Single Stage Thinking and The Fallacy of Composition

I’ve been going through Thomas Sowell’s primers on economics, starting with Basic Economics and continuing with Applied Economics.  This has me thinking a bit more on these subjects.

A lot of where politics goes wrong (for the economy and the people as a whole–not for the politicians) is through the twin fallacies of Single Stage Thinking and Composition.

Single Stage thinking is where one takes the first effects of a policy and not following through on where things go as you continue farther and farther from the initial impetus.  For example, a city might increase its tax revenue for popular municipal projects, whether a new sports stadium, new city parks, or a brand new hospital by increasing taxes on businesses located within the city.  It’s not easy for a business, especially a factory with land and machinery that’s hard, and expensive, to relocate elsewhere so they have no choice but to pay the higher taxes.  And the politician gets the benefit of public acclaim (and votes in the next election) for the municipal project.  But over time, things change.  If the business has more than one location, when they have a downturn (as all businesses do–ask me sometime about how silly that scene seen in fiction where the hard rolling businessman is told that some stock he owns has fallen a fraction of a point and he says to sell because he “only backs winners”), it’s this high tax city where they cut production first.  Some smaller businesses (or even large ones) that might have been struggling, but with the possibility of getting through the tough times might find the additional tax burden “the straw that broke the camels back” and go out of business.  And there’s always some turnover of business–some fail while others start up–the folk looking to start new businesses look at the city’s taxes and decide maybe they’d be better in a different city with more favorable taxes.  And these second and third order effects start causing tax revenue to fall, perhaps even lower than it was before the tax rate was increased because there is simply less income being taxed.

All these things take time.  They don’t happen instantly.  And by the time the pinch is felt, no one associates the increase of taxes that started that downhill slide with the results.  The politician who rode the cheers for the municipal projects to re-election might well have moved on to higher office.

Now this is not even to say that the municipal projects were necessarily unworthy.  A new hospital may be of considerable value to the community.  But how worthy the project was does not change the effects of the changing tax structure.  And the very nature of politics provides incentives for the politician to go for the quick approval regardless of what the effects down the road might be.

The second fallacy is the fallacy of composition:  the idea that if something is good for some part of the economy, it’s good for the economy as a whole.  The classic example is protectionist tariffs.  I have used the example of tariffs on imported steel before.  Yes, they may be good for jobs in the domestic steel industry, but that is by increasing the cost of steel–it doesn’t bring the cost of domestic steel down to compete with imported; it drives the cost of imported up to match (or exceed) domestic steel.  And that means the cost to everyone who uses steel needs to pay more.  And that means things that are manufactured from steel, or even just manufactured using steel machinery (because the cost of that machinery also goes up and has to be recovered), which basically boils down to just about all manufactured goods.  Oh, it may take time for the costs to spread since existing machinery will still be in use, but the cost of maintaining that machinery will go up as well.  And one of the first principles of economics is that people will buy less of something as the price increases.  This reduces the quantity demanded for all those goods and services–people make do, hold onto things longer, find less expensive alternatives which could be as simple as buying used instead of new, or simply do without in some cases.  And that makes the demand for labor to provide all these goods and services.  And so, while jobs were saved in steel manufacturing, jobs were lost in other sectors of the economy leading to a net reduction in productivity and a lower overall standard of living.  So better for the steel production industry is not better for the economy as a whole.

Some might think that the case with steel is an exceptional case since steel is such an important metal to so much of the rest of the economy.  So let’s consider a more limited case.  Let’s look at cars.  And to limit it still further let’s ignore the effect that increasing the cost of transportation actually affects the price, and therefore the quantity demanded, of goods transported on the roads.  Tariffs on imported cars can look pretty good to domestic car makers.  Once again, though, we’re raising the cost of cars to the consumer.  This reduces the quantity demanded for new cars.  Now maybe that works out well for the domestic producers if the drop in quantity demanded fell more heavily on the imports so that the quantity demanded of new cars actually increased.  But what then?  There were certainly people right on the edge of buying new vs buying used.  Only the low-cost alternative for “new” is out of the picture.  So they buy used.  This increases the demand for used cars and thereby increases the prices.  Depending on a number of factors that may or may not lead to fewer used cars sold (“demand” and “quantity demanded” are two different but related things).  The average age of cars on the road goes up.  Older cars are more likely to break down.  So we have more missed work (and lost productivity) while people have to deal with their mechanical woes.  And on top of all that, people having to spend more money on their cars, new or used, means they have less money to spend on other things, reducing demand in other sectors of the economy.  And the end result is a net reduction in productivity and a lower overall standard of living.  So “better” for the domestic auto production industry is not better for the economy.

You might note that while I focused on First Order Thinking in the first example and Fallacy of Composition in the second and third, they all involved both.  I called them twin fallacies because they are so often intertwined.  First Order Thinking causes one to ignore the extended effects that show why the “good” one is seeking to accomplish may not be good for the overall economy.  And seeing that immediate good provides an incentive to stop there and presume that it must lead to an overall benefit.

Most people don’t think these things through.  It’s not that they are stupid or uneducated.  It’s that it takes a deliberate effort and the consequences often are not obvious.  Indeed, even some of the most knowledgeable economists in the world are known to differ on the effects of specific policies.  People don’t have the time to consider everything that might influence the economics behind political choices.  And so they end up seizing on something that sounds good and seems “intuitive”–even though intuitive is very often wrong.

And we’re right back to why Economics is “The Dismal Science” again.



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