let the discussion continue in the comments.

So the most basic argument for supply and production being both more important than and necessary precursors for demand is intuitive: 

You can’t consume that which has not yet been produced. Or “You can’t even talk about eating apples until you grow them first.”

Seems simple enough.

To which demand-side advocates have their own sophisticated counter: “If no one has the ability to demand/buy the apples, they won't get grown. Demand must come before supply.”

Both arguments seen to have some merit.

SAY’S LAW OF MARKETS

This dilemma was famously studied, discussed, and settled (for a while) by French classical economist Jean-Baptiste Say (1767-1832) in his 1803 book “A Treatise on Political Economy.” 

Say was a contemporary of Thomas Jefferson with whom he corresponded frequently and sent a copy of his book. His ideas also got him into trouble with Napoleon Bonaparte who dismissed him from his post in the French Tribunat. From there Say laid low, working in private business before reemerging as an academic upon Napoleon's defeat at Waterloo.

Say’s book is enormous and, as a treatise, covers a wide range of topics from trade to tariffs to money to taxation, but his most discussed chapter is on supply and demand where he established what economists refer to as “Say’s Law of Markets.”

The Correspondent will provide supporting quotes in a moment, but Say argued that in a market economy one’s ability to demand originates first from supply itself. That is, it’s what you produce that makes your demand possible in the first place.

Thus it’s true that Ford might not produce lots of cars until they see consumers demand them, but for consumers to demand Ford cars they must first produce something of value themselves.

Or in an 1803 example, the baker goes to the market to buy fish, but the money he obtained to demand the fish first came from his production of bread.

Remember that in 1803 Say was talking about a market economy, not money forcibly seized by criminals or governments and redistributed to someone who is unable or unwilling to produce. 

Also an heir may not produce as much as his wealthy retiree parents, but he can still command a lot of demand if the parents will their estate to him. All this means is the parents derived their demand from previous production and transferred it to someone else.

But back to Say who summed up his position writing:

“A product is no sooner created than it, from that instant, affords a market for other products.”

Say is often criticized for stating an economy’s total quantity of supply always and instantly equals the total quantity of demand, something he never claimed. He appreciated that aggregate supply and aggregate demand tend to be in equilibrium but that sometimes there can be a mismatch. 

But in Say’s view the mismatch is usually the result of businessmen erring in their plans and producing supply that the public doesn’t value very much—ie. the wrong kind of supply, such as producing millions of “Epstein really killed himself” tee shirts.

But he did argue that there can be no long-term *general* overproduction of supply or “glut” in an economy for which he is also criticized. More on that in Part 2.

IS SAY’S LAW CORRECT?

One can test Say’s Law—that demand originates from the ability to first produce something else—using a simple thought experiment:

Imagine a huge freight ship full of BMW’s departs Germany and docks at Manhattan Island. Only it arrives in the year 1500, before western Europeans had colonized the area.

There’s no question the local natives would be fascinated by BMW cars and would instantly want to buy some. But do you think they would command enough demand for the cargo ship to go home empty, or would it return to Germany still full of unsold cars?

Clearly it would go back full. The natives might like BMW’s, but they have little ability to demand them. 

And why do they have so little ability to demand? Because natives in the year 1500 produce so little supply to constitute that demand. The most they might have to offer is a few fish or some corn or squash: hardly enough to trade for a giant ship full of BMW’s.

Now fast forward to the year 2022. The ship arrives in New York City with its stock of BMW’s. Will the ship go home empty or return with its cargo?

Obviously it will go back empty. New Yorkers like BMW’s as much as the natives of 1500 did, but the difference is New Yorkers have a much greater ability to demand BMW’s because they are so much more productive. Their ample demand derives from their greater ability to produce.

Hence yes, demand matters, but since demand originates from the ability to create supply first, supply remains more important.

In fact, one not even need use a thought experiment. Just look at countries today.

What makes some countries rich and other countries poor? How are Americans able to demand cool electronics, cars, and an endless array of other products and luxury goods from around the world, while no one will sell them en masse to the citizens of Zimbabwe?

The answer is Americans’ ability to demand comes from America’s enormous capacity to produce. Zimbabwe can demand very little because it produces so little.

Or just compare one nation to itself, only separated by time.

Fifty years ago the citizens of South Korea would have loved to drive fancy cars, live in high rises with air conditioning, have closets full of designer clothes and handbags, and fly on Boeing jets to faraway vacation destinations.

But very few did. Most South Koreans were poor by western standards and had no ability to demand such luxury goods because their economy was still not very productive in 1972.

Fast forward to 2022 and Koreans’ standards of living have improved enormously. Most have cars. Most live in high rises, have air conditioning, modern appliances, designer clothes, and most fly on exotic vacations.

What changed? The answer is easy. Koreans can demand more and better goods and services because their economies are so much more productive than they were fifty years ago.

As Say himself wrote in 1803:

“It is the capability of production which makes the difference between a country and a desert."

Or as economist Benjamin Anderson wrote in 1949:

“The prevailing view among economists… …has long been that purchasing power grows out of production. The great producing countries are the great consuming countries.”

Conclusion? In a market economy the capacity to demand derives from the ability to supply. If you want to demand, you must first supply. If you wish to consume, you must first produce. Supply comes before demand. Production comes before consumption.

Say would have agreed.

In the concluding chapter we’ll discuss the great academic challenge to Say’s Law of Markets: Keynesian economics.