Say's law: How does real income grow?

Economics Economics Questions
1

Hi, I’m new,

From the perspective of say’s law, how are real wealth and real income created. According to logic there are two ways in which real income is increased.

  1. Increase your productivity and thus your purchasing power increases

  2. Others increase their productivity, industry competetion occurs, drives down prices, and thus increases your purchasing power.

But, metaphysically speaking, how does this happen? Say’s law says that your purchasing power, and thus income, is determined by your ability to produce. Thus, if your producitivty increases, this should increase your purchasing power and thus your real income and thus wealth. But this is a chicken and an egg problem. Let me use an example.

Let’s say all spending equals income in the economy and it is in perfect equilibrium. Each individuals real income equals his spending, and all total income equals total spending. Each individual’s spending power is determined by his income, which is determined by his producitivty.

Let’s a say I am a shoemaker in this situation. Given my labor, capital, land, and technology I can produce 50 shoes each week. This determined my purchasing power and thus my real income, spending and wealth, etc.

Then, my producivity increases through an new innovation and I ca now produce 100 shoes with all the same previous resources. According to basic theory this means I should become wealthier and my standard of living should increase.

But if nobody else’s real income has gone up, then who can purchase my new 50 shoes? My purchasing power can only increase if other’s purchase my goods. But there’s nobody to purchase it.

Its like there’s some missing gap here that I’m missing. In other words, how do you put say’s law and economic growth together, at its deepest metaphysical level. I can’t figure it out.

Help is appreciated,

Joe

2

Let us say the quantity of money is absolutely fixed and cannot be increased or decreased. Let us now take all real goods and services in the economy and place them on the left side of a ledger each week. We count all houses, farms, cars, businesses and, yes, shoes, in the ledger. As you said, this should be a constant. On the right side of the ledger, place the number of money units in existence, which is also a constant. Let us say it is 1,000,000 units.

Now, the shoemaker creates in addition to his usual 50 shoes per week another 50 shoes due to the new innovation. At the end of this week, there will be everything that was on the left side of the ledger plus an additional 50 shoes. On the right side of the ledger will be the 1,000,000 units of money.

However, note that by adding the 50 shoes to the left side of the ledger, the purchasing power of a unit of money has increased. One unit of money is now more valuable than it used to be since it can be exchanged for everything it could be exchanged before plus an additional 50 shoes. Real wealth consists solely of real goods and services. Money has no intrinsic value and is only valuable because it enables indirect exchange, profit&loss calculation, and so on.

Does that answer your question?

Clayton -

3

Thank you for replying Clayton.

I can’t explain what I don’t understand. I can’t put it into words. I just cannot visualize the process that is going on.

I wish I could say more, but no matter how many times I read what you wrote, even though I know it is correct and is the answer, nothing is ticking up there.

4

The problem could be that you’re thinking of the value of a unit of money as an absolute in itself, much like a meter or a kilogram is an absolute measurement. The reality is that money is just another good - even though it’s in a category by itself - and its value fluctuates based on supply and demand just like the value of apples fluctuates based on supply and demand. If the number of apples in the economy stays constant and the number of all other goods were to double, apples would be twice as valuable as they were before the doubling. Similarly, if the number of dollars in the economy stays constant and the number of all other goods were to double, dollars would be twice as valuable as they were before the doubling.

Clayton -

5

Think of a video of man making shoes and a man baking bread played first in slow-mo, then in fast forward.

6

Welcome joemac. Have you taken into account that prices of shoes aren’t fixed? Everything is sold at some price. So if the shoe production doubles, the price of shoes would go down to where they are all sold. Society has enough income to buy everything. Higher real income is not a requirement to buy more stuff, real income goes up because people can buy more stuff for the same money. The shoe-maker might only become a bit richer, not twice as rich.

7

Smartass. And you’re not fooling any of us with that class photo from 1975…

Clayton -

8

But if I create so many new shoes, the price will fall until they all sell. But where will the buyers get the money to purchase it? Any income they spend on this item will have to be taken from someone else. Everytime an individual becomes more productive and can sell more products than before (and thus become a little bit wealthier), the price will obviously fall, but spending by consumers will simply be moved from other suppliers (of other goods) towards these cheap new shoes. In other words, anyone who attempts to grow richer through increases in productivity will automatically cause someone else to become poorer.

Can this whole process be explained purely in a barter economy, before money enters into the system?

Here’s one from Arnold kling, “Note that as a matter of simple arithmetic, labor moves from industries where productivity grows faster than demand to industries where demand grows faster than productivity.”

Surely some professional economists has explained this process in detail? I’ve searched everywhere but strangely this post is the first time anyone has discussed this issue.

9

And the price of everything else falls with them… think of it as the opposite of inflation. Inflation occurs when money is printed, all else remaining equal. Deflation occurs when money is taken out of the system, all else remaining equal. However, if the money remains the same and the number of goods increases, deflation also occurs since the same money can now purchase more. Vice versa if the number of goods is decreased (think of a country in which 90% of everything is bombed to oblivion… wouldn’t prices would go up?)

Normally, this increase in real goods and services versus money is so gradual as to be unnoticeable. During the 1990’s, however, growth in the number of goods and services in the tech industry quickly outpaced the gradual inflation rate which usually masks such growth in other sectors of the economy and prices precipitously fell in consumer and commercial computer hardware and software even as the Federal Reserve continued to print money at unprecedented rates in the late 1990’s.

If I can purchase shoes for less, I can sell my labor at a slightly lower price, and my employer can sell his products at a slightly lower price, so on and so forth.

Well, profits are the natural reward for innovation in the market. The first to innovate gets the biggest advantage by being the first to sell at the new, lower price point. Quickly, other shoemakers will imitate the innovation and the price of shoes generally will fall which will affect the price of everything… there will be more shoes in the world and everything will be slightly less expensive due to the reduced cost of shodding oneself.

Clayton -

10

Wow. Nice to know you can be treated with some decency here. I may have to update my stance in the scholarship thread.

11

The price of anything else wouldn’t be affected by an increase in the shoe supply. Price deflation is not the opposite of monetary inflation. Just the price of shoes will go down. Prices of other goods might be lowered in order to compete with cheaper shoes, but only if businessmen decide to do so. Although…

… essentially wages compensate you for the cost of having to wear shoes. When that cost goes down, wages will adjust. That means production of everything becomes a bit cheaper.

Shoes from other producers will still sell, just at that lower price. They will be poorer. But that’s how capitalism works, there are always losers. That’s why producers who don’t want to lose their market share generally support state regulation that stifles innovation. That’s why the business elite always opposes free markets.

I don’t know. Surely somebody has. It might be helpful to think of labor as just another natural resource. Economists talk about that a lot.

12

Smartass. And you’re not fooling any of us with that class photo from 1975…

If this is some sort of personal attack I’d ask you refrained from making them and handled it via private messages.

Inflation occurs when money is printed, all else remaining equal. Deflation occurs when money is taken out of the system, all else remaining equal. However, if the money remains the same and the number of goods increases, deflation also occurs since the same money can now purchase more. Vice versa if the number of goods is decreased (think of a country in which 90% of everything is bombed to oblivion… wouldn’t prices would go up?)

Is it correct to speak of inflation/deflation in this context when the Ms (and presumably Md) remains unchanged? They’re not to be confused with price increases/reductions (which attend upon them all else remaining equal.)

13

I’d rather he doesn’t share his views on my looks via PM either.

14

Just a small point concerning the idea that when someone gains someone else loses. I don’t think that’s true especially with technological advancement. You are assuming that the new innovation in shoe-making can only be applied in that context. What is this innovation? Take steam power for instance. I don’t know for sure, but it’s possible that at one time it was only used in a small number of applications. Then, after a time it would be used in other, more productive ways in various fields and industries. This, I think, can be true of other technological advances as well. The atomic bomb for instance. While the destructive power of it is great, the underlying theories and science behind it can be used to produce energy. Same with the shoe-making example. The concepts behind the the shoe-making innovation can be applied to other industries in different ways.

15

Innovating means that your competitors lose out in the short term. That’s necessarily so. Of course society is better off as a whole because of innovation, but not everyone can win at the same time in capitalism.

Also, nukes were not invented by private business, but by the state. Nuclear energy has a profitable application and would likely have been invented if the state had never invented nukes. Same with microwave ovens and the internet.

16

Well, right, short term. I was thinking more long term. As far as nukes go it was just an example and I guess a bad one really. I do think, though, that some form of nuclear power will become the dominant energy source for a future economy.

17

Yes.

Nominal income for the shoemaker increases, as he sells more shoes at lower prices. However, let’s assume nominal income for all other industries have decreased as households shift some expenditures from all other goods to the shoes.

Furthermore, let’s assume total income for the whole economy is fixed, and output for all other industries (except shoes) have remained unchanged.

Even though the nominal incomes for the other industries have decreased, the real incomes for these industries have actually increased, because the total output for the whole economy has increased on a constant money supply.

Think about it another way. Imagine a pie chart, representing total income, which the shoemaker has a share of the pie. His increased output enlarges his share, while unchanged output of all the other industries reduces their shares.

However, even though the shares of everyone else have decreased, the total pie has become bigger, and each share of the pie is bigger too, since total output has increased for everyone.

Because total income is equal to total expenditures, these expenditures (from wages, rent, profit, and factors) will be spent on more goods than before. Total nominal income remains the same, but total real income has increased.

Let’s alter the scenario and assume that shoes are a luxury good. Everyone else are wearing sandals, since few could afford the shoes.

Let’s assume the shoemaker keep increasing his production continually, increasing supply, and reducing shoe prices. Lower prices, means higher real income, and so more can afford the shoes.

Because shoes are a normal good, while sandals are an inferior good, increased real income will shift expenditures from sandals to shoes.

From the pie chart, the shoe industries is winning more of its share, while the sandal industry is losing some of its share. Because of this competition, the shoe industry increases output, while the sandal industry decreases output.

However, this scenario presents a measurement problem for measuring output. Even though shoe output has increased, while sandal output has decreased, there is no consistent way of summing those two goods, except through prices and quantities.

It is very possible, that total output calculated may seem unchanged, when in reality the composition and quality of the goods have changed.

This is a problem, because even though real income may seem constant, in reality the quality of life for the consumers have increased.

18

The most simple answer to your question is that you can buy your own shoes. This probably doesn’t help you visualize though so I’ll try to offer a more in depth one.

You have 3 people producing goods A, B and C. Each can produce 6 units of goods a month and, for simplicity, we’ll say that the produced goods all have equivelant value (similar cost). Each person consumes 2 units of A, B and C every month and they purchase the two goods that they don’t produce.

The guy producing C all of a sudden doubles his productivity and can now produce 12 units a month. Now the guy producing C can buy 4 units of A and B along with consuming 4 units of C. Meanwhile, the guys producing A and B can consume 1 unit of A and B and 4 units of C.

Before:

  • Produces 6A; Consumes 2A + 2B + 2C
  • Produces 6B; Consumes 2A + 2B + 2C
  • Produces 6C; Consumes 2A + 2B + 2C

After:

  • Produces 6A; Consumes 1A + 1B + 4C
  • Produces 6B; Consumes 1A +1B + 4C
  • Produces 12C; Consumes 4A + 4B + 4C

Of course, the distribution doesn’t have to be that, it could be any combination such as:

  • Produces 6A; Consumes 2B + 4C
  • Produces 6B; Consumes 6C
  • Produces 12C; Consumes 6A + 4B + 2C

This is a contrived example and doesn’t take into account a lot of real world factors such as marginal utility but the point is that an increase in productivity can result in a redistribution of what people purchase. In your shoe example, because he can double his productivity he can lower the price of his shoes which means more people will buy them and some may buy more than one or replace their shoes more frequently. This means their money isn’t going to other goods they previously purchased so those now unpurchased goods are available on the market which the shoe maker can now purchase.

On a large scale there is so much changing at all times in terms of productivity that this all happens without anyone realizing it or being able to keep track of it which is why it helps to simplify the problem down to a very basic example in order to see what is really going on. In the above example the things to note are that doubling of productivity leads to a doubling of consumption and it also leads to a doubling (on average) of the amount that everyone consumes of good C. What the doubly productive producer consumes is unimportant, he could consume all 12C and not any A or B if he wanted. What matters is that there are twice as many units of C in the market and he has twice the purchasing power he used to.

19

You made 50 more shoes. Since we assume there was demand for more shoes that did not get met [which is why you made those extra shoes in the first place] then peopl ewill buy them. But they did not buy them until now because they were too expensive. So you sell the shoes for less. What you lose in cheaper shoe prices you gain in selling more shoes.

You can now buy more things because you have more money. But this wealth spreads to everyone. Because they have the same shoes at a lower price. And some people went from barefoot to shod.

20

This is an excellent barter example Micah71381 has provided. Here are my modifications:

Producer Output Produced Output Saved Expenditures (from others) Income (to Producer) Consumption Gains Loses
A 6A 2A 4A 2B + 2C 2A + 2B + 2C
B 6B 2B 4B 2A + 2C 2A + 2B + 2C
C 6C 2C 4C 2A + 2B 2A + 2B + 2C

Income (to producer) is what you received from the trade. Expenditures (from others) is what you give to the trade.

Expenditures are simply the Output you produced minus the Output you saved for yourself. In other words:

Expenditures = Output Produced - Output Saved

Producer Output Produced Output Saved Expenditures (from others) Income (to Producer) Consumption Gains Loses
A 6A 1A 5A 2B + 5C 1A + 2B + 5C 3C 1A
B 6B 1B 5B 2A + 5C 2A + 1B + 5C 3C 1B
C 12C 2C 10C 3A + 3B 3A + 3B + 2C 1A + 1B None

Let’s say Produce C doubles his output from 6C to 12C (refer to the above table). Here is the breakdown of effects:

  1. Producer C expenditures (from others) have increased from 4C to 10 C. Producer C still saves 2C for himself.

  2. Income for Producer C has increased from 2A + 2B to 3A + 3B.

  3. Because Income must equal Expenditures, increased expenditures by Producer C means increased income to Producer A and Produce B. Producer A income has increased 2B + 2C to 2B + 5C. Producer B incomes has increased from 2A + 2C to 2A + 5C.

  4. Even though Producer A and Producer B Output has remain unchanged at 6A and 6B, respectively, their income has increased by 3C, respectively. But Produce A and Producer B gives up one unit from savings in trade to Producer C.

Net effect is this:

  • Producer C increases his consumption (gains) by 1A + 1B, while he loses nothing.

  • Producer A increases his consumption (gains) by 3C, while decreases his consumption (loses) by 1A.

  • Producer B increases his consumption (gains) by 3C, while decreases his consumption (loses) by 1B.

In summary, Producer C increases his Income by increasing his productivity, but through his increased Income, he must also increase his Expenditures, which then increases the incomes of Producer A and Producer B.

Even though Producer A and Producer B loses something, they gain in trade with more of something else.

If you have any more questions, feel free to ask.