Chapter 3 assesses the relationship between country size and govern-ment size. Major findings are the following:
– The negative relationship between country size and government size prevails even in the 90ies. No matter which control variables are included, the coefficient for the number of inhabitants is almost al-ways significant. However, it is noteworthy that the results hinge critically on the definition of country size. When GDP or GNP is used as a proxy for country size instead of the number of inhabi-tants, the picture is not clear-cut anymore. This means an economies of scale effect is more closely associated with population than with a country’s economic size, confirming prior theoretical considera -tions and our model. Furthermore, we have to emphasize that this result cannot serve as a basis for political advise, in the sense that larger entities would more or less automatically lead to lower per capita costs in the public sector. There are doubtlessly a lot of other, more effective organizational possibilities to lower costs in VSC, apart from size considerations.
– Our basic results are in line with Alesina and Wacziarg, with two notable exceptions. Their result concerning the irrelevance of proxy for country size cannot be confirmed, as explained above.
Additionally, one has to be skeptical concerning the sign of the co-efficient for the control variable per capita income. According to Alesina and Wacziarg, wealthier countries should have smaller gov -ernments, which is counterintuitive and contradicts theoretical reasoning. It can be shown that the summary statistics of the data used by them displays means which are far from being realistic, but it is not entirely clear whether their regressions are also based on questionable data.
– The hypothesis of a decreasing size effect over time concerning sig-nificance as well as magnitude due to more open countries and glo-bal and/or transnational public goods has to be rejected. Some pos-sible explanations for this result have been presented above, but the
result may also be a consequence of the lack of data for some VSC and should be investigated more thoroughly in future work.
– Remote island economies have to bear considerable disadvantages, which become the more severe, the fewer inhabitants they have. In short, small countries surrounded by peaceful neighbors can com-pensate for the disadvantage of size that arises from diseconomies of scale; small countries surrounded by villainous neighbors or by the sea with long distances to other countries cannot.
– The size effect is predominantly assigned to economies of scale in the provision of public goods, albeit there are a few other good ex-planations for the phenomenon. A case study of Liechtenstein (Gantner and Eibl, 1999), however, has shown that a small country’s disadvantage appears in areas where local public goods are wide-spread and public monopoly is prevalent (e.g., education, garbage disposal, sewage). The method applied here is not designed to address this question adequately, which leaves opportunities for fur -ther research to clarify this point. The problem of a thorough study on the determinants of the size effect is that it would require high-ly disaggregated data.
At this point it is necessary to draw attention to a few caveats, some of which have already been discussed above. The lack of data for certain groups of countries, especially for VSC, may bias the results considera-bly. Additionally, it must be borne in mind that two different data sour-ces, the Penn World Tables and IMF data, are used for inter-temporal comparisons. The correlation coefficient of the government consump -tion data of these two compila-tions is not convincingly high, but at least significant. A data compilation with fully comparable data is, however, not available.
Furthermore, it is not entirely convincing that econometric estima-tions seem to point in another direction than reality at first sight. If smal-ler countries bear clear disadvantages, why are country secessions so nu-merous nowadays? As an economist, one has to be convinced that there are not only political but also at least a few economic arguments in play when split ups are at stake. Perhaps the public sector is, indeed, a burden for every region planning to split up, and other economic factors
(espe-cially in the private sector) outweigh this disadvantage. Nevertheless, the development of split ups suggests a decreasing importance of country size, which cannot be detected in the regressions.67 Finally, the extent of federalism in different countries may play a crucial role. If regional governments produced and/or provided public goods on an inefficient scale, this would influence the results. The approach applied in this study implicitly assumes that there is no federal structure.
Recalling our discussion on the appropriate definition of a VSC in Section 2.3.2, we can now confirm our presumption. VSC have relative-ly larger public sectors than larger countries, and the prime suspects of this result from a theoretical viewpoint are diseconomies of scale. We therefore propose to define VSC in terms of the costs associated with publicly provided goods in accordance with the discussion in Section 2.3.2. Note that the number of inhabitants is implicitly accounted for in feature (c), and therefore only countries with a small population fulfill Definition 3:
Definition 3:A VSC is a country with the following characteristics:
(a) full sovereignty and international recognition
(b) the set of public goods provided by the VSC is comparable to the set of public goods provided by other sovereign countries.
(c) a considerable part of the publicly provided goods exhibit dis -economiesof scale in their production if they are produced in-house.
Note finally that there are three apparent possibilities for VSC to cope with those diseconomies of scale:
– They can simply accept their cost disadvantage. This would imply, from an economic viewpoint, that there have to be considerable advantages in other respects (advantage of sovereignty, more happi -ness in VSC), because otherwise the formation of VSC would not be stable in the long run, and there would hardly be so many of them in the world.
67 We will come back to this question in Chapter 5.
– They try to avoid or minimize diseconomies of scale by special ar-rangements of public good provision (outsourcing, free riding etc.), thus diminishing the cost disadvantage. In the outsourcing case, VSC can be examples for larger countries with regard to their pub -lic goods provision.
– They do not provide or, if possible, only partially provide certain public goods. They may also provide certain public goods on infe-rior quality levels compared to other countries.68
Most likely, all three analytically distinguished possibilities may play a role in explaining the existence of VSC. In the following Chapters 4 and 5, we study the extent to which those possibilities actually apply.
68 Note that the effect to which such solutions diminish citizens’ happiness is a very difficult question to answer.