An Economic Model

Print pagePDF pageEmail page

Dr. John Psarouthakis
Executive Editor

This is the introduction of a paper of mine published in a related journal that I will post in the Business Thinker when that can be done. The title of this article is “An Economic Model of Government Expenditures and Economic Development” The journal is Economics and Finance Notes.

The economy is a complex system in which firms, households  and government interact to determine the process of wealth creation and,ultimately, the economic well-being of the nation. Economic theory has traditionally focused on the analysis of each subsystem (firms, households and government), however it has created a high controversy in the study of the complete system behavior, as well as the relevant role of the government in the macroeconomic context. Despite this controversy, firms and governments share certain objectives. Both are social organizations created to add value for stakeholders and voters through, at least, reducing transaction costs in the economy.

Poor performance of governments tend to generate negative externalities for the economy (or higher transaction costs) that are reflected in macroeconomic variables such as output, involuntary unemployment, slowdown of profitability and capital creation and/or utilization, and increase in inflation. In other words, the economic performance of the overall system depends significantly on the government involvement needed to reduce transaction costs given the characteristics of the economy.

One of the major difficulties in the analysis of government involvement is the identification of variables that defines the optimal size of the public sector relative to the private sector. Despite this difficulty, it is possible to evaluate the public action by looking at the overall economic performance of the system for a given period of time, and infer from this evaluation the nature of the relationship between the government and the economy.

Households and firms implicitly define a demand for government involvement through the periodic evaluation in the political market of the public sector performance. In this sense, the government’s ability to adopt optimal policies and to redistribute their benefits and costs in the society defines the probability for a government to stay in power.

In other terms, in an economy in which the market determines the allocation of resources in the country, it is likely that the market influences the degree and the economic form of government involvement needed to satisfy the well being requirements of the society at that time.

If we consider or assume that the process of wealth creation is the one main objective of a democratic market economy, then a successful government will be the one that will adopt policies that will keep the economy in a steady and a positive growth path under an equitable income distribution basis. This is true independently of the assumptions considered by the policy maker about the economy (for instance, full employment economy, sticky prices, information asymmetries, and coordination failures between markets).

The objective of this paper is to present certain intuitive interpretations as to how the market evaluates the government performance and how the government involvement interacts with the overall economy in the short and long run terms. The approach presented consists of the analysis of the government’s behavior by using the guidelines of manager’s evaluation of performance and th firm’s overhead in the performance of the firm. This approach implies that a firm is considered as a “micro-nation” that is created in order to manage scarce resources and save transaction costs in its economy.

In this paper, two basic questions are formulated; the first is about what the structural relation between the economy and the government is, and the second relates to the set of conditions which the government is likely to expand or contract in its involvement in the economy. The following section describes some intuitive views about the optimal dollar size of management (government) and gives insights about the endogenous determination of government size by the overall economic environment. In the third section, we present a dynamic model for government interaction and suggest that both the acceleration of the income generation in the economy and the growth in the government involvement are linked to the increment of the transaction costs in the economy. In the fourth section, data from OECD countries is presented in order to study the economic conditions that might induce a change in the government involvement. Also presented are statistical links between the expansion of government and the acceleration of the economy.

There is a large body of related publications. However, during the development of our work we studied closer those that are listed as references at the end of this paper. This list of published works is equivalent to “annotated bibliography” and not as specific references mentioned in the text.

Leave a Reply

Your email address will not be published. Required fields are marked *