The Demand for Military Expenditure

Author(s): R. P. Smith
Source: The Economic Journal, Vol. 90, No. 360 (Dec., 1980), pp. 811-820
Published by: Wiley on behalf of the Royal Economic Society
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 The EconomicJournal, 90 (DecemberI980), 8i I-820
Printedin GreatBritain

THE DEMAND FOR MILITARY EXPENDITURE*

Much of the discussionof the economics of national security policy and military
expenditure has implicit in it a 'rational' or 'neoclassical' model of defence.
This assumes that social welfare is a function of civilian output and an
unobserved variable, security; and that security depends, among other things,
on military expenditure. The role of the state is then to balance the welfare
benefits of extra security derived from military expenditure with its opportunity
cost in foregone civilian output.' Below a formal version of this account is used
to derive a demand function for military expenditure, which is estimated on
U.K. data. It should be recognised that there are a variety of other models of
the determination of military expenditure, derived from, for instance, theories
about: the dynamics of an arms race; the behaviour of bureaucracies; the
operation of the military industrialcomplex; or the requirementsof the capitalist
mode of production. A discussionof the various theories can be found in Smith
(I977). The primary concern here will be to consider the neoclassical model on
its own terms rather than compare it with alternative theories. Section I
derives the model, section II illustrates its use on U.K. data, and Section III
contains conclusions and comments.

I. THE MODEL

Suppose that there exists some measure of aggregate social welfare, W, which is
a function of security, S, and of civilian output, C, i.e.
W = W(S, C). (I)
Security should be regarded not as any objective measure, but as a subjective
peace of mind, based on perceptions of freedom from attack.2 This perceived
security is produced by military expenditure conditional on the strategic
environment. Thus a production function for security can be written
S=S(M, E) (2)
where M is the volume of military purchasesand E, the strategic environment.
The exact specification of E is considered below, but it will include other
countries' military expenditure. Finally total output is made up of civilian and
military expenditure, and is regarded as exogenous.
Y= pC+qM (3)
where p and q are the respective prices relative to the price of the total output.
* I am grateful to Saadet Deger for research assistance, to the SSRC for finance under grant
HR 5113/I, and to John Muellbauer and the editors for comments.
I The most influential exposition of this approach is in Hitch and McKean (I 960), and the approach
is closely related to the 'rational policy' model of Allison (I97I).
2 The state under consideration is assumed to be peaceloving, but its security could also include the
ability to indulge in successful aggression.
[ 8iI ]

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8I2 THE ECONOMIC JOURNAL [DECEMBER

To derive a demand function for military expenditure, it is not necessary to

take a position on how the social welfare function (i) is derived. It may result
from the operation of an informed democratic consensus; the advice of expert
economists; or the machinations of the military industrial complex. All that is
required is that it should be maximised subject to (2) and (3) . If this is done, the
first order conditions can be written

WSSM = (q/ p)Wc (4)

where Ws is the partial derivative of the welfare function with respect to S, etc.
The condition merely says that the welfare gained from additional military
expenditure is equalised at the margin with the opportunity cost of military
expenditure - the welfare lost from foregone civilian output.
To make the model operational requires (i) some assumption about the form
of the functions W( ) and S( ) and (ii) a specification for E. With regard to (i) it
will be assumed that the welfare function is CES, i.e.

W = A[dCa + (,- d)S-a]-lIa (IA)

and that the security function is Cobb-Douglas:

S = BMbEc. (2A)

These forms were chosen because the elasticity of substitution between civilian
output and security is easily interpreted and of some interest; while a Cobb-
Douglas security function is implicit in many discussions of arms control. What
is often assumed is that E is the military expenditure of an opponent, and that
c = - b with o < b < I. With this formulation increases in military expendi-
ture have a declining marginal utility, and increases in expenditure matched by
an opponent leave security unchanged.
Equation (4) can be rewritten

Ws/WC= (q/ p)/SM.

For the CES welfare function

,s/WCC = [( -d) /d] (C/S)l+a

and for the Cobb-Douglas security function

SM = bSM-1.

Thus for this specific case, the first order condition for a maximum is

[(I -d)/d] (C/S)l+a = (q/p)/(bSM`1). (4A)

Taking logarithms, using (2 A) to solve for S, and rewriting the equation with M
as the dependent variable gives

ln M = A0+A1 ln C+A2 ln (q/p) +A3 ln E (5)

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I980] THE DEMAND FOR MILITARY EXPENDITURE 8I3

where
AO = {ln[( I-d)/d] + ln b-a ln B}/(I + ab)
A1 = (I +a)/(I +ab)
A2 = -I/(I+ab)
A3 = -ac/(I+ab).

Thus given a specification for E the model provides a log-linear equation in

observable variables, in which the elasticity of substitution between security and
civilian output and the exponents in the security production function are
identified.

II. THE CASE OF THE UNITED KINGDOM

To apply the model suggested above to the United Kingdom it is necessary to

specify quantitative indicators of how British decision makers perceive the
strategic environment. In general this will depend on the size of the state
concerned, geographical position and political boundaries; but in a time series
analysis for one country these can be assumed constant and the dominant
factor will be any apparent threat. Judgements about the degree of threat will
be based on estimates of the intentions and relative capability of potential
enemies. The United States has great capability to inflict damage on the United
Kingdom, but since it is widely believed that the United States has little
intention of doing so, this possibility is not a major factor in UK security
decisions. The traditional indicator of capability is a country's stock of arnis,
though it also depends on morale, readiness, suitability of available weapons
systems, etc. However, since the influence of the UK stock on the balance of
East-West capability is small, relative stocks are unlikely to play a major part in
the determination of UK military expenditure. The military do compare forces
and equipment available to NATO and the WTO on likely battle zones, but
such comparisons are known to be notoriously fragile. Their significance depends
on choice of scenario; morale and training; and likely performance of untried
weapons systems and personnel in a real war. Such calculations have an
important role in determining deployment and procurement decisions, but
given that their interpretation is fraught with difficulty, they seem unlikely to
have much influence on total expenditure. What is crucial to the expenditure
decisions, particularly for a small country like the United Kingdom, is some
judgement about intentions.
The focus of UK defence policy in the post-war period has increasingly
shifted to an emphasis on Western Europe and the North-East Atlantic (e.g. see
Greenwood and Hazel, 1977), and within this area it is the intentions and
posture of the United States and USSR that determines the threat to the
United Kingdom. The primary indicator of their intentions, and a major
influence on international tension, is the share of output that each devotes to
military expenditure. For instance, in the discussion of 'Warsaw Pact Capability'
in the I979 Statement on the Defence Estimates (Cmnd 7474, para I2I) great
emphasis is given to the Soviet share of military expenditure in GNP. Likewise
in the United States weight is given to the political impact military expenditure

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814 THE ECONOMIC JOURNAL [DECEMBER

levels have on foreign perceptions of American influence and commitment,

quite apart from specific military requirements.
Given that superpower shares of military expenditure in output are treated as
important indicators of threat, United Kingdom decision makers may respond
in either of two ways, depending on how they interpret the NATO alliance. On
the one hand they may act as 'followers' of the United States, treating the US
share as an indicator of the threat to NATO. An increase in the US share is
then interpreted as signalling an increase in tension, and a reduction in UK
security which requires compensating increases in UK military expenditure. In
this case rather than taking advantage of free US protection, the United
Kingdom bears its share of the burden of common defence. Follower behaviour
might also result if US expenditures provided no protection to the United
Kingdom but increased the probability of a war occurring which would involve
the United Kingdom. Then higher expenditure by the ally, increases tension
and so the threat to the United Kingdom. In both cases the perceived threat
increases with US expenditure. Thus if SA is the US share: E = SA. Alterna-
tively, the United States may be seen to be providing protection to the alliance
as a public good, allowing the United Kingdom to 'free ride' to some extent.
Then the prime British concern is with the adequacy of American resolve and
protection relative to the perceived Soviet threat. To the extent that the protec-
tion is inadequate UK military expenditure has to be increased to compensate.
This suggests that it is relative shares that are important, and thus if SR is the
Soviet share E = SR/SA. In both cases an increase in E, the threat, represents
a reduction in security. But in the 'follower' case an increase in US military
expenditure signals an increase in threat requiring more British military
expenditure; while in the 'free rider' case it signals an increase in protection
(for a given Soviet share) allowing reductions in expenditure. The two responses
can be nested in a security function of the form

S = BMb SAC SRd.

The follower reaction implies c < o and d = o; the free rider reaction that
c > o and d = - c. It will be assumed that the superpowers discount UK
military expenditure, allowing SA and SR to be treated as exogenous. In the
estimation observations on SA and SR for the previous year were used, since the
values of these variables are only known to UK decision makers with a lag.
Against this it can be argued that the intelligence community devotes consider-
able resources to predicting them. But once such expectations are allowed for,
the determination of military expenditure becomes a problem in game theory
and optimal control; rather than static maximisation as analysed here.
The model given above was derived on the basis of the argument that
superpower shares of military expenditure, determine the degree of international
tension, and through this the threat perceived by the United Kingdom. In
addition, that over the post war period this threat has been the major influence
on the strategic environment faced by UK decision makers, and thus on UK
military expenditure. But since the estimated equation just relates UK military

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1980] THE DEMAND FOR MILITARY EXPENDITURE 8I5

expenditure to that of the superpowers,and there are no quantitative measures

of the intervening variables, (tension, threat, environment) the estimated
reduced form could be generated by other characterisationsof the pattern of
international relations. For example UK decision makersmight see superpower
military expenditures as a product rather than a cause of international tension,
and regard this tension as having a separate effect on security in addition to the
effect that superpowermilitary expenditure has via its capability to protect or
endanger the United Kingdom. In that case,
S - BMb SAC,SRC2Tc3

where T is the UK estimate of tension, so c3 is negative; while cl is positive if

US expenditure protects the United Kingdom, and c2 is negative if USSR
expenditure endangers the United Kingdom. Since international tension is
largely the outcome of superpower interaction, the UK estimate of tension
could be regarded as the product of the US and USSR estimates of tension, on
which they base their military expenditure decisions, e.g.
T= TA TR
where SA = TAei
SR = TRe2 el, e2 >0'
Thus the estimated security function would correspond to
S = BMb SAc1+caIeISRc2+c81e2.

The exponents thus reflect the net effect of the capability and signalling roles of
US and USSR shares. Within this model, the 'follower' mode of response
described above correspondsto the case where the negative signalling effect of
is large relative to the other parameters. While the 'free rider'
SA(csfe1)
response could correspond to the case where signalling effects are small (el, e2
close to zero) and the degree to which US and USSR shares protect and
endanger are of the same absolute size. The terms 'follower' and 'free rider'
will continue to be used, but the precise interpretation of the coefficientsof SA
and SR must be treated as contingent on a specific perception of international
interactions.
The theory gives an equation for the equilibrium level of military expendi-
ture, and it was decided to allow for partial adjustment to this equilibrium by
assuming that
M/M_1 = (M*/M_)r
M* the equilibrium level being given by equation (5). The equation to be
estimated is then
ln M = Bo+B1ln C+B2 ln (q/p)+B3 ln SA+B4 ln SR+B5 lniV 1+e.
Although, medium term defence policy in the United Kingdom seems to be
non-partisan (dummies for party in power were insignificant) the recurrent
pattern of cuts, expansions, defence reviews etc. seems to have introduced a
definite pattern into defence expenditure. This was allowed for by assuming
28 ECS 90

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 8i6 THE ECONOMIC JOURNAL [DECEMBER

that e followed a second order autoregressiveprocess.

e6 -=Pl6-1+P26-2+ V

V being treated as N (o, o-2j). Given that C will be jointly determined with M
the equation was estimated by instrumental variables, though it was assumed
that relative prices were independent of the pattern of demand. Using annual
data for I95I-75, the results were:

Coefficient Estimate t
Bo o- 3.87 209
B1 r(i +a)/(i +ab) OI28 0 95
B2 -r/(i +ab) -o-623 -2-6o
B3 -racl(i ab) + -0_I49 -2-I8
B4 -rad/(i +ab) OrI75 2-29
B5 (i -r) 0429 2.63

PI = O028 P2 o
-O4I R2 = O9I22

DW = i*9i SER = o0O38

All the coefficients except that for civilian output are reasonably well
determined, and all have acceptable signs. It appears that the United Kingdom
is a free rider within NATO. The implied estimate of the elasticity of substitu-
tion between security and civilian output is 4-87, indicating that British security
decisions are very sensitive to the cost of provision, just as post war history
would lead one to expect. The implied equilibrium security function is:
S = BMA0105 SAO 236 SR-0 280.

As would be expected UK security is not very sensitive to its own military

expenditure, since this is dwarfed by that.of the super-powers. Since B3 is not
significantly different from - B4, one can treat the crucial indicator as being the
ratio of the super-power shares. This equation can be used to generate an index
of security and of the marginal product of UK military expenditure in terms of
security.' Setting both indexes to IOO in I970, security shows very little varia-
tion, moving between about 96 and I03, with no trend. The marginal product
index, however, has a strong upward trend, rising from a low of 63 in I953 to
a peak of ioi in I975. This increase reflects the combination of stable security
with a downward trend in real military expenditure.
The estimates of the autoregressive error process indicate that last year's
errorsare persistedwith to a certain extent, but the errorsof the year before are
offset. Given the length of the decision lags involved this seems a plausible error
adjustmentprocess. Over the period I 95 I-75, UK military expenditure in I 970
prices varied between f3,695 million in I953 and ?2,390 million in I974. The
standard errorof the regressionis about JIoo million. In only two years was the
residual more than C200 million, I 954 and I 967. In both these years the equation
1 While the use of cardinal indicators of what are usually thought of as ordinal concepts present
difficulties, e.g. see Sen (1979), it is a widespread practice in economics.

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I980] THE DEMAND FOR MILITARY EXPENDITURE 817
underestimated military expenditure. The I954 error reflects slower than
expected demobilisation after the Korean War. The high I967 figure coincides
with the major restructuringof Britishimperial commitments, recognisedin the
Prime Minister's announcement in January, I968 that the defence effort would
be concentrated in Europe and the North Atlantic.
At the suggestionof the editors, various specification tests were carried out on
the equation reported above, to ensure that the form of the security function
used could be accepted relative to more general specifications. These included
introducing the levels of military expenditure and income in the United States
and USSR separately; making E a CES function of SA and SR; and making S
a CES function of M and E. In each case the specification above was accepted
relative to the alternative at the 5% level. Details of these tests are given in an
appendix. It should be recognised that the purpose of this exerciseis to examine
the explanatory power of a simple optimising model, using convenient func-
tional forms, and at best it cannot be expected to be more than an empirical
approximation-we return to this point in the conclusion.

III. CONCLUSION

This paper has investigated the empirical implications of the conventional

account of national security policy, in which a rational state balances the
welfare benefits of extra security with the opportunity cost of military expendi-
ture. It was shown that this account implies a demand function, or government
reaction function, determining military expenditure, and such a function was
estimated for the United Kingdom. The estimated equation was reasonably
well determined, and suggested that the elasticity of substitution between
security and civilian output was quite high; that UK security was relatively
insensitive to its own military expenditure; that it largely depended on the
ratio of US to USSR shares of military expenditure in output; and that the
United Kingdom was a free rider on US spending. The limitations of the model
and results are fairly obvious, but it seems useful to summarise them.
The assumption that military expenditure is determined by a unitary state
maximising a well defined social welfare function might be questioned in the
light of what is known about the behaviour of politicians, bureaucratsand arms
salesmen. The assumption that output is exogenously determined implies that
increases in military expenditure are not financed by increased utilisation and
reductions in unemployment as much Keynesian and radical argument would
suggest. The results are conditional on the specification chosen for the welfare
and security functions and the stochastic structure. The theory has relatively
little to say about these specifications, and different choices may give different
results. The estimates do not provide a test of the model relative to alternative
theories, and any ad hoc reaction function is likely to include similar variables
(for other reaction functions see Smith, I978). Even if the model is accepted,
the fact that the level of military expenditure is derived from an optimising
process does not imply that the level generated is optimal. Judgements about
the optimality of the level depend on whether the state is maximising the correct
28-2

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8I8 THE ECONOMIC JOURNAL [DECEMBER

welfare function, and has accurate perceptions of the strategic environment and
the contribution of military expenditure to security. Finally it should be noted
that data on military expenditure must be treated with caution.

R. P. SMITH

BirkbeckCollege,Universityof London
FebruaryI980
Date of receiptoffinal typescript:

APPENDIX I: DATA

M Current Expenditureon Goods and Servicesfor Military Defence in the

United Kingdom at I970 prices. Source NationalIncomeandExpenditure,
various years.
C GDP at factor cost in I970 prices less M. Source N.l.E.
(q/p) The ratio of the implicit deflatorsfor M and C. Source N.LE. The price
index for military expenditure has risen faster over the period than that
for all output.
SA National Security Expendituresin the United States as a percentage of
GNP. Source EconomicReportof thePresident,I976.
SR Soviet military expenditures as a percentage of Net Material Product.
Source SIPRI Yearbooks 'World Armaments and Disarmament', I978
and previous years.

The definition of expenditures treated as military differs between countries,

and in particular the Soviet figures are controversial. The SIPRI series used is
lower than many current estimates (e.g. by the CIA now) but is quite close to
the estimates that were used through most of the estimation period (e.g. by the
CIA prior to I975). The issues involved are discussed in Cockle (I978). No
attempt was made to correct either US or Soviet figures to allow for expendi-
tures unrelated to UK security, caused by the Sino-Soviet hostilities in the
USSR, or the Vietnam War in the United States. In the case of the US far
eastern expendituresit could be argued that these allowed Britain to maintain
international interestswhile withdrawing troops from East of Suez, so support-
ing UK security.

APPENDIX II: ROBUSTNESS

The purpose of this appendix is to examine the robustnessof the equation given
in the text; in particularit considers: (i) Whether the levels of military expendi-
ture in the United States and USSR, rather than the shares in output are the
appropriate explanatory variables; (2) Whether E should be made a CES
rather than Cobb-Douglas function of SA and SR; (3) Whether S should be
made a CES rather than Cobb-Douglas function of M and E.
(i) For the first set of tests the unrestricted equation is taken to be:

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I980] THE DEMAND FOR MILITARY EXPENDITURE 8I9
In M = AO+Al In C+A2 In (q/p) +A3 In MA+A4 InYA +A5 In MR
+A6 In YR+A7 In MA1

where M is UK military expenditure, MA is US military expenditure, YA, US

GNP and MR and YR Soviet military expenditure and NMP respectively.
Estimates for unrestricted equation, allowing for second order serial correlation
are:
Estimate t Statistic

AO 5.695 2.54
A1 -o-o84 -0X29
A2 -0X292 - I -04
A3 -0_050 - o.67
A4 - 0356 -I.I3
A5 OX22I I .78
A6 0o073 O43
A7 o0552 2-25

Pi O?573
P2 O?454
R2 O9I7
DW 2-I7
SER 0o037
The unrestricted equation has I 7 degrees of freedom and a Log likelihood (LL)
of 47o045. Imposing the restrictions A3 = - A4 and A5 = -A6 reduces the LL
to 44-920. The likelihood ratio test statistic, which is Chi Squared with two
degrees of freedom if the restrictions are true, is 4-25, allowing us to accept the
restrictions at the 5% level. Imposing the further restriction (A3 = -A4 =
- A5 = A6) that the ratio of the shares determines the perceived threat reduces
LL to 44.784. Relative to the unrestricted equation this gives a test statistic of
2-26 I, well below the critical value for 3 restrictions. In the unrestricted equation
collinearity causes problems; the standard errors are larger and A1, A4, and A6
have wrong signs. The restriction suggested by the theory, that it is shares, as
indicators of intentions, that matter to UK threat perceptions, is not rejected by
the data and improves both the efficiency of the estimates and the extent to
which coefficients conform to prior expectations. Setting A4 and A5 to zero, i.e.
making threat depend on the levels rather than the shares produces a slightly
higher LL (44 7 I 7) but causes A1 to have the wrong sign. Since the difference in
R2 is small (0o9305 for shares, o09346 for levels); the theory suggests the use of
shares; and the shares equation has all the coefficients correctly signed; the
equation given in the text is to be preferred.
(2) Supposing the function determining E was CES of the form:

ln E = ln D-- In (aSA-c + bSR-c).

Expanding around c = o this can be approximated by (Kmenta, I967)

ln E = ln D + valn SA + vbln SR - 1cvab(ln SA-ln SR)2.

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 820 THE ECONOMIC JOURNAL [DECEMBER 1980]
Thus by assuming E is a Cobb-Douglas function when CES is valid, the last
term has been incorrectly omitted from the equation. If (ln SA - ln SR)2 is
added to the equation in the text it has a t statistic of only o0o57, and none of
the signs of the other variables are altered. Thus the Cobb-Douglas form can be
accepted.
(3) In a similar manner if the function determining S is CES, the equation in
the text lacks a term in (ln M - ln E) 2. The problem is that ln M is the depen-
dent variable, ln E is not directly observable, and estimating the unrestricted
equation poses substantial difficulties.However, a Lagrange multiplier test can
be used in these circumstances (Engle, I978). Using the estimates on the null
hypothesis (i.e. those given in the text) construct the predicted values of ln M
and ln E, and use these to form
Z = (ln M-ln E)2.
Then regressthe residualsfrom the regressionunder the null on all the indepen-
dent variables including Z, using the covariance matrix estimated under the
null. Then asymptotically, T times the R2 from this regressionis Chi Squared
with one degree of freedom, if the Cobb-Douglas restriction is true. The R2
from the regressionis o *I 48, there are 25 observations,so the test statistic is 3.7.
Thus the restriction can be accepted at the 5% level, though it would be
rejected at the IO% level. Most of the contribution of Z comes in explaining the
residuals of I952-3, the Korean War period. It can be concluded that the
Cobb-Douglas is an acceptable approximation around the post war average
values of M, but, one might be sceptical about how well it would predict
responsesto large changes in the strategic environment.

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