The fallacy of composition lies behind the failure of farmers to earn more income when each farmer increases their crop. The price of a bushel drops more than their extra bushels can make up for. A similar trap can lurk in personal decisions.
If you don’t pay your taxes, the government will not grind to a halt. Its services will continue. National defense stays at the ready. The Federal Aviation board will continue to track down causes of airplane crashes and make regulations to avoid that cause in the future. Skip your taxes and you have more cash in your pocket.
If others see you prospering by tax avoidance, they may decide to do the same. However, when everybody does that, the government doesn’t have enough income to continue all its services. The Food and Drug Administration could stop ensuring that food products are safe and contain the ingredients claimed. The administrative system which provided many services could no longer provide them all.
Public infrastructure—roads, bridges, airports, water, electricity, power supply, and so on—is at risk when government doesn’t have sufficient funds for its tasks. That is certainly not to say that government should be given all the funds it initially requests. The requests must be vetted, but skimping on taxes—individually on April 15 or as a society by levying too low a rate to support the government’s mandates—is a path to a failed society.
The price of a successful society is an individual’s payment of levied taxes and laws requiring a sufficient tax rate on all participants in the economy. Only in that way can government provide the services our representatives approve and mandate.
Natural Resource Management
Another good example of the need to guard against the actions of the Fallacy of Composition and ignore the allocation that the free market’s Invisible Hand would lead involve occupations and personal activities with constrained resources.
For instance, fishing. There are quotas placed on the individual count allowed. Quotas are a reaction against depletion which would occur if everyone took as much as they could. Regulators recognize that although one boat doing so would not cause harm, all boats doing so would.
Potential loss of beneficial animals and securing minerals and forests for future generations are three other areas that require limitations. Each of these could suffer collapse if the fallacy of composition were ignored—if everyone was allowed to exploit as they wished, because one could with profit.
Individual can profit if only a small portion of the society follows their path, because then the pricing mechanism does not change system. Avoiding the Fallacy of Composition allows one to use the prices the Invisible Hand originally arrived at.
However, if everyone follows the few, the system changes and one’s advantage is lost (the Fallacy of Composition kicks in).
This leads to an unexpected mathematics. Each individual sees a gain until abruptly the group action affects the market and they earn less. A series of pluses results in a negative. Individual positive events combine to product a negative impact.
Positive + positive + positive + … = negative
Not like the old math, 1+1 = 2, is it?
The Invisible Hand holds that the market aggregates individual needs into a balanced system. Yet considering the Fallacy of Composition, there are many cases where actions that benefited individuals lead to negative consequences if the entire group takes them.
A solution some people arrive at, of dubious ethics, is to keep secret any change that they think will benefit them, so everyone doesn’t do it and negate their advantage.
But personal secrecy is not the most striking shortcoming of relying on free markets to allocate resources. The Invisible Hand’s biggest scar arises from a stronger violation of its required conditions.