Economics versus Accounting

This past Thursday, I recorded a podcast with the GMU Econ Society. Their podcast is called “Loose, Vague, and Indeterminate.” The episode will air in a few weeks and I will post a link when it does.

One of the points I discussed in the podcast was the difference between economics and accounting. Oftentimes, the two get mixed together and accounting identities are treated as akin to economic theories, or accounting outcomes are treated as akin to economic outcomes.

One such stark example of this is the optimal tariff. The optimal tariff is an implication of the so-called Standard Trade Model where, if a country has some pricing power in the market (ie, they are a large enough part of the market that reducing the amount bought can affect world prices), then there exists a tariff which can be imposed by the domestic government that is non-zero and maximizes net economic welfare.

However, there is a key feature causing the optimal tariff to be a net economic welfare gain: it relies on not counting costs to foreigners. If the costs to foreigners are included in, then the tariff becomes just like any other tax and is net welfare reducing.

So, the results of the optimal tariff are driven by accounting decisions (what is included, what is not, and how we add them up) but not economic theory. The economics of the model do not change regardless of whether or not foreigners are included in the welfare calculation: people still face scarcity, there are trade-offs, folks respond to incentives, etc. Further, economic theory does not necessarily tell us whether foreigners should be included in the calculation or not. The responses of foreigners are included (and is why most economists treat the optimal tariff as an interesting theoretical tidbit rather than a serious policy consideration), but whether or not they should be included in the accounting is not.

Economists sometimes get caught up in the accounting. To be fair, it does serve a purpose. Welfare analysis helps test our theories, although it must be done carefully. When economics becomes about accounting, we tend to lose a lot of the economic insights and the science is reduced to mere maximizing. What James Buchanan argued was economists should keep in mind the entire universe of exchange. That economics is about human interaction. The economist focuses not just on welfare calculations or NIPA accounts, but the whole world in which these transactions and interactions take place. That is our subject matter, and keeping that focus in mind will prevent many silly economic fallacies from taking hold.