schweizer armee the economics of defensemiloek.de/mas_2010_economics_of_defense_ptbaltes.pdf ·...

13.08.2012

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Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich

11ETH Zürich, Autumn 2010

Speaker: PD Dr. Peter T. Baltes, Lecturer in Economics of Defense, MILAK

The Economics of Defense:

A Very Short Overview


2

Economics of Defense:What is it?

Why is it relevant?How can it improve military decisions?


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Economics of Defense

The Swiss Army= Sub-system,

responsible for the protectionof the Swiss Society

The Economy= Sub-system, devoted to the

allocation of scarce resources

Economics= Providing theories to explain / justify

the real allocation in societies

Economics of Defense – Approximating Its Meaning

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Can W e Justify a Specific Allocation of Scarce Resources?

Internally (peace times)

?oror

The Military and the Scarce Resources 1


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Internally (war times)

?or



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Internally Externally


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Military Core

(Grand-)Strategy

Operations

Tactical level

Politics

Cultural aspects

The Multidimensionality of Military Actions

Interdisciplinary Understanding in Defense / Security Sciences?Offering a comprehensive approach capable to incorporateall relevant dimensions of military actions in one consistent perspective.

…

…

……

…

…


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The contract design for bodyguards

PLATO (*428/427 BC † 348/348 BC)

Source: Glyptothek München

Economics and the Military in History 1


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SUN TZU ( 4.-2. century BC)

Source: http://lh3.ggpht.com

Trade-off“strike range of raids”versus“security of supply”

Militär und W irtschaftlichkeitsdenkenin der Geschichte: eine Auswahl


http://lh3.ggpht.com

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Evaluating victories in accordance with cost-benefit-analysis

PYRRHOS (*319/318 BC † 272 BC)

Source: www.vroma.org …



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Money is the most important asset in wars.

CICERO (*106 BC † 43 v. BC)

Source: www.aeria.phil.uni-erlangen.de



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Money is not the most important asset.

MACHIAVELLI (*1469 AD † 1527 AD)

Source: www.wordpress.com

Much more important is the availability of (militia) soldiers.


www.vroma.org �

www.aeria.phil.uni

www.wordpress.com

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13

Bren

npun

kte

der M

ilitär

ökon

omie

(Bal

tes,

Lüt

hi, S

uter

201

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Economics of Defense:A Road-Map

Economics of Defense:A Road-Map


14Swiss Society

Politics

The Ups and Downs of threatsrelevant to Swiss Security

Foreigncountries

Country1

Country2

Country3

CountryM

u

d

d

d

u

u

d

d

d

u

u

u

d

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d

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Natural disasters

Civi l war

Conventional militaryAggression

Violent demonstration, but far away

Global peace

t1t0 tN-1t3t2 tNZeit

Natio

nal

Secu

rity

Hom

elan

dSe

curit

y

Security dimension

Self-protection

Armed Forces

Force managementEfficient use of the military resourcesby taking the complete life-cycle into account

Mission 1

Mission 2

Mission 3

Mission P

Technology I

Technologiy II

TechnologyX

Operation

Phase-out

Recruitment Procurement

Unit 1

Unit 2

Unit G

Unit K

Real estate

Military equipment

Personnel

Logistics

Coordination and Leadership

Training

Dispossession

(pre-emptive) purchase option

Purchase based on market conditions

„Court Supplier“

MultinationalDefense Industry

„Global market“

Military equipment

Real estate

Personnel

Militia

Professional Soldiers

Mercenaries

Scrapping

Conversion

Selling to partner countries

Contributions to international peace missions

Hot War

Cold War

Country-specific

Deterrence

General military

deterrence

Sanctions / Embargos

International law

moral suasionSet of political options

Currentrangeof missions

Intelligence Service:Identification & evaluation of threat scenarios. - Probability of occurrence?- Occurrence in time? - (monetary) Consequences?

Baltes / Lüthi / Suter

Cul

ture

Envi

ronm

ent

Dem

ogra

phy

Security concept: Bringing the set of political options in line …+ with the general political goals of the Swiss society,+ with the various threat scenarios+ with the political, military, economic, social etc. capabilities of Swiss society


15Swiss Society

Politics

The Ups and Downs of threatsrelevant to Swiss Security

Foreigncountries

Country1

Country2

Country3

CountryM

u

d

d

d

u

u

d

d

d

u

u

u

d

d

u

u

d

u

d

u

Natural disasters

Civi l war

Conventional militaryAggression

Violent demonstration, but far away

Global peace

t1t0 tN-1t3t2 tNZeit

Natio

nal

Secu

rity

Hom

elan

dSe

curit

y

Security dimension

Self-protection

Armed Forces

Force managementEfficient use of the military resourcesby taking the complete life-cycle into account

Mission 1

Mission 2

Mission 3

Mission P

Technology I

Technologiy II

TechnologyX

Operation

Phase-out

Recruitment Procurement

Unit 1

Unit 2

Unit G

Unit K

Real estate

Military equipment

Personnel

Logistics

Coordination and Leadership

Training

Dispossession

(pre-emptive) purchase option

Purchase based on market conditions

„Court Supplier“

MultinationalDefense Industry

„Global market“

Military equipment

Real estate

Personnel

Militia

Professional Soldiers

Mercenaries

Scrapping

Conversion

Selling to partner countries

Contributions to international peace missions

Hot War

Cold War

Country-specific

Deterrence

General military

deterrence

Sanctions / Embargos

International law

moral suasionSet of political options

Currentrangeof missions

Intelligence service:Identification & evaluation of threat scenarios. - Probability of occurrence?- Occurrence in time? - (monetary) Consequences?

Baltes / Lüthi / Suter

Cul

ture

Envi

ronm

ent

Dem

ogra

phy

Security concept: Bringing the set of political options in line …+ with the general political goals of the Swiss society,+ with the various threat scenarios+ with the political, military, economic, social etc. capabilities of Swiss society

Cuts in defense budget – how to react?

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Economics of Defense : A Check-list

Application of the economic perspective on military actions.

The primary function of the Economics of Defense= Consulting the military in regard to the use of scarce resources

What are the main economic lines of reasoning?

Under which conditions are these argumentations relevant to military decisions? When are they not?

The military – a special case of an economic organization?

The Swiss Armed Forces – a special case in Europe? The Swiss Militia – a limbering dinosaur or the best response to modern threats?


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Chapter 2300 Years of Economic Thought

What are the major lessons?Are the lessons relevant to military actions?A personal and very incomplete assessment


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Efficacy:

Efficiency:

Efficacy:

Efficiency:

Source: www.moneymuseum.com

1 shot =

1 shot =

How to Evaluate the Allocation of Resources– the Criteria of „Efficacy“ and „Efficiency“

www.moneymuseum.com

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Firepower

Mobility

Protection

ideal: Life cycle costreal: Cost of Procurement plus

200 M. plus CHF

200 M. plusCHF

Integrating the Economic Dimension into Military Decisions 1


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Firepower

Mobility

Protection

ideal: Life cycle costreal: Cost of Procurement plus

200 M. plus CHF

200 M. plusCHF

Integrating the Economic Dimension into Military Decisions 3


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Firepower

Mobility

C2

Protection

200 M. plus CHF

250 M. plus CHF

Cost-Efficiency, Type 1: The Minimum Principle

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Firepower

Mobility

C2

Protection

200 M. plus CHF

200 M. plus CHF

Cost-Efficiency, Type 2: The Maximum Principle


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Firepower

Mobility

C2

Protection

200 M. plus CHF

10 M. plus CHF

10 M. plusCHF

Opportunity cost:„There is no such thing like a free lunch.“

Lesson No. 1


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• Probability that the target survives intact when two howitzers are firing independently :

Target destroyed Target left intact

1-pT= 70 %

pT = 30 %

Howitzer 2

destroyed intact

1-pT = 70 %

pT= 30 %

… …

1-pT= 70 %

Howitzer 2

destroyed intact

pT= 30 %

… …

Howitzer 1

21 0.7 0.7 49%Tp • Analogously, the target is destroyed by at least one howitzer with a

probability of: 21 1 1 49% 51%Tp

A Simple Mathematical Model of Gunnery

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Lesson No. 2: Diminishing Marginal Returns (of Investment)

Militärökonomie:Begriff und Relevanz für CH?

x: Number of howitzersemployed1 3 64

70 %

10 %

2 5 7 8

20 %

30 %

40 %

50 %

60 %

80 %

90 %

100 %

30%

21%

1 0,7 x

15% 10%

• More than 100 policemen had been looking for the trigger-happy senior citizen in Biel.What is the assessment of this force number by the Economics of Defense?


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Demand function: Relationship between one additional unit in demand and the maximum willingness to pay for this unit. The First Law of Demand: If the price decreases, then the total quantity in demand increases vice versa.

x: Number of howitzers employed

Price (willingness to pay)

Demand

Marginal cost

Supply

Supply function: Reflects the producer’s cost of supplying one additional unit.

Equilibrium

?

Step 1: The demand perspectiveStep 2: The supply perspective

Lesson No. 3a: The Market as a Welfare Maximizing Mechanism


27x: number of howitzers employed

Price (marginal willingness to pay)

Demand

Marginal cost

Supply

Equilibrium

No one can experience an increase in welfare without someone else being worse off.

Pareto-Efficiency /Pareto-Optimality

Lesson No. 3b: The Market as a Welfare Maximizing Mechanism

“A state can be Pareto optimalwith some people in extreme miseryand others rolling in luxury,so long as the miserable cannot be made better off without cuttinginto the luxury of the rich.“Amartya Sen – Nobel laureate 1998

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Source: http://www.nato.int ….

Source:www.globsecurity.org

“It is not from the benevolence of the butcher…. that we expect our dinner, but from their regard to their own self interest.”

Lesson No. 3c: The Market Provides Incentives that Induce the Self Interest of Individuals to Maximize the Society’s Welfare (Invisible Hand).


29200 400 600 800 1000 1200 1400

50

100

150

Price

x: number of howitzers employed

Lesson No. 4: The Market Cross as a Tool of Forecasting

The price of a substitute good decreases.

Population‘s income is going to increase.


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Lesson No. 5a: Division of Labor Increases Welfare• The Production of pins requires several steps (Drawing the

wire, straightening and cutting it, attaching the head etc.).• One man taking care of the whole workflow produces an

output of 20 pins per day.• Thus, ten man working in this fashion are able to produce

200 pins per day.• However, if each of these ten man focuses on one to three

steps of the workflow, they will be able to come up with 48.000 pins per day.

The crew of a German field gun in the periodbetween the two World Wars

• Smith: Specialization is only restricted by the (size of the) market.

http://www.nato.int

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?Ricardo: Pursue a role specialization based on comparative cost advantages.

Just a small outlook to what lurks around the corner (slide pp. 44)However, specialization also implies a major drawback: The higher level of dependence…

Assumption:APC enjoys an absolute cost advantage.

Lesson No. 5b: Comparative versus Absolute Cost Advantage


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Average annual variability(standard deviation, %)

Number of stocksin portfolio1 2 4 8 12 16 20

10

20

30

40

50

1,000

Market / Systematic risk

Idiosyncratic / Unsystematic risk

Lesson No. 6: Risk – “Don’t Put All Your Eggs in One Basket.”

Combined warfare= Portfolio diversification?


330 1 2 3 4 5 Tanks

20

40

60

80

100Average cost pertank

Lesson No. 7: Economies of Scale and Riding Down the Experience Curve

1. Economies of Scale static perspective

= =+

One possible explanation: Increasing production capacities allowsfor a better usage of those inputs that cause fixed cost.

2. Experience Curve dynamic perspective

Each time the output doubles,average total cost decrease

by 10 to 30 %.

One possible explanation: Workers get familiar with the workflow.This reduces production time of each unit, the number of defective parts etc.

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Lesson No. 8: Don’t Expect to Outsmart the Market on a Regular Base


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Lesson No. 9: Cost Traps

Are the in- or outflows really caused by the corresponding project?

Sunk Costs: Costs that have occurred in the past and can not be recovered are irrelevant for the decision to continue or abandon the project.

“W e can not withdraw from Afghanistan because then all the dead and all the sacrifices would have been in vain.” Right?


36

200 400 600 800 1000 1200 1400

50

100

150

Price

x: number of howitzers employed

Lesson No. 10: The Market Economy as an Implicit Kantian Contract

Revisiting the case of“The price of a substitute good decreases.”

Kant’s Categorical Imperative:“Act only according to that maxim

whereby you can at the same time willthat it should become a universal law.”

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The classical example of a negative externality: Air pollution caused by the production of goods.

Lesson No. 11a: Externalities as a Threat to Market Optimality


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The classical example of a negative externality: Air pollution caused by the production of goods.

Lesson No. 11b: How to Solve the Problem of Externalities 1

Proposal 1: Force the owner of the enterprise to buy the houses affected by the air pollution and have him / her live there.


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xi

Pi

MC i

Demand curve for good i

Marginal costs according to the individual perspective of the producing companies

Marginal costs according to the aggregate perspective of the affected society

Difference caused by the costs of cleaning the air pollution etc. relevant to the whole society

Profit maximizing, fully competitive equilibrium for the industry when ignoring the social costs of production

Social welfare lossdue to the externalitiesis ignored as well.

Internalization proposed by Pigou (1912) to correct this market failure:Each production unit is taxed by t to reflect its social costs.

t

This shifts the producers’ aggregate marginal cost curve to the correct position – inducing them to fully take the social costs into account.

Lesson No. 11c: How to Solve the Problem of Externalities 2

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xi

Pi

MC i

Demand curve for good i

Marginal costs according to the individual perspectiveof the producing companies

Marginal costs according to the aggregate perspectiveof the affected society

t

Lesson No. 11d: Actually, There Seems (!) to be No Problem with Externalities

Coase (1961) takes the critical assumptions of Neo-classical Economics– perfect information and lightning speed for transactions – serious. His conclusions: a) With these assumptions fulfilled, the polluter and the injured parties can (at no cost) strike a deal (offering compensations).

b) The result of this deal will always be the efficient outcome. c) It is not important who (polluters or injured) owns the resources affected by externalities.

Polluter owns the right to pollute injured party must offer compen-sations to have him stop it.

Polluter must offer the injured party compensations for being allowed to pollute.


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Exchange implies mutual benefits.Actor 1

Actor 2

BreadCheese

Benefit of receiving bread

Welfare position of actor 1

Cost of loosing cheese

Benefit of obtaining cheese


Cost of giving bread away as a payment in kind.

Because all rational participants voluntarilyagree to exchange, we can be sure that the exchange causes to all of them an improvementin their welfare position.

Lesson No. 12: The Economic Roots of (Military) Conflicts 1


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Clausewitz: The goal of all wars is to deprive the enemy of his own will. Thus, his consent to a transfer of resources is not necessary anymore.

Investing in the procurement of the knife is attractive for actor 1 as long as the cost of procurement do not exceed the benefits represented by the “red square“.

Actor 1

Actor 2

BreadCheeseBenefit from bread


In comparison:Net benefit by exchange

Deterrence: Increasing the costs of aggression for the potential aggressor.

Successful deterrence:Net advantage through voluntary exchangeis greater than the net benefit through aggression.

Avoided payment in cheese

Lesson No. 12: The Economic Roots of (Military) Conflicts 2

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The most important aspect of economic theory

in our days is no longer concentrated

on competition and efficiency

but on information asymmetries

and the design conceptsto overcome these asymmetries.

Joseph E. Stiglitz,Nobel Laureate 2001

Introduction to the Economics of Information


44

q

Wage S+

S-

D+

D-

ØD

Ø’D

Lesson No. 13: The Problem of Adverse Selection (Ex Ante)


45

Question:When taking a taxi, in many countries you must pay a two-part tariff /nonlinear tariff.

Lesson 14: Asymmetric Information – Moral Hazard (Ex Post)

A two-part tariff represents a combination of …

• with a variable fee for each kilometer / mile traveled.

• a (constant) flat fee up front / initial fare

W hy are two-part tariffs employed in taxi business?

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The Setting

• You are visiting a foreign country for the first time.

• You have just arrived at the airport.

• Now you need a transfer to your final destination.

• Should you take the bus or a taxi?

• You decide to take a taxi.


47

The taxi driver knows how to get to your final destination.

He is aninformation insider.

You do not.

You are aninformation outsider.

A situation ofasymmetric information

The Coordination Problem


48

A situation of asymmetric information

The cab driver has an incentive to exploit ex posthis information advantage (shirking).

If a linear tariff is employed, he most likely will not get youto your destination taking the shortest route.

The Consequence

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Fuel consumption

The fare must reflect…

“Wear and tear” of the taxi

Idle times (finding new clients)

The Tariff must be relatedto the distance traveled / time spent by the driver.

The driver’s time spent on the job

The Cab Driver’s Tariff Calculation


50

d = Distance in Miles

A linear tariff: For each mile traveled, the passenger paysf = 1 Euro (and nothing else).

Distance of Trip 1Distance Spent Looking for Trip 2Distance of Trip 2Distance Spent Looking for Trip 3Distance of Trip 3

Revenue From Trip 1:

11 dfR Revenue Lost by Searching

Implications of a Linear Tariff

f = 1 Euro

Driver Starts to Work & Immediately Finds a Customer Driver Stops Working


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d

A linear tariff: For each mile traveled, the passenger pays f = 1 Euro (and nothing else).

f

By using a linear tariff the cab driver is induced to exploit the asymmetric information by maximizing the distance of each trip.

The Cab Driver Extends Trip 1’ DistanceAdditional Revenue Gained by Shirking

A Linear Tariff Regime Results in Shirking

Let us assume the customers are completely ignorant.

Why does simply increasing the fee make no difference?

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52d

f

The cab driver (homo oeconomicus!) will only stop cheating if behaving honestly secures him at least the same total revenue.

The linear tariff offers the opportunity to avoid revenue losses resulting from looking for new costumers.

Thus the gains by cheating must be distributed among all the trips the cab driver is able to serve when behaving honestly (Condition 1).

This additional revenue must be paid independently of the corresponding trip distance (Condition 2): Hence: An initial fare.

The Two-Part Tariff: Central Idea


53

Under certain conditions (see below), paying an initial fare induces the cab driver to behave honestly because he then has the incentive …

to maximize the number of trips

instead of maximizing the distance of single trips.

Variant 2 – The Two-Part Tariff: Main Effects

However, the tariff’s impact on the driver’s behavior comes at a price:

Maximizing the number of trips implies an incentive for the driver to drive in a more risky way in order to increase income.

Real Life: Number of cab drivers forced to participate in “corrective refresher courses” to regain their driving license because of being caught driving too fast etc.?

Intermediate Result:This case of taxi tariffs illustrates a general insight into the Economics of Information: There is no such thing as a dominating coordination design. Fighting one problem of asymmetric information by a corresponding contract element triggers another incentive problem that must be taken care of by another specific contract element.


54

Setting up a two-part tariff may change the incentive structure for the taxidriver: He can be induced to behave honestly even in view of an information disadvantage for the client.

The paradigm of asymmetric information provides new insights into why certain coordination mechanisms are employed in reality.

But overcoming constellations of asymmetric information comes with a price: The information insider has to receive an information rent.

Reason: He has an information advantage, so he must be given an incentive to voluntarily abandon his options to shirk by exploiting this advantage (efficiency loss).

Conclusions

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5555

Tigers on the RetreatHow the Swiss search for a successor to its outdated F-5 fighters

resulted in a contract designcapable of overcoming information asymmetries

?


56

The two fighter aircraftemployed by the Swiss Air Force

F 18 C/D(in service since 1996)

F 5 II (in service since 1979)


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What has happened so far … (Part 1)

The search for the successorstarted in earnest in late 2007.

Rafale

Gripen

Eurofighter

Typhoon

?

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15th January 2009: Request for proposal by armasuisse

Price Option:

W hat is the price of 22 aircraft?

Quantity Option:

How many aircraft for 2.2 billion Swiss francs?

What has happened so far … (Part 2)

Main question of the paper:

W hy is this design employed?


59

The Political Background to Swiss Arms Deals

The notorious Mirage III “S” dealof the 1960s

Budget cap of 2.2 billion Swiss francs

= guarantees that there will be no “bad surprises” (to critics as well as promoters of the deal) in the wake of the procurement process

The actual motivebehind the request’s design


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Complementing Interpretation ( The Economics of Information)

The coordination issue:

The efficiency of arms deals is threatened by information asymmetries between supplier and procurement agency.

The problem of moral hazard / credence goods:

The supplier may claim unjustified cost overruns to extort some extra profit.

Explaining the design features:

The combination of price option & quantity option may inducethe supplier to refrain from shirking.

A double dividend?

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Supplier‘s profit of the Swiss deal is made up of two components

1. „Instant“ profit of selling aircraft to Switzerland:

2. Present value of future profits ( selling the aircraft to other countries):

The lever of the contract design

Components are interrelated:Swiss contest serves as a signal to other countries

The design confronts the supplier with a trade-off:

Shirking increases instant profit, but lowers future profit.

2

1


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• There is only one supplier.

k0 STC a x

a0 = „Combat Multiplier“

Costs are positively related to the combat multiplier

k = „Cost Exponent“ with

Concavity of the total cost function reflects experience curveeffect

The model:Total costs

• Total costs (TC) of the Swiss lot, xS:

Fixed costs are Zero.

k 0,1

• Total costs (TC) of xS include “sufficient” compensation for business risk etc.


63

• There is only one supplier.

z2 Sx

xS = „Swiss lot“

z = „Profit Exponent“ with

Future profit increases with the number of aircraft sold to Switzerland. Why?

Concavity of the profit function.

The model:Incorporating the present value

of future deals

• Present value of future profit is:

z 0,1

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Information Asymmetry

Supplier: perfect knowledge.

0a a ,a

• Cost exponent k is known (due to previous deals).

Armasuisse:

Modeling the information asymmetry between supplier & procurement agency

• Profit exponent z is known, too.

• Knowledge of the combat multiplier a0 is limited to:


65

The supplier’s reaction to the request for proposal= choosing a level of exaggeration that in turn determines total profit.

Supplier exaggerates the costs to extort some extra profit= Shirking.

Supplier behaves honestly.

Shirking by the Supplier

0

a*av 1,V with : V

0

0

a*av 1

Supplier understates the costs= Foot in the door technique.

*v 0,1


66

Supplier’s total profit

S

21

k k zvx 0 S 0 S Sv a x a x x

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A numerical example – Part 1


68

A numerical example – Part 2


69

Results and further research

• The supplier has no incentive to refrain from shirking in the case of the price option.

• In the case of the quantity option, the supplier will not shirkin certain scenarios (preference to apply f-i-t-d-t = offset operations)

• A lottery that mixes price option and quantity option provokes a consistent reaction by the supplier.

• When to buy an aircraft?Trade-off: Buying earlier implies teething problems, danger of dead-end technology, but less shirking.

• Further research:Budget is a strategic variable to shift the decision from “Shirking” to “No shirking”.

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70

quantity of soldiers employed

Wage

Marginal cost

Competitive Wage

Service pay (Militia soldier)

Welfareloss

Militia

Militia versus Professional Army: The Economic Point of View 1


71

Country Active soldiers(2002)

Total Expenditures for Personnel

Expenditures per active

soldier

Expenditures for equipment

GreatBritain

Germany

France

210.450

296.000

260.000

14.739.000.000 $

16.422.000.000 $

20.595.000.000 $

70.035,64 $

55.479,73 $

79.211,54 $

8.710.000.000 $

3.807.000.000 $

7.229.000.000 $

Militia versus Professional Army: The Economic Point of View 2


72

Chapter 3Economics of Defense – A Wrap-Up

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Wants

Skills

Economy

Means

Restrictions

• self interest / opportunism

• unlimited wants

• bounded rationality

• limited resources

• individual mind / body

How to justify a specific claim to a resource?Main challenge

The benefit of establishing the trinity:No coordination issues

The disadvantage of establishing the trinity:

No specialization possible


74

Motivation Information

There are no “Wunderwaffen”.

Example: “Befehlstaktik” or “Auftragstaktik”?

Each constellation requires a tailored coordination design.


75

• Path-dependency of designs

• Different designs= different incentives

Wants

Skills

The Military

Means

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