University of Strathclyde Honours year in Economics

___________________________________________________________

Forage Cap and Bowler Hat Defence Procurement at stake in a time of budgetary cuts ___________________________________________________________ - Dissertation supervised by Dr Frank STEPHEN -

Julien A. MATHONNIÈRE 1998

Summary

S

tate budgets in general, and those allocated to defence ministries in particular, are suffering from drastic cuts that advocate the need to reassert the way defence resources are spent . Indeed, options are open that may improve efficiency in terms of lesser costs and more consistent acquisition programmes. For the sake of this study, and because defence economics is so large a field of research that we cannot possibly cover any aspect in such a limited space, we assume from the start that nations know the optimal quantity of defence which is required to protect their citizens efficiently. We therefore assume that they are rational in choosing an appropriate level of security, that is, that they can quantify in some way the demand for defence. Broadly speaking, there are two main approaches to this topic. On the one hand, we have a possible macroeconomic approach that may focus -among other examples- on the effects of military expenditures on growth and development, or employment... On the other hand, we can opt for a microeconomic approach which would rather focus on defence procurement, military labour or the defence industry. This is the second approach we have selected in this dissertation where defence procurement will be examined in detail from a microeconomic perspective. We shall consider a three-sided or three parts treatment of the subject. In a first time, we would like to focus on issues concerning the imperfections of contracting within the market as it is, that is, imperfect, and hence the need to implement a procurement policy and to overcome cost estimation problems. In a second time, we would like to concentrate on the new economics of defence procurement that have brought new insights into procurement practices. Pioneering works will be examined, as well as the important contribution of game theory (again , a microeconomic approach), and regulation will be considered in the light of such developments and its compatibility with market incentives. Finally, the introduction of competition within defence procurement will be investigated and evaluated. We shall define its specificity in the latter field, try to relate it to the performance of the defence industry, and assess the overall impact on the acquisition process.

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A case study on the French Rafale aircraft in Appendix E will enable to illustrate some of the major points that have been dealt with in the dissertation.

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Acknowledgements

I would like to express my gratitude to the French Service d'Information et de Relations Publiques des Armées (SIRPA) for providing me with a considerable amount of information on the major defence acquisition programmes in France, and in particular on the Rafale fighter aircraft. I would also like to thank Commandant Bernard Henry for discussing with me some major issues in defence procurement last September. His advice has been very useful and an invaluable opportunity to better grasp the theoretical concepts. Finally, I would like to thank Dr Frank Stephen for patiently reading the successive drafts of this study, providing useful references where needed and correcting my "vocabulary shortcomings". I did appreciate his detailoriented comments and I am glad he accepted to be my supervisor for this project.

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CONTENTS Summary

ii

Acknowledgements

iii

List of Tables and Figures

vi

List of Abbreviations and Acronyms

vii

Introduction

1

I. The imperfections of contracting within the market features 7 A. The market features of defence procurement 1) The characteristics specific to defence markets 2) Their implications for defence procurement B. Procurement policy and planning 1) The need for a procurement policy 2) The set of choices involved in the procurement policy 2.1 The policy options 2.2 The choice of equipment 2.3 The choice of contractor 2.4 The choice of contract 2.5 The incentives to choose 2.6 The decision-making 3) The different contract types and their limitations 3.1 Fixed-price contracts 3.2 Cost-plus contracts 3.3 Incentive contracts C. The difficulty of cost estimation 1) The gaps in the field of cost-estimating relationships 2) The estimation methods and their drawbacks 2.1 Engineering estimates 2.2 Comparative methods 2.3 Parametric methods 2.4 Learning curves

II. The new economics of defence procurement

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8 8 10 12 12 14 14 15 15 15 16 17 17 18 18 19 21 21 22 22 22 23 23 25

A. A brief survey of interesting theoretical developments 1) The pioneering works of Scherer 2) An overview of the subsequent developments B. Game theory applied to defence procurement 1) The formulation of a game applied to defence procurement 2) The works of McAfee and McMillan, and Rogerson 3) An interpretation C. The case for and against regulation 1) Profit controls and their compatibility with market incentives 2) "The usefulness of inefficient procurement"

26 26 29 31 31 32 34 35 35 37

III. The introduction of competition within defence procurement 39 A. Measuring competition against collaboration 40 1) The specificity of competition in the field of defence procurement 40 2) Nato and Europe : from standardisation to the opportunity of creating a European procurement policy 43 B. The relation to defence industry performance 45 1) The ability of the defence industry to integrate competition 45 2) The impact on defence industry performance 46 2.1 Research and development 46 2.2 Technology transfer 47 2.3 Economies of scale and learning 47 3) Sovereignty and the case for a national base 48 C. The overall impact on defence procurement 50 1) The performance indicators 50 1.1 Fixed-price contract under total package procurement 51 1.2 Cost control, delivery schedule and equipment performance 51 1.3 Profitability 52 2) A long road to competition? 54

Conclusions

56

Appendices

58

• A. Some literature on defence economics • B. Evolution of the US and NATO military equipment expenditure • C. The gradual introduction of competition in American defence procurement • D. An overlook at the defence industry in the major European states and the US

59 61

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63 64

• E. The French Rafale aircraft: a short case study • F. Correspondence

67 77

Bibliography Internet Resources

80 85

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List of Tables and Figures

Introduction • Table : World defence expenditure, military manpower and arms export (1989-1990) 4

I. The imperfections of contracting within the market features • Figure : The United Kingdom Defence Equipment Markets

9

• Figure : A typical procurement cycle

13

• Figure : The relationship between the different contract types

20

II. The new economics of defence procurement n/a

III. The introduction of competition within defence procurement • Table : The different possible stages of competition within a procurement cycle 42 • Figure : The price effects of competition

Conclusion n/a

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53

List of Abbreviations and Acronyms

DCAA DCN DGA DIB DoD EFA EU FTA GDP GIAT GPS MIC MoD MoUs MPs NATO R&D UK US

Defense Contract Audit Agency (US) Direction des Chantiers Navals (France) Direction Générale de l'Armement (France) Defence Industrial Base Department of Defense (US) Euro Fighter Aircraft European Union Future Transportation Aircraft Gross Domestic Product Groupement des Industries de l'Armement Terrestre (France) Global Positioning System Military-industrial Complex Ministry of Defence (UK / France) Memoranda of Understanding Members of Parliament North Atlantic Treaty Organisation Research and Development United Kingdom United States

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Introduction "On the Usefulness of Defence Economics" Context

W

ith the end to the Cold War and its strictly bipolar order, defence policy has entered a period of momentous change. Many challenges are to be faced that relate simultaneously to

the proliferation of multi-sided threats and a higher constraint placed on states' budgets. The need to spend on those systems that protect and deter aggression has been emphasised, and paradoxically, issues concerning disarmament given a new impetus. Costs and benefits are involved that require economic investigation to improve efficiency and find better value for money. The conflictual relationship of the above geostrategic issues to these budgetary cuts imposes the application of rigorous economic analysis if resources are to be allocated between competing interests in both the defence and civilian sectors. By applying the tools of economics to defencerelated issues, defence economics tailors economic methods to a specific set of topics, while taking account of institutional aspects that are unique to the defence sector.

Specificity As pointed out by Todd Sandler and Keith Hartley, "defence economics differs from other field of economics in at least three ways : (1) the set of agents studied (e.g., defence contractors, branches of the military); (2) the institutional arrangements of the defence establishment (e.g., procurement

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practices); and (3) the set of issues investigated "1. Naturally, as in any other field of economics, some fundamental and basic problems can be examined in the narrower context of defence economics. For example, the provision of defence may be studied in the light of allocative efficiency, public choice consideration, distribution where income is involved, stability through arms races or price trends of defence outputs... The influence of defence spending on economic aggregate and industrial performance can also be measured to enable international comparisons. As can be seen from above, both macroeconomic and microeconomic analysis seem relevant to defence economics.

Nature Defence is a pure public good, that is, a good which is non rival and non excludable. The provision of defence usually requires public supply financed by tax levies. As a matter of fact, the huge amounts of capital and labour required in the provision of national security to one country would probably yields an under supply by the market without the intervention of the state. No private firm could possibly provide national defence at a country scale even if capital and labour were available, simply by lack of profitable returns. The provision of defence therefore falls into the field of public economics which forms an important component of defence economics. Moreover, arming a nation may induce positive or negative externalities on another nation, depending on whether it is an ally or an adversary. Both the above aspects are associated with some kind of market failure. The former, because the nonexcludability of a good eliminates incentives for a user to support the provision of this good, while nonrivalry means that there is no reason to restrict users. The latter, because externalities may require 1

Sandler, Todd and Hartley, Keith, 1995. "The Economics of Defense", p.xi.

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government intervention. One may in fact agree with this view of economics developed by Michael Intriligator : "Defense economics is concerned with that part of the overall economy involving defense-related issues, including the level of defense spending, both in total and as a fraction of the overall economy; the impacts of defense expenditure, both domestically for output and employment and internationally for impact on other nations; the reasons for the existence and size of the defense sector; the relation of defense spending to technical change; and the implications of defense spending and the defense sector for international stability or instability "2. As can be seen above, the importance of integrating strategic concerns when studying the interdependency of military spending decisions at an international level is strongly emphasised. This formal definition has been completed by Judith Reppy's comments on the nature and scope of defence economics which is seen as that which "incorporates Intriligator's examples as a subset of the domain of the field, but that pays more attention to the unique institutional features of the systems being analysed "3. This makes sense since in the light of such a definition, particularisms such as cost-plus contracts (whereby the risks of changing the performance specifications of a weapon system are shifted from the supplier to the buyer), for example, become more understandable when one knows that the buyer may reserve the option to change the performance parameters at a later stage.

2

Intriligator, Michael, 1990. "On the Nature and Scope of Defence Economics", Defence Economics, vol. 1(1), p.3. 3 Reppy, Judith, 1991. "On the Nature and Scope of Defence Economics : A Comment", Defence Economics, vol. 2(3), p.269.

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Importance There is probably little need to say that the place of defence economics seems undoubtedly a very central one. As a matter of fact, although defence expenditures vary among nations, an average 5 percent of gross domestic product (GDP) is devoted to defence. A figure that can go up to 20 percent for some Middle Eastern countries. Considerable allocative influence on nations is therefore to be found, especially when research and development is included. Given the current levels of military expenditures, an economic analysis of the short-run and long-run choices and trade-offs posed by defence seems more than relevant if not essential.

World defence expenditures (1990) Industrialised countries $800 billion

Less developed countries $150 billion

World Military manpower (1990) Industrialised countries Less developed countries 10 million 18 million + 22 million civilians 750,000 to 1,5 million scientists and engineers Arms imports (1989) Industrialised countries $10.7 billion

Less developed countries $34.6 billion

Source : Compiled from data found in Todd Sandler and Keith Hartley, "The Economics of Defense", p. 8

It can be seen from the above figures that the defence sector is a crucial component of the economy that is indeed worthy of study. Factors are contained that may contribute to the understanding of industrial policy, growth and development, employment, international trade, allocative efficiency, fiscal and monetary policies...etc. One can reasonably presume

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that heavy military spending will contribute to budget deficit, the crowding out of investment and high interest rates4. Those many issues are to be addressed by defence economics to equip policy makers with a more accurate vision of the economy and thus, contribute to more efficient decision-making. (See Appendix B )

Interest Interest in defence economics originally took off during the Cold War in the early 1960s. It has gathered a new momentum in recent years thanks to the large number of books that have been published in the past ten years, the appearance of articles in the top general economics journals, and the publication of a field journal, Defence and Peace Economics (formerly known as Defence Economics ), starting in 1990. The need to completely and globally re-assess nations' security needs provides a new bedrock to defence economics on which it is expected to grow amidst the many defence problems to sort out. (For a better idea on the interest expressed in defence economics, See Appendix A on the main written contributions)

Methodology Defence economics proceeds from a two-components methodological approach. On the one hand, being a policy science, it uses the primary tools of theoretical and empirical economic analysis to determine an optimal policy likely to bring about the desired outcomes. Of course, theories have to be tested in the light of empirical data (that must be available) and possibly corrected and/or improved if necessary. On the other hand, sub-branches of economics will be resorted to depending on the field of study. Among other 4

Sandler, Todd and Hartley, Keith, 1995. Op. cit., pp.8-10.

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examples, international economics apply to the analysis of arms trade, industrial organisation to the study of defence industry, public choice to that of defence procurement, labour economics to the observation of military manpower, public economics to the study of alliances, arms races and defence budgeting, macroeconomics that of defence expenditures on domestic growth...etc. Testing theories and defining or improving decisionmaking models falls into the field of applied economics.

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I The imperfections of contracting within the market features

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I. The imperfections of contracting within the market features A. The market features of defence procurement In 1996, US$m 20,758 and 58,630 for European NATO nations and for the United States, respectively, were accounted for by the procurement of major weapons systems5. With such figures, it is probably an understatement to say that defence procurement is a major business. But it is also a peculiar one with respect to the role of the government, cost trends, technical progress, cost curves and regulation. 1) The characteristics specific to defence markets Like any other market, defence markets unsurprisingly bring together demand and supply sides through a legally binding contract, whereby the buyer agrees to pay a certain price for a specified product (theoretically) delivered on time. In some instances, regulatory requirements might be imposed by the government on the contractor such as profit controls. Where the market differs is in the following aspects. First, the government occupies a central place as the sole or major buyer of "defence" (monopsony), which strongly influences the structure and performance of the domestic defence industry (technology, autonomy...). In this context, a view has been developed that defence procurement should be used as an instrument of industrial policy. It 5 SIPRI, 1997. "Yearbook 1997: World Armaments and Disarmament", pp.185-187. These figures represent 17.9% and 26.5% of total military expenditure respectively.

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is naturally opposed by free market supporters who underlined the fact that governments have no competence as entrepreneurs and may additionally fail at improving economic performance. Indeed, should procurement encompass so wide economic and social objectives such as protecting the national defence industrial base (DIB)?

The United Kingdom Defence Equipment Markets

Demand for Defence Equipment

Supply for Defence Equipment Contract

Ministry of Defence

Defence Industries

Armed Forces

UK

Overseas

Regulation Ministry of Defence Accountants Technical Costs ____________________ Review Board for Non-Competitive Government Contracts Source: SANDLER, Todd and HARTLEY, Keith, 1995. "The Economics of Defense", p.115.

Secondly, the cost of defence equipment is increasingly escalating. Although more productive, the replacement systems are much costlier than previous generations. Philip Pugh has estimated this cost to double every 7.25 years, encouraging the search for alternative

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procurement policies as defence budgets are unable to match such costs increases6. Thirdly, major technical innovations require a higher concentration of production and research and development (R&D) facilities. That is, a smaller number of larger firms departing from the perfect competition ideal, a trend likely to be reinforced by the many cuts in defence spending. As a consequence, national markets may be forced to open if competition is to be maintained. Fourthly, decreasing costs are characteristic of a number of defence industries, those involving high technologies in particular. Again, national markets might be insufficient to exploit scale economies and reduce production costs. R&D costs have to be spread over a larger quantity of goods for firms to be able to indulge scale and learning economies. Finally, the defence market is regulated by the government (open or close), costs are monitored and profits subject to control. The regulation aims at avoiding costs overruns (no excess profits) and retaining the industrial base (no excessive losses). 2) Their implications for defence procurement Several strategies are used at the policy level to maintain procurement contracts within reasonable limits of costs, time and suitable quality. Among these are to be found:

6

Pugh, Philip, 1993. "The Procurement Nexus", Defence Economics, p.181.

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- the incentive contracts; - various regulatory arrangements relating to the disclosure of costs and the control of profits; - the use of competition at various stages in a project's life cycle as we will see in more details in part III. The distinctive features of the defence market present a series of implications regarding more particularly defence procurement. a/ Although endowed with taxation, regulatory and coercive powers, the buyer may be influenced on the political market place by lobbies or electoral considerations. b/ The use of costly, rapidly changing, high technology means that procurement is dominated by uncertainty about buyer costs and performance requirements. On the one side, the contractor is aware of the technical possibilities and costs, while on the other side, the monopsonist is able to change technical requirement at discretion. Strategic behaviour is therefore part of the buyer-supplier relationship. c/ All major public contracts being necessarily incomplete, an optimal trade-off has to be found between flexibility and the prevention of opportunism. As pointed out by Jean Tirole, this difficulty is accentuated on defence markets by the risk of collusion between buyer and contractor personnel in the form of friendship between Ministry of Defence officials and firms that have been dealt with repeatedly7. 7

Tirole, Jean, 1988. "The Theory of Industrial Organization", p.27.

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d/ Defence procurement is regulated in the areas of cost-estimation, accountancy practices and the profitability of non-competitive work. Also, future contingencies and possible disagreements are regulated. Cost are controlled through principles such as the equality of information, truth in negotiation laws, post costing and ultimately, the renegotiation of excessive profits. Quality is protected by some kind of guarantee incorporated in contracts and the work of inspection teams. B. Procurement policy and planning 1) The need for a procurement policy As underlined by Martyn Bittleston, "a nation's defence equipment plan is no less important and serious than any other element of its military preparedness. Having the right equipment available to meet the full spectrum of military need, in the right quantities, in the right place and at the right time, and, increasingly, at the right price, is of vital concern to commanders "8. Of course, all this is far from being simple. Armaments programmes often spread over extended development periods, lasting an average ten years, while the completion of the planned production can possibly double this figure.

8 Bittleston, Martyn, 1990. "Co-operation or Competition? Defence Procurement Options for the 1990s", p.10.

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A typical procurement cycle

Source: BITTLESTON, Martyn, 1990. "Cooperation or Competition? Defence Procurement Options for the 1990s", p.50.

The trouble is that specifications being made years before, operational threats may have changed, requiring updates of equipments which paradoxically tend to be obsolescent the day they enter service! Consequently, huge investments are necessary to keep the defence R&D sector at the leading edge of technology. Four reasons can be put forward that account for the need of new equipment, although, as explained by M. Bittleston, it is difficult to draw a clear line between each of them9: - the development of new military concepts or strategies demanding new or enhanced capabilities; - intelligence assessment of future or altered military threats;

9

Bittleston, Martyn, 1990. Op. cit., p.11.

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- the development of new technology offering new capabilities of significant military utility; - the need to replace existing equipment which is no longer reliable or cannot be maintained. Unfortunately, most western nations do not possess any clearly articulated procurement policies, and when they are, they are not consistent and strictly adhered to10. A twofold explanation accounts for this position. On the one hand, this is a good way to keep a range of options open. On the other hand, refusing the purely domestic choice avoids possible trade penalties and disputes on the international stage. 2) The set of choices involved in the procurement policy 2.1 The policy option It is to be chosen from a range of four, ranging from the nationalist option of autarchy at one extreme, to buying competitively from abroad ("off-the-shelf"). International collaboration and licensed production stand in between. Again, strategic choices have to be weighed against the potential benefits of international trade and comparative advantage based on specialisation.

10 We shall examine the dramatic consequences of inconsistent procurement policies in the short case study presented in Appendix E on the French Rafale aircraft programme.

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2.2 The choice of equipment This choice has implications for technical innovation as we underlined it before, and arbitrage is to be exercised over competing demands from the different armed forces for the lion's share. While security requirements are supposed to prevail, the general principle of Buggin's turn applies in practice11. 2.3 The choice of contractor It can be selected by direct negotiation or by competition (price and non price), and restricted to domestic firms or open to foreign firms. Naturally, international opening will certainly be strongly resisted domestically on many a ground (employment protection, loss of sovereignty, technology leaking...), although such goals may be achieved by other more efficient means. Again, a question is raised concerning the finality of employment: protection of the citizens or protection of the DIB? 2.4 The choice of contract Three types of contracts are available. 1> Fixed-price contract: it is a contract where the firm receives the contract price, no more, no less. Allowance is made to price variation based on an agreed price index reflecting inflation in labour and capital (with an agreed price variation). 11 That is, if the Navy has been equipped with a new aircraft carrier in year Y, then it will be the turn of the Air Force to have its new fighter the following year and then, that of the Army for a new tank the year after that.

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2> Cost-plus contract: it is a contract where the contractor recoups all its costs incurred at the project, plus an agreed profit rate based on costs or with a fixed fee. This contract is preferred to fixed-price

contracts

for

development

works

where

considerable uncertainty is at stake. 3> Incentive contract: this contract incorporates rewards and penalties to the contractor in order to enhance its productivity level and avoid cost overruns and programme delays. The trouble when designing a contract is that the buyer is not always able to define a priori and in advance all its detailed requirements. Therefore, it needs a contract allowing for modifications of specifications. Two policy issues arise within the negotiation of contracts. One is to determine how risks should be distributed between buyer and contractor. The other is to measure the implications of these different contractual arrangements on the firm's behaviour and efficiency, and their ability to meet the buyer's requirements. 2.5 The incentives to choose Efficient solutions depend upon the set of incentives and penalties incorporated into the employment contracts of the procurement staff in the armed forces and defence industries. There seems to be a natural inclination to spend and few inducements to economise, especially when savings on one side go to the other side.

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2.6 The decision-making Finally, the decision-making process led by a committee will depend upon a host of factors such as the size, objectives, composition of membership, conditions of entry and exit, background of the chairman and most influent members or voting arrangements. But as explained by Todd Sandler and Keith Hartley, "public choice analysis provides two predictions of relevance to defense contracting and procurement policy. First, governments policies tend to favour producers more than consumers. Second, budget-maximising bureaucracies will be inefficient: their budgets will be too large as they exaggerate the demand for their services and underestimate the cost of their preferred activities "12. 3) The different contract types and their limitations Some contractual relationships between buyer and supplier have been determined by the distinctive features of defence markets aforementioned. But while contracting for standard, ordinary items is a rather simple administrative formality, the real problem comes with the need to negotiate long-terms contracts under uncertainty. The contractual relationship will be further complicated by asymmetrical information, adverse selection, moral hazard, risk sharing and monitoring. 3.1 Fixed-price contracts 12

Sandler, Todd and Hartley, Keith, 1995. Op. cit., p.119.

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Fixed-price contracts are generally used under competition or sole source purchasing where technological and economic uncertainties are negligible (little information asymmetry), and where firms are profit-maximisers. When a prime contractor receives a fixed-price contract (with agreed price variations), it has every incentive to negotiate firm prices with its suppliers so that it can appropriate for itself all the financial benefits of price variations. An alternative solution might be the award of a competitively determined fixed-price contract where contractors would be left with the sole responsibility of determining future inflation and incorporating it in their bid (knowing that the lowest bid will, of course, be favoured by the buyer). Unfortunately, departures appear from the profit-maximising ideal on both the supply and demand sides, often by lack of appropriate incentives. 3.2 Cost-plus contracts Cost-plus contracts avoid excessive profits but they present a potential for cost maximisation. In those contracts, the government (buyer) acts as an insurer by bearing the risks linked to contract uncertainties. Naturally, these genuine "blank cheques" lead to inefficiency, labour hoarding, cost escalation and "gold plating". As observed by William Samuelson, if the firm is risk averse and government risk neutral (thank to its ability to pool risks), costplus contracts represent an optimal risk sharing arrangement, but they remain inefficient13. Paradoxically, fixed-price contracts are

13 Samuelson, William F., 1983. "Competitive Bidding for Defence Contracts" in Engelbrecht-Wiggans, R. et al. (eds.), Auctions, Bidding and Contracting, p.392-393.

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suboptimal in terms of risk sharing but they offer efficiency advantages. Fixed-price and cost-plus contracts show the necessary trade-offs between risk sharing (insurance) and efficiency. Incentive contracts, the third blend of contracts stands as a compromise. 3.3 Incentives contracts They involve bargaining between buyer and seller about target cost, target profit, risk sharing ratio and government's maximum price liability. Some economists have argued that such contracts might be the optimal type of contract, allowing savings of an average 3 percent14.

As shown by Peter De Mayo, incentive

contracts will provide firms with an incentive to negotiate a high cost target, a favourable sharing arrangement and a high maximum price liability15. Budget-based schemes have been proposed that may control this behaviour by creating desirable reporting and performance incentives.. They include an incentive fee depending on actual costs and on a cost estimate (target cost), that is, proportional to budget variance. As a result, the government receive more accurate information that is useful for its budgetplanning process since the contracting firm has an incentive to submit true, realistic and unbiased cost estimates16.

14

McAfee, R. Preston and McMillan, John, 1986a. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics, p.333. Unfortunately, their evaluation seems based on merely unrealistic assumptions. 15 De Mayo, Peter, 1983. "Bidding on New Ship Construction" in Engelbrecht-Wiggans, R. et al (eds.), Op. cit., pp.381 and 385-386. 16 See Reichelstein, Stefan, 1992. "Constructing Incentive Schemes for Government Contracts: An Application of Agency Theory", Accounting Review .

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The relationship between the different existing contract types has been depicted by Jean-Pierre Ponssard below:

The relationship between the different contract types17

Source: Ponssard, Jean-Pierre, 1983. "Military Procurement in France: Regulations and Incentive Contracts" in Engelbrecht-Wiggans, R. et al (eds.), Op. cit., p.511.

A conclusion is offered by Martin Shubik: "It is easy to produce a general impossibility theorem to show that no simple rule will be universally optimal for the multi-faceted needs of large-scale procurement "18. If auctions, for example, are good for selling many commodities, they are not for the procurement of large systems. Fixed-price contracts (sealed bids) seem attractive but risk sharing problems may arise, whilst cost-plus contracts offer simplicity, risk sharing but poor incentives19. 17

On this figure, price is based on estimated costs (C0) (target costs) plus a target profit, ∏t [where P0 = C0 + ∏t . Fixed-price contracts are represented by a horizontal price line, cost-plus by a positive slope with profits as a mark-up on the 45° line, and incentive contracts are intermediate between the two, the slope of the line reflecting the sharing ratio. 18 Shubik, Martin, 1983. "On Auctions, Bidding and Contracting", in Engelbrecht-Wiggans, R. et al (eds.), Op. cit., p.23. 19 Shubik, Martin, 1983. "On Auctions, Bidding and Contracting", in Engelbrecht-Wiggans, R. et al (eds.), Op. cit., pp.23-24.

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C. The difficulty of cost estimation 1) The gap in the field of cost-estimating relationships There seems to be a kind of deficiency in the field of industrial economics. Good case studies on cost conditions in defence industries are lacking that may provide evidence on long-run cost curves and minimum efficient scale, allow international comparisons and a better understanding of the relationship between scale and learning curves. No empirical data are available on the efficient scale of production, whereas the budget cuts and programmes stretch-outs (to preserve the defence industrial base) renders this issue more acute than ever. With an increased concern for budget reductions and the search for efficiency savings, a revaluation of cost implication of the current scale of production (and the possible extent of its excess capacity) seems more than necessary. There is indeed a widely held view in the defence community that weapons production occur in too large plants relative to output actually produced and could be more easily manufactured in smaller-scaled plants20 should the procurement rate be not persistently over-estimated, and decision-making better organised. 2) The estimation methods and their drawbacks

20 See Rogerson, William P., 1991a. "Incentives, the Budgetary Process, and Inefficiently Low Production Rates in Defense Procurement", Defence Economics.

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Various methods are used to estimate the development and production costs of large scale equipment programmes. The trouble is that they tend to be very unreliable with some projects increasing in real costs by 40 to 70 percent from the early estimates to completion. This inflation is mainly due to modifications and changes in requirements throughout the development phase that are unpredictable at the very beginning of the project. In such a situation, better estimating techniques and/or alternative procurement policies (e.g. competitive fixed-price contracts) should be envisaged. 2.1 Engineering estimates They consist in the estimation of the costs of all the materials, equipment, components, labour, and overheads involved in the project. One immediately sees the drawbacks of such a method given technical specifications can be altered overtime. That is, the composition and cost of capital and labour will also necessarily be modified. In that lies the unreliability of this type of estimating methods. 2.2 Comparative methods They are based on historical comparisons of similar projects (e.g. combat aircrafts...). Rules of thumb may be introduced to evaluate, among other examples, life cycle costs or development costs to unit. The trouble is these extrapolations are based on past relationships that need to be adjusted to allow for variations in the complexity of new programmes compared with older ones. This is precisely where evaluation becomes difficult.

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2.3 Parametric methods They aim to forecast future R&D projects costs and are often based on the cost profiles of historical R&D project data. They resort to multiple regression analysis and have been widely used, particularly for estimating the development and production costs of aerospace equipment. As a statistical method, they tend to be slightly more accurate than the two previous methods. But again, adjustments have to be made that are extremely difficult to determine. Changes in materials, design concepts, systems integration and manufacturing techniques are likely to bias the cost-estimation relationship in such a way that it is no longer reliable. 2.4 Learning curves They apply to production programmes, and reflect the fact that productivity increases with experience. Therefore, they provide a useful tool for manufacturing costs estimation. They are usually expressed as follows: y = aX-b

where y : number of man hours per unit produced; X : cumulative output of a given type of equipment; a : man hours required for the first unit;

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b : slope of the learning curve usually defined in relation to a doubling of cumulative output. Naturally, difficulties are encountered in trying to estimate a and b. Moreover, questions arise on whether learning curve continues indefinitely, and whether b remains constant or not. As a matter of fact, modifications and breaks may affect learning curves. And more problematic in general is the fact that underlying determinants and causes of learning are usually not explained satisfactorily.

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II The new economics of defence procurement

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II. The new economics of defence procurement A. A brief survey of interesting theoretical developments Attempts have been and are still being made to assess defence procurement in which economists traditionally apply their standard economic models of free trade and competition, including the opportunities for competitive bidding at various stages of a product's life cycle. Pioneering contributions were brought from the 1960s onwards that favoured analysis in the light of a (new) microeconomic approach to defence procurement. They were essentially the works of American economists from the Rand Corporation, a think tank at the forefront of research in this field. 1) The pioneering works of Scherer An early definitive study was F. Scherer's The Weapons Acquisition Process: Economic Incentives (1964)21. The book starts by outlining four features of the weapons acquisition process. • Uncertainty and risk involved in the development work often result in the shifting of financial risks from contractors to the Government,

usually

by

means

of

cost-plus

(or

cost-

reimbursement) contracts. • Once a contractor is engaged in a project, it tends to acquire highly specialised information and physical assets. This results in a bilateral monopoly bargaining situation where the Government's

21 Indeed, in this book, F. Scherer puts forwards some ideas about what was going to be a major issue: transaction costs. Other important contributions will be later brought, notably by Williamson concerning public contracting.

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commitment restricts its ability to shop around and bring in alternative contractors. • Consequently, a conventional market is not possible, and buyer and seller have to rely on a non-market quasi-administrative relationship. • The absence of market forces also remove natural incentives to efficiency. So that the Government has to intervene either through controls on contractors, or through incentive mechanisms to instigate a reward and penalty game. The four aforementioned features, it is argued here, more generally apply to all public contracts, not least long-term planning is involved (e.g. civil engineering, major construction projects...etc.). This is not to say they are not unique to defence contracting. They are probably even more unique to defence procurement than for any other longterm public contract because of the "amount" of uncertainty involved in research and development in the defence sector. Break-outs and second sourcing have been used as means of achieving competitive bidding. As explained by Scherer, by the early 1960s, US evidence appeared to show that competitive break-outs22 resulted in price reductions of roughly 20 percent compared with prices negotiated non competitively23, despite transaction costs and the possible immobility of certain specialised factors of production24.

22

Break-outs can involve no competition with governement buying parts directly from subcontractors; or subcontractors can enter into competitive bidding; or the complete production can be subject to competitive bidding. 23 Scherer, F., 1964. "The Weapons Acquisition Process: The Economic Incentives", p.106. 24 This might be the case, for example, of a contractor possessing immobile specialised facilities such as heavy machinery.

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Second sourcing is an alternative option to break outs, thereby one or more firms are selected to produce a weapon system (or subsystem) concurrently with the original contractor. It was used extensively during World War II and the Korean War, although often for reasons other than competition25. But again, as with break-outs competition, second sourcing is naturally not costless.

Important learning

economies may also provide the incumbent (original contractor) with a decisive advantage over a new entrant. As pointed out by Scherer, where economies of scale are substantial, it is not certain that the production order is able to support more than one firm if it is to remain efficient. The outcome of any contract negotiation will reflect the bargaining power of the two parties involved, as well as their bargaining strategies and tactics through contractual incentives. A strategic advantage is held in the knowledge of costs by contractors (which subsequently might resist any government's demand for access to their accounting data). Naturally, the Government is not resourceless and can resort to domestic or foreign competition to check a price bid, although incompleteness might enable the contractor to make cost-quality trade-offs26.

25

Scherer, F., 1964. Op. cit., pp.118-119. A subsequent example of second sourcing, quotes Scherer, involved the US Navy's Sidewinder programme. Sharing the production work between Philco (the original contractor) and General Electric (second source) on the basis of each firm's success in reducing costs allowed a deflation of the unit price by one seventh of its price,although the price reductions also reflected learning curve effects based on a 76 percent progress curve. 26 Scherer, F., 1964. Op. cit., chapter 8.

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2) An overview of the subsequent developments A multitude of subsequent developments have sprung from Scherer's initial work and have been incorporated into the literature on defence contracting. We shall cite the major ones below. (a) Principal-agent model. The buyer-seller relationship has been treated in a principal-agent framework with the defence ministry as the principal (buyer and regulator) and the prime contractor as the agent (supplier and regulated firm)27. (b) Transaction costs and contract theory. Specifying, negotiating, agreeing, and monitoring contracts involves transaction costs; transactions are characterised by bounded rationality (limited information) and opportunism (incentives to hoard valuable information); and, inevitably, many contracts are incompletely specified28. (c) Information asymmetry. There are information asymmetries between the buyer and contractor in situations of uncertainty and where procurement is characterised by adverse selection, moral hazard and risk sharing between purchaser and supplier29. Adverse selection means that the government does not know the firm's expected costs and moral hazard arises where the government cannot observe the selected contractor's efforts to minimise costs (e.g. firms

27 See McAfee, R. Preston and McMillan, John, 1986a. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics. See also Laffont, Jean-Jacques and Tirole, Jean, 1993. "A Theory of Incentives in Procurement and Regulation". 28 See Williamson, Oliver E., 1986. "Economic Organization". 29 See Cummins, J. Michael, 1977. "Incentive Contracting for National Defence: A Problem of Optimal Risk Sharing".

- 29 -

which pay only a small share of any cost overruns have a diminished economic incentive to minimise costs). (iv) Game theory. Game theory has been used to analyse strategic behaviour and interaction by both the purchaser and the contractors30. (v) It has been recognised that defence contractors might not be profit maximisers, especially in imperfect and regulated markets31. (vi) Efficient outcomes do not require large numbers of firms in an industry (as the perfectly competitive model). Instead, contestability (the threat of rivalry) rather than industry structure determines performance32. (vi) Public choice analysis and economic models of regulation provide new insights into procurement policy33.

30

See Laffont, Jean-Jacques, 1986. "Towards a Normative Theory of Incentive Contract between Government and Private Firms", Journal of Political Economy. See also Shubik, Martin, 1983. "On Auctions, Bidding and Contracting", in Engelbrecht-Wiggans, R. et al (eds.), Op. cit., pp.3-29. 31 See Williamson, Oliver E., 1986. Op. cit. 32 See Baumol, William, 1982. "Contestable Markets: An Uprising in the Theory of Industrial Structure", American Economic Review. 33 See Cowen, Tyler and Lee, Dwight, 1992. "The Usefulness of Inefficient Procurement", Defence Economics. See also Leitzel, Jim, 1992. "Competition in Procurement", Policy Sciences, and Lichtenberg, Frank R., 1989. "Contributions to Federal Election Campaigns by Government Contractors", Journal of Industrial Economics.

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B. Game theory applied to defence procurement 1) The formulation of a game applied to defence procurement Fundamentally, a game involves two or more agents known as 'players', whose interactions determine their pay-offs or outcomes. The game can be co-operative or non-cooperative, information perfect or information imperfect, and is always determined by the players, their strategies, and the outcomes associated with various strategy combinations. The players involved in defence procurement are the government, the Military and the producer (defence industries). The Military is frequently referred to as the contractor. For the sake of theoretical research, economists often suppress one of these agents to focus on the two others. So that some formulations emphasise the interaction between government and military34, while others focus on those between government and firms35, and still others observe the interactions between the military and the firms36. Either the sequential nature of the game or its information structure can be analysed. Sequential aspects usually involve the description of a two-period game. In the first period, one player 'moves' and decides a choice variable, based on his/her anticipation of the other player's

34 See Rogerson William P., 1990. "Quality and Quantity in Military Procurement", American Economic Review. Also 1991a. "Incentives, the Budgetary Process, and Inefficiently Low Production Rates in Defense Procurement". 35 See Cummins, J. Michael, 1977. Op. cit. and McAfee, R. Preston and McMillan, John, 1986a. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics. 36 See Tirole, Jean, 1986. "Procurement and Renegotiation", Journal of Political Economy.

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optimising choice in the second period. The game is then solved by 'backward induction', that is, by first depicting the optimising choice in the second period, and then using this choice as a constraint on the optimising choice in the first period37. Informational aspects are relevant to the procurement problem when one player is informed and the other is not about, for example, one influencing variable. In business economics, this situation has been termed information asymmetry, and is germane to the principal-agent analysis in which the agent knows its own efforts but the principal, although able to observe an outcome, cannot observe effort. 2) The works of McAfee and McMillan, and Rogerson McAfee and McMillan examined bidding for contracts in a principalagent framework where n

potential agents bid for a defence

procurement contract38. If the agents are risk averse and the principal is risk neutral, then the optimal (linear) incentive compatible contract is never cost-plus and is usually an incentive contract with risks shared. For an incentive contract, the agent receives a fixed-price (i.e. its bid price) and a proportion of the cost overrun (i.e. the difference between the actual cost and the bid cost). As this proportion falls, the agent is motivated to keep cost down after getting the contract, since more of the cost overrun falls on its shoulders. But the agent is also expected to raise its bid during the competitive round as too low a bid puts greater cost on the agent as the sharing proportion falls.

37 In other words, the order in which players move is reverted to enable the agents to anticipate their counterpart's reaction to their own behaviour. 38 McAfee, R. Preston and McMillan, John, 1986a. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics.

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Additionally, a fall in the recoverable proportion of cost overruns means greater risks for the agent, who will require greater compensation. An optimal contract fixes the risk-sharing proportion so as to equate the marginal benefit from greater cost-reduction effort by the agent with the marginal cost from reduced-bidding competition and larger compensation for risk sharing. This is a noncooperative game, because the strategic interactions of the two players - the military (contractor) and the firm (the agent) are taken into account. The principal moves first and fixes the parameter of the contract, then the agent acts to decide its bid and, if successful, its effort choice. Since the game is solved backwards, the solution is found in reverse order. In two interesting contributions, William Rogerson presented two sequential game representations of the procurement process39. In one representation, the military first chooses the quality or sophistication of a weapon system, and then the Congress chooses an output level, taking the military choice of quality as given. Asymmetric goals characterise the players: the military is concerned with maximising the military value of a proposed weapons system, while the Congress is interested in maximising the net (of cost) military value of a proposed weapons system. Rogerson showed in his 1990 study that the organisational setting for military procurement decision making leads to a greater than first-best level for quality. The resulting level for quantity may be too great or too little and depends, among other things, on whether quality and quantity are substitutable.

39 Rogerson, William P., 1990. "Quality and Quantity in Military Procurement", American Economic Review. / 1991b. "Excess Capacity in Weapons Production: An Empirical Analysis", Defence Economics.

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In an other game, Rogerson analyses defence procurement when plant scale and output level are decided. The same players are involved. Rogerson demonstrated that the plant scale and output are too high in equilibrium. Furthermore, output is produced in too large a plant, which, in turn, raises per unit cost. The Military is better informed about technical design decisions concerning production facilities than is the Congress and hence, the latter delegates the scale of plant decision to the military. After scale is decided, the Congress determines the output decision. By choosing a larger than first-best scale decision, the military is able to induce the Congress to pick a larger than first-best output level. This arises because an augmented scale reduces marginal cost and this, in turn, increases the attractiveness of higher production runs. 3) An interpretation The above theoretical works give us a new insight into the assessment of defence procurement: procurement decisions are organised in a way that creates strategic interactions which do not further society's interest. This is precisely where game theory comes onto the stage, by enabling economists and politicians to design more optimal procurement policies. For example, the beneficial effect of fixing a budget prior to the negotiation (i.e. prior to the beginning of the sequential game) has been investigated by W. Rogerson40. With sufficient foresight, such a budget may yield a first-best outcome. Where players' interests are not concerned with the same objective functions, strategic interactions become a crucial consideration. 40

Rogerson, William P., 1990 and 1991a. Op. cit.

- 34 -

Introducing additional constraints, such as incentive compatible mechanisms, can also possibly yield a better outcome. More generally, the microeconomic approach encompassed in game theory seems to be a particularly appropriate tool for analysing procurement. C. The case for and against regulation 1) Profit controls and their compatibility with market incentives Procurement

agencies

have

the

responsibility

of

designing

procurement contracts based on fair and reasonable prices, and which allow for efficiency incentives without offering contractors the possibility of excessive profits at the taxpayer's expenses. Competition is a relatively efficient mechanism thereby market forces and resulting competitive pressures stimulate efficiency and profits policed through entry and exit. Unfortunately, competition is not always possible and often situations arise where prices and profits have to be negotiated. Where procurement agencies' estimations are unreliable, a fixedprice might be agreed at too high a level, allowing the contractor to earn "excessive profits". Various regulatory rules have been therefore introduced to respond to this situation. They are concerned with equality of information, post costing, and renegotiation of profits, usually through a regulatory agency41. Additionally, the costs are monitored by the procurement agency's cost-estimating staff and its accountants, together with a clearly specified set of rules about

41 For example, the Review Board for Non-Competitive Government Contracts in the UK, the Defence Contract Audit Agency (DCCA) in the US, or the Cour des Comptes in France.

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allowable costs and overhead rates, whether fixed-price or cost-plus contracts are involved. There are nonetheless major drawbacks to these regulatory rules. Profit controls within an imperfect, regulated market provide firms with an incentive to pursue non profit objectives such as managerial preferences for staff, luxury offices, and a 'quiet life', as it has been pointed out by Oliver Williamson42. More generally, depending on how costs are allocated, often contracts intrinsically provide firms with an incentive to distort their output and/or input decisions so as to shift overheads to the regulated sector (risks of costs overruns). Moreover, regulation is not costless since transaction costs are involved in the policing, monitoring, checking and controlling functions. A study has examined the adverse effects of defence procurement overregulations on the timeliness and costs of developing weapons43. The study estimated that regulatory control costs probably accounted for 5 to 10 percent of the total programme costs, and increased procurement rate by 15 percent every ten years44. Regulation remains nonetheless attractive to politicians worried (for electoral purposes) about being actively involved in protecting the "public interest" (or at least giving the impression they do!). In a time of severe budgetary cuts, criticism of weapons acquisition programmes tend to become a much more tricky issue advocating the need

to

expand

regulatory

42

arrangements.

But

extreme

Williamson, Oliver E., 1986. Op. cit. Smith, G. and al., 1988. "A Preliminary Perspective on Regulatory Activities and Effects in Weapons Acquisition". 44 However, no evidence was provided on the effects of regulatory activity on the performance or quality of the final product. 43

- 36 -

micromanagement (i.e. monitoring and controlling in detail) might also adversely affect creativity and initiative, and lead to a focus on monitoring inputs rather than outputs (e.g. number of hours in the office). Furthermore, the virtual elimination of waste in procurement may indeed have a prohibitive cost45. The rising cost of regulation may act as a disincentive on the firms' willingness to do business with the government and may increase exits from the market46. 2) "The usefulness of inefficient procurement" Reducing waste in the military seems to be a very 'fashionable' idea with possibly further defence budgets cuts to come. And it may well sound like a paradox, but public choice analysis has shown that in some circumstances, economic waste represented some kind of political incentive. As a matter of fact, there is probably a good reason accounting for the 'non-elimination' of waste in the form of excessive profits, expensive gold-plated equipment, and operationally questionable weapons. The military-industrial complex (MIC) is often seen as a major source of waste and the primary obstacle to reforms which could reduce waste. Therefore, there might be an interest in preserving waste by such a special interest group. As pointed out by Dwight Lee, reducing the political power of the MIC might result in an increase in the general level of inefficiency in the economy as the

45

See Austin, R. and Larkey, P., 1992. "The Unintended Consequences of Micromanagement: The Case Study of Procuring Mission Critical Computer Resources", Policy Sciences. 46 By this token, critics of US defence procurement have suggested that reforms need to focus on markettype incentives rather than increased government regulation (i.e. incentives and regulation do not go together). See Gansler, Jacques S., 1989. "Affording Defense: The Changes That are Needed", National Contract Management Journal.

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composition of government's spending becomes more distorted towards other civilian specific interests programmes that are not "technology fostering" (health, education...)47. Similarly, a public choice and rent seeking analysis has shown the extent to which inefficient procurement can be an optimal second best means of encouraging public goods production. In the absence of political rents, politicians have no motivation to incur the costs of setting a procurement agenda. Cowen and Lee have constructed a model where defence contractors earn excess profits and use some portion of these profits to goad or bribe politicians into procuring48. It is therefore based on the interaction between the two players. Politicians have the ability to hand out contracts for public goods production to special interests. The special interests that compete for these contracts are private, profit-maximising firms. These contractors earn rents and these rents give them the motivation and ability to induce politicians to procure public goods. As concluded by the authors, "the rents that suppliers of public goods receive in the form of cost overrides and excessive charge serve a socially useful purpose. [...] Second best optimality may dictate both that private contractors earn excess profits, and that they have the opportunity to influence politicians "49.

47

Lee, Dwight R., 1990. "The Politics and Pitfalls of Reducing Waste in the Military", Defence Economics. 48 Cowen, Tyler and Lee, Dwight, 1992. "The Usefulness of Inefficient Procurement", Defence Economics, p.219-227. 49 Ibid, p.226.

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III The introduction of competition within defence procurement

- 39 -

III. The introduction of competition within defence procurement A. Measuring competition against collaboration 1) Measuring competition against collaboration Single source procurement has been criticised as a possible source of inefficiency among defence contractors. It has therefore been suggested that competition be introduced to generate substantial price reductions50. As argued by Jean-Jacques Laffont, "competition solves... the moral hazard problem by solving the adverse selection problem..."51. In the meantime, bidding decreases the rents received by the firms which eventually win the contract52. Although market-type incentives have been preferred sometimes to government regulation, none of these options, as outline by Jacques Gansler, seems to be the "right answer" rather than the other53. Instead, competition would be one element of a package of policy measures that have been recommended such as: • improving the quality of acquisition personnel; • streamlining the acquisition organisation and procedures; • expanding the use of commercial products; • introducing a greater use of commercial style competition54. 50

See for example Leitzel, Jim, 1992. "Competition in Procurement", Policy Sciences. Laffont, Jean-Jacques, 1986. "Towards a Normative Theory of Incentive Contracts between Government and Private Firms", Economic Journal, p.25. 52 For further information on bounded rationality and private information, as well as moral hazard and incentive performance, see Milgrom, Paul and Roberts, John, 1992. "Economics, Organization and Management", chapters 5 and 6 respectively. 53 Gansler, Jacques, 1989. "Affording Defense: The Changes that are Needed", National Contract Management Journal , p.9. 54 Gansler, Jacques, 1989. Op. cit. 51

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Interestingly, Gansler estimates that competition would produce net savings of 20 percent for about half of the US production programmes55. In the United Kingdom, this figure was expected to be around 10 percent on the equipment budget56, approximate figures that unfortunately do not lay on any acute estimation basis. Martyn Bittleston advocates competition on the ground that "ceteris paribus, competition spurs efficiency, alters attitudes and lowers prices "57, notably by allowing foreign firms to bid for national defence contracts. Historically, attitudes toward competition have changed over time from relative reluctance, in the 1970s, to open and unconditional support nowadays. It was indeed suspected of requiring more time and effort (e.g. in evaluating proposals), of increasing the chances of disputes and protests from contractors, and disrupting long established relationships between them and the government. However, steps were already being taken toward a broader acceptation of competition. (See Appendix C ) Traditionally, the award of a contract on a single source basis relies on competition bids based on design and development proposals that are made at the very outset of the project. Consequently, the firm winning the contract can establish a monopoly position with potentially adverse implications for innovation, efficiency, prices and profits. But as suggested by Todd Sandler and Keith Hartley, "there is considerable potential for introducing and extending competition 55

Gansler, Jacques, 1989. Op. cit., p.14. HCP 189, 1991. "Ministry of Defence: Initiatives on Defence Procurement", p.3. 57 Bittleston, Martyn, 1990. Op. cit., p.62. 56

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at various stages in the project's life cycle "58. Depending on the size and composition of domestic defence industry, competition can include or not overseas firms.

The different possible stages of competition within a procurement cycle Competition possible at

Type of competition

1 Design stage

Non-price Maximum (i.e. varieties of designs are proposed )

2 Development stage prototype

Non-price; Great to prototype stage budget limit (i.e. competitive prototyping between two rival firms or industrial teams that share risks and works)

3 Production stage • for all production work (winner takes all) • for individual batches of production (dual sourcing)

Price

Risks - uncertainty

Little - none

Price (i.e. an alternative supplier is thrown in and compete for production batches with the other firm OR the threat of rivalry maintained as a storing option to create incentives )

4 In-service support, repairs, servicing, midlife up-dates

Price

Some - none

5 Disposal

Price

None to great (nuclear)

Source: Sandler, Todd and Hartley, Keith, "The Economics of Defense", p.147

58

Sandler, Todd and Hartley, Keith, 1995. Op. cit., p.147.

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2) NATO and Europe: from standardisation to the opportunity of creating a European procurement policy NATO has often been criticised for failing to obtain the industrial benefits of standardisation. Without the absolute certitude that an attack on a member country would systematically yield reappraisal from its allies, independent capabilities have been preferred to specialisation in force structures. It is argued that some benefits may result from the application of a doctrine of comparative advantage, should the member states agree on allowing free trade in arms and equipment among themselves. But its actual implementation is hindered by at least two hurdles. First, a redistribution of production would have to be operated between countries that may benefit the USA to the detriment of Europe. Second, conventional wisdom often sees comparative advantage in the high technology industry rather than the less advanced sectors, which may foster the development of a leading sector to the detriment of the rest of the industry. So far, standardisation has been achieved on a bilateral basis between the USA and its NATO allies through what is known as the Memoranda of Understanding (MoUs). The latter are precisely designed to promote standardisation and interoperability, but they resort to political bargaining and not competition or market forces. The potential benefits of specialisation and international trade have been recognised as early as from 1960. The advantage was at least two-fold in that not only the nations could pursue their comparative advantages in different spheres of production, but further gains would also be achieved from the economies of scale and learning

- 43 -

associated with concentrating production in one or few suppliers59. Contributions also have been made that have put forward the potential benefits of standardisation with industry rationalisation and specialisation through NATO. This has been advocated not least because of the waste resulting from massive duplication of research and development costs within NATO, short production runs failing to indulge scale economies, and the associated wasteful duplication of logistics support60. Therefore, a North Atlantic common defence market has been regarded as an interesting solution where open government procurement for military goods may be extended to civil technologies as well in order to improve military effectiveness and reduce waste. Efforts are increasingly being made today within the European Union (EU). Although the concept of a European DIB seems attractive, it remains open to critical scrutiny. On the one hand, it seems a means of rationalising Europe's defence industrial capabilities, promoting collaboration, and creating a European DIB capable of competing with the US. On the other hand, many issues are still to be addressed concerning the meaning of a European DIB and all its requirements such as the minimum size, industrial composition, types of contracts to be used, type of industrial structure, ownership as well as the costs of supporting it and all the problems related to decision-making (and the compensation of potential losers)...etc. But the existence of the European DIB presupposes the possible extension of the single European market to defence equipment beforehand, since article 223 of the treaty of Rome excludes arms production and trade. 59

See Hitch, C.J. and McKean, Roland N., 1960. "The Economics of Defense in the Nuclear Age". See Callaghan, Thomas A. Jr., 1975. "US-European Economic Co-operation in Military and Civil Technology". 60

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Although substantial savings might result from this initiative, barriers exist to radical change in the form of nationalism, the desire of independence, and the opposition from industries, regions and countries likely to loose. B. The relation to defence industry performance 1) The ability of defence industry to integrate competition Competition is a kind of incentive that seems intensively sought after because it is thought to be dramatically lacking among defence suppliers. This is undoubtedly true at the level of an individual nation, where the ability to build ships, aircrafts or nuclear weapons among other examples - is expensive to create and to maintain. Empirical observation suggests that in Europe, often a single national firm has the required capability to manufacture these high technology products, and even that firm may need the government's support to survive. As this situation seems unlikely to alter, the resulting barriers to defence entry and exit remain disproportionally extensive. But if it seems difficult to remove those "giant" monopoly or nearmonopoly suppliers for the reasons aforementioned, room is nonetheless left to competition at the sub-system and component levels, where 'small remains beautiful'. Commercial success is then rather a matter of ingenuity, market initiatives and low overheads61.

61 Software and information technologies, for example, are two fields where barriers of entry have been broken, not least because no major capital investment is required and because economies of scale scarcely apply.

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A quick overlook at the defence industry in the US and the major European countries is presented in Appendix D. 2) The impact on defence industry performance 2.1 Research and development Two separate sets of effects should be considered. Firstly, the timing of competition is important. Competition introduced at the initial stage in the case of sole source procurement, usually induces firms in low bidding in order to earn monopoly profits on the resulting contracts they may obtain for production and spares. In the case of dual sourcing, bidding is expected to be less aggressive as a second entrant will necessarily reduce the incumbent's profit in the long run. Consequently, the defence ministries pay the initial development and production a higher price, but this may be offset by the saving on second source reprocurement. Secondly, it has been suggested by Rogerson that adverse effects on research and procurement may also arise62. To some extent, profit should be seen as a reward for earlier innovative activity by defence contractors. A firm willing to win a contract will spend its own financial resources in research and development in order to be awarded the production contract. Now, this reward tends to decrease or disappear with competition, which may eventually

62 Rogerson, William P., 1989. "Profit Regulation of Defence Contractors and Prizes for Innovation", Journal of Political Economy.

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represent a disincentive to innovate and lead to lesser research and development expenditure. 2.2 Technology transfer Introducing competition at the production stage requires technology transfers and hence, involves transaction costs. Not only legal disputes may arise over intellectual property rights, but costs also have to be faced in ensuring that a second source will fully understand the initial developer's designs, drawings and specifications. Of course, the latter has incentives to hoard valuable information and to conceal knowledge from the second supplier. Also, firms may be required to concede data rights to the government, which may encourage exit from the market as some of them will not accept to sacrifice their commercial operations (by being adversely affected by government data requirements) to the lower expected profitability of defence contracts63. 2.3 Economies of scale and learning A typical way to introduce competition at the production stage is to use dual sourcing, whereby the production is split between two firms, with either the lower-cost firm being awarded the majority of production, or all future contracts being awarded to one of the two firms in a "one-off" competition64. But such a principle may involve costs to the new entrant reflected in the unit cost advantage of the incumbent (which has moved along the learning 63 See Brunette, R., 1989. "US Congress Requires Limitations on Competition for Innovative Defense Contractors and Sub-contractors", National Contract Management Journal. 64 See Leitzel, Jim, 1992. Op. cit.

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curve),

due

to

production

experience.

The

resulting

uncompetitiveness is often aggravated by additional set-up costs needed to create a second supplier65. On the other hand, introducing competition at the production stage is expected to remove cross-inefficiency in the incumbent firm. Although the new entrant's costs might be higher, they nonetheless provide information on the incumbent's costs and a means of limiting its profits. Indeed, it has been suggested that it may be optimal to replace the incumbent even when the entrant has higher production costs66. 3) Sovereignty and the case for a national base It had been suggested that in the case of the United Kingdom, the MoD could "either procure weapons or maintain the DIB - not both"67. Although the situation is not yet that stark, pressures have already provoked some substantial changes in national defence equipment procurement practices. Naturally, it is probably a euphemism to say that the search of better value for money abroad has not yet secured the highest levels of support from home defence industries! Reciprocal purchasing policies have been agreed between France and the UK, and both countries have bought US AWACS aircrafts. The extent to which the purchase of defence equipment abroad may

65 See Anton, James J. and Yao, Dennis A., 1987. "Second Sourcing and the Experience Curve: Price Competition in Defense Procurement", Rand Journal of Economics. See also Leitzel, Jim, 1992. Op. cit. 66 See Demski, Joel S., Sappington, David E.M., and Spiller, Pablo T., 1987. "Managing Supplier Switching", Rand Journal of Economics. 67Hartley, Keith, Hussain, Farooq and Smith, Ron, 1987. The Political Quarterly, vol.58(1) [Oxford: Basil Blackwell Ltd.], p.72. Quoted in Bittleston, Martyn, 1990. Op. cit., p.41.

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develop is, in fact, strongly determined by the different nations' commitment to self-sufficiency and autarchy in defence production. Although considerable at the system level (i.e. the weapon system as a whole), it seems less substantial at the sub-system level, and in some cases surprisingly low when it comes to components. There is also considerable reliance still on American technology. A system like the Global Positioning System (GPS) is originally a US technology and is still operated by a network of US satellites. It is nonetheless sold to most of the developed countries armed forces nowadays. Three sets of factors are involved in the case for the preservation of a national DIB: strategic, economic and technological factors. • Strategic factors It is tempting to retain the capacity for sensible technologies (e.g. communications, cypher equipment, nuclear...), and to tailor equipment to one's need, but is an increasingly costly bet on the future. It might not be needed at all, and might also not necessarily make any difference should a conflict arise. • Economic factors As argued by Martyn Bittleston, "the question to be answered, [here] is whether minimising trade deficits is worth more to an economy than paying a price premium to support and buy from national companies "68. Offsetting schemes exist (reciprocal trade agreements) that may neutralise the adverse effect on the balance of payments. Also, job losses must be weighed against a possibly 68

Bittleston, Martyn, 1990. Op. cit., p.44.

- 49 -

better allocation of manpower in the civil sector, where jobs are also less expensive to create (less capital intensive). • Technological factors Retaining a national DIB allows the pursuit of technological excellence through R&D, and holding this high ground means power and prosperity. But again, technological developments originating from the defence sector have to be weighed against those from the civil sector, and the spins-off from the former toward the latter realistically quantified. Indeed, the need to leverage commercial technologies is gradually acknowledged69. Therefore, the procurement dilemma lies in the conflict between the growing cost of maintaining a broad spectrum of industrial capabilities within the defence sector, and the risk of loosing sovereignty by giving it up and exposing the companies involved to free competition. C. The overall impact on defence procurement 1) The performance indicators Various performance indicators provide evidence on the possible benefits and drawbacks of competition within the defence market. To a great extent, they concern the United States rather than the UK where comparatively few empirical studies of the impact of competitive procurement policy are available.

69 See the declaration of Kaminsky, Paul G., 1997. "Fielding Equipment Second to None", Defense Issues. Available from the US DoD Internet Site.

- 50 -

1.1 Fixed-price contract under total package procurement Fixed-price is seen as a hazardous type of contract, when projects involve

substantial

technological

uncertainties.

Bones

of

contention may arise that will necessarily involve transaction costs in trying to settle the disputes between contractors and the government. Disputes may prove even more difficult to sort out if the result is likely to be the exit of a major firm70. The additional trouble is that firms tend to bid too low to win the contract, so that the total costs of the projects are necessarily underestimated. One may argue that it is a lesser problem when provisions have been made for the modification of technical specifications during the development phase (e.g. by using a cost-plus contract). This proves more tricky in the case of a fixed price contract since most of it will have to be renegotiated, involving considerable transaction costs. Fixed-prices can preserve or increase margins (rather than cost-plus contracts do) only if sufficient contingency against technical risk is built into the price. And contractors negotiate contracts which minimise their financial exposure. So that the fixed-price trade-off lies between the competitive price and the contractor footing the bill when things go wrong. 1.2 Cost control, delivery schedule and equipment performance This is a second method to assess competition, and has been resorted to assess the impact of the 1970s Packard Initiatives (advocating the use of hardware competition) in the US. The better 70

See Fox, Ronald G., 1974. Op. cit.

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performance and schedule ratios, and substantially lesser cost growth of competitive programmes came to support the claimed advantages of competition. For example an average cost growth ratio of 1.16 compare with 1.53 for projects with little or no competition was found71. It is possible that such results might have been biased by two small a sampling, and therefore influenced by other endogenous factors. A comparison of the 1960s and 1970s American programmes, as a further means of assessing the impact of the Packard Initiatives, yields similar results. Thus, an average cost growth of 1.44 in the 1960s compare with 1.34 in the 1970s has been found72. 1.3 Profitability As shown in the diagram below, the introduction of competition is predicted to result in lower prices due to two factors: first, a shift effect -whereby for a same output, profits fall down due to the introduction of (an) alternative supplier(s) that induce price reductions - and second, a rotation effect reflecting a steeper price reduction curve - whereby the cost of production decreases faster with output.

71 Dews, E. et al., 1979. "Acquisition Policy Effectiveness: Department of Defense Experience in the 1970s"; p.28. 72 Ibid, p.57.

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The price effects of competition

Source: Sandler, Todd and Hartley, Keith, "The Economics of Defense", p.153

Greer and Liao have related industry capacity utilisation to prices and profitability73. When capacity utilisation falls under 80 percent on average, the industry is "hungry". And below this point dual source procurement seems to lead to net savings. The authors consequently argue that introducing dual sourcing when capacity has reached the peak of 80 percent is not a sensible idea. Of course, these conclusions are derived from empirical observations. As far the UK is concerned, unequal price savings ranging between 10 and 17 percent have been claimed by defence contractors, as well as alleged better export performance and a wider supplier base74.

73 GREER, Willis R. and LIAO, Shu S., 1984. "A New Look at Risk and Profitability in Defence Contracting", National Contrcat Management Journal. 74 HCP 189, 1991. Op. cit.

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2) A long road to competition? From all the above developments, it results that competition may hardly exist without the intervention of governments. Given the present conditions of the defence market, competition will not spring spontaneously, even from the strong desire to reduce costs. It has to be implemented by defence procurement officials who, in turn, might have discretion in determining the way it will apply. This intrusion of the political sphere is not without creating some problems. As a matter of fact, some collusions may arise between government officials and the defence industries, including starker anticompetitive behaviours such as the traffic of influence, and other 'under the table' deals. To a certain extent, this is already the case in the US, where huge corporate lobbying group (e.g. Cassidy and Associates

in

Washington) sell their services to defence firms wishing to be awarded a procurement contract by a given government (mainly US)75. In France, it is also well known that the directors of some defence industries are either members of the Parliament (Dassault ), or 'close friends of the President' (Thomson ), which grant them a relative protection against possible competitors... at the expense of competition itself. All the existing cases against competition are naturally put forward to find some sort of justification against change: the alleged higher cost of dual sourcing, the adverse effects of research and development,

75 They usually have among their ranks a number of people who are ex-officials from the government, or still members of political institutions such as defence committees in the Congress, the White House...etc.

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the risks of cartellisation arising from team arrangements...etc. The hope for change now lies in the recent developments of game theory, strategic behaviour, the very central transaction costs theory, contestability and the strong advocacy for a free market.

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Conclusion

W

ith state budgets being squeezed under the relentless pressure of economic and social priorities, defence procurement is at stake more than ever before. In Europe, meeting the economic

criteria for monetary integration has become a major issue which seems incompatible with the generous defence budgets that have hitherto prevailed. In the US, the growing cost of international leadership and the technological advance of the civil industry are calling for "downsized" military budgets. Military expenditures are no longer the favoured ones, and the turn of the century seems to herald a renewed concerned for improved procurement practices. In this dissertation, we strove to underline the necessity to implement an efficient and well thought-out procurement policy to overcome the market imperfections. We also tried to point at the different forms of contracting, their limitations and the available alternatives for improvement. Controlling the procurement costs, and keeping them as low as possible has become such an acute issue, that a lot of effort will have to be devoted to improving cost estimation methods if efficiency is to be achieved. New economic theoretical developments have provided new insights on defence procurement, in particular game theory. Information asymmetries and transaction costs are involved in defence contracting that need to be better appraised if costs are to be successfully monitored. Regulation is a possible option, but might also exhibit adverse effects where profit control is involved. We even suggested that a certain amount of waste could be useful,

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provided it is supported by an actual political will. Otherwise we will have some more Rafale -type programmes. The introduction of competition seems no longer a pertinent idea but rather a requirement to keep acquisition costs down. Naturally, cooperation might be an alternative solution and, as far Europe is concerned, might pave the way toward a European defence industry, while standardisation would enable common

procurement

practices.

However,

attempts

have

proved

unsuccessful so far, and the competitiveness of foreign markets remains arrogantly tempting to acquire certain pieces of equipment. Again, this seems to be the evidence that competition fosters efficiency in terms of price competition and delivery schedules. Moreover, the ability to leverage technologies that are increasingly available on commercial markets, and at a lesser cost, has been recently recognised by the US. National sovereignty is a remainder from the past, and the unfailing and old-fashioned argument of domestic lobbies. The extent to which defence procurement will respond to the growing constraint put on budgets will depend on the government's success at incorporating and exploiting the most recent economic concepts we have developed supra. Equally important will be the importance granted to lessons learned by the past, and how to avoid their repetition in the future. But efficiency also remains a matter of consistent choices, and as could be seen from the Rafale

example, consistency is primarily a question of

common sense.

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Appendices

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_______________

Appendix A _______________

Some literature on defence economics

ON ARMS RACE MODELS Brito, Dagobert L.

1972

Intriligator, Michael D.

1975

Intriligator, Michael D. and Brito, Dagobert L.

1976 1978 1985

Isard, Walter and Anderton, Charles H.

1985

"A Dynamic Model of an Armament Race", International Economic Review, vol.13(2), pp.359-375. "Strategic Considerations in the Richardson Model of Arms Races", Journal of Political Economy, vol.83(2), pp.339-353. "Formal Models of Arms Races", Journal of Peace Science, vol.2(1), pp.77-88. "Nuclear Proliferation and Stability", Journal of Peace Science, vol.3(1), pp.173-183. "Wolfson on Economic Warfare", Conflict Management and Peace Science, vol.8(2), pp.21-26. "Arms Race Models: A Survey and Synthesis", Conflict Management and Peace Science, vol.8(2), pp.27-98.

ON THE BUILD-UP OF OPPOSING MILITARY ARSENALS Among the superpowers McGuire, Martin C. 1977 "A Quantitative Study of the Strategic Arms Race in the Missile Age", Review of Economics and Statistics, vol.59(3), pp.328-339. Among the Middle Eastern countries Lebovic, James H. and 1987 "Military Burden, Security Needs and Economic Ishaq, Ashfaq Growth in the Middle East", Journal of Conflict Resolution, vol.31(1), pp.106-138. Linden, Mikael 1991 "The Dynamics and the Instability of the Middle East Military Expenditures in Years 19551984", Defence Economics, vol.2(3), pp.199208. Ward, Michael D. and 1987 "Dynamics of Military Spending in Israel", Mintz, Alex Journal of Conflict Resolution, vol.31(1), pp.86105. Among the Asian countries

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Deger, Saadet

1986 1986

Deger, Saadet and Sen, Somnath

1990

"Economic Development and Defense Expenditure", Economic Development and Cultural Change, vol.35(1), pp.179-196. "Military Expenditure in Third World Countries: The Economic Effects". London: Routledge & Kegan Paul. "Military Expenditure: The Political Economy of International Security". Oxford: Oxford University Press and SIPRI.

ON THE IMPACT OF MILITARY SPENDING ON GROWTH Benoit, Emile

1973

"Defense and Economic Growth in Developing Countries". Boston: D.C. Heath.

ON THE STUDY OF INCENTIVE CONTRACTS TO INVESTIGATE DEFENCE PROCUREMENT PRACTICES Cummins, J. Michael

1977

Tirole, Jean

1986

McAfee, R. Preston and McMillan, John

1986 1986

Rogerson, William P.

1990 1991

"Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing", Bell Journal of Economics, vol.8(1), pp.168-185. "Procurement and Renegotiation", Journal of Political Economy, vol.94(2), pp.235-259. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics, vol.17(3), pp.326-338. "Incentives in Government Contracting". Toronto: University of Toronto Press. "Quality and Quantity in Military Procurement", American Economic Review, vol.80(1), pp.8392. "Incentives, the Budgetary Process, and Inefficiently Low Production Rates in Defense Procurement", Defence Economics, vol.3(1), pp.1-18.

ON THE ISSUE OF CONSCRIPTION vs. AN ALL-VOLUNTEER FORCE Altman, H.

1969

Ash, Collin, Udis, Bernard and McNown, Robert F.

1983

Fisher, Anthony C.

1969

"Earnings, Unemployment and the Supply of Enlisted Volunteers", Journal of Human Resources, vol.4(1), pp.38-59. "Enlistments in the All-Volunteer Forces: A Military Personnel Supply Model and Its Forecasts", American Economic Review, vol.73(1), pp.145-155. "The Cost of the Draft and the Cost of Ending the Draft", American Economic Review, vol.59(3), pp.239-254.

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Greene, Kenneth V. and Newlon, Daniel H.

1973

Hansen, W Lee and Weisbrod, Burton A.

1967

Oi, Walter Y.

1967

"The Pareto Optimality of Eliminating a Lottery Draft", Quarterly Review of Economics and Business, vol.13(4), pp.61-70. "The Economics of the Military Draft", Quarterly Journal of Economics, vol.81(3), pp.395-421. "The Economic Cost of the Draft", American Economic Review, vol.57(2), pp.59-62.

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_______________

Appendix B _______________

Evolution of the US and NATO military equipment expenditures • •

Equipment in US$m at 1990 prices. Rate of change in percentage.

1. USA Year Equipment Rate of change

1987 87,772 1.5

1988 80,317 -8.5

1989 81,068 0.9

1990 75,930 -6.3

1991 73,435 -3.3

Year Equipment Rate of change

1992 65,063 -11.4

1993 59,204 -9.0

1994 74,179 25.3

1995 66,213 -10.7

1996 58,630 -11.5

Source : SIPRI, 1997. "Yearbook 1997: World Armaments and Disarmament", p.185.

2. NATO Europe Year Equipment Rate of change

1987 30,656 4.2

1988 30,086 -1.9

1989 28,162 -6.4

1990 24,794 -12.0

1991 23,889 -3.6

Year Equipment Rate of change

1992 21,108 -11.6

1993 23,379 10.8

1994 22,234 -4.9

1995 19,828 -10.8

1996 20,758 4.7

Source : SIPRI, 1997. "Yearbook 1997: World Armaments and Disarmament", p.187.

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3. NATO Total Year Equipment Rate of change

1987 120,886 2.3

1988 112,741 -6.7

1989 111,352 -1.2

1990 102,688 -7.8

1991 99,210 -3.4

Year Equipment Rate of change

1992 88,121 -11.2

1993 84,587 -4.0

1994 98,186 16.1

1995 87,808 -10.6

1996 81,054 -7.7

Source : SIPRI, 1997. "Yearbook 1997: World Armaments and Disarmament", p.187.

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_______________

Appendix C _______________

The gradual introduction of competition in American defence procurement Although critical toward competition, the US policy was already changing at the beginning of the 1970s, and was about to take several steps for a more open attitude towards competition. They can be seen in the table below. Naturally, provisions were made for circumstances under which competition might increase total programme costs without commensurate offsetting benefits.

Date

Measure

1970

Packard Initiatives

1984 1986

1987

Objective

To extent competition between prime contractors throughout the development stage, so avoiding developer monopoly when awarding initial production contracts. Competition in Contracting To require the US DoD to use "full and Act (CICA) open competition" through competitive purchasing. Defense Authorization Act To prevent the DoD from beginning full scale development for major systems until Congress has received an acquisition strategy requiring dual sourcing and second sourcing for production work of major systems and sub-systems. DoD Appropriations Act To require the use of competitive prototypes in developing major weapons systems.

Source: Compiled from the data given by Sandler, Todd and Hartley, Keith, "The Economics of Defense", p.146.

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_______________

Appendix D _______________

An overlook at the defence industry in the major European states and the US 1. The major defence suppliers in Europe Firm France • Aérospatiale • Dassault • Matra Défense • Thomson CSF Germany • Daimler Benz • MBB • Rheinmetall • SEL • Siemens United Kingdom • British Aerospace • Ferranti International Signal • GEC • Racal

Average sales ($m)

% Defence

Ownership

3,350 2,100 2,400 4,800

77 66 38 90

Government 49% family / 46% government Privatised 57% government ('mixed' co.)

33,600 2,800 1,370 2,600 23,600

? 57 37 11 2

Public company Bought by Daimler Benz in 1989 Public Company Bought by CGE (France) in 1987 Public company

9,000 1,500

56 80

Privatised (public) company Public company

9,320 2,200

38 18

Public company Public company

Source: Bittleston, Martyn, 1990. "Co-operation or Competition? Defence Procurement Options for the 1990s", p.40.

2. An overlook at the defence industry performance in the US and Europe See table next page.

- 65 -

- 66 -

- 67 -

_______________

Appendix E _______________

The French Rafale Aircraft : a short case study76 Note : Four other case studies have been realised in the framework of this dissertation. Unfortunately, they have not been incorporated to this assignment due to quantitative restrictions. They are listed below, and are available for review if requested : • The US at the leading edge of procurement. • The European armaments procurement cooperation. • Concurrent engineering in British procurement policies. • The American Defense Contract Audit Agency (DCAA).

This case study has been chosen in priority because it provides a clear illustration of several of the important points that have been developed in this dissertation. It should therefore enable the reader to better understand : • the consequences of a lack of consistency in procurement policies, and the fact it is no longer affordable; • the difficulty to estimates costs and contingencies in contracting; • the consequences of non-regulation and the "uselessness of inefficient procurement" when the amount of waste is too high; • the difficulty of French defence industry to face competition; • the cost of national sovereignty and the use of procurement as an instrument of industrial policy.. "The financial burden of the Rafale does not allow the Air Force to face its many responsibilities anymore "77. These are the terms in which the French Air Force Chief of Staff described the Rafale programme before members 76 This case study has been compiled from a series of articles provided by the French MoD, and listed in the bibliography. 77 "Le Programme Rafale", L'Expansion, no.511, 30 October-9 November 1995.

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of Parliament in October 1995. Budgetary pressures have exacerbated the contention over the French fighter aircraft which is now looking more like an unrealistic caprice. Indeed, buying the American F18 to replace the Navy's obsolete fighters would have been twice less expensive.

1. A serious lack of consistency Deemed a "billions gulf "78 from the beginning, the Rafale has persistently suffered from a series of procurement inconsistencies due to renunciations, gross estimation mistakes and the lack of political will. Under the constant lobbying of special interests (i.e. Dassault Industries and sectional interests within the MoD), the programme will pursue a steady course without being ever discussed on the essential features. It was though obviously inconsistent with the French shortcomings in terms of intelligence, spatial observation, ground transportation...etc, as they had been underlined during the Gulf war. So why such a choice? The Rafale was meant to replace five different types of aircrafts in one shot, and therefore be the most flexible fighter ever built. But it is now one whose instalments are on the brink of driving the Air Force to bankruptcy. While the cost of the programme constantly increases, the successive governments are unable to pursue a consistent procurement policy. What is voted by a right-wing majority is vetoed by its left-wing successor. Meanwhile, budget pressures from other ministries (e.g. social security) render the allowable defence resources increasingly scarce, thereby aggravating the costly delays of the programme. With the growth of orders

78 The expression is from the right wing RPR deputy Michel Bernard, and was first used in an interview by the weekly magazine L'Express in 1988. Quoted in the above article.

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and manufacturing, the burden might double by the year 2000, shifting from 4 to 8 billion francs per annum. Left in a "state of patent disaster "79, the programme is now openly criticised, and its abortion even envisaged. It might have been the subject of serious studies within the MoD, and has been strongly suggested by leftwing politicians. The possibility to acquire a greater number of the recently improved French Mirage 2000 , deemed efficient and twice less expensive, stands as an additional argument to abandon the Rafale. Alternatively, economical options are put forward such as the suppression of a 234 units order for the Air Force. More inconsistencies again. Originally conceived for the Air Force, it is now to be delivered to the Navy only.

From 1978 to 2000 : a succession of launchings and postponements 1978, Beginning of the 1988, Jacques Chirac, the research on the future then Prime Minister, fighter aircraft. officially heralds the launching of the programme, the 26 January. In April, the first prototype is ordered. Five are to be produced. Four only will be actually manufactured.

1995, The first eight series units are ordered (seven for the Navy and one for the Air Force) within the 1994 and 1995 budgets. The 1996 finance law does not plan any Rafale orders.

1983, Charles Hernu, 1991, Flight of the first Air 1997, Scheduled delivery of minister of defence, Force version prototype. the first aircrafts to the authorises Dassault to make Navy. a technological demonstrator, the Rafale A.

79 The expression is from the former socialist Prime Minister Michel Rocard. Quoted in "Le Programme Rafale", L'Expansion, no.511, 30 October-9 November 1995.

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1985, Marcel Dassault present, in person, the 14 December, the Rafale A that he will labelled a "worldwide aircraft".

1992, The first deliveries are postponed from 1996 to early 1997. The 23 December, Pierre Joxe, minister of defence, signs the industrialisation contract. 1986, First flight of the 1993, The first deliveries demonstration Rafale. are postponed to six months later.

1999-2005, After testing et pilots training, the first Rafale squadron (Navy version) should be operational aboard the nuclear aircraft carrier Charles-de-Gaulle.

Source: "Le Programme Rafale", L'Expansion, no.511, 30 October-9 November 1995

2. The problematic underestimation of costs and contingencies The Rafale has probably reached summits in uncontrolled costs and time schedules, not least because of the inconsistency of the pluri-annual procurement laws in France as we mentioned it above. Financial failure is compounded by the incorporation of unforeseen technical modifications due to technological improvements. These modifications obey a simple rule: to be adopted, it must be profitable from the thirteenth aircraft produced. This is the only way to segregate uneconomical alterations. Memorable was the letter addressed by the procurement executive to Dassault Aviation complaining about "the capacities of your [Serge Dassault's] firm to control the costs of such a programme "80. Instead of finding a cost compatible with the state budgetary resources (as requested by the MoD), Dassault arrogantly presented, in July 1993, the thirteenth augmentation since the beginning of the programme. The up-dated all-around costs of the Rafale are presented below, and should leave any reader a bit perplex. It has nonetheless to be noted that the cost of the Rafale is inferior to that of the Euro Fighter Aircraft (EFA) (340 million francs per unit). 80

"Le Prix du Rafale Dassault s'envole pour la 13è fois", Le Canard Enchaîné , 22 September 1993.

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- 72 -

Programmes costs Billion francs 1995

Development* Production • industrialisation • purchase of 320 aircrafts • replacement aircrafts • simulators Total cost Unit price of Rafale C (Air Force - Combat) Unit price Rafale B (Air Force - Bombardier) Unit price Rafale M (Marine)

47,25 156,8 16,2 101,5 37,9 1,2 204 incl. 193,4 for the State 304 million FFr 322 million FFr 315 million FFr

*25% of which is financed by the industry Source : "Le Coût du Rafale n'est pas excessif", Air et Cosmos, Friday 17 May 1996.

Moreover, political alternance does not ease the process, and instead of smoothening the procurement mechanisms, changing majorities hamper the effective completion of an over-ambitious procurement. Costs estimations are often partisan and aimed at supporting political arguments, instead of providing useful information for a realistic assessment. In September 1991, the government will decide to abandon the single-seat version of the Rafale (although a prototype was already flying), to compensate for the costs overrides81.

3. "The uselessness of inefficient procurement"

81 "Vers la Suppression de la Version Monoplace du Rafale", Agence France Presse, news release AFP 020950, September 1991.

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Some French MPs have recently realised there would not be enough money for both the Rafale and the much needed Future Transportation Aircraft (FTA). The FTA, designed to move troops and their equipment on remote battlefields, is a politically strategic programme since it has been added on the priority list of the German defence. The realisation of this aircraft might be granted to the Airbus Industrie consortium, and trigger a genuine common purchasing policy of military equipment. In common with Germany at least. But France (who really needs the FTA to replace her obsolete Transall ) will probably find it very difficult to finance her share (some 4 billion francs a year) if the Rafale programme is not carried out head up. Again, criticisms arise and the French military-industrial complex tries to deviate the shot. But the uselessness of this inefficient procurement programme is obvious. It can no longer be aborted, because consequences would be disastrous. Tremendous amounts of money have already been spent that would be totally wasted in case of renunciation. A demonstrator and four prototypes have been built, and 80 percent of the development work has been achieved, while the industrialisation is in progress. A huge protest would probably arise from the 150 firms involved in the project, including 30 major names of the armament sector. Industrials have participated for 25 percent to the development costs (40 billion francs). They are therefore entitled to claim some kind of benefit from this investment, especially on the export markets. Some of them might not survive the shock, and the major ones like Dassault Aviation (cell), Thomson (radar), the Snecma (reactor) or Matra (missiles), would probably have to shut production units and offices, thereby affecting the French aeronautic industry as a whole.

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Too much waste has led the Rafale to a point of no return. 100,000 jobs are directly or indirectly generated by this programme, 45,000 of which might disappear or not be created as the result of delays in procurement.

4. The difficulty to face foreign competition In May 1996, a parliamentary report expressed worries about the potential success on the Rafale on the export markets82. The trouble is that delays in the programme might durably compromise the chances to export the aircraft overseas. It is true that the programme is two or three years ahead of other competitors such as the EFA or the future American fighter aircraft. But it seems extremely difficult to sell an aircraft abroad if the seller does not possess an operational squadron himself (due to budgetary shortcomings). The procurement law has therefore scheduled the delivery of a couple of Rafale to the Air Force before 2000, while Dassault and other participating industries wait for additional orders to guarantee chances on international markets. The United Arab Emirates have indeed manifested their interest by submitting a proposition for 80 Rafale. Norway and Saudi Arabia might also be interested. Unfortunately, Dassault

lacks orders from overseas. The aircraft

manufacturer has failed to win major contracts in Switzerland and Saudi Arabia where the American F18 has been preferred. The difference is that they are available since almost ten years, an obvious advantage being the possibility to buy fifty second-had F18 for the price of twelve Rafale (Navy version). Therefore, the temptation is great to buy overseas and acquire

82 "Un Rapport Parlementaire Craint un Echec Commercial pour le Rafale", Agence France Presse, news release AFP 142008, May 1996.

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American F18 just "off-he-shelf". Even the President himself might possibly support such an initiative, despite its choice of the Rafale in 1987. He himself admits having made a serious mistake in not opting for the F18. Some unbeatable competition for Dassault ?

State of completion of the Rafale programme Component Cell Motor Navy adaptation Radar (air-to-air functions) Radar (air-to-land function) Counter-measures Software

Rate of completion 98% 97% 80% 70% 10% 20% 50%

Source : "Le Coût du Rafale n'est pas excessif", Air et Cosmos, Friday 17 May 1996.

Dassault Industries exhibit the typical patterns of a State dependent firm. Dassault can not ensure alone the funding of R&D. The support from the State is absolutely vital. And consequently, any withdrawal from the latter will induce delays in production and delivery, competitive disadvantage with foreign competitors and depletion of the industrial capacity of the firm. S. Dassault complains about the American aggressiveness on foreign markets ("they are on every markets and do not want to give up "83), and requests the government's help, again ("The purchase of armaments is a political act. We cannot sell anything alone ")84. As we mentioned it earlier, circumstances arise in which defence procurement might be used as an instrument of industrial policy. This is precisely what seems to happen here when successive cabinets have tried to swap additional orders of Rafale aircrafts

83 84

"Dassault Voudrait un Coup de Pouce Governemental à l'Export", Les Echos, 18 November 1991. Ibid.

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against a merger of Dassault with L'Aérospatiale in order to increase the concentration of the French aerospace industry.85

5. The prohibitive cost of national sovereignty The Rafale is the proof that national sovereignty becomes prohibitively costly. To palliate to this unaffordable cost, it has been suggested that the first squadron of Rafale might be funded by banks. This initiative, called "debudgeting", might be financed by the private sector (banks and industries) in place of the State86. In exchange of a rent or licence, some equipment is placed at the disposition of the Armed Forces. In this precise case, the operation would be realised by a bank syndicate due to the very high cost of acquiring the aircrafts. If such a project was concretised, Dassault might actually dispose of the much needed reference squadron to promote the Rafale abroad. In the meantime, it would innovate a concept that is slowly but gradually gaining momentum in the procurement practices.

The more expensive of the French programmes In billion francs 1994

Rafale (flexible fighter aircraft) Triomphant (nuclear submarine) M5 (sea-to-land nuclear ballistic missile) Leclerc (combat tank) Tigre (combat helicopter) Charles-de-Gaulle (nuclear aircraft carrier) Hélios (military observation satellite) NH90 (transport helicopter) MICA (air-to-air missile)

200,0 77,0 60,0 41,9 40,0 17,2 11,3 9,0 8,8

Rafale 85 "Les Commandes d'Avions Rafale Nucléaire sur la Sellette", La Tribune, 8 July 1997. See also "Le prix caché du Rafale", L'Express, 21 January 1993. 86 "Financement Privé pour les Programmes d'Armements", Air et Cosmos, 12 July 1996.

- 77 -

150,0 40,0 8,8

Purchase of 320 aircrafts Research and Development Industrialisation Source: L'Expansion, no.511, 30 October-9 November 1995

The Rafale programme provides a clear evidence, and French procurement of fighters aircrafts absorbs roughly 40 percent of the Air Force budget due to enormous financial volumes87. From the above, saying that national sovereignty is hardly an affordable policy any longer seems a statement of the obvious.

87 "Le Problème des Coûts Pourrait Provoquer des Modifications dans les Programmes d'Achat de Chasseurs", Defense News (French ed.), 16-22 October 1995.

- 78 -

_______________

Appendix F _______________

Correspondence

- 79 -

- 80 -

- 81 -

Bibliography * Additional references are presented in Appendix A concerning some more general topics in defence economics. ANTON, James J. and YAO, Dennis A., 1987. "Second Sourcing and the Experience Curve: Price Competition in Defense Procurement", Rand Journal of Economics, vol.18(1) (Spring), pp.57-76. AUSTIN, R. and LARKEY, P., 1992. "The Unintended Consequences of Micromanagement: The Case Study of Procuring Mission Critical Computer Resources", Policy Sciences, vol.25(1), pp.3-28. BAUMOL, William, 1982. "Contestable Markets: An Uprising in the Theory of Industrila Structure", American Economic Review, vol.72, pp.1-15. BITTLESTON, Michael, 1990. "Cooperation or Competition? Defence Procurement Options for the 1990s". London: Adelphi Paper 250, IISS. BOWER, Anthony G. and OSBAND, Kent, 1991. "When More is Less: Defense Profit Policy in a Competitive Environment", Rand Journal of Economics, vol.22(1), pp.107-119. BRUNETTE, R., 1989. "US Congress Requires Limitations on Competition for Innovative Defense Contractors and Sub-contractors", National Contract Management Journal, vol.23(1), pp.85-89. CALLAGHAN, Thomas A. Jr., 1975. "US-European Economic Cooperation in Military and Civil Technology". Washington DC: Georgetown University. COWEN, Tyler and LEE, Dwight, 1992. "The Usefulness of Inefficient Procurement", Defence Economics, vol.3(3), pp.219-228. CUMMINS, J. Michael, 1977. "Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing", Bell Journal of Economics, vol.8(1), pp. 168-185. DEMSKI, Joel S., SAPPINGTON, David E.M., and SPILLER, Pablo T., 1987. "Managing Supplier Switching", Rand Journal of Economics, vol.18(1), (Spring), pp.77-97. DEWS, E. and al., 1979. "Acquisition Policy Effectiveness: Department of Defense Experience in the 1970s", Santa Monica: Rand. ENGELBRECHT-WIGGANS, R. and al. (eds.), 1983. "Auctions, Bidding and Contracting". New York: New York University Press. FOX, Ronald J., 1974. "Arming America: How the US Buys Weapons". Boston: Harvard University Press.

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GANSLER, Jacques S., 1989. "Affording Defense: The Changes That are Needed", National Contract Management Journal, vol.23(1), pp.1-22. GREER, Willis R. and LIAO, Shu S., 1984. "A New Look at Risk and Profitability in Defense Contracting", National Contract Management Journal (Summer), pp.2330. HCP 189, 1991. "Ministry of Defence: Initiatives on Defence Procurement". National Audit Office. London: HMSO, February. HITCH, C.J. and McKEAN, Roland N., 1960. "The Economics of Defense in the Nuclear Age". Cambridge, MA: Harvard University Press. INTRILIGATOR, Michael, 1990. "On the Nature and Scope of Defence Economics", Defence Economics, vol.1(1), pp.3-11. KAMINSKY, Paul G., 1997. "Fielding Equipment Second to None", Defense Issues, vol.12, No.16. KOVACIC, William E., 1992. "Regulatory Controls as Barriers to Entry in Government Procurement", Policy Sciences, vol.25, pp.29-42. LAFFONT, Jean-Jacques, 1986. "Towards a Normative Theory of Incentive Contracts between Government and Private Firms", Economic Journal, Supplement, vol.97, pp.17-31. LAFFONT, Jean-Jacques and TIROLE, Jean, 1993. "A Theory of Incentives in Procurement and Regulation". Cambridge, MA: MIT. LEE, Dwight R., 1990. "The Politics and Pitfalls of Reducing Waste in the Military", Defence Economics, vol.1(2), pp.129-139. LEITZEL, Jim, 1992. "Competition in Procurement", Policy Sciences, vol.25(1), (February), pp.43-56. LICHTENBERG, Frank R., 1989. "Contributions to Federal Election Campaigns by Government Contractors", Journal of Industrial Economics, vol.38(1), pp.31-48. MAYER, Kenneth R., 1991. "The Political Economy of Defence Contracting". London: Yale University Press. McAFEE, R. Preston and McMILLAN, John, 1986a. "Bidding for Contracts: A Principal-Agent Analysis", Rand Journal of Economics, vol.17(3), pp.326-338. McAFEE, R. Preston and McMILLAN, John, 1986b. "Incentives on Government Contracting". Toronto: University of Toronto Press. MILGROM, Paul and ROBERTS, John, 1992. "Economics, Organization and Management". London: Prentice-Hall International.

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PUGH, Philip, 1986. "The Procurement Nexus", Defence Economics, vol.4(2), pp.179194. REICHELSTEIN, Stefan, 1992. "Constructing Incentive Schemes for Government Contracts: An Application of Agency Theory", Accounting Review, vol.67(4) (October), pp.712-731. REPPY, Judith, 1991. "On the Nature and Scope of Defence Economics: A Comment", Defence Economics, vol.2(3), pp.269-271. RIARDON, Michael and SAPPINGTON, David E. M., 1989. "Second Sourcing", Rand Journal of Economics, vol.20(1), pp.41-58. ROGERSON, William P., 1989. "Profit Regulation of Defence Contractors and Prizes for Innovation", Journal of Political Economy, vol.97(6), pp.1284-1305. ROGERSON, William P., 1990. "Quality and Quantity in Military Procurement", American Economic Review, vol.80(1), pp.83-92. ROGERSON, William P., 1991a. "Incentives, the Budgetary Process, and Inefficiently Low Production Rates in Defense Procurement", Defence Economics, vol.3(1), pp.1-18. ROGERSON, William P., 1991b. "Excess Capacity in Weapons Production: An Empirical Analysis", Defence Economics, vol.2(3), pp.235-250. SANDLER, Todd and HARTLEY Keith, 1995. "The Economics of Defense". Cambridge: Cambridge University Press. SCHERER, F., 1964. "The Weapons Acquisition Process: The Economic Incentives". Boston: Harvard University Press. SIPRI (Stockholm International Peace Research Institute), 1997. "Yearbook 1997: World Armaments and Disarmament". Stockholm: Stockholm International Peace Research Institute). SISSONS, L.G., 1986. "Cost Estimating for Defence Contracts". London: Crown Eagle, Government Contracting Series, Longman. SMITH, G. and al., 1988. "A Preliminary Perspective on Regulatory Activities and Effects in Weapons Acquisition". Santa Monica: Rand, R-3578, March. TIROLE, Jean, 1986. "Procurement and Renegotiation", Journal of Political Economy, vol.94(2), pp.235-259. TIROLE, Jean, 1988. "The Theory of Industrial Organization". Cambridge, MA: MIT Press. WILLIAMSON, Oliver E., 1986. "Economic Organization". Brighton: Wheatsheaf.

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Concerning the Rafale case study, a package of press cuts has been kindly provided by the French Ministry of Defence (SIRPA - Service of Information and Public Relation of the Armed Forces). It would be too long to list every article. Therefore, we shall only cite the most extensively used of these articles below: •

FRANCE PRESSE news releases • • • • • • • • • •

•

Air et Cosmos • • • • •

•

"Les conséquences du retard du programme Rafale", 22 November 1993. "Le coût du programme Rafale n'est pas excessif", 17 May 1996. "Financement privé pour les programmes d'armements", 12 July 1996. "Le coût du programme Rafale en sensible baisse", 22 November 1996. "Nouvelles étapes dans le développement du Rafale", 31 October 1997.

Le Canard Enchaîné •

•

"Le programme Rafale peut être différé", selon M. Hollande (PS), AFP 062321, June 1991. "EFA/Rafale, contre-exemple de la coopération des industries militaires européennes", AFP 054429, June 1991. "Les coûts du Rafale, du Leclerc et du Tigre rendus publics officiellement", AFP 051939, July 1991. "Vers la supression de la version monoplace du Rafale", AFP 020950, September 1991. " La commission de la Défense à l'Assemblée unanime pour que le programme Rafale ne soit pas retardé", AFP 221311, October 1991. "Le premier Rafale de série version Marine sera commandé en 1992", AFP 311547, October 1991. "Rafale: le dernier exemple d'un programme franco-français?", AFP 091735, December 1991. "L'armée de l'Air ne s'équiperait plus que de 235 avions de combat Rafale", AFP 131727, September 1992. "Lancement de la production de l'avion de combat Rafale", AFP 221745, December 1992. "Un rapport parlementaire craint un échec commercial pour le Rafale", AFP 142008, May 1996.

"Le prix du Rafale Dassault s'envole pour la 13è fois", 22 September 1993.

Defense News •

"Le problème des coûts pourrait provoquer des modifications dans les programmes d'achat de chasseurs", 16-22 October 1995.

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•

Les Echos • •

•

L'Expansion •

•

"Le programme Rafale reprend son vol", 10 December 1991.

Le Monde • •

•

"Rafale's split personality", October 1991.

Libération •

•

"Le prix caché du Rafale", 21 January 1993.

International Defense Review •

•

"Le programme Rafale", No.511, 30 October-9 November 1995.

L'Express •

•

"Rafale: les industriels sollicités pour une rallonge", 10 December 1991. "Dassault voudrait un coup de pouce governemental à l'export", 18 November 1991.

"L'armée de l'air s'inquiète de sa capacité à financer le Rafale", 23 April 1996. "Le groupe Dassault-Aviation est frappé de plein fouet par le déclin des commandes militaires françaises", 9 September 1991.

La Tribune •

"Les commandes d'avions Rafale nucléaire sur la sellette", 18 July 1997.

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Internet Resources

ORGANISATION

COUNTRY

WEB SITE LOCATION

Congressional Budget Office (CBO)

USA

http://www.cbo.gov

Department of Defense - US

USA

http://www.dtic.dla.mil/defenselink

Ministry of Defence - UK

UK

http://www.mod.uk

Rand Corporation

USA

http://www.rand.org

Denmark

http://www.sipri.se

Stockholm International Peace Research Institute (SIPRI)

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