defense economics

8/3/2019 Defense Economics

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DEFENSE ECONOMICS

History of defence economics:Significant interest in defense economics as an emerging field coincided with the appearance of

three now-classic works in 1960: Charles J. Hitch and Roland McKean (1960), The Economics of

Defense in the Nuclear Age; Lewis F. Richardson (1960), Arms and Insecurity; and Thomas C.

Schelling (1960), The Strategy of Conflict. The pioneering book by Hitch and McKean applied

economic concepts of allocative efficiency to the defense sector and inspired researchers for the

next generation to investigate defense economic issues. The interest in defense economics

blossomed during the Cold War, sparked, in part, by Richardson's (1960) arms race model.A large

literature grew that applied economic analysis to the study of arms races and their stability (seethe Brito and Intriligator chapter). This theoretical literature was accompanied by a parallel

literature that attempted to document the empirical existence of arms races [see, e.g., McGuire

(1977) and Linden (1991)]. Finally, Schelling (1960) introduced game-theoretic notions to the

study of conflict and defense. The book served to clarify the meaning of deterrence, compellent

threats and promises, and strategic moves. Although Schelling's work did not emphasize formal

modelling, many of his ideas have been subsequently formalized with recent advances in gametheory - e.g., the notion of a perfect equilibrium in which noncredible threats are culled from

feasible equilibria.There were three further pioneering contributions in the 1960s. A US study

byPeck and Scherer (1962) on The Weapons Acquisition Process analyzed the nonmarket goods

to the study of burden sharing within military alliances. Subsequent papers analyzed burden


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sharing, allocative efficiency, and the allies'demand for defense expenditure [see the Murdochchapter and Sandier (1993)]. During the 1970s, the literature of defense economics emphasized atleast five issues or subfields. First, arms races received much attention with important pieces by

Brito (1972) and Intriligator (1975) that provided a strategic foundation to the Richardsonian arms

race equations. Second, the appearance of Benoit's (1973) book began a controversy over whether

military expenditure is growth promoting or growth inhibiting. This controversy continues to the

present day (see the chapters by Ram, and Deger and Sen). Third, economists devoted attention tothe economics of alternative systems of military recruitment: conscription versus the all-volunteer

army (see the Warner and Asch chapter). Fourth, defense economists investigated thedefense

industries in terms of profitability, procurement practices, conversion impacts, competition, and

industrial policies (see the chapters by Dunne, Hartley, Lichtenberg,and Rogerson). Fifth, regionalimpacts of defense expenditure were studied with a variety of tools (see the Braddon chapter).In the

1980s and 1990s, these earlier topics were pursued along with some new ones. Advances in thestudy of asymmetric information and game theory were applied to the study of incentive contractsand procurement practices, as shown in the Rogerson chapter. Game theory was also used in the

study of terrorism and the analysis of negotiation strategy between terrorists and the authorities (see

the Enders and Sandier chapter). Modern general equilibrium analysis was employed to examine

insurrections and appropriative behavior as highlighted by the Grossman chapter. Game-theoretic

concepts and insights drawn from rent-seeking analysis were used by Jack Hirshleifer to theorizeabout the notion of conflict. Within the last fifteen years, other topics of defense economics included

an analysis of defense R&D (the Lichtenberg chapter), arms trade (the Anderton chapter),

disarmament (the Fontanel chapter), and conversion (the Fontanel and Hartley chapters).The


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modern study of defense economics employs the latest theoretical and empirical tools. Game-theoretic concepts are used in a number of subfields ofdefense economics, including the study of alliances, arms races, incentive contracting, terrorism,

insurrections, and conflict. A crucial game-theoretic notion of equilibrium, which shows up in a

number of places in the volume, is that of a Nash equilibrium. If no player or agent would

unilaterally want to change his or her strategic choice, then a Nash equilibrium is achieved. At such

an equilibrium, each player is optimizing his or her choice variable(s) subject to the best-responsechoices of his or her counterpart(s). In dynamic settings where interactions are repeated, a Nash

equilibria exist, some of which rely on noncredible threats that may hurt the threateners sufficiently

that they are unwilling to carry them out. Refinements to the Nash equilibrium concepts have been

developed to remove such noncredible threats and to maintain a greater degree of rationality onbehalf of agents. Subgame perfection is but one of many refinements. An equilibrium is subgame

perfect if it contains a Nash equilibrium for all component subgames, so that no player wouldunilaterally characteristics of weapons acquisition, the nature of competition for defense contracts,and the results of weapons programs. A companion volume by Scherer appeared in 1964: The

Weapons Acquisition Process: Economic Incentives. This volume examined including a theoretical

and empirical analysis of different types of contracts (e.g.,fixed price; cost plus). In 1966, Olson and

Zeckhauser applied the theory of want to change his or her strategy at any point in the game.

Current analysis of defense economics employs principal-agent analysis, rational expectations,dynamic optimization, and other theoretical advances.Modern defense economics also uses the latest

refinements in econometrics. In recent years, time-series analysis and its refinements have figured

prominently in defense economics. For example, the technique of vector autoregressive analysis

(VAR),whereby the interrelationships of multiple time series are studied, has been used to analyze


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terrorism and the impact of defense expenditure on growth and employment.Other time-series

techniques - causality tests, intervention analysis, and cointegration tests - have been usedthroughout defense economics. Military manpower studies have applied the latest techniques of

regression analysis to investigate recruitment, retention, military labor supply, and military labor

demand. Time-series cross-sectional methods have been recently applied to the growth and defense

controversy [Macnair et al. (1995)]. Some of these techniques are more advanced than the data

available for satisfactory empirical work. Often sophisticated econometric techniques use availablestatistics, failing to recognize the limitations of the data arising from its aggregative nature and the

use of different definitions of military expenditure .

On the nature of defense economicsDefense economics is the study of resource allocation, income distribution, economic

growth, and stabilization applied to defense-related topics. As such, defense economics

involves an investigation of the impact of defense expenditures, both domestically and

internationally, on macroeconomic variables such as employment, output, and growth.

It also has a microeconomic dimension involving analysis of the defense industrial base,

collaborative programs, offsets, the pricing and profitability of military contracts, and

the regulation of contractors. Defense economics draws from a variety of economicsubfields. In particular, public economics is important, because the provision of defense

(security) can be viewed as a public goods, whose benefits are nonrival and

nonexcludable within a nation and among allies. Another market failure, germane to

defense economics, is that of an externality, which arises when the action of one agent


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influences the well-being of another and no means of compensation exists. For defenseeconomics, the arming of one nation may yield positive (on allies) or negative (on

adversaries) externalities on another nation. However, measuring the "output" ofdefense spending is fraught with difficulties and the problem is often ignored,

or assumed away, or presented in generalizations such as security, protection, and deterrence.

Industrial organization is another branch of economics that figures crucially in the study of thedefense industrial base (the Dunne chapter), procurement (the Rogerson chapter), defense R&D (the

Lichtenberg chapter), and industrial policies such as collaboration, licensed production and offsets

(the Hartley chapter). Other relevant subfields include labor economics, international economics,public choice, economic growth, and macroeconomics. Public choice is particularly appropriate to

defense economics, because it focuses on nonmarket decision-making. By modelling the behavior of

voters, political parties, governments, bureaucracies, and other interest groups, it provides aframework for analyzing the "military-industrial complex".

Defense economics encompasses aspects and topics from peace science and conflict studies. Thus,

the economics of disarmament and conversion (the Fontanel and Hartley chapters) are relevant

topics. There is no ideological presumption in defense economics; that is, defense economists are not

inclined towards military expenditures and armed conflict. They are, instead, concerned with

understanding the processes and dynamics of arms expenditures, conflict and its resolution, and anyeconomic aspects associated with the defense sector. Defense economics has a strong policy

orientation; analysis is often undertaken to make policy recommendations regarding publicly

financed defense outlays. And, in the last resort, economists cannot ignore the opportunities forapplying economic theory and empirical techniques to a sector which is a major user of scarce


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resources and which has the potential to protect or destroy civilization. A further discussion and

analysis of the nature and scope of defense economics is taken up in the McGuire chapter. In recentyears, the scope of defense economics has expanded to consider a broader range of security matters

that include nonmilitary issues such as the protection of the environment from transnational

pollution (e.g., ozone shield depletion, global warming, acid rain). We have taken a narrower and

more traditional view of defense economics so as to preserve the field's well-definedidentity.

Importance of defense economics today:Even though the Cold War has ended and the superpower confrontation has declined greatly,

defense economics is still of great importance. In fact, the events of the late 1980s and early 1990s

may have increased the need and importance of defense economics, especially in regards to

resource allocation and the application of economics methods to security-related issues. First, thedownsizing of military budgets in the first half of the 1990s highlights a host of economic challenges.

Falling budgets and rising equipment costs will force nations to seek efficiency improvements in the

acquisition of weapons and the provision of armed forces. Nations will be more willing to buyavailable equipment off-theshelf from overseas suppliers rather than paying the price of supporting

a national defense industrial base. Within the armed forces, there will be pressures to substitute, say,

equipment for manpower, reserves for regulars, women for men, and civilians for military personnel(e.g., via contractorizing activities traditionally undertaken "inhouse" by the military, such as

catering, repair, and maintenance). Unit costs may also be higher on new weapon systems when

scale economies are present unless an arms producer is able to resort to foreign sales, which may

imply other kinds of risks and costs to the supplier nation. Faced with procurement cuts, defense


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firms have merged to take advantage of economies of scale and economies of scope. In so doing,

national defense industries have become more concentrated and less competitive. This downsizingtrend may have bottomed out. In 1994, the Clinton administration gave an emergency allocation to

the military to meet readiness requirements. The Anderton chapter mentions that the arms trade may

be on the rise again. Second, the breakup of the Soviet Union and Eastern Europe has unleashed

ethnic conflicts that have erupted into civil war once central power was diminished. In addition, the

breakup of the Soviet Union has raised the risk of nuclear weapons getting into the hands ofterrorists and the proliferation of nuclear-weapon nations. Third, since these trouble spots can

create conflict externalities for neighboring states, the role of peacekeeping forces and their

financial support have grown in importance. Fourth, the Gulf War of 1991 points to a source of

conflict in the future - that is, wars fought over disputed and/or scarce resources, such as commonoil pools. Fifth, recent defense treaties raise a host of allocative concerns as the elimination of

weapons creates expenditures on their disposals, environmental cleanup, verification, and thedevelopment of alternative classes of weapons. Peace as well as confrontation have their costs.

Recent reallocations of resources have had regional and national impacts on employment and

output. Sixth, nonconventional conflict in the form of terrorism and insurrections presents exigencies

that have allocative and distributional concerns. The provision of defense is still an important

activity that requires huge resource allocations to meet a variety of contingencies and uncertainties.

Economic aspects of the defense sector continue to be important and to require study. Interestcontinues to grow in the economics field for applying economic methods to defense issues.


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What is defense economics?

The study of war, in all its diverse aspects - avoidance, causes, preparations, initiation, conduct,

termination, consequences, etc. - has engaged scholarly energies from every conceivable origin and

discipline. Where does economics - economics as concerned with the consequences of resourcescarcity, and the necessity to allocate among alternatives - fit in with philosophy, history, biology,

psychology, law, political science, mathematics, religion and so on? The family of economic

problems studied over the past half-century in the cause of defense and security is indeed dauntinglyvast.

Economic Performance in the Defense Industries:

Principal among the performance dimensions by which an industry is evaluated are efficiency,

equity, stability, and technical progress. Since my concern here is not with technical progress as

such but with progress per dollar of expenditure, I take as given that progress is occurring andemphasize instead the efficiency aspect of this performance. Equity is mainly concerned with income

distribution objectives.

Defense Contracts: Incentives & Performance:

Ability in sales and employment within individual firms over time has seemed unnecessarily high,considering the over-all stability of expenditures on weapons and space development and

procurement. However, the stability statistics on sales and employment have never really been

developed. A rough of this performance can be obtained by fitting a least-squares-linear-trend lineto the annual sales and employment histories of the principal firms in the aerospace industry and the


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industry aggregate, as well as for firms of comparable size in four other producers goods industries,

over the period 19541963. The standard deviation of the residuals was then computed and,dividing by the mean level of activity, my measure of variability is the coefficient of variation

of the residuals.

BARGAININGBEHAVIOR

The principal difficulty in evaluating the effect of incentive contracts on cost performance rests onthe negotiation of target costs. If negotiated target costs are identical under both types of contract,and if the technical characteristics of the tasks to be performed are similar, the observation that

target costs tend to be overrun using CPFF contracts but underrun when a positive sharing rate is

employed clearly suggests that costs are more carefully controlled by the firm under profit-incentive

contracts.

But the assumption that estimated target costs are unchanged is very much open to question.It isgenerally accepted that the contractor is inclined to underestimate full costs when CPFF contracts

are used, in order to improve his prospects for winning the contract. And the Services may, at least

tacitly, encourage such underestimation to gain budgetary support for the program, while later

agreeing to additional fees on overrun costs.24 A substantial identity of interest between thecontracting parties exists in these circumstances. When contracts are shifted to an incentive-fee

basis, how-23 Department of Defense, Incentive Contracting Guide, 1963, especially pp.523 and 5 254.

24 Scherer, The Weapons Acquisition Process, pp. 27, 131, 157

institutional Structures and Defense Spending:


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ever, a penalty for overruns is operative. Here, I would expect that either the attitude of the

contractor toward the bargain would harden or that a tacit understanding that task uncertainty willbe resolved in the contractor's favor through change orders and contract amendments would exist

(or both). Let us examine the shift in bargaining posture first. Although an underestimation bias

exists when CPFF contracts are in force, an overestimation bias may operate when incentive-fee

contracts are used; for the greater the differential between negotiated target costs and true expected

costs, the larger the potential profit return to the contractor. Thus, if we let ir be expected profit, ?TTbe negotiated target fee,25 CT be negotiated target cost, C be expected cost, and be the sharing rate,

we have 7T= lrT + a(CT C). Under CPFF contracts, a is zero and hence the last term vanishes.When a positive sharing rate is selected, however, the cost difference between negotiated and

expected cost necessarily affects profits; and to assume that bargaining behavior is unaffected by

this change in circumstances is unwarranted.

It is possible, of course, that any toughening of the attitude on the part of the contractor would beoffset by a corresponding toughening in the attitude of the bargaining agent for the government.

Indeed, it has been argued that the government, as almost the sole purchaser, has an enormousadvantage in its dealings with defense contractors. Moore observes, however, that the government

has been either unable or unwilling to realize this monopsonistic bargaining advantage, and

suggests

that one reason is that it "lacks the skills and resources to make the necessary technical and costevaluations of contractors' proposals, but instead must rely on information supplied by the firm."


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Conclusion

Defence firms and national defence industries continue to face an uncertain future. No one can

predict accurately the future: it is unknown and unknowable. As always, firms which have the

entrepreneurship to anticipate the future correctly will survive; others will fail. Governments arefaced with difficult choices about their national defence industries. Falling defence budgets,

reflecting a preference for increased social welfare spending and a peace dividend, mean that

supporting national defence industries can be costly. The alternative would be for governmentsto act like a competitive buyer, opening-up their national defence markets to foreign firms and

buying defence equipment from the lowest-cost suppliers in the world market. Such a policy would

benefit taxpayers and the Armed Forces but the losers would be the national defence industrialbase.

REFERENCES

America, Washington DC. AIA (2000).Aerospace: Facts and Figures 1999/2000, Aerospace Industries

Association of BICC (1999). Conversion Survey 1999, Bonn International Center for Conversions, Bonn.

EC (1996). The Challenges Facing the European Defence-Related Industry: A

Contribution for Action at the European Level, European Commission, DG XV, February,

Brussels.

Hartley K (1983).NATO Arms Co-operation, Allen and Unwin, London.

Hartley K, 1991. The Economics of Defence Policy, Brasseys, London.

Hartley K and Cox A (1992). The Costs of Non-Europe in Defence Procurement, Executive

Summary, European Commission, DGIII, July (unpublished).

Hartley K and Sandler T (1995),Handbook of Defence Economics, Handbook in Economics,


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North Holland.

Hartley K and Tisdell C, 1981. Micro-Economic Policy, J Wiley, London.HCP 613 (2000). Ministry of Defence: Major Projects Report 1999,National Audit Office,

The Stationery Office, London.

Kirkpatrick D (1995). The rising unit costs of defence equipment: the reasons and the results,

Defence and Peace Economics, 9, 4, 263-288.

Mueller D C, 1989. Public Choice II, Cambridge University Press, Cambridge.

Prest A, 1976. The economic rationale of subsidies to industry in Whiting A (ed), The Economicsof Industrial Subsidies, HMSO, London.

Sandler T and Hartley K (1995). The Economics of Defense, Cambridge University Press,

Cambridge.

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