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Common pitfalls in economic analysis

There are two “pitfalls” that should be avoided when conducting economic analysis: the fallacy of composition and the false-cause fallacy. The fallacy of composition is the belief that if one individual or firm benefits from some action, all individuals or all firms will benefit from the same action. While this may in fact be the case, it is not necessarily so. Suppose a hairdresser’s decides to lower the prices it charges on all its services. It believes the lower prices will attract customers away from other hairdressers’. If, however, the other hairdressers’ follow suit and lower their prices by the same amount, then it is not necessarily true that all hairdressers’ will be better off; while more people may choose to cut their hair, each hairdresser’s will receive less money per client, and each hairdresser’s market share is unlikely to change. Hence the profits of all hairdressers’ could fall.

The false-cause fallacy often arises in economic analysis of two correlated actions or events. When one observes that two actions or events seem to be correlated, it is often tempting to conclude that one event has caused the other. But by doing so, one may be committing the false-cause fallacy, which is the simple fact that correlation does not imply causation. For example, suppose that new tape-recorder prices have steadily increased over some period of time and the new tape-recorder sales have also increased over this same period. One might then conclude that an increase in the price of new tape-recorders causes an increase in their sales. This false conclusion is an example of the false-cause fallacy; the positive correlation between the two events does not imply that there is any causation between them. In order to explain why both events are taking place simultaneously, one may have to look at other factors — for example, rising consumer incomes, inflation, or rising producer costs.

2. Demand, supply, and elasticity In every market, there are both buyers and sellers. The buyers’ willingness to buy a particular good (at various prices) is referred to as the buyers’ demand for that good. The sellers’ willingness to supply a particular good (at various prices) is referred to as the sellers’ supply of that good.

Reasons for a change in demand

It is important to keep straight the difference between a change in quantity demanded, and a change in demand. There is only one reason for a change in the quantity demanded of some good: a change in its price; however, there are several reasons for a change in demand for the good, including:

1. Changes in the price of related goods: the demand for a good may be changed by increases or decreases in the prices of the other, related goods. These related goods are usually divided into two categories called substitutes (for example, butter and margarine) and complements (for example, shoes and shoelaces).

2. Changes in income: the demand for a good may also be affected by changes in the incomes of buyers. Normally, as incomes rise, the demand for a good will usually increase at all prices, and vice versa. Goods for which changes in demand vary directly with changes in income are called normal goods. There are some goods, however, for which an increase in income leads to a decrease in demand and a decrease in income leads to an increase in demand. Goods for which changes in demand vary inversely with changes in income are called inferior goods. For example, consider meat and bread. As incomes increase, people demand relatively more meat and relatively less bread, implying that meat may be regarded as a normal good, and bread may be considered an inferior good.

3. Changes in preferences: as peoples’ preferences for goods and services change over time, the demand for these goods and services will also shift. For example, as the price for gasoline has risen, automobile buyers have demanded more fuel-efficient, “economy” cars, and fewer gas-guzzling, “luxury” cars.

4. Changes in expectations: if buyers expect that they will have a job for many years to come, they will be more willing to purchase goods such as cars and homes that require payments over a long period of time. If buyers fear losing their jobs, perhaps because of an adverse economic climate, they will demand fewer goods requiring long-term payments.

Supply

The buyers’ demand for goods is not the only factor determining market prices and quantities. The sellers’ supply of goods and services also plays a role in determining market prices and quantities. According to the law of supply, a direct relationship exists between the price of a good and the quantity supplied of that good. A change in supply is not caused by a change in the price of the good being supplied; that would induce a change in the quantity demanded. A change in supply is caused by other factors, including:

1. Changes in the prices for other goods: suppliers are often able to

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