What is ‘effective demand’?18 July, 2016 at 11:04 | Posted in Economics | 7 Comments
Economists of all shades have generally misunderstood the theoretical structure of Keynes’s The General Theory. Quite often this is a result of misunderstanding the concept of ‘effective demand’ — one of the key theoretical innovations of The General Theory.
Jesper Jespersen untangles the concept and shows how Keynes, by taking uncertainty seriously, contributed to forming an analytical alternative to the prevailing neoclassical general equilibrium framework:
Effective demand is one of the distinctive analytical concepts that Keynes developed in The General Theory. Demand and demand management have thereby come to represent one of the distinct trademarks of Keynesian macroeconomic theory and policy. It is not without reason that the central position of this concept has left the impression that Keynes’s macroeconomic model predominantly consists of theories for determining demand, while the supply side is neglected. From here it is a short step within a superficial interpretation to conclude that Keynes (and post-Keynesians) had ended up in a theoretical dead end, where macroeconomic development is exclusively determined by demand factors …
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.
Therefore, it was somewhat unfortunate that Keynes called his new analytical concept ‘effective demand’, which may have contributed to misleading generations of open minded macroeconomists to concluding that it was exclusively realized demand for consumer and investment goods that drives the macroeconomic development. Hereby a gateway for the IS/LM-model interpretation of effective demand was opened, where demand creates its own supply.
On the contrary, it is the interaction between the sum of the individual firms’ sales expectations (aggregate demand) and their estimated production costs (aggregate supply) that together with a number of institutional conditions (bank credit, labour market organization, global competition and technology) determine the business sector decisions on output as a whole and employment …
The supply side in the goods market is an aggregate presentation of firms’ cost functions considered as a whole. It shows a relation between what Keynes called ‘supply price’, i.e. the sales proceeds that, given the production function and cost structures, is needed to ‘just make it worth the while of the entrepreneurs to give that employment’ (Keynes, 1936: 24). This means that behind the supply curve there is a combination of variable costs plus an expected profit at different levels of employment. At each level firms try to maximise their profit, if they succeed there is no (further) incentive for firms to change production or employment.
These assumptions entail that the aggregate supply function (what Keynes called the Z-curve) is upward sloping and represents the proceeds that has to be expected by the industry as a whole to make a certain employment ‘worth undertaken’ … In fact, this aggregate supply function looks like it was taken directly from a standard, neoclassical textbook, where decreasing marginal productivity of labour within the representative firm is assumed; the main difference is that Keynes is dealing with the aggregate sum of heterogeneous firms i.e. the industry as a whole.
The other equally important part of effective demand is aggregate demand function, which is the value of the sales that firms as a whole expect at different levels of macro-activity measured by employment (as a whole) …
Firms make a kind of survey-based expectation with regard to the most likely development in sales and proceeds in the nearer future. This expectation of aggregate demand (as a whole) is a useful point of departure for the individual firms when they have to form their specific expectation of future proceeds. This sales expectation will therefore centre around the future macroeconomic demand (and on the intensity of international competition).
Accordingly, Keynes’s macro-theory has a microeconomic foundation of firms trying to maximise profit, but differs from neoclassical theory by introducing uncertainty related to the future, which makes an explicit introduction of aggregate demand relevant i.e. the expected sales proceeds by business as a whole.
‘Effective demand’ is nothing but the value of the aggregate demand function where it equals the aggregate supply function, which is at the point where the firms expect to maximize their profits. To Keynes — contrary to the ‘classical’ theory, which assumes that aggregate demand always accommodates to aggregate supply and hence is consistent with ‘effective demand’ having an infinite range of values — ‘effective demand’ has a unique equilibrium value. And — most importantly — that value may be at a level below the one that is compatible with full employment.