Fallacy of Composition in Economics

By Dr. Hassan Shirvani —-The fallacy of composition refers to the logically untenable position that what is true for a member of a group must necessarily also be true for the group as a whole. Perhaps a good example of this fallacy is the assertion that since an individual in a crowded room can obtain a better view by standing on a chair, then it must follow that all the individuals in the room can also improve their views by simultaneously standing on their chairs.

Despite the widespread familiarity with the above fallacy, much of the everyday discussions of economic issues are characterized by a failure to observe it. In this brief post, we review some of the most prominent examples of this failure and their consequences for the conduct of economic analysis and policy.

SAVINGS

The first example concerns the paradox of saving. This paradox simply asserts that while a typical household can save more by spending less, all households together cannot. The reason for this is that spending by one household constitutes income for another. Under these conditions, any concerted attempt on the part of some households to collectively increase their savings can only reduce incomes and savings for other households.   The net effect on aggregate savings will thus be close to null. This conclusion particularly shows that attempts at government austerity during recessions are particularly prone to failure. As governments try to save more by tightening their belts, the reduced public spending can only result in lower household incomes and, hence, smaller tax revenues. The reduced taxes will, in turn, offset the effects of lower public expenditures, with little or no net effect on the size of the government budget deficit.

EXCHANGE RATE POLICY

Another example of the composition fallacy in economics relates to the exchange rate policy. As it is well-known, countries can improve their balance of international payments through the devaluation of their currencies. By lowering the values of their currencies, countries can make their imports more expensive and their exports more competitive, thus lowering their imports and increasing their exports, with the overall improvement of their trade balances. However, once again, what will work for one country will not necessarily work for all countries combined.   Thus, the so-called beggar-thy-neighbor policy, in which countries resort to competitive devaluations to improve their international economic standings are often doomed to fail. It is simply not possible for all countries to raise their exports and reduce their imports simultaneously, as the exports of one country are simply the imports of another country.

DEBT

As a final example of the above fallacy, we can mention the excessive and often unwarranted obsession with debt.  Extrapolating once again from the case of a typical household to the society at large, it is often asserted that debt is a four-letter word.  Even Shakespeare seems to offer the admonition of “Neither a borrower nor a lender be.” Even if this sounds like a wise advice for a spendthrift household living beyond its means, it certainly is not for the economy as a whole.  If households refuse to borrow, then there will be no possibility for surplus sectors in the economy to find profitable outlets for their savings.  This will in turn result in the abandonment of many socially productive projects due to lack of funds, resulting in less capital formation and lower living standards.

 

In summary, when debating economic issues, one should always be careful about the fallacy of composition, lest one is led astray into taking false economic positions.

 

Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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