Academic journal article Economic Inquiry

A Macroeconomic Model on the Quality of Government and Economic Performance

Academic journal article Economic Inquiry

A Macroeconomic Model on the Quality of Government and Economic Performance

Article excerpt

I. INTRODUCTION

The empirical analysis of Hall and Jones (1999) suggests that the fundamental determinant of a country's economic performance is its social infrastructure--the institutions and government policies that provide incentives for individuals. Those incentives can encourage productive activity or predatory behavior like rent-seeking and corruption. Although suppression of rent-seeking appears to be most efficient if it is carried out by the government, the power to make and enforce rules makes the government itself particularly prone to expropriation. For instance, while bureaucrats protect property by suppressing private rent-seeking that interferes with productive activity, they may also seek rents themselves by soliciting bribes from citizens. (1) How do the efficiency of bureaucrats in protecting property rights and the degree of their corruption affect the relative rewards received by producers, private rent-seekers, and bureaucrats? And, how does the reward structure interact with the allocation of talent between productive and unproductive activity and, hence, influence a country's economic performance? (2)

To address the above issues, we work with an essentially standard macroeconomic model of production and trade externality based on the work of Diamond (1982), in which productive activity is subject to private and public expropriation. Private rent-seekers and bureaucrats do not produce; they are completely dependent on producers' efforts. One important feature is the presence of a negative externality the unproductive activity exerts on the relative rewards that determine the allocation of agent across activity (see Murphy, Shleifer, and Vishny 1993). We first consider, as a benchmark, a model where the size of bureaucracy is exogenously given, and then endogenize it as an individual's choice.

Under an exogenous bureaucracy, an agent chooses to be a producer or a private rent-seeker. Producers conduct transactions in the decentralized markets. More productive activity yields higher returns to both producers and private rent-seekers, and this strategic complementarity results in multiple Pareto-rankable equilibria. The equilibrium with a larger population of producers and less rent-seeking features higher welfare. By choosing a small size of bureaucracy, the government can establish the superior equilibrium as the unique outcome, that also achieves the constrained optimum. Social welfare, however, is decreasing in the size of bureaucracy in this equilibrium. The implication is that, the smaller the size of bureaucracy, the higher the welfare.

The optimal size of bureaucracy depends on two opposite influences on producers' incentives. One is the positive effect through better property rights protection. The other includes various negative effects as a result of corruption, tax burdens, and the fact that resources taken up in the public sector could otherwise be devoted to production. If the population of bureaucrats is endogenously determined, equilibria exist as long as bureaucrats' efficiency is high and corruption is low. The equilibrium with a larger bureaucracy is associated with higher production and welfare. The reason is that, with sufficient efficiency in deterring private rent-seeking and low corruption, a larger bureaucracy makes private production more profitable by reducing resources allocated to private rent-seeking, and the resulting externality further improves the relative rewards to productive activity. In general, the equilibrium size of the bureaucracy is not optimal. One resulting implication is that, for the equilibrium with a smaller bureaucracy, society would benefit by increasing the size of bureaucracy despite the fact that bureaucrats are corrupt.

Many believe that the size of government is an important factor for determining economic performance; however, Hall and Jones (1999, p. 111), argue that the characteristics of an economy such as the size of government should better be thought as outcomes rather than determinants. …

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