When using economic analysis, why must we be careful when attempting to generalize individual effects into economy-wide effects? This is precisely the distinction between partial equilibrium and general equilibrium models – and the trap is known as the fallacy of composition. It can be enticing to try to extend individual effects to economy-wide effects, as Nick Rowe suggests:
Q1. What happens if they built robots that could do my job as well as I could, and those robots got cheaper and cheaper over time? My wages would have to fall so I could compete with the robots, and I would be worse off.
Q2. What happens if they built robots that could do everyone’s job as well as they could, and those robots got cheaper and cheaper over time? Everyone’s wages would have to fall so they could compete with the robots, and everyone would be worse off.
Q1 is a partial equilibrium question and answer.
Q2 is a general equilibrium question and answer.
If you say “Therefore” between my Q1 and Q2, you are committing a Fallacy of Composition.
Why is such a fallacy so enticing? Well, because actually thinking about the total impact of the individual effects is challenging:
Trying to add up all the partial equilibrium effects in the case of robots is almost impossibly hard. Let’s see. If a robot could replace me, and my wages fell, what would that do to the cost of a university education? And how would that affect prices and other people’s wages? And how would the Bank of Canada react if it pushed down prices across the economy? And what about investment in robots, and the jobs created there? What would I do instead? And what would happen to profits of robot manufacturers? And the owners of robots?
There is no way that anyone, economist or not, could trace through all the effects of cheap robots competing to do my job. And there is absolutely no way whatsoever that anyone could do that for my job, and then repeat it for all the jobs in the economy, and then add up all the effects.