A Fallacy of Composition

   (254 K)

The representative agent framework has endowed macroeconomists with powerful microeconomic tools. Unfortunately, it has also blurred the distinction between statements that are valid at the individual level from those that apply to the aggregate. In this paper I argue that probability theory puts strong restrictions on the joint behavior of a large number of units that are less than fully synchronized, and that many fallacies arise from disregarding these restrictions. For example, the observation that the aggregate price level is more rigid to downward changes than to upward changes, has led many authors to suggest asymmetries at the firm level as responsible for the alleged macroeconomic fact. However, the basic insight developed in this paper shows that asymmetric pricing policies at the firm level do not necessarily imply asymmetries in upward and downward adjustments of the aggregate price level; and asymmetries in the aggregate price level need not come from asymmetries at the firm level. Similarly, asymmetric factor adjustment costs at the firm level need not imply asymmetric responses of the aggregate capital stock and the level of employment to positive and negative shocks.

Published: American Economic Review, December 1992

This paper is available as PDF (254 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX