DEFENSE ECONOMICS

History of defence economics:

Significant interest in defense economics as an emerging field coincided with the appearance of three now-classic works in 1960: Charles J. Hitch and Roland McKean (1960), The Economics of Defense in the Nuclear Age; Lewis F. Richardson (1960), Arms and Insecurity; and Thomas C. Schelling (1960), The Strategy of Conflict. The pioneering book by Hitch and McKean applied economic concepts of allocative efficiency to the defense sector and inspired researchers for the next generation to investigate defense economic issues. The interest in defense economics blossomed during the Cold War, sparked, in part, by Richardson's (1960) arms race model.A large literature grew that applied economic analysis to the study of arms races and their stability (see the Brito and Intriligator chapter). This theoretical literature was accompanied by a parallel literature that attempted to document the empirical existence of arms races [see, e.g., McGuire (1977) and Linden (1991)]. Finally, Schelling (1960) introduced game-theoretic notions to the study of conflict and defense. The book served to clarify the meaning of deterrence, compellent threats and promises, and strategic moves. Although Schelling's work did not emphasize formal modelling, many of his ideas have been subsequently formalized with recent advances in game theory - e.g., the notion of a perfect equilibrium in which noncredible threats are culled from feasible equilibria.There were three further pioneering contributions in the 1960s. A US study byPeck and Scherer (1962) on The Weapons Acquisition Process analyzed the nonmarket goods to the study of burden sharing within military alliances. Subsequent papers analyzed burden

sharing, allocative efficiency, and the allies' demand for defense expenditure [see the Murdoch chapter and Sandier (1993)]. During the 1970s, the literature of defense economics emphasized at least five issues or subfields. First, arms races received much attention with important pieces by Brito (1972) and Intriligator (1975) that provided a strategic foundation to the Richardsonian arms race equations. Second, the appearance of Benoit's (1973) book began a controversy over whether military expenditure is growth promoting or growth inhibiting. This controversy continues to the present day (see the chapters by Ram, and Deger and Sen). Third, economists devoted attention to the economics of alternative systems of military recruitment: conscription versus the all-volunteer army (see the Warner and Asch chapter). Fourth, defense economists investigated thedefense industries in terms of profitability, procurement practices, conversion impacts, competition, and industrial policies (see the chapters by Dunne, Hartley, Lichtenberg,and Rogerson). Fifth, regional impacts of defense expenditure were studied with a variety of tools (see the Braddon chapter).In the 1980s and 1990s, these earlier topics were pursued along with some new ones. Advances in the study of asymmetric information and game theory were applied to the study of incentive contracts and procurement practices, as shown in the Rogerson chapter. Game theory was also used in the study of terrorism and the analysis of negotiation strategy between terrorists and the authorities (see the Enders and Sandier chapter). Modern general equilibrium analysis was employed to examine insurrections and appropriative behavior as highlighted by the Grossman chapter. Game-theoretic concepts and insights drawn from rent-seeking analysis were used by Jack Hirshleifer to theorize about the notion of conflict. Within the last fifteen years, other topics of defense economics included an analysis of defense R&D (the Lichtenberg chapter), arms trade (the Anderton chapter), disarmament (the Fontanel chapter), and conversion (the Fontanel and Hartley chapters).The

modern study of defense economics employs the latest theoretical and empirical tools. Gametheoretic concepts are used in a number of subfields of defense economics, including the study of alliances, arms races, incentive contracting, terrorism, insurrections, and conflict. A crucial game-theoretic notion of equilibrium, which shows up in a number of places in the volume, is that of a Nash equilibrium. If no player or agent would unilaterally want to change his or her strategic choice, then a Nash equilibrium is achieved. At such an equilibrium, each player is optimizing his or her choice variable(s) subject to the best-response choices of his or her counterpart(s). In dynamic settings where interactions are repeated, a Nash equilibria exist, some of which rely on noncredible threats that may hurt the threateners sufficiently that they are unwilling to carry them out. Refinements to the Nash equilibrium concepts have been developed to remove such noncredible threats and to maintain a greater degree of rationality on behalf of agents. Subgame perfection is but one of many refinements. An equilibrium is subgame perfect if it contains a Nash equilibrium for all component subgames, so that no player would unilaterally characteristics of weapons acquisition, the nature of competition for defense contracts, and the results of weapons programs. A companion volume by Scherer appeared in 1964: The Weapons Acquisition Process: Economic Incentives. This volume examined including a theoretical and empirical analysis of different types of contracts (e.g.,fixed price; cost plus). In 1966, Olson and Zeckhauser applied the theory of want to change his or her strategy at any point in the game. Current analysis of defense economics employs principal-agent analysis, rational expectations, dynamic optimization, and other theoretical advances.Modern defense economics also uses the latest refinements in econometrics. In recent years, time-series analysis and its refinements have figured prominently in defense economics. For example, the technique of vector autoregressive analysis (VAR),whereby the interrelationships of multiple time series are studied, has been used to analyze

terrorism and the impact of defense expenditure on growth and employment.Other time-series techniques - causality tests, intervention analysis, and cointegration tests - have been used throughout defense economics. Military manpower studies have applied the latest techniques of regression analysis to investigate recruitment, retention, military labor supply, and military labor demand. Time-series cross-sectional methods have been recently applied to the growth and defense controversy [Macnair et al. (1995)]. Some of these techniques are more advanced than the data available for satisfactory empirical work. Often sophisticated econometric techniques use available statistics, failing to recognize the limitations of the data arising from its aggregative nature and the use of different definitions of military expenditure .

On the nature of defense economics

Defense economics is the study of resource allocation, income distribution, economic growth, and stabilization applied to defense-related topics. As such, defense economics involves an investigation of the impact of defense expenditures, both domestically and internationally, on macroeconomic variables such as employment, output, and growth. It also has a microeconomic dimension involving analysis of the defense industrial base, collaborative programs, offsets, the pricing and profitability of military contracts, and the regulation of contractors. Defense economics draws from a variety of economic subfields. In particular, public economics is important, because the provision of defense (security) can be viewed as a public goods, whose benefits are nonrival and nonexcludable within a nation and among allies. Another market failure, germane to defense economics, is that of an externality, which arises when the action of one agent

influences the well-being of another and no means of compensation exists. For defense economics, the arming of one nation may yield positive (on allies) or negative (on adversaries) externalities on another nation. However, measuring the "output" of defense spending is fraught with difficulties and the problem is often ignored, or assumed away, or presented in generalizations such as security, protection, and deterrence. Industrial organization is another branch of economics that figures crucially in the study of the defense industrial base (the Dunne chapter), procurement (the Rogerson chapter), defense R&D (the Lichtenberg chapter), and industrial policies such as collaboration, licensed production and offsets (the Hartley chapter). Other relevant subfields include labor economics, international economics, public choice, economic growth, and macroeconomics. Public choice is particularly appropriate to defense economics, because it focuses on nonmarket decision-making. By modelling the behavior of voters, political parties, governments, bureaucracies, and other interest groups, it provides a framework for analyzing the "military-industrial complex". Defense economics encompasses aspects and topics from peace science and conflict studies. Thus, the economics of disarmament and conversion (the Fontanel and Hartley chapters) are relevant topics. There is no ideological presumption in defense economics; that is, defense economists are not inclined towards military expenditures and armed conflict. They are, instead, concerned with understanding the processes and dynamics of arms expenditures, conflict and its resolution, and any economic aspects associated with the defense sector. Defense economics has a strong policy orientation; analysis is often undertaken to make policy recommendations regarding publicly financed defense outlays. And, in the last resort, economists cannot ignore the opportunities for applying economic theory and empirical techniques to a sector which is a major user of scarce

resources and which has the potential to protect or destroy civilization. A further discussion and analysis of the nature and scope of defense economics is taken up in the McGuire chapter. In recent years, the scope of defense economics has expanded to consider a broader range of security matters that include nonmilitary issues such as the protection of the environment from transnational pollution (e.g., ozone shield depletion, global warming, acid rain). We have taken a narrower and more traditional view of defense economics so as to preserve the field's well-definedidentity.

Importance of defense economics today:

Even though the Cold War has ended and the superpower confrontation has declined greatly, defense economics is still of great importance. In fact, the events of the late 1980s and early 1990s may have increased the need and importance of defense economics, especially in regards to resource allocation and the application of economics methods to security-related issues. First, the downsizing of military budgets in the first half of the 1990s highlights a host of economic challenges. Falling budgets and rising equipment costs will force nations to seek efficiency improvements in the acquisition of weapons and the provision of armed forces. Nations will be more willing to buy available equipment off-theshelf from overseas suppliers rather than paying the price of supporting a national defense industrial base. Within the armed forces, there will be pressures to substitute, say, equipment for manpower, reserves for regulars, women for men, and civilians for military personnel (e.g., via contractorizing activities traditionally undertaken "inhouse" by the military, such as catering, repair, and maintenance). Unit costs may also be higher on new weapon systems when scale economies are present unless an arms producer is able to resort to foreign sales, which may imply other kinds of risks and costs to the supplier nation. Faced with procurement cuts, defense

firms have merged to take advantage of economies of scale and economies of scope. In so doing, national defense industries have become more concentrated and less competitive. This downsizing trend may have bottomed out. In 1994, the Clinton administration gave an emergency allocation to the military to meet readiness requirements. The Anderton chapter mentions that the arms trade may be on the rise again. Second, the breakup of the Soviet Union and Eastern Europe has unleashed ethnic conflicts that have erupted into civil war once central power was diminished. In addition, the breakup of the Soviet Union has raised the risk of nuclear weapons getting into the hands of terrorists and the proliferation of nuclear-weapon nations. Third, since these trouble spots can create conflict externalities for neighboring states, the role of peacekeeping forces and their financial support have grown in importance. Fourth, the Gulf War of 1991 points to a source of conflict in the future - that is, wars fought over disputed and/or scarce resources, such as common oil pools. Fifth, recent defense treaties raise a host of allocative concerns as the elimination of weapons creates expenditures on their disposals, environmental cleanup, verification, and the development of alternative classes of weapons. Peace as well as confrontation have their costs. Recent reallocations of resources have had regional and national impacts on employment and output. Sixth, nonconventional conflict in the form of terrorism and insurrections presents exigencies that have allocative and distributional concerns. The provision of defense is still an important activity that requires huge resource allocations to meet a variety of contingencies and uncertainties. Economic aspects of the defense sector continue to be important and to require study. Interest continues to grow in the economics field for applying economic methods to defense issues.

What is defense economics?

The study of war, in all its diverse aspects - avoidance, causes, preparations, initiation, conduct, termination, consequences, etc. - has engaged scholarly energies from every conceivable origin and discipline. Where does economics - economics as concerned with the consequences of resource scarcity, and the necessity to allocate among alternatives - fit in with philosophy, history, biology, psychology, law, political science, mathematics, religion and so on? The family of economic problems studied over the past half-century in the cause of defense and security is indeed dauntingly vast.
Economic Performance in the Defense Industries:

Principal among the performance dimensions by which an industry is evaluated are efficiency, equity, stability, and technical progress. Since my concern here is not with technical progress as such but with progress per dollar of expenditure, I take as given that progress is occurring and emphasize instead the efficiency aspect of this performance. Equity is mainly concerned with income distribution objectives.

Defense Contracts: Incentives & Performance:

Ability in sales and employment within individual firms over time has seemed unnecessarily high, considering the over-all stability of expenditures on weapons and space development and procurement. However, the stability statistics on sales and employment have never really been developed. A rough of this performance can be obtained by fitting a least-squares-linear-trend line to the annual sales and employment histories of the principal firms in the aerospace industry and the

industry aggregate, as well as for firms of comparable size in four other producers goods industries, over the period 19541963. The standard deviation of the residuals was then computed and, dividing by the mean level of activity, my measure of variability is the coefficient of variation of the residuals.
BARGAINING BEHAVIOR

The principal difficulty in evaluating the effect of incentive contracts on cost performance rests on the negotiation of target costs. If negotiated target costs are identical under both types of contract, and if the technical characteristics of the tasks to be performed are similar, the observation that target costs tend to be overrun using CPFF contracts but underrun when a positive sharing rate is employed clearly suggests that costs are more carefully controlled by the firm under profit-incentive contracts. But the assumption that estimated target costs are unchanged is very much open to question.It is generally accepted that the contractor is inclined to underestimate full costs when CPFF contracts are used, in order to improve his prospects for winning the contract. And the Services may, at least tacitly, encourage such underestimation to gain budgetary support for the program, while later agreeing to additional fees on overrun costs.24 A substantial identity of interest between the contracting parties exists in these circumstances. When contracts are shifted to an incentive-fee basis, how23 Department of Defense, Incentive Contracting Guide, 1963, especially pp. 523 and 5 254. 24 Scherer, The Weapons Acquisition Process, pp. 27, 131, 157 institutional Structures and Defense Spending:

ever, a penalty for overruns is operative. Here, I would expect that either the attitude of the contractor toward the bargain would harden or that a tacit understanding that task uncertainty will be resolved in the contractor's favor through change orders and contract amendments would exist (or both). Let us examine the shift in bargaining posture first. Although an underestimation bias exists when CPFF contracts are in force, an overestimation bias may operate when incentive-fee contracts are used; for the greater the differential between negotiated target costs and true expected costs, the larger the potential profit return to the contractor. Thus, if we let ir be expected profit, ?TT be negotiated target fee,25 CT be negotiated target cost, C be expected cost, and be the sharing rate, we have 7T = lrT + a(CT C). Under CPFF contracts, a is zero and hence the last term vanishes. When a positive sharing rate is selected, however, the cost difference between negotiated and expected cost necessarily affects profits; and to assume that bargaining behavior is unaffected by this change in circumstances is unwarranted. It is possible, of course, that any toughening of the attitude on the part of the contractor would be offset by a corresponding toughening in the attitude of the bargaining agent for the government. Indeed, it has been argued that the government, as almost the sole purchaser, has an enormous advantage in its dealings with defense contractors. Moore observes, however, that the government has been either unable or unwilling to realize this monopsonistic bargaining advantage, and suggests that one reason is that it "lacks the skills and resources to make the necessary technical and cost evaluations of contractors' proposals, but instead must rely on information supplied by the firm."

Conclusion

Defence firms and national defence industries continue to face an uncertain future. No one can predict accurately the future: it is unknown and unknowable. As always, firms which have the entrepreneurship to anticipate the future correctly will survive; others will fail. Governments are faced with difficult choices about their national defence industries. Falling defence budgets, reflecting a preference for increased social welfare spending and a peace dividend, mean that supporting national defence industries can be costly. The alternative would be for governments to act like a competitive buyer, opening-up their national defence markets to foreign firms and buying defence equipment from the lowest-cost suppliers in the world market. Such a policy would benefit taxpayers and the Armed Forces but the losers would be the national defence industrial base.

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