3: The Principle of Effective Demand

This is a summary chapter, and Keynes promises to define the terms more precisely later. So I don’t want to waste much time quibbling. I am looking forward especially to the definition of ‘user cost’ in Chapter 6. Here it is a black hole, nobody’s income. I assume it means depreciation.

It seems – but I could be wrong – that Keynes does not consider ‘capital’ (in the means-of-production sense) to be a ‘factor of production’ – as some neoclassicals distinguish between ‘entrepreneur’ and owner-of-capital, even if they are the same person, so that the entrepreneur rents the services of capital. I think Keynes is taking a more commonsense approach. Some parts of capital are bought in the immediate period from other entrepreneurs, others are means-of-production the entrepreneur already has (dealt with through ‘user cost’). In neither case are the payments (or imputed payments) treated as part of ‘total income’. I get this impression from footnote 2 on page 24: “…since user cost is obviously dependent both on the degree of integration of industry and on the extent to which entrepreneurs buy from one another…”

Keynes stresses that both the aggregate supply price and the aggregate demand price is based on the entrepreneurs’ expectations of a certain quantity of proceeds. The expectation could be wrong, but it is the expectation and not the actual result that determines how many people and how much capacity entrepreneurs will employ. And it is the entrepreneurs’ expectations that are relevant, and not the expectations of those doing the demanding. ‘Aggregate supply price’ depends on the behaviour of entrepreneurs, so does not include ‘user cost’, which is a deduction from the income they are trying to maximise. But the actual price of goods will include user cost, so the effective price for buyers is higher than the effective price for sellers, with the gap being user cost.

I want to get in the habit here of writing out the equations in words to make sure I understand them, so I’ll do it even when they’re this basic.

Aggregate supply function: Z = ø(N): the proceeds making it worthwhile to employ a certain number of workers depends in some way on the number of workers employed.

Aggregate demand function: D = f(N): the proceeds entrepreneurs expect to receive depends in some way on the number of workers employed.

The level of employment will tend towards the point where Z and D are equal, because entrepreneurs have an incentive to increase employment if they expect the proceeds they receive from output produced by the current level of employment to exceed the amount that would make it just worthwhile to employ that number of workers. (Likewise, they have an incentive to reduce employment if they expect to get less than the amount making the current level of employment worthwhile to them.)

This point of intersection is ‘effective demand’ – and it’s interesting to note that this is not the popular definition of ‘effective demand’, at least as I understood it: where ‘effective demand’ means demand with money to back it. Here, a certain level of aggregate demand is ‘effective’ because it’s the point that determines supply.

This is the essence of Keynes’ whole theory of employment:

Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend. [p. 25]

It differs from the classical Say’s Law theory of employment, which according to Keynes implies that Z and D are equal regardless of the level of employment. “That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.” [p. 26] Here we start to see what Keynes meant in the last chapter about Say’s Law and the classical theory of employment standing or falling together, and we get another definition of ‘full employment’, now related to demand as well as the behaviour of labour: full employment is the point at which “a further increase in the value of effective demand will no longer be accompanied by any increase in output” because the marginal disutility of a higher quantity of labour exceeds the real wage.

This chapter also makes clearer the substance of Keynes’ objection to Say’s Law. Actual expenditure may be by definition equal to actual income, but the functions above refer to entrepreneurs expectations, which determines their behaviour before the outcome of that behaviour is known.

The next section is a precis of the rest of the book. There’s not much point in summarising it even further here. The main thing to note is that Keynes’ system is still based around equilibrium – of aggregate supply and aggregate demand, as defined above – but there is no a priori reason why this equilibrium point should also be the point of full employment, again as defined above. It will be at that point only “by accident or design”, and the key determining factors of effective demand are the “inducement to invest” (dependent on “the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks”) and the “propensity to consume”. [pp. 27-28]

The last section asks why the “great puzzle of Effective Demand… vanished from economic literature”, except where it “could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas”. [p. 32] His sardonic answer wouldn’t be out of place in Veblen, and seems calculated to outrage the “fellow economists” to which his book is “chiefly addressed” [p. v]:

That [classical economics] reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority. [p. 33]

Published in: on 8 October, 2007 at 8:49 am  Leave a Comment  

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