Thursday, February 9, 2012

The Paradox of Toil

Gauti Eggertsson at the New York Fed has a provocative new paper entitled "The Paradox of Toil," which argues, in parallel with Keynes's "Paradox of Thrift," that while a single individual can work a little more, if everyone looks for more work, the result won't necessarily be an increase in total employment.

Eggertsson's "paradox of toil" is an example of the fallacy of composition: if you generalize from what one individual does to what will happen in the aggregate if everybody does it, you won't necessarily get the right result.  One person can increase his saving by reducing his spending because this has no effect on his income.  But if everyone reduces their spending, everyone's income will fall, which makes saving more difficult.

Here's the logic behind Eggertsson's paradox of toil: "Everybody trying to work more . . . puts downward pressure on current and future wages . . . Firms cut their prices today and in the future and stand ready to supply whatever is demanded at those prices. . .  This leads to expectations of deflation, which increase the real interest rate . . . and the central bank can’t offset this by cutting the nominal rate because the rate cannot be below zero.  Higher real interest rates lead to lower demand because people prefer to spend in the future rather than today, since prices are expected to be lower in the future . . . Because of lower spending today, firms demand less labor.  Thus, more labor supply leads to lower wages, more deflation, and higher real rates, which leads to less spending, which leads to less hiring of workers.  Therein lays the paradox."

The fallacy of composition is an under-appreciated concept with broad application: 
  • Although one country can devalue its currency to improve its trade balance, every country can't do this
  • One person can increase her liquidity by selling her assets for cash, but everyone can't do this because the community's assets must be held by someone
  • Although one firm can increase its sales revenue by reducing its wage costs, if every firm attempts this, total wage income and total sales to workers will decline
Keynes, himself, made all these points, and while he's usually characterized as a partial equilibrium theorist in the Marshallian mode, these fallacies of composition all arise from failing to take account of general equilibrium considerations.

1 comment:

  1. If an average firm should suddenly produce more it would most likely produce more than there was a ready market for, at least without altering related parts of the economy (which might be the whole economy) - or else the firm would have been bigger already. And some firms could not produce more because of limited supply of raw materials or sufficiently educated workers, or some other relevant resources I’m sure exists. And some products are probably filling the existent need already, in rich countries at least; bread comes to mind. And some parts of the market are actually shrinking: there’s not much hope of growth in the production of photographic film, the workers at Kodak willing to do twenty hours shifts notwithstanding.

    So I don’t see any need for any paradox of toil, as long as the capital structure is not converted into some uniform ooze produced by every worker running in the same type of treadmill, something that can be fetched as finished products through a tap in the back of every shop. The macro economy is merely a language tool, like Bishop Berkeley’s triangle, it doesn’t exist as something that continually reacts on reactions spreading through the economy, like a real market.

    We could all be richer if we all made more of an effort, of that I’m certain, but a big part of that effort would be finding all the different things that we should produce variably more of, and also adjusting continually to the emerging production patterns.

    S. J. B. in Norway