THE FALLACY OF COMPOSITION

THE FALLACY OF COMPOSITION

Not necessarily. Because one action on its own is efficient, it does
not mean that all similar actions added together will bring about
the most efficient, economical allocation of resources as a whole.
That is the FALLACY OF COMPOSITION.
Suppose you leave work early to avoid the rush hour and miss
all the traffic. That is a perfectly reasonable and rational action that
succeeds on its own. But if everyone chooses to do likewise then, in
aggregate, this action fails. Everyone gets stuck in the traffic.
John Maynard Keynes, the brilliant twentieth-century economist
who revolutionised the subject, applied the same logic to
money, incomes and employment. Two examples will suffice.
First, consider the role of savings. If you and I save a larger
proportion of our income this year then next year we will be that
much richer. Put, say, 10 per cent of our income away then next
year not only will we have 10 per cent more but we might get
added interest too. Save more this year and we earn more next year.
Now think through the consequences if the whole country did
the same. If everyone stopped spending 10 per cent this year and
saved more, then national consumption will drop. All businesses
would sell less, earn less and thus would have to reduce costs and
© 2004 Tony Cleaver
outputs – lay off workers and/or cut wages. National income would
fall by 10 per cent. So, if everyone saves more, everyone loses.
Next look at the case of wages. Market economics asserts that if,
in your job, you ask for wages that are too high you won’t get taken
on by employers. Conversely, if wages are too low there may be
plenty of businesses willing to employ such cheap labour but there
will be too few workers willing to sell their skills for so little.Wages
will adjust over time, therefore to a level that just equates the
amount of work offered to the supply of the labour willing to take
it on. The equilibrium wage equates demand (from employers) to
the supply of labour.
This is the key function of the price mechanism – to clear
markets. By this argument, there can be no unemployment. If there
was, the excess supply of labour would bid wages down, employers’
demand for labour would increase such that the unemployment
would gradually disappear.
You should be able to see that this self-adjusting mechanism,
even if it does work in one labour market, cannot work in all
markets added together. A fall in wages in one sector, say the
restaurant trade, might well attract employers to employ more
waiters, kitchen staff, etc. But if wages fell across the whole
economy, assuming no immediate and corresponding fall in prices,
national income would again fall, aggregate consumption must fall,
there would be less business for everyone, and so employment in all
sectors would fall in the short run, not rise.
We thus enter the world of macroeconomics – the economics of
all markets in a country aggregated together. We need different
theories, analyses, models to understand the workings of entire
nations since, as has been demonstrated, what works efficiently at
the level of individual consumers and producers need not work in
aggregate for society as a whole.