What Is Walras's Law?
Let me explain Walras's Law to you directly: it's an economic theory that says if there's excess supply in one market, there has to be excess demand in another market to balance things out. This law insists that if all other markets are in equilibrium, the one you're looking at must be too. In contrast, Keynesian economics suggests that one market can be out of balance without a matching imbalance somewhere else.
Key Takeaways
- Walras's Law implies that for any excess demand or oversupply for a single good, a corresponding excess supply or overdemand exists for at least one other good, which defines market equilibrium.
- This law is based on equilibrium theory, requiring all markets to be cleared of excess supply and demand to reach equilibrium.
- Keynesian economic theory contrasts with Walras's Law by allowing one market to be imbalanced without another market being out of balance.
- Walras's Law operates on the principle of the invisible hand: where there's excess demand, it raises prices, and where there's excess supply, it decreases prices until equilibrium is achieved.
- Critics point out that quantifying utility, which influences demand, makes Walras's Law hard to formulate as a mathematical equation.
Understanding Walras's Law
Walras's Law gets its name from the French economist Léon Walras (1834-1910), who developed general equilibrium theory and founded the Lausanne School of economics. You can find his key insights in his book Elements of Pure Economics, published in 1874. Walras, together with William Jevons and Carl Menger, is considered one of the founding fathers of neoclassical economics.
This law assumes the invisible hand is working to bring markets into equilibrium. If there's excess demand, the invisible hand pushes prices up; if there's excess supply, it pulls prices down for consumers, driving everything toward balance.
Producers react rationally to interest rate changes: they cut production when rates rise and invest more in facilities when rates fall. Walras built these dynamics on the idea that consumers act in their self-interest and firms aim to maximize profits.
Limitations of Walras's Law
In practice, real-world observations often don't align with Walras's theory. Even if all other markets are in equilibrium, an excess of supply or demand in one market means it's not balanced, showing that the law views markets as a whole rather than individually.
Economists building on Walras's work have noted that quantifying 'utility'—a subjective concept—poses a major challenge in turning the law into mathematical equations, which was Walras's goal. Measuring utility for individuals and aggregating it across a population isn't feasible, critics say. Without this, the law doesn't hold up because utility drives demand.
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