Scottish poet Robert Burns warned us that the best laid plans of economists and society often can go awry. When economic policies or institutions go awry, the problem often is a “fallacy of composition” in some underlying thinking. It can affect the best of us.
A fallacy of composition is one of a series of errors in logic that students used to learn in introductory philosophy courses. It means assuming that what is true for an individual is true for a larger group.
The classic example is straining to see the action at a basketball game. If one person stands up to see, she can get a better view of what is going on. Therefore, if everyone stood up to see, everyone could get a better view. Wrong!
Some analysts argue that we now are beginning to see the results of a fallacy of composition in stock markets. Over the last decade, there was much evidence that simply buying a mutual fund that replicated a market index such as the Standard & Poor’s 500 provided superior returns over time than investing in actively managed funds.
Many investors – including some large institutional ones – now have their money in index funds. It is an apparent optimal strategy for many.
However, as larger fractions of all stock are held in mutual funds that simply follow given indexes, the remaining shares that are traded in response to new information about individual firms form a narrower base. Fewer traders have incentive to evaluate firms’ decisions and finances thoroughly.
The market can become less liquid and more susceptible to manipulation — particularly by large hedge funds — and prices become more volatile. With fewer analysts actively following firms, there is less market discipline on corporate decision-making.
What was optimal for any individual – putting one’s money in an index fund – becomes harmful for the economy as a whole.
Health care pricing gives another example. Before World War II, when most health care was purchased by uninsured households on a fee-for-service basis, hospital and physician fees represented a rough market outcome. Most patients paid the fees on the schedule.
Now, with most Americans covered by some sort of third-party payer, less than a fifth of households pay the “usual, customary and reasonable” fees posted by doctors, hospitals, clinics and drug companies. The actual fees reimbursed by insurers often reflect a deep discount from these posted fees.
With most households insulated from the marginal cost of health care, the official fee schedules do not represent any sort of market equilibrium. Nor do many people actually pay these fees. They rather serve a function like that of sticker prices on new cars – a starting point for bargaining rather than a price that any but a few buyers really pay.
There also is a fallacy of composition underlying some arguments for personal retirement accounts as a “reform” of Social Security. But that is the subject of another column.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.