Sunday, January 04, 2009

FoC (2) - Examples

What is true at the microeconomic level is not necessarily true at the macroeconomic level. Here are some commonly stated examples.

  1. The best action for a business during a time of recession might be to lay off staff and reduce production. This makes sense for the individual business, but all firms lay off staff, incomes will fall, sales might decline and the recession might deepen. A response that is good for a particular business might be bad for the economy, if all businesses take the same action.
  2. An individual business can increase profits by reducing expenses. However, one businesses expense is another businesses sale, so if all firms try to increase their profits by reducing expenses, they might all experience a reduction in profits, as sales decline.
  3. If large numbers of investors attempt to get out of debt by selling assets. Irving Fisher described this back in 1933, observing that when people who are deeply in debt get into trouble they usually sell assets. He called it a “stampede to liquidity.” Investors dump stocks and property for any price they can get – desperate to pay off their debts before they are dragged into bankruptcy. What is good for every individual investor turns out to be bad for the economy itself. Asset prices fall. Sales fall. Unemployment rises. The slump deepens.
  4. Tariffs can reduce imports providing protection for local manufacturers. However, if every country in imposes trade barriers, world trade will decline and every nation will be worse off. What works for one nation may be harmful for the world economy.
  5. During an economic crisis, a sensible household will reduce spending and save as much as possible to prepare for the uncertainty that lies ahead. However, if all households take this action, sales will decline and businesses will struggle leading to further unemployment. The action is that sensible for any one household harms all households in the economy. Keynes called this the paradox of thrift.
    The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth (Paradox of Thrift).
    Keynes claimed that thrift is good for an individual, but if everyone saves more, it may cause a recession by reducing consumer demand. He argued that the common assumption that thrift is good for the economy, because thrift is good for the individual is a fallacy of composition.
I will explain in my next few posts why most of these examples are misleading.

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