Saturday, May 30, 2015

What is "effective demand" and why do we care?

Chapter three of The General Theory is The Principle of Effective Demand. Keynes opens the chapter with some definitions. I want to skip a few of them and get to the ones where he defines the term "effective demand".

We begin with supply and demand. We begin with the "aggregate supply function" Z and the "aggregate demand function" D:
Let Z be the aggregate supply price of the output from employing N men ....

Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men ....

Now ... if D is greater than Z, there will be an incentive to entrepreneurs to increase employment ... up to the value of N for which Z has become equal to D. Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.

So effective demand occurs at the equilibrium point where the supply curve and the demand curve intersect -- where they intersect in the expectations of entrepreneurs. That's according to Keynes. And I think he's the one who invented the term, so his is the definition I want to use.

To my simple mind, thinking like a consumer, thinking of demand as a quantity demanded -- gasp!! -- the term makes perfect sense. "Effective" demand is given by actual purchases: by how much we spent. I can't think of a better fit for the word "effective". This goes back to Adam Smith:

The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand; since it may be sufficient to effectuate the bringing of the commodity to market.

But as we all know, now, "quantity demanded" is not the same as demand. So, "how much we spent" to buy that quantity can't be demand, either. And that means that "actual purchases" cannot be demand. (Clearly, "actual purchases" are the same as "quantity demanded"!)

Yeah, I have trouble with that. As a demand-side entity, I think I express demand by buying things. I don't think I express demand by woulda-buying more at a lower price and woulda-buying less at a higher price. If your price is too high and I buy little, well, that's the demand I express then. If you think you can get me to buy more by lowering the price, go for it.

Effective demand occurs at the intersection of supply and demand, where supply is

the expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment

and demand is

the proceeds which entrepreneurs expect to receive from the employment of N men

according to Keynes. Demand in this view is the demand for labor. Supply is not supply at all, but is the minimum acceptable return that brings supply to market. This is altogether supply-side machinery.

So why do I care about effective demand? I guess I don't.

Come to think of it, why do I care about the grand distinction between "demand" and "quantity demanded"? Because economists tell me this distinction exists?? That ain't gonna happen.

I'm easily convinced of things, by good argument. The argument that economists make a distinction, that's not good argument. Seems like an appeal to authority.

Or maybe it's just ego.


Oilfield Trash said...


The importance of the principle of effective demand lies in pointing out the cause and remedy of unemployment.

Unemployment is caused by a deficiency of effective demand and it can be removed by an increase in consumption expenditure or/and investment expenditure and in case private expenditures are insufficient and ineffective in bringing about the required level of employment, the same can be achieved by government expenditure.

The principle of effective demand repudiates Say’s law of markets that supply creates its own demand and that full employment equilibrium is a normal situation in the economy.

It is not “ altogether supply-side machinery.”

The Arthurian said...

Yeah, OT, that's what I thought. (Only I didn't think it as clearly as you.) But I'm not trying to evaluate effective demand based on what I thought or on what you thought or on what any of the many interpreters of Keynes thought. I'm trying to evaluate it based on what Keynes said.

I pruned it down to those two "expectation of proceeds" statements because I thought that was the best minimal representation of Chapter Three.

In section ii of the chapter, item (3), Keynes says effective demand is the sum of "the amount which the community is expected to spend on consumption" plus "the amount which it is expected to devote to new investment". That's the familiar version. And that's more like how I think of "demand" except I think actual spending, not expected spending. (But then, I'm not one to plan ahead.)

Sumner & Glasner & the lot of them apparently say demand at any moment is a whole range of expected quantities demanded, depending on price. Keynes pins effective demand down to a single point. "The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand."

I think it is interesting that Sumner dismisses "quantity demanded" in favor of a whole range of possible quantities demanded, while Keynes pins it down to the single point because that is the significant quantity.

I guess they base it on expectations because employment today depends on how employers expect things will turn out tomorrow, when the product is sold.

It is not “altogether supply-side machinery.”

Don't get defensive :)

Oilfield Trash said...


The belief that price and quantity are jointly determined by the interaction of supply and demand is perhaps the most central tenet of conventional economics.
Marshall’s words that supply and demand are like the two blades of a pair of scissors: both are needed to do the job, and it’s impossible to say that one or the other determines anything on its own, sum sit up best for me.

The bigger story is while you can at a simplified level show downward sloping demand curves for individuals you cannot do the same for market demand curves. Society is more complicated than the sum of its individual members, and a society’s behavior cannot be modeled by simply adding up the behaviors of all the individuals in it.

If demand curves are not always downward sloping then the notion that demand for a commodity falls as its price rises, supply rises as price rises, and the intersection of the two curves determines both the quantity sold and the price does not hold true in markets.

The Arthurian said...

Okay. (After a year and more...) At Syll's

Syll quotes Jesper Jespersen:
It is the behaviour of profit-seeking firms acting under the ontological condition of uncertainty that is at the centre of post-Keynesian concept of effective demand. It is entrepreneurs’ expectations with regard to demand and supply factor that determine their plans for output as a whole and by that the effective demand for labour.

Jespersen's is an exactly correct representation of what Keynes said, which I quoted in the last section of the post.

Wow. I wasn't really sure I was reading Keynes right. I feel better about it now.