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Economic challenges of developed small
states in a globalised economy
November 2011
Gylfi Zoega
University of Iceland
Economic models commonly assume constant returns to scale
in production
 
Y   AL  K
where Y is output, A is the level of productivity, L is labour and
K is capital and +=1. A measures both production technologies AT and
social technologies AS (Eggertsson, 2008).
Size matters if +>1, there are scale economies due to increased
division of labour (as in A. Smith, 1776).
By social technology we mean:
– Formal rules, government and institutions
– Social norms
– Beliefs
– Enforcement mechanisms
Due to the failure of collective action, self-interests of ruling groups,
beliefs, values or limited understanding societies may end up with
inefficient social institutions.
Example: religion (heaven and hell) used more where
administration is weak (Hull and Bold, 1994).
How does government fit in? We start with the production function
where


A

 





Ag Lg 




L
p 









AT
and Ag is chosen from a set of possible institutions I where
Lg denotes public employment and Lp private employment.
– Increasing returns to scale in public administration (Alesina and
Spoalare, 1997) and defence (Harden,1985):  > 1
– Fixed costs of providing public goods.
• Per capita cost of public good provision is likely to be
decreasing in country size. Example: National defence, foreign
service, …
– Administrative burden increasing in size (Kazarda, 1974): >1.
Benefits of small size
– Kasarda (1974) argues that social systems experience an
increasing administrative ratio with increasing system size.
Mayhew and Levingar (1976) find that the expected level of
interaction in a system is a multiplicative function – instead of
additive – of system size.
– In contrast Noell (1974) found in a study of 50 state
governments in the U.S. that the proportion employed in state
governments declines with increasing system size. This implies
economies of scale in public administration.
– Blau (1972) finds a downward-sloping relationship between size
and administrative burden where economies of scale first
dominate but at a declining rate.
– Nolan (1979) finds a U-shaped relationship where economies of
scale first dominate.
Public sector challenges in small countries
(Farrugia, 1993, and others)
– Multitasking within public sector.
•
•
•
•
Wider perspectives.
This weakens expertise in each area.
Increases job pressures, lowers job satisfaction.
Difficult tasks sometimes postponed due to the daily demands
for prompt decision making.
– Small populations.
• Limited number of able individuals with required training
(Streeten, 1993).
• Competing demands: pundit–politician–professor.
– International commitments.
• Necessary
• Time consuming
Public sector challenges – continued.
– Interpersonal relations.
• Closely integrated network of personal relationships.
–
–
–
–
–
Facilitates and obstructs communications.
Informal decision making processes.
Quick implementation of decisions.
Conflicting pressures.
Decisions can be modified due to personal interventions and
community pressures.
– Nepotism and corruption in extreme situations.
• Transparency.
– Lack of anonymity problematic.
– Social cohesion.
•
•
•
•
Factions, grudges, polarisation.
Small issues assume national prominence in small states.
Community rivalry and civil strife.
Deadweight losses.
– Small country syndrome.
• Small countries tend to have a strong national and cultural
identity
• Attempt to emulate larger countries without realising their
uniqueness.
Other issues.
– Imperfect competition in non-traded goods sector.
– Lack of diversification into more activities makes small
economies vulnerable to terms of trade shocks (Armstrong
and Read, 1998).
The data: volatility but no obvious effects on growth and
income per capita. Head (1995) finds that the variances of
both output growth and consumption growth are negatively
correlated with population size.
Output per capita and population
All countries
12,000
Output per capita and population
U.S. excluded
10,000
12,000
GDP per capita
(US $ in 1980)
10,000
8,000
8,000
6,000
6,000
4,000
4,000
2,000
2,000
GDP per capita
(US $ in 1980)
0
0
50,000 100,000 150,000 200,000 250,000
Population in 1980
0
0
40,000
80,000
120,000
Population in 1980
Variance of output growth and population
U.S. excluded
Variance of output growth and population
All countries
5
5
Variance of
growth rate
4
of Y
Variance of
growth rate
of Y
4
3
3
2
2
1
1
0
0
0
50,000
100,000 150,000 200,000 250,000
Population in 1980
0
40,000
80,000
120,000
Population in 1980
Variance of output growth and GDP
All countries
Variance of output growth and GDP
U.S. excluded
5
5
Variance of GDP
growth
Variance of GDP
growth
4
4
3
3
2
2
1
1
0
0
0
400
800
1,200 1,600 2,000 2,400 2,800
GDP in 1980
0
200
400
600
800
1,000
GDP in 1980
5.0
5.0
4.5
4.5
4.0
4.0
3.5
3.5
3.0
SIGMAC
SIGMAC
Variance of consumption growth and population Variance of consumption growth and population
All countries
U.S. excluded
2.5
3.0
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0
50,000 100,000 150,000 200,000 250,000
POP80
0.5
0
40,000
80,000
Population in 1980
POP80
120,000
Population in 1980
• Small states have more volatile output and consumption
(Easterly and Kray, 2000, Head, 1995).
– Due to less diversified endowments and production.
Globalisation
Globalisation involves an increase in the scale and complexity of
businesses. Firms may then enjoy economies of scale by
extending their operations to other countries. Increased trade
linkages also make systems more complex.
In contrast public administration is constrained by the local labour force and
Local institutions.




Ag Lg   p 

  A L
Y
K

 
 p


 
  
 







L







– Public sector workers may not be able to provide adequate
supervision of domestic businesses.
– They may not fully understand international regulations.
– Systems become too complicated for politicians to
understand fully.
• Bureaucrats become more important but at the same time their
comprehension is also limited.
– Danger that adherence to the letter of the law instead of an
understanding of their meaning prevails.
Examples:
Icelandic fishing industry: successful
and secret!
Pharmaceutical industry: successful
Less successful:
The globalisation of Iceland’s banking system.
Large size is no guarantee:
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