One of the most important concepts that are being teach in economics, and most importantly in macroeconomics, is the notion of the fallacy of composition.
Students and others who haven’t been exposed to macroeconomics naturally extrapolate from their own individual situation to society and the economy as a whole.
Students and others who haven’t been exposed to macroeconomics naturally extrapolate from their own individual situation to society and the economy as a whole.
This often leads to the problem of the fallacy of composition. Of course, that isn’t just restricted to economics. While a few people could exit the doors of a crowded movie theater, all of us could not.
The macroeconomics example of the fallacy of composition most often used is the paradox of thrift. Any individual can increase his saving by reducing his spending — on consumption goods. So long as his decision does not affect his income — and there is no reason to assume that it would — he ends up with less consumption and more saving.
The macroeconomics example of the fallacy of composition most often used is the paradox of thrift. Any individual can increase his saving by reducing his spending — on consumption goods. So long as his decision does not affect his income — and there is no reason to assume that it would — he ends up with less consumption and more saving.
The example I always use involves Kassim who usually eats an ayamku spring at Ayamku restaurant every day. He decides to forego one ayamku spring per week, to accumulate savings. Of course, so long as he sticks to his plan, he will add to his savings (and financial wealth) every week.
The question is this: what if everyone did the same thing as Kassim — would the reduction of the consumption of ayamku spring raise aggregate (national) saving (and financial wealth)?
The answer is that it will not. Why not? Because Ayamku will not sell as many ayamku spring, it will begin to lay-off workers and reduce its orders for chicken, cucumber, cabbage, rice, and so on.
All those workers who lose their jobs will have lower incomes, and will have to reduce their own saving. You can use the notion of the multiplier to show that this process comes to a stop when the lower saving by all those who lost their jobs equals the higher saving of all those who cut their ayamku spring consumption. At the aggregate level, there is no accumulation of savings (financial wealth).
Of course that is a simple and even silly example. But the underlying explanation is that when we look at the individual’s increase of saving, we can safely ignore any macro effects because they are so small that they have only an infinitely small impact on the economy as a whole.
But if everyone tries to increase saving, we cannot ignore the effects of lower spending on the economy as a whole. That is the point that has to be driven home especially when countries all over the world are on fiscal austerity mode including our country, Brunei Darussalam.
