23 CHAPTER National Defense PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-2 National Defense  In 1960, comprised half of federal government spending  In 1999, just over 16%  Defense spending can be adjusted on the margin  Especially expenditures to defend U.S. interests internationally

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-3 The Level of Military Expenditures

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-4 The Marginal Benefits of Additional Expenditures  Marginal Costs of Military = Marginal Benefits  MB decline as dollars are spent on less vital items

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-5 The Marginal Benefits of Additional Expenditures The Optimal Level of Military Expenditures

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-6 The Arms Race and the War on Terror  What if reaction of other nations to military spending is negative?  Arms race  Potential prisoner’s dilemma  Incentive to heavily arm  End up worse off as result

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-7 The Arms Race and the War on Terror An Arms Race as a Prisoners’ Dilemma Game

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-8 Military Alliances  Optimal sharing group may be larger than one nation  Economic rational for alliances  Example: NATO  Increased security also increases propensity for war

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 23-9 Economic Warfare  Arms races can cause major economic problems  Example: Soviet Union during Cold War  Economic warfare can be used to bankrupt an adversary

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Do Democracies Spend Enough?  Military spending reduces current consumption  Might be investment towards future consumption  Example: 1991 war with Iraq  Democratic governments might be biased towards short-term spending  Leads to inadequate military investment

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Military Procurement Contracts  How can contracts be written to purchase uncertain items?  Fixed fee  Often infeasible  Cost plus fixed fee  Little incentive to control costs

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Military Procurement Contracts  Cost plus percentage fee  Incentive to overspend  Cost plus incentive fee  Limited applicability  The perfect contract  Does not exist

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Procurement Versus Life- Cycle Costs  True cost is cost over life-cycle  Two aspects relevant to military expenditures  Cost of maintenance  Cost of finishing a started program

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Conscription Versus Volunteers  Advantages of conscription  Lower personnel costs  Constant costs  Disadvantages of conscription  Heavy tax on conscripted  Misallocates labor resources

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Conscription Versus Volunteers