Handbook of Defense Economics, Vol. 1

INTRODUCTION TO THE SERIES

The aim of the Handbooks in Economics series is to produce Handbooks for various branches of economics, each of which is a definitive source, reference, and teaching supplement for use by professional researchers and advanced graduate students. Each Handbook provides self-contained surveys of the current state of a branch of economics in the form of chapters prepared by leading specialists on various aspects of this branch of economics. These surveys summarize not only received results but also newer developments, from recent journal articles and discussion papers. Some original material is also included, but the main goal is to provide comprehensive and accessible surveys. The Handbooks are intended to provide not only useful reference volumes for professional collections but also possible supplementary readings for advanced courses for graduate students in economics. KENNETH

J.

ARROW and MICHAEL D. INTRILIGATOR

ACKNOWLEDGEMENTS

We are indebted to the many colleagues who have directly and indirectly contributed to this Handbook. Michael Intriligator was centrally involved in initiating the volume. Our distinguished contributors responded willingly and enthusiastically to our various comments and suggestions and were a pleasure to work with. Colleagues whom we have worked with on a variety of defense economics issues include Jon Cauley, John A.C. Conybeare, Walter Enders, John F. Forbes, Nick Hooper, Harvey Lapan, Dwight Lee, Stephen Martin and James Murdoch. Typing and correcting manuscripts requires care and patience. Roberta Blackburn, Margaret Cafferky, Anne Hrbek, Eileen Mericle and Sue Streeter excelled themselves in producing the final version of the manuscript. Our thanks also to the staff at North-Holland. At a personal level, we owe much to the support of our wives (Winifred and Jeannie) and our children (Cecilia, Lucy, Adam and Tristan) . Keith Hartley's research was supported in part by the Economic and Social Research Council and the Leverhulme Trust. York, England Ames, Iowa May 1 995

Keith Hartley Todd Sandler

Chapter 1 INTRODUCTION KEITH HARTLEY

University of York TODD SANDLER

Iowa State University

Contents

Abstract Keywords 1 . Introduction 2. A brief history of the field 3. On the nature of defense economics 4. Importance of defense economics today 5 . Organization of the book References

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T. Sandler © 1995 Elsevier Science B. V. All rights reserved

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Abstract

This chapter defines defense economics and indicates how it differs from other subfields of economics. The nature and topics of defense economics are presented. A brief history of the field is also reviewed. The current importance of defense economics in the post-cold war era is discussed. Finally, the organization of the book and its component chapters are presented.

Keywords

alliance burden sharing, arms races, arms trade, contract design, conversion, disarmament, discretionary budget, econometrics, externality, game theory, history of defense economics, industrial policies, insurrections, military manpower, Nash equilibrium, procurement, public choice, public goods

Ch. 1: Introduction

3

1. Introduction

Defense economics applies the tools of economics to the study of defense and defense­ related issues, including disarmament and peace. When applying these tools, defense economists must tailor economic methods, both theoretical and empirical, to defense issues and policies, while taking account of institutional aspects that characterize the defense sector. For example, the study of procurement practices in the United States must include the relevant participants - the Congress, the defense contractors, and the military - and how they interact and sequence their actions in making equipment choices. Relevant defense issues include an analysis of alliance burden sharing, the impact of contract design on the efficiency of procurement, the study of arms races and stability, the effects of defense expenditure on economic growth and development, the allocative implications of disarmament treaties, the impact of industrial policies on the defense sector, the employment implications of conversion, the study of insurrections and conflict, and policies to regulate the arms trade. The field of defense economics is broad in its scope and intersects with a variety of economic subfields, including public economics, public choice, microeconomics and macroeconomics, regional economics, and international economics. In recent years, defense economics has grown in importance, as documented by the large number of articles in general j ournals, the appearance of numerous books, and the publication of a field j ournal, Defence and Peace Economics (formerly Defence Economics). Contributions in defense economics have made fundamental advances to game theory [e.g., Thomas Schelling ( 1960), The Strategy of Conflict], procurement theory [Cummins ( 1 977), Laffont and Tirole ( 1 9 93), McAfee and McMillan ( 1986), Tirole ( 1986)], and the econometrics of military manpower [Ash, Udis and McNown ( 1983)]. The study of defense economics is of importance to a large audience that includes researchers, teachers, practitioners, taxpayers and students, who are concerned with allocative, distributional, dynamic, and stabilization influences of defense expenditures and policies. Although the share of gross domestic product (GDP) devoted to defense varies greatly among nations, in 1 990 and on average nations devoted approximately five percent of GDP to defense [Hartley et al. ( 1993, p. 1 7)]. However, between 1 989 and the early 1 990s, world military expenditure declined [Deger ( 1 993)]. In many countries, such as the United States, defense expenditure is a sizable share of the discretionary budget of the central government. As a consequence, the study of resource allocation and economic policy is incomplete unless defense issues are analyzed. The Handbook of Defense Economics is intended to take stock of the myriad contributions of the last three and half decades. To accomplish this purpose, we have assembled many of the leading scholars who have authored some of the seminal pieces in the field. The nineteen chapters of the Handbook present the fundamental concepts and analyses in a form that should prove useful to researchers and students. Thus, authors have presented key tools and analyses of the field in a way that emphasizes intuition and significance. Theoretical analysis, econometric techniques, and policy

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issues are addressed. The chapters fall into two essential categories: surveys (chapters by Smith, Murdoch, Brito and Intriligator, Enders and Sandler, Ram, Deger and Sen, Rogerson, Warner and Asch, Lichtenberg, Hartley, and Anderton) and conceptual studies (McGuire, Brzoska, Hirshleifer, Grossman, Dunne, Braddon, and Fontanel). Survey chapters present a synthesis, interpretation, and evaluation of the literature for particular subfields of defense economics, whereas the conceptual chapters elucidate the analysis of specific topics. Both types of chapters provide directions for future research. Novel ideas and insights are contained throughout the volume, insofar as authors use their chapters to give an overview and to push the analysis forward. We have provided editorial guidance so that authors wrote chapters that present an up­ to-date statement of a line of inquiry, while emphasizing some pedagogical tools. As with earlier Handbooks, we intend that the chapters serve researchers and find their way onto student reading lists.

2. A brief history of the field

Significant interest in defense economics as an emerging field coincided with the appearance of three now-classic works in 1 960: Charles J. Hitch and Roland McKean ( 1 960), The Economics of Defense in the Nuclear Age; Lewis F. Richardson ( 1 960), Arms and Insecurity; and Thomas C. Schelling ( 1 960), 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 ( 1 960) 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 (1 977) and Linden ( 1 99 1 )] . Finally, Schelling ( 1 960) 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 1 960s. A US study by Peck and Scherer ( 1 962) on The Weapons Acquisition Process analyzed the nonmarket characteristics of weapons acquisition, the nature of competition for defense contracts, and the results of weapons programs. A companion volume by Scherer appeared in 1 964: The Weapons Acquisition Process: Economic Incentives. This volume examined the competitive and contractual incentives in US weapons acquisition programs, including a theoretical and empirical analysis of different types of contracts (e.g., fixed price; cost plus). In 1 966, Olson and Zeckhauser applied the theory of public

Ch. 1:

introduction

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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 Sandler ( 1 993)]. During the 1 970s, the literature of defense economics emphasized at least five issues or subfields. First, arms races received much attention with important pieces by Brito ( 1 972) and Intriligator ( 1 97 5) that provided a strategic foundation to the Richardsonian arms race equations. Second, the appearance of Benoit's ( 1 973) 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 the defense 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 1 980s and 1 990s, 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 Sandler 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), di sarmament (the Fontanel chapter), and conversion (the Fontanel and Hartley chapters). The modern study of defense economics employs the latest theoretical and empirical tools. Game-theoretic 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 n o 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 multiplicity of 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

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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 de­ fense 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. ( 1 995)] . 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 (see the Brzoska chapter).

3. 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 good, 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

Ch. 1:

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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-defined identity.

4. 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. ln fact, the events of the late 1980s and early 1 990s 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 1 990s 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-the­ shelf 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 "in­ house" 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

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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 1 994, 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 1 99 1 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.

5. Organization of the book

The book contains eighteen additional chapters that include all essential subfields of defense economics. Coverage varies among chapters owing to the background litera­ ture: some areas (e.g., arms races) have a large literature, while others (insurrections) have a much smaller literature. Chapters 2 (M.C. McGuire) and 3 (M. Brzoska) set the stage for the study of defense economics. McGuire introduces the notion of defense economics, its origin and meaning. In the chapter by Brzoska, the reader learns about the various data sets available to study world military expenditure and their limitations. The next three chapters concern the demand and supply of military expenditure within the nation, among allies, and between adversaries. Chapter 4 (R. Smith) examines the theoretical and empirical issues surrounding the estimation of a nation's demand for military expenditure. In chapter 5 (J.C. Murdoch), the economic theory of alliances is presented, based on the theory of pure and impure public goods. Empirical tests are also reviewed . Chapter 6 (D.L. Brito and M.D. Intriligator) focuses on arms races, beginning with Richardson's ( 1 960) formulation. Dynamic methods and optimization

Ch. 1: Introduction

9

techniques are used to display a variety of models. This chapter also applies the models and their recent extensions to study nuclear weapon proliferation and other relevant policy issues. Using modem tools from public economics, J. Hirshleifer (chapter 7) presents some theoretical representations to analyze conflict among agents. The modem theories of rent seeking and tournaments are behind some of the models in this provocative presentation. Chapter 8 (H.I. Grossman) focuses on appropriative behavior, whereby a nation's ruler must allocate resources to maintain his or her ability to live off of the population, while elements within the population attempt to capture the ruler's accumulated assets. Tools of general equilibrium are employed. Grossman clearly distinguishes his theoretical paradigms from other treatments of rebellion. In chapter 9, W Enders and T. Sandler present rational-actor models of terrorist behavior based on choice-theoretic and game-theoretic approaches. A host of empirical techniques are displayed for testing the effectiveness of anti-terrorist policies. Chapters 1 0 (R. Ram) and 1 1 (S. Deger and S. Sen) are devoted to investigating the impact of defense expenditure on growth and development, and are motivated, in part, by Benoit's ( 1973) surprising finding that defense was growth-enhancing in some developing countries. In the chapter by Prof. Ram, theoretical and empirical 1 aspects of the Feder-Ram model for analyzing the influence of defense on growth are discussed . The Feder-Ram model has been applied to developed and underdeveloped countries. In the subsequent chapter, Drs. Deger and Sen review the issues surrounding the impacts of defense on developing countries. An emphasis is given to displaying empirical studies of this impact. Defense inputs (capital, labor, and R&D), the defense industry, industrial policies, and the regional impacts of defense spending are the subjects of the chapters 1 2- 17. These chapters are devoted to both demand- and supply-side factors. Modem tools of microeconomic analysis are applied by WP. Rogerson (chapter 1 2) to study the incentive aspects of defense procurement and R&D. This chapter stresses principal­ agent analysis and game theory, while also reviewing some empirical evidence. Military manpower issues - recruitment, enlistment, retention, the draft versus the all-volunteer army, and other labor supply and demand concerns - are analyzed by J.T. Warner and B. Asch in chapter 1 3 . Theoretical and empirical issues are presented in their survey, but, in keeping with the literature, the emphasis is on empirical techniques and analysis. This study is followed chapter 1 4 (P. Dunne) on the defense industrial base, including discussions of defense equipment markets, the competitiveness of defense industries, and cost considerations in weapons production. A portion of this chapter is concerned with reviewing the definitions of the defense industrial base and military industrial complex.

1 The Feder-Ram model is a supply-side model based on the analysis in Feder ( 1 983), Ram ( 1 986), and Biswas and Ram ( 1 986).

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Prof. Lichtenberg (chapter 1 5) analyzes a host of issues surrounding the economics of defense R&D, including mechanisms designed to encourage firms to pursue defense R&D, the private and social returns from military R&D, and the ability of defense contractors to shift R&D costs from commercial to defense R&D. Social returns to ·defense R&D are investigated with a production function/productivity growth framework. Chapter 1 6 (K. Hartley) carries the analysis of the defense industry further by reviewing industrial policies used in Europe and the United States. Policy options include the use of international collaboration involving the joint development and production of weapons, the implementation of licensed production and co-production between two or more nations, the encouragement of trade flows in weapons sales among allies, and the reliance on offset agreements for purchasing governments to recover some of the purchase price. Conversion issues are also considered as part of industrial adjustment policies. In chapter 1 7 , Dr. Braddon then investigates the regional impact of the defense industries and sector on employment, output, and growth. This chapter presents alternative theoretical tools (i.e., input-output analysis, regional multiplier techniques) and econometric models for identifying regional impacts. Selected case studies are also reviewed. The final two chapters are devoted to peace science aspects of defense economics. Prof. Anderton (chapter 1 8) surveys the cumulative work on the economics of arms trade and concludes that this subfield is "ripe for foundational contributions" that develop a theoretical underpinning for arms trade analysis. Anderton furthers this goal by presenting some theoretical representations concerning the economic aspects of arms trade. This chapter also examines whether arms sales are peace­ promoting or peace-inhibiting. Furthermore, recent trends in arms trade are indicated. In chapter 19 (J. Fontanel), both the theoretical and empirical economic consequences of disarmament are examined. The influences of disarmament on stability, weapon proliferation, and economic development are also investigated . The chapter concludes by reviewing public policies for conversion. It is our intention that this Handbook will serve as a reference source, a teaching tool, and a stimulant for future research. Certainly, there is no shortage of research opportunities embracing theoretical, empirical, and policy issues. For example, there is a need to monitor the impacts of disarmament at the national, local, and industrial levels and to study conversion to identify the features of successful and failed conversions. Uncertainty means that economists need to focus on the costs and benefits of alternative methods of reconstituting armed forces and national defense industries to meet future emergencies and conflicts (e.g., via reserve forces; dual-use technologies; technology demonstrators). The efficiency with which the military uses its resources remains a vastly under-researched field embracing such issues as budgeting, substitution possibilities, employment contracts, incentives, and performance indicators. Finally, efforts to achieve and maintain a more peaceful world are likely to focus on the United Nations as a peace-making and peace-keeping organization with opportunities for applying economic models of alliances and burden sharing.

Ch. I:

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References Ash, C., B. Udis and R.F. McNown, 1 983, Enlistments in the all-volunteer force: A military persounel supply model and its forecasts, American Economic Review 73, 144-155. Benoit, E., 1 973, Defense and economic growth in developing countries (D.C. Heath, Boston, MA). Biswas, B., and R. Ram, 1 986, Military expenditures and economic growth in less developed countries: An augmented model and further evidence, Economic Development and Cultural Change 34, 3 6 1 -372. Brito, D.L., 1 972, A dynamic model of an armament race, International Economic Review 13, 359-375. Cummins, J.M., 1 977, Incentives contracting for national defense: A problem of optimal risk sharing, Bell Journal of Economics 8, 1 68-1 85. Deger, S., 1 993, World military expenditure, in: World armaments and disarmament: Stockholm International Peace Research Institute (SIPRI) yearbook 1 993 (SIPRI, Stockholm) 337-397. Feder, G., 1 983, On exports and economic growth, Journal of Development Economics 12, 59-73. Hartley, K., et a!., 1 993, Economic aspects of disarmament: Disarmament as an investment process (United Nations, New York). Hitch, C.J., and R.N. McKean, 1 960, The economics of defense in the nuclear age (Harvard University Press, Cambridge, MA). Intriligator, M.D., 1 975, Strategic considerations in the Richardson model of arms races, Journal of Political Economy 83, 339-353. Laffont, J.-J., and J. Tirole, 1 993, A theory of incentives in procurement and regulation (MIT Press, Cambridge, MA). Linden, M., 1 991 , The dynamics and the instability of the Middle East military expenditures in years 1 955-1 984, Defence Economics 2, 1 99-208. Macnair, E.S., J.C. Murdoch, C.-R. Pi and T. Sandler, 1 995, Growth and defense: Pooled estimates for the NATO alliance, 1 95 1- 1 988, Southern Economic Journal 61, 846-860. McAfee, R.P., and J. McMillan, 1 986, Incentives in government contracting (University of Toronto Press, Toronto). McGuire, M.C., 1 977, A quantitative study of the strategic arms race in the missile age, Review of Economics and Statistics 59, 328-339. Olson, M., and R. Zeckhauser, 1 966, An economic theory of alliances, Review of Economics and Statistics 48, 266-279. Peck, M.J., and F.M. Scherer, 1 962, The weapons acquisition process (Harvard University Press, Cambridge, MA). Ram, R., 1 986, Government size and economic growth: A new framework and some evidence from cross-section and time-series data, American Economic Review 76, 1 91 -203. Richardson, L.F., 1 960, Arms and insecurity: A mathematical study of the causes and origins of war (Homewood, Pittsburgh, PA). Sandler, T., 1 993, The economic theory of alliances: A survey, Journal of Conflict Resolution 37, 446-483. Schelling, T.C., 1 960, The strategy of conflict (Harvard University Press, Cambridge, MA). Scherer, F.M., 1 964, The weapons acquisition process: Economic incentives (Harvard University Press, Cambridge, MA). Tirole, J., 1 986, Procurement and renegotiation, Journal of Political Economy 94, 235-259.

Chapter 2 DEFENSE ECONOMICS A ND INTERNATIONAL SECURITY MARTIN C. McGUIRE*

University of California, Irvine

Contents

Abstract Keywords I. Introduction

1 . 1 . What is defense economics? 1 .2. Some examples where economics has made central contributions to security studies 1 .2. 1 . Defense strategy and resource allocations 1 .2.2. Analysis of deterrence 1 .2.3. Economic models of alliances 1 .2.4. National power, economic survival, and international trade 1 .2.5. Arms races and strategic interactions 1 .2.6. Economic ecology and international conflict

2. Interactions between economics and defense 2 . 1 . Levels of interaction 2.2. Historical evolution

3. Themes in the history o f Defense Economics 3 . 1 . World War II 3.2. Early Cold War 3.3. Later Cold War 3.3 . 1 . Alliances, burden sharing, and erosion of US hegemony 3.3.2. Long run sustainability of defense and relative decline of the US 3.3.3. Economic warfare/defense: a game of economic ruin 3.3.4. Economic equity and defense: military manpower and conscription 3.3.5. Defense industry analysis, acquisition and contracting 3.4. Post Cold War 3.4. 1 . The emergence of positive theories of defense 3.4.2. New directions in the normative analysis of defense

4. Agenda for Defense Economics 4 . 1 . Continuing/inherited policy concerns 4.2. Normative issues arising from world economic change and the collapse of Communism

*

The author thanks the Heinz Chair Endowment for research support.

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T Sandler © 1995 Elsevier Science B. V. All rights reserved

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M.C. McGuire 4.2. 1 . Economics of transition 4.2.2. New definition of nationaVintemational security 4.2.3. New economic instruments for security 4.2.4. New concepts of alli ances and replacement for bi-polar world hegemony 4.3. Positive analysis of international power equilibria

5. Concluding remark References

34 35 35 36 36 39 39

Abstract

Defense economics derives from and is embedded in the multi-dimensional array of issues each country must address when providing for its national security. Applying economic concepts and methods, it attempts to evaluate this great diversity of security related questions, and to understand how each country's security interacts and fits in with the security of all nations in the international system. Included in Defense Economics are such overarching questions as: definition of what security actually is; how resource scarcity, distribution, and stage of economic development influences the security obtainable by each nation in the international system; relationships between defense sectors and national economies within and across countries; efficiency in provision of security; incentive structures which promote or resolve conflict; institutional arrangements which promote or retard peace, stability, and equity.

Keywords

alliances, arms races, arms trade, conflict resolution, defense budgets, deterrence, disarmament, economic development, economic warfare, foreign aid, international conflict, national security, military strategy, nuclear proliferation, peace, war

Ch. 2: Defense Economics and International Security

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"National Security, from the point o f view of an economist, may be said to depend on three things: ( 1 ) the quantity of national resources available, now and in the future; (2) the proportion of these resources allocated to national security purposes; and (3 ) the efficiency with which the [Hitch and McKean (1960, p. 4)]. resources so allocated are used."

1 . Introduction

1.1. 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. A partial list of these would include the items in Table 1. Table l Themes in economics of defense and international security Deterrence, war avoi dance, war initiation and termination Strategic interactions, arms races, arms control Alliance formation, resource allocation, and behavior Defense macro-economy interactions during war, peace, disarmament, and conversion Command vs market economies as resources for defense Mobilization, war recovery, and reconstitution of forces Optimization and efficiency in force level and composition Capital-labor utilization: manpower, conscription, and volunteerism Military readiness, strategic materials, and defense industry policy Procurement, acquisition, and defense contract analysis Trade dependence, export control, trade sanctions, and economic warfare Foreign aid, developing economies, and defense in the third world International management of nuclear materials, non-proliferation Extragovernmental threats, terrorism, drugs, refugees, ethnic and religious fanaticisms

Although lengthy, this list provides little clue as to the structure or evolution of "Defense Economics". Some readers approaching this volume might have thought the term meant the study of how to provide and manage military forces efficiently, but it clearly reaches far beyond that important subj ect. Others, while admitting a larger set of topics, may see them as a disjointed set of issues somehow relating to the military

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M. C. McGuire

affairs of a country which happen to have proven of interest to economists. Still other readers may construe the "Defense" in "Defense Economics" exclusively as defense of the West. But that perspective has been overtaken by world events and can no longer be sustained. For purposes of this essay "Defense" must include the many diverse protective and aggressive activities undertaken by nations and their governments to define, advance, and preserve their interests among the tribe of nations. So economics of defense must include the effects of resource scarcity both as placing limits upon such aggressive or protective activities, and as giving rise to them at the same time. Moreover, because nations function within an international system of other states, and numerous other non-governmental actors, the economics of defense must incorporate interactions among the various nation-states all seeking security in the larger regional and international economies of which they form a part. In short, Defense Economics must recognize the impact defense activities impose upon the larger international economy, and the effect of that economy-system upon defense. This is a demanding program, the more so given that problems of defense/security have mutated continuously over recent generations to a degree that in 1995 the meaning of national, international, or global security seems elusive, and the question "defense of whom from whom and what?" more germane. Clearly to produce some integrated idea of what Defense Economics is, requires more than a simple enumeration of topics. 1

1.2. Some examples where economics has made central contributions to security studies For some of the topics in Table 1, economists have provided the central clues which have defined the problem. In other instances the security problem has served as a paradigm context for application of previously known principles. And in still other cases consistent application of economic principles has produced unexpected insight. As examples, I list six cases below, in which economic insights have been crucial in understanding a security or defense phenomenon.

1 For each of these topics the economic way of thinking has proven highly useful and has engaged economists over prolonged periods. Nevertheless, as pointed out by Intriligator ( 1 990) "Defense Economics" or "Economics of International Security" has been slow to develop into a recognized field supported by graduate and undergraduate course curricula, research departments, and specialty research journals. Why this is so may be due to the fact that economists must share the study of Defense Economics with other fields, and may not have a decisive voice in policy determination. Because the rapidly evolving technology is crucial to a country's defense effectiveness, and because political, social, and psychological factors can be so central in defense studies, economists necessarily only contribute a fraction to ongoing policy and academic debates. Another reason may have been a normative quality which has informed defense studies producing political and ideological distinctions among economists. But this normative aspect has diminished rather steadily with the passage of the decades.

Ch. 2:

].2.1.

17

Defense Economics and International Security

Defense strategy and resource allocations

Application of widely accepted notions of efficiency in resource allocation to problems of national security is perhaps the most widely held and minimalist definition of Defense Economics. The concept of government as a producer of quantifiable (if difficult to measure) outputs which use scarce inputs available at various prices, at one time revolutionary, has become commonplace. The idea of quantifying benefits, valuing resource inputs, incorporating intangibles, and therefore determining cost efficient defenses grew out of earlier operations research efforts - for example in submarine search programs, or bomber target selection criteria [US Strategic Bombing Survey ( 1 945-46), Hitch ( 1 958)]. Subsequently, with the rise of systems analysis in defense, economists would come to argue that "strategy, technology, and economy are not three independent "considerations" . . . but interdependent elements of the same problem. Strategies are ways of using budgets or resources to achieve military objectives. Technology defines the possible strategies . . . The economic problem is to choose that strategy which is most efficient . . . or economical." [Hitch and McKean ( 1 960, p. 3)] Similarly, economics identified the public good nature of defense and, therefore, the requirement for a collective logic of efficient overall provision, which demands that the sum of marginal benefits equal marginal costs at the true optimal amount of defense. Thus defining "MB" as the marginal benefit of defense and "MC" as the marginal cost the formula I: MB MC - in principle - solves the elusive problem of commensurability between dollars and security

=

1.2.2.

2.

Analysis of deterrence

Another important application of the economic way of thinking to defense arose in developing an understanding of deterrence. Two economists stand out for first uncovering how deterrence is a matter of incentives parties impose upon each other by conditioning each others' expectations. These were Schelling and Ellsberg. "Deterrence", as Schelling ( 1960) explained ". . . is concerned with influencing the choices that another party will make . . . by influencing his expectations of how we will behave. It involves confronting him with evidence for believing that our behavior will be determined by his behavior". Before the explosion of game theory into economics at all levels, economists introduced the crucial importance of credibility of a deterrent threat as captured in forward looking anticipation of future incentives 3 and measured by a critical risk [Ellsberg ( 1956)]. To deter an opponent both effectiveness of retaliation and credibility that it will be employed are necessary. The idea of critical 2 The summation is taken over all individuals within "our" group whether they benefit from defense or not, but excludes those outside "our" group who disbenefit, such as the enemy. 3 This work anticipated the forward looking backward induction repeated move equilibria now so commonplace in game theoretic concepts of equilibrium.

18

M. C. McGuire

=

risk can be illustrated using v;n n to denote the utility of country i, under situation m,n. If both countries i and j refrain from attack then m NA, n NA. But if i attacks (m = A) then } may retaliate (n = R) with probability p, or not retaliate (n=NR) with =

probability ( 1- p ). Country j's obj ective should be to make the risk p to i that it, }, will retaliate so great that:

V�A,NA > pV�,R + ( 1 - p) V�,NR·

(1)

Ellsberg's required critical risk then i s a value of p that insures that an expected value maximizing country, i, will prefer to refrain from attack. Further analyses of such deterrence incentive structures incorporated asymmetry of information, manipulations of payoffs (and thus meta-games), control of agenda, promises, threats, commitments, and the advantages or disadvantages of a last move into deterrence analysis. The implications of this theory for crisis behavior (e.g. city evacuation in nuclear crisis), and nuclear force design/operation were developed in a literature on efficacy of secure, survivable but expensive weapons, versus cheap vulnerable ones [Kent and Thaler ( 1 989)].

1.2.3. Economic models of alliances A third example in which economics effectively defined a crucial defense problem is the economic theory of alliances. Here Olson and Zeckhauser ( 1966) perceived that the defense provisions of each member of an alliance was really a voluntary contribution to the public consumption good of the group. The implications of this idea swiftly followed; that an alliance will provide its members with an inefficient, suboptimal level of defense. The reason for the inefficiency is that in equilibrium under voluntary provision of a public good 2:: ME > MC; here ME and MC are as defined above and the summation is taken over the alliance group members. Also, it is inferred that larger (richer) members have a tendency to provide disproportionately large shares (necessarily so if preferences and the costs of public good supply are identical among members). An explosion of the literature ensued applying the voluntary public good provision model to military alliances and other international groupings [Sandler and Cauley ( 1975)].

1.2.4. National power, economic survival, and international trade A fourth example of interaction between economics and security originates with the observation that protection of domestic industries against import competition may be justified when a country is subject to a risk of trade interruption. In earlier days of the Cold War such realization produced arguments for strategic material stockpiling, standby production capabilities, and "warm" production base maintenance whether to enhance survival from nuclear attack [Winter ( 1 963)] or preserve a war mobilization [Lincoln ( 1 954)] and fighting capability in less extreme conditions.

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This has been elaborated in more formal insurance models i n recent years by economists concerned with the trade and supply interruption (e.g. oil embargo, or critical material supply disruption) [Mayer ( 1 977), Tolley and Wilman ( 1 978), Srinivasan ( 1 987), McGuire ( 1 990a)] . To understand the general logic of this argument, consider a small country which exports good x, and imports y, at given world prices of Px in terms ofy. When trade is disrupted, this country can and must consume only what it produces; in ordinary times it can export/import. Suppose that the country must choose a single production program both for "war" and "peace" because resources cannot be shifted across industries during war. The chance of "war" or trade disruption is given as Jr. Then for n = 0, the country should choose a program such that its marginal rate of transformation, "MRT", between x andy equals its marginal rate of substitution, "MRS", and both equal PxiPy· If n = 1 then disruption is certain and the country should select (x,y) such that MRS = MRT at autarky along the transformation curve. But if 0 < n < 1 then there is a definite risk of trade disruption, and domestic production should be subsidized but not so much as to support the autarkic maximum. Here the object of an enemy attack and of self defense (or deterrence) may be the economy itself. Recognition that efficacious defense (defined as that which improves the chance of peace at some cost in resources) and trade may be connected, has led to more general explorations of theoretical and empirical relationships between the two [Polachek ( 1 980), McGuire and Shibata ( 1 988), Ihori (1994)], including the prospect that trade dependence may actually increase the risks that trade will be disrupted. 1.2.5.

Arms races and strategic interactions

Another example of the utilization of economics in defense and security studies was the elaboration of L.F. Richardson's ( 1 960) ecological models of arms races a massive literature which includes several important insights from economics. For example it has been shown that the mechanistic reaction curves he derived from postulated differential equation processes among states, could also be derived from economic optimizing behavior of nations, confronted with a missile duel technology [Boulding ( 1 962), McGuire ( 1 965), Brito ( 1 972), Intriligator ( 1 975)]. Thus the broad range of allocations processes, solution concepts and techniques inherent in Coumot, Stackelberg, and other modem models of market organization became available to analyze the strategic interactions among countries, to suggest equilibrium outcomes, and to measure progress toward arms limiting equilibria [Shubik ( 1 987), Fontanel ( 1 994)]. This has generated an extensive empirical literature estimating actual arms interactions between the USA and the Soviet Union [McGuire ( 1977)], between NATO and the Warsaw Pact [Murdoch and Sandler (1 982)], between the Soviet Union and Japan plus the USA [Okamura ( 1 99 1 )], and with respect to regional arms races such as between Israel and its Arab neighbors [McGuire ( 1 982)]. Secondly it has been shown that arms race incentives and processes may be logically linked to a country's motives to begin, conduct, and terminate war; and these in tum derived from the tensions between aggression and deterrence and the payoffs a country

M. C. McGuire

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perceives from such behavior [Brito and lntri1igator ( 1985), Wittman ( 1 99 1 )] . Such models linking arms accumulation processes, with incentives to use armaments also found application in the strategic debates surrounding missile defense and "star wars" programs [Kent ( 1 964), Bailey ( 1 973), McGuire ( 1 987a, 1 992), Schelling (1 967)]. 1.2.6.

Economic ecology and international conflict

Boulding ( 1 962) was among the first to perceive that the population dynamics and survival/extinction mechanisms modeled by earlier ecologists could be applied to international struggle conceived as the result of economic conflicts. Thus Boulding adapted models of price wars and spatial competition to explain equilibrium in the frontier configurations among States or absorption of one nation by another. The notion that the configuration of nation states and national borders was an equilibrium has also been propounded by Thompson ( 1 974) and by Friedman ( 1 977). Insightful extensions to these approaches have been suggested by Hirshleifer ( 1 987, 1 99 1 ) in work which draws on elements from the economics of property rights, and of theft and rent-seeking to build economic-ecologic models of resource allocation between production and war/theft in systems of nations - the economics of "ongoing conflict". As the Cold War terminated, borders dissolved, and ethnic conflicts escalated, the practical significance of this work has increased apace.

2. Interactions between economics and defense

Does this small drawing of examples suggest any structure of interdependence between economics and defense or security beyond naive enumeration? Here one might pursue two approaches, a strictly conceptual or taxonomic, and a historical approach. 2.1.

Levels of interaction

Economics figures in the security nexus at least at these four levels of interdepen­ dence: (i) Economic management for effectiveness and efficiency in defense, including orchestration of policies deriving from all military and economic policy tools available to the modern State. (ii) The national economy as a source of resource support for security, and a target through which to weaken or to punish enemies. Military capability is only one of many defense instruments supported by economic strength. Other instruments include trade policies, aid programs, financial leverage, debt posture, immigration regulation and leverage, and other economic policy tools of all sorts. (iii) Macro-effects of defense on national economies and interactions among national economies within the international system, including the incidence of defense on economic growth, stability, and prosperity.

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(iv) Economics as an explanation or a source of the security problems of nations: Are the security threats which diverse nations or regions pose for one another based on economic factors? More specifically, are such threats ultimately based on quarrels over property and wealth, and how to acquire or produce it? Historically, American interests certainly included such factors as safety of US citizens and property at home or abroad, discrimination against US exports or financial interests, control over colonies and possessions, together with a generally stable world order, which fostered liberty and free commerce. This level of interdependence between economics and security is premised on the notion that, at bottom, international security concerns the economic incentives nations face to acquire wealth. Preferences, technology, and wealth distribution may be such as to make conquest, colonization, and property seizure most cost effective, or instead may encourage production, savings, investment, and trade. A systemic equilibrium configuration of nations would balance these various forces. 2.2.

Historical evolution

Just as a taxonomic or conceptual approach may impose order on the diversity of topics included in "economics of security" a historical approach can help to identify topics temporarily eclipsed, trends or cycles. More particularly, a historical account will reveal how the focus of Defense Economics has shifted in recent years toward the last two of the foregoing categories. Table 2 (overleaf) presents a summary of the more prominent elements of each of the above categories as they evolved over time. For purposes of exposition recent history is divided into four time periods. The table describes how the economics/security nexus over these periods of time has shifted among categories, and gives selected important issues in the economics of defense at the various periods.

3. Themes in the history of Defense Economics 3.1.

World War II

Defense Economics as a modern study evolved from highly practical problems of assembling and utilizing the human and material resources in the Second World War, that is out of war production, logistics management [Lincoln ( 1 954)] and operations (or operational) research. Having derived from a policy need, Defense Economics, during this period, was primarily normative. The main macro-economic themes of war production, and material management, asked basically how to manage a command economy with tolerable inflation, how most efficiently to cripple an enemy's economy and whether this could be accomplished by military force [see US Strategic Bombing Survey ( 1 945-46)], or whether "economic warfare" could effectively disable an

M.C. McGuire

22 Table 2 Historical evolution of defense economics Economically efficient defense management

The economy as a resource base for defense

Historical period: World War

Effects of defense on nat'! economies and the int'l system

Economics as an explanation of the need for defense

Examples of defining issues

II and Korea 1942-1953

Logistics management

Economy as a support for military strength

Inflation, debt, and war finance

Control of world's resources

Effectiveness of strategic bombing

Operations research

War mobilization and production

Post-war reconstruction

Territorial integrity

Strategic materials and stockpiling

Disarmament and deflation

World order

Marshall Plan

Manpower management Historical period: early Cold War

1953-1970

Cost effectiveness analysis and program budgeting

The economy an instrument of national security

Sustainability of defense

Containment

Recovery from nuclear attack

Strategic interactions, arms race analysis

Trade, aid, development and defense

Effect of defense on investment, growth, stability

Control of world resources

Military/economic aid, alliances, trade control

Military manpower, R&D, weapon procurement

Economic isolation of Eastern Bloc

East vs. West growth

World order, nuclear survival, domino theory

Missile build-up, arms control

Historical period: later Cold War

1971-1990

Burden shares, cost incentives, and alliance efficiency

Economic sanctions and warfare: unfriendly economies as targets

Defense a source of competitive decline

Preserve int'l boundaries

Missile defense

Force readiness and defense industry policy

Economic punishment of East Bloc countries

Defense as a cause of under­ development

Protect Western economies

Int'l arms trade; non-proliferation terrorism

Defense acquisition and contracting management

Long run competition with USSR

Defense a game of economic ruin

World order, nuclear survival

Missile build-down

continued on next page

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23

Defense Economics and International Security

Table 2, continued Economically efficient defense management

The economy as a resource base for defense

Historical period: post Cold War

Effects of defense on nat'! economies and the int'l system

Economics as an explanation of the need for defense

Examples of defining issues

1990-

Defense conversion and downsizing

Investment and trade becomes a substitute for war/conquest

Resource allocation in conflict: trade versus conquest

Security a world wide public good

International trade in nuclear materials

Disarmament

Incentives for nations to enrich themselves peacefully

Defense, Form of governance, and economic performance

Equilibrium distribution of property

Role of NGO's in int'l security

Management of non-traditional peacekeeping missions

Management of violent means of property determination

Endogenous alliance formation

Configurations of nation states in int'l system

Manage boundary revisions, contain local conflicts; migrations, human rights, refugees

opponent's economic capacity to wage war [Knorr (1956)] and finally how to convert to peace-economy without deflation. 3.2.

Early Cold War

As the national security problem of the US deepened into the Cold War, the policy requirement mutated from how to win a hot war into how to prevail in a protracted conflict In this environment economics of defense developed along several paths. At the micro-level, operations research led to the development of cost-effectiveness and cost-benefit analysis. The subtleties and paradoxes of deterrence attracted the attention of economists. And increasingly, other policy tools in addition to the military became recognized as instruments to advance national security. Thus, the concept that governments - through effective use of the economy as a policy implement in addition to the military - could induce or sustain a variety of strategic objectives was early established as a doctrine of national security [Knorr ( 1 956), Hirschman ( 1 945)]. The idea that the economy itself is an instrument of defense policy, while economic principles would govern effective organization and application of such instruments, was elaborated during this era. Among the economic instruments for rewarding friends and penalizing enemies for strategic policy purposes one must include: ( 1 ) trade policy in its broadest terms - including strategic export control, boycotts, concessionary terms of trade, quota allocations, economic sanctions [Wan ( 1 961)] ; (2) foreign economic, technical, agricultural and military assistance; (3) foreign intelligence, information,

M. C. McGuire

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propaganda, and cultural outreach. These all came to be instruments directed toward a common goal of US national security, and orchestrated by principles of economic effectiveness and efficiency. The early stages of this period being characterized by an optimism over survival from nuclear attack were marked by numerous economic studies of how to manage after an exchange [Winter ( 1 963)]. Simultaneously, realism over the irreversible growth in weapons inventories and staggering costs of defense prompted intense study of the macro-economic consequences of the Cold War itself [Klein and Mori ( 1 973), Weidenbaum ( 1 974, 1 992), Leontieff and Hoffenberg ( 1 96 1)], and particular focus on the capacities of socialist versus free enterprise capitalist economies to sustain a 39% deflection of GNP into defense indefinitely. Although we now know that the real Socialist System was unable to sustain these costs over more than a generation, the record was by no means obvious in the 1 950's and 60's. Nor are the ultimate costs to the United States obvious - costs which continue to fall due into the present. The central theme of Defense Economics in this period - as in the preceding period - was normative. Nevertheless, with a widening perception of the uses of the economy as an instrument of security, interest in its positive role in the international security system grew apace. The roots of positive economic analysis of defense arise from early ecological modeling of warlike behavior of nations. The game theoretic structure implicit in Richardson models was exploited to yield positive explanation of international conflict as an economic process. Such economists as Schelling ( 1 960), and Boulding ( 1 962) applied these tools to generalized models of international conflict 4. Boulding, for instance, recognized that the sources of conflict, might be based solely on preferences - ethnic or national hatreds, inherited perhaps - or might have their basis in quarrels over ownership or use of property, or markets, resources or other items of economic value. In doing so he anticipated current concerns by a generation. On a less sweeping general level it was recognized that arms accumulations by competing countries might follow a pattern of economic interaction similar to oligopoly and that oligopoly models, therefore, could apply to competitions between attack and defense technologies [Kent ( 1 964), McGuire ( 1967)], and in understanding how deterrence models and arms race models fit together to generate a lesser or greater risk of war itself. 3. 3.

Later Cold War

As the Cold War matured, the range of issues to which economists would address themselves in the name of security continued to increase. Several of these merit

4

Boulding recognized that the basis for conflict, might be based solely on preferences - ethnic or national hatreds, inherited perhaps, or might have their basis in quarrels over ownership or use of property, or markets, resources or other items of economic value; in doing so he anticipated current concerns by a generation.

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special attention. Although the subjects to follow by no means exhaust the inventory of relevant topics they represent a fair sampling.

3.3. 1 .

Alliances, burden sharing, and erosion of US hegemony

The study of group formation and behavior in defensive alliances drew special attention with the wider appreciation of game theory throughout economics. The agenda setting study of Olson and Zeckhauser ( 1 966) had predicted proportional disparities in the distribution of individual country contributions in favor of the poorer countries in an alliance. With impressive results, this model has been elaborated by many, has been subjected to wide test, and has been extended to the analysis of the voluntary provision of a variety of international public goods (such as foreign aid). Special attention also has been given to the effects of impurity of public goods, or of alliance goods with both a public and a private Goint supply) dimension [Sandler ( 1977), McGuire ( 1 990b)] extending to less formal alliances than NATO or the Warsaw Pact [Dudley (1 979)] and to merging the public consumption good model of alliances with international trade concepts of trading blocks, customs unions, and free trade areas [Wong ( 1 99 1)]. As in the study of arms races, a large policy and empirical literature grew up to estimate the structure of alliance allocative interactions. This literature estimates the effects of impurity of public goods but also attempts to identify alternative allocation processes - whether driven by Nash-Cournot behavior of individual countries or other more cooperative protocols [Denoon ( 1 985), McGuire and Groth (1 985), Murdoch and Sandler ( 1 982, 1984), Murdoch, Sandler and Hansen ( 1 9 9 1 ), Sandler and Murdoch ( 1 990)] . Extensions of the basic model to include impure public goods models of alliance defense provision have been particularly suggestive. "Impurity" may take several forms. One of these is congestion wherein the average cost of providing a unit of public good varies with the size of membership of the alliance and possibly also with the quantity or quality of public defense provided to the group. For example operational coordination requirements or equipment, training, or communication compatibility requirements may increase simply with membership size. In this case, when defense may lie on a spectrum between "public" and "private", one task of empirical economics is to identity its location on that spectrum. Another example of imperfection or impurity of public good may arise when resources allocated to the public good also create a joint private good. Any individual country's contribution to defense against a common threat may simultaneously generate strictly "private" or exclusive benefits for the country making the contribution. Thus forces contributed for defense may serve for internal security needs as well. Still another form of imperfection in the defense public good may arise because the spillovers created by different countries' contributions may not be perfect substitutes for each other. For example, operationally equivalent German and American air wings might not be weighted identically in the defense objective

26

M. C. McGuire

function of the British Defence Ministry. In the conventional pure public good case we would write the utility function of any single country, i, as follows: (2) where wi denotes country i's income or wealth, g i denotes its contribution to common defense with unit cost assumed to be constant at $ 1 , and L gi denotes the aggregate provision of defense by all alliance members. Now to incorporate impurity of public good one might write (3) where the congestion effect is introduced as p(n) with "p" being the price or average cost of g, and "n" the number of alliance members; the joint product effect is included as f i (gi), and the differential spillover effect is represented by the parameters Y} to indicate the coefficient i attaches to public good provision by j. Most recent empirical estimates of the original formulation as well as of more complex versions thereof, include Conybeare, Murdoch and Sandler ( 1 994) and references therein. Further comparative static analyses of the properties of equilibrium in the voluntary provision model have produced insights of direct relevance to Defense-Economic issues: most particularly the neutrality of income redistribution among alliance members suggests that an alliance's aggregate expenditure may be independent of the distribution of wealth among its members - thus directly challenging the meaning of "exploitation of the great by the small". Extensions of this theme analyzing the effects of average cost differentials among alliance partners have demonstrated that an alliance partner with higher average costs of contributing will benefit in Nash­ Cournot equilibrium from displacing supply onto other members of the alliance. The implication that individual countries may gain from being inefficient, high cost providers of defense in an alliance, has caused these effects to be termed "adverse cost control incentives" [Jack ( 1 991)]. 3.3.2.

Long run sustainability of defense and relative decline of the US

Parallel to these academic developments, as the Cold War ground on and Japan and Germany prospered, Defense Economic policy became increasingly concerned about how alliances divide the costs of common defense - the issue of burden sharing and how division of burdens were affected by work force skill/education levels, wage rates, productivity levels, technological sophistication, levels of research and development and other measures of a nation's competitive success. Underlying such concern was awareness that defense shares of Japan and NATO had dramatically lagged

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their economic growth. To what extent was the decline in American competitiveness due to a generation of resource focus on defense? The theoretical possibility that defense deflects technological advance, capital investment, and creative human capital with highest skills for technical innovation away from growth had long interested economists [Weidenbaum ( 1 974, 1 992)]. The proposition that defense deflected and retarded growth of Western economies argued forcefully by Smith ( 1 980), while others prophetically pointed to the still more onerous burden of the Soviet "Empire" [Rowen and Wolf ( 1 990)]. Similarly, development economists were concerned with analyses of Benoit ( 1 978) and such critics as Deger and Smith ( 1 983), Deger ( 1986), or Faini, Annez and Taylor ( 1 984), arguing whether defense efforts retarded development by reducing/deflecting growth inducing investment and skimming off technology and trained manpower to the same effect, or instead stimulated growth via manpower skill acquisition benefits of military experience. During these later stages of the Cold War the reality of US relative decline and loss of competitiveness led to fears of an ultimate eclipse of US geopolitical predominance. Academic analyses bearing on strategic overreach [Olson (1982)] combined with growing realizations of the economic constraint on strategy [Denoon ( 1 985)] led to corresponding defense policy concerns over how a country with declining real wages, having lost its technical preeminence, could over a very long period - possibly a generation - sustain big defense to protect high tech, high wage allies. Had America's comparative advantage in defense turned merely to provision of "cheap" labor? This issue remains of crucial interest to defense economics. 3. 3. 3.

Economic warfare/defense: a game of economic ruin

Such concerns of this late Cold War period about the very long term consequences of high defense regimes were reflected in several analyses such as Wolfson and Farrell (1987), exploring the concept that the East-West struggle had evolved into a game of economic punishment and endurance leading (whether intended or not) to eventual economic ruin. Thus the military instrument itself was analyzed essentially as a method of economic warfare. The mechanism of economic punishment proposed was that self-protection from a military threat forced countries to divert resources from technological advance and investment with inevitable long run destruction of their ability to compete, of their consumption standards, military effectiveness, and finally even the sustainability of regimes. The idea that imposition of economic costs on an adversary might be militarily effective had been the object of economic analysis before. For example, Schelling (1 967) had explored how raising the cost to an adversary of achieving his objectives may be of benefit even when we are indifferent about those objectives per se. If the enemy's demand elasticity structure is such that he will reduce effort directed against an objective we value, then such "a strategy of inflicting cost" can be efficacious. Moreover the idea that one country might use its economy and financial system as instruments of economic war had a significant history from the inter-war period, which

M. C. McGuire

28

in turn had formed a foundation for economic theories of trade and of financial warfare. Wan ( 1 96 1 ), using international trade modelling, had developed a subtle and comprehensive analysis of how export/import tariffs-subsidies, as well as State intervention via dumping, boycotts, and embargoes can be used to benefit or harm a "target" nation's economy. This and a small parallel literature on use of financial instruments to harm a target country, form conceptual foundations for a theory of economic sanctions which has received little notice, possibly because repeated analyses of sanctions themselves [Hufbauer and Schott ( 1 985)] has shown them to be frequently ineffective. Arguably, use of the economy as an instrument to drive an adversary to ruin was deliberately and concretely applied in the Reagan Administration with the consequence that the Cold War is now history. History has yet to show however whether strategic competition was a game of ruin for both protagonists. 3. 3.4.

Economic equity and defense: military manpower and conscription

Armies are labor intensive. How to obtain manpower to staff them has been a permanent question throughout history, and economists have been concerned with manpower procurement before World War II. Prominent Cold War studies of efficient and equitable methods for acquiring manpower particularly include Oi ( 1 967) and A. Fisher ( 1 969). Primary issues of concern have included the (a) effects of military manpower acquisition upon the economy, (b) budgetary versus true economic costs of conscription, (c) distributive consequences of conscription and (d) retirement versus retention incentive systems for volunteers. An aftermath of the Vietnam War was to raise acutely the question of equity of conscription. Economics contributed significantly to this issue with the insight that conscription really is the economic equivalent of a special tax upon the draftee. Viewed in these terms, the equity argument against conscription becomes the more convincing, though still to be balanced against arguments that all citizens ought to share equally in risks associated with military service, or that stratification of armed forces by economic or social class is undemocratic and undesirable. In this context, economics made important contributions to the US defense establishment's conversion to volunteer armed forces in the 1 970's, and management of military manpower continues to be an important economic issue [see Olvey, Golden and Kelly ( 1 984)]. 3. 3. 5.

Defense industry analysis, acquisition and contracting

Next to manpower costs, resources required to arm military forces are second. Fifty years of defense procurement (averaging 1 % to 2% of US G.D.P. and directed by policy makers from the top of officialdom) has unsurprisingly created a thriving field for analysis with strong connections to industrial organization. Since early work of Peck and Scherer ( 1 962) and Williamson ( 1 967), this field has focussed on contract incentives, principal agent issues, budgetary and decentralization structures, and research development productivities. Studies in this field, both positive and normative,

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29

illuminate a variety of issues as to how governments can procure required equipment at satisfactory costs to the society, tolerable profits to the private suppliers, and sufficient incentives to producers. These early efforts have evolved in the context of more general developments in industrial organization emphasizing information asymmetries between the government principal and the contracting firm/agent, the game-theoretic structure of interactions among agencies and firms; and these in tum have led to emphasis on auction and bidding mechanisms, single versus multi-source contract design, and the multi-dimensional nature of government's objective function [see Rogerson (Ch. 12)]. Behind such technical implementation problems lay complex issues of the national need for a self-sufficient defense production base, trade-offs between stockpiling and "warm" production base maintenance, and dependability of foreign suppliers in time of emergency or war. Are governments actually better at forecasting risks of emergency or conflict than are private producers? If the private sector can anticipate probabilistic demands which would arise in time of emergency, war, or limited conflict, would the profit motive lead it to make adequate provision for emergencies? Can one depend only on domestic suppliers in this context or might foreign suppliers - whose "excess windfall" profits could not be expropriated - be more likely to maintain needed "excess" capacities? Further up the chain of reasoning one finds considerations of the types of weapon systems required in an evolving framework of international conflict. Economics has assisted in clarifying this question by applying ideas from production theory to defense provision. Thus, studies of efficient capital-labor utilization undergird the force structures of the larger countries, as does analysis of multi-use versus single use weapons, study of reliability versus replaceability, and the host of issues encompassed under the term "logistics". 3.4.

Post Cold War

The recent upheavals in international politics have again altered/extended the range of topics central to Defense Economics. The end of the Cold War and the dissolution of the Soviet Union have produced a profound alteration in the rationale for defense, the objects of defense and, therefore, the means to achieve them - an upheaval which has evoked beginnings of a re-examination of the security question from top to bottom. Possibly of still greater significance, however, the end of the Cold War has seen growth in the positive study of defense as an economic endeavor pursued in the name of survival by countries and/or their rulers. Ultimately, as a superior positive understanding of this phenomenon arises, and of the equilibrium system of nations generated by national behaviors, it will shape both the objectives of each country's defense strivings, and the instruments favored to influence results. 3.4. 1.

Th e emergence of positive theories of defense

Perhaps acceleration in study of this intriguing development in Defense Economics was evoked by the fragmentation of the USSR and East Bloc countries. Once national

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borders and the number of countries into which the Soviet Union would divide became a concrete issue, the economic principles for determining the equilibrium and/or optimum of such configurations would become important. Whatever the practical application, a defining element in the post Cold War study of Defense Economics is a new literature which attempts to characterize the configuration of national boundaries as explicable in economic terms, and the result of economic forces. One source for a positive theory returns again to Lanchester ( 1 956)/Richardson ( 1 960) models of ecological struggle and survival as adopted to international behavior. But those more or less mechanistic analyses of international conflict and defense lack micro-foundations for a country's or its ruler's rationale for allocating resources to defense; therefore, they do not exploit the strength of economics in building from individual, self serving, maximizing behavior to systems evolution. The post World War II origins of this literature in positive economics derive foremost from earlier foundations of the economics of property rights and rent seeking, most notably that of Tullock ( 1 974) and followers. If property ownership is prior to production of economic benefit, then property is at risk of expropriation and may be worth protecting from theft. In short, property must be defended in anarchic systems, and defense requires allocations of resources. Thus, the economic concept now emerging as a positive explanation for conflict and security is that ultimately the organization of the world into nation-states is the result of struggle and eventual balance between resources allocated to offense - that is to property right capture, conquest, and control - and resources devoted to defense - that is to protection from, defeat of, or neutralization of the attack. At the margin, mutual neutralization of resource allocations to weapons or systems of conquest and those of defense becomes a necessary characteristic of an equilibrium configuration of nations, each controlling its own territory/property. (Some resource allocations or weapons may serve both offensive and defensive purposes.) At the forefront in analyses of these political economy foundations of the international structure is Hirshleifer in a series of papers [Hirshleifer ( 1 987, 1 99 1 , Ch. 7)]. Inspired by insights from economic ecology and evolutionary game theory, Hirshleifer has postulated economies in which conflict is ongoing, and the opportunity cost of protecting one's production is that one produces less and therefore has less to protect. This work also draws on earlier analyses of Thompson ( 1 974), and Friedman (1 977), as well as Tullock ( 1 974). Of special interest is how defensive and acquisitive resources offset each other when competing for property rights, and how the protocol of play or competition (Cournot behavior, Stackelberg leadership etc.) influence the outcome. Others, including Wittman ( 199 1 ), have begun to model a spatial element in these equilibria, in a fashion related to Boulding's ( 1 962) concept of a country's loss of strength gradient - the postulate that a country's capacity to control others declines with distance from its center of power. 3.4.2. New directions in the normative analysis of defense Ultimately, economics will provide an adequate positive explanation for and shared understanding of how geography, technology, costs, and mechanisms for coalition

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formation, generate opportunities for peaceful enrichment through investment, pro­ duction and trade, as well as opportunities for acquisition through conquest and expropriation. Such insights, one might expect, will profoundly reshape how individual nations define and pursue their individual security. Already the precursors of such an understanding with their implications for the fragmentation of countries following upon the 1 990's revolution in Eastern Europe have considerably extended the role of economics in security studies. Most notably, new definitions of security are now perceived as appropriate, which emphasize economic security as having merged with territorial security of States, which focus on the economic behavior of states and populations as the source of security threats (migration, pollution and other externalities, resource depletions, restraint of trade), and which regard territorial threats as deriving essentially from economic motives and forces. This development shifts the definition of security away from individual protection from unilateral territorial invasion, and toward universal issues of management of collective risks. In this context, the planet-wide security interest in national border determination, including recognition of what constitutes a country, is seen as having greater weight than before, and the necessarily myopic interests of individual groups less weight. If security is essentially, largely, or in part, perceived to be a world wide collective good issue - which represents an enormous change in perspective - a major share of the burden of national security falls on solutions to the free rider problem. Thus, a critical element in post Cold War security involves alliance formation and the implied collaboration and compromise. Although the essentials of security seem to have become globalized, a residue of old fashioned parochial national security endures. Defense against physical conquest, occupation, or the exaction of tribute, will always be a vital national interest for each individual country and a global vital interest where the boundaries at issue are those of the great powers. The growing conundrum of international security concerns how to conceptualize a large range of frequently collective problems to face the increasingly numerous tribe of nations. While admitting that deforestation, or global warming, refugee migrations, or massive human rights transgressions may be critical international collective problems, are they security problems in the sense of inducing a role for armed forces? Similarly for narcotics trade, terrorism, conventional arms, and large scale ethnic or religiously motivated barbarisms [see Sandler ( 1 992)]. Borders may be violated not only by foreign troops, but no less by pollution, drugs, crime, refugee migrations etc., but does this mean that such invasions have become the modern national security "threats"? The new twist in the challenge to economics posed by such military or social threats is to devise incentive structures which can make domestic production, saving, and foreign trade more advantageous to potential transgressors than efforts toward territorial expansion, or exploitation of externalities. 4. Agenda for Defense Economics

As the range of topics treated in this volume testifies, the tasks for "Defense Economics" are indeed challenging. Economics is summoned to illuminate an ever

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larger range of pressing issues concerning conflict among states, between groups not organized into states, between these two classes, and concerning the preservation and evolution of the security among them. These security problems are increasingly seen as economic in their source, outcomes, and solutions. Moreover, the spectacle of policy makers floundering in "ad hockery", should provide ample incentive to economists to tackle the tough issues. How might we organize these to gain some insight ourselves as to the likely future focus of this field of study? There are, I think, three broad avenues along which Defense Economics will evolve in the future. These may interleave one another but be distinguishable nevertheless. (a) First, is a group of inherited, continuing concerns which have long occupied Defense Economics. Some questions from the earlier repertoire may have lapsed ­ such as how to "prevail" in a thermonuclear war. Many other inherited issues, however, continue as important as ever. (b) Second, is a broad range of new policy issues deriving from the economic and political evolution which produced the end of the Cold War, dissolution of the USSR, and collapse of Communism. (c) And third, is a set of conceptual issues, both positive and normative, concerning the economic incentive structures in the international system and their implications for war, security, and peace. I take these areas up in the order mentioned. 4. 1 .

Continuing/inherited policy concerns

With respect to these issues, "a principal task of defence economics . . . is to develop an analytic framework that takes into account the specialized institutions of the defence sector in order to deal with the standard economic problems of choice, efficiency, and growth in a realistic and policy-relevant manner, while remaining firmly rooted in the intellectual traditions of economics in order to exploit advances made in the larger field" [Reppy ( 1 9 9 1 , p. 270)]. These represent extrapolations of the conventional analyses which has evolved to become defense policy. Some of these may be quite straightforward, others requiring highly innovative new analysis. I will mention only a few from the huge existing menu. Arguably most important of the inherited problems of security concerns nuclear issues, particularly the imperative to preserve nuclear deterrence and avoid nuclear weapons use between or among powers with large weapon inventories and delivery systems. This category encompasses questions of proliferation of nuclear weapons, including disposal of retired weapons and effects of increasing membership in a nuclear club. With respect to the latter how does increased membership influence the likelihood of abstinence from use, stability and dynamics of deterrence, and the opportunities for confrontation and compellence [Schelling ( 1 966), Intriligator and Brito ( 1 98 1 , 1 984)]. Management of nuclear downsizing involves important issues in cost effectiveness and the avoidance of destabilizing incentive structures for use of

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such weapons. Safety within the cone of mutual deterrence [Intriligator ( 1 975)] may involve not merely numbers of weapons (or megatonnage) but also specific sequencing of build down [Kent and Thaler ( 1 989)]. The unavoidable, if regrettable, truth that potential thern1onuclear war is a permanent feature of the landscape of international politics insures the lasting importance of economic analysis of such issues. Included especially are the incentives, costs, and resulting (in)stabilities which arise in control of strategic nuclear defense, particularly avoidance of surprise developments in missile defense ([McGuire (1987a, 1 992)] . The fact that the nuclear threat persists in a more amorphous, less direct and structured, less understood strategic environment of multiple interests and overlapping coalitions, makes this problem more treacherous than ever. Aside from nuclear questions, included in the "inherited" or "continuing" category is a large set of parallel ongoing issues concerning management of technological improvements in defense particularly great power conventional forces. The advance of conventional "smart" weapons technology making "surgical" or "sanitized" warfare closer and closer to reality would demand serious re-examination of conditions for use of force, and the wide array of traditional issues as to efficiency in their provision, including defense procurement and contracting, defense industrial policy and preparedness. Among the more intriguing insights to emerge from current ongoing analyses of these questions are the incentives which countries create for themselves by "conservatively" preparing for the worst. As pointed out by Wolfson ( 1 99 1 ) if readiness causes some of the costs of war to be borne before the decision to go to war, then at the time of decision, the true costs of war will in part be "sunk" and thereby diminish incentives to compromise. Is this an instance of myopia and inconsistency in multi­ period planning - so prominent a feature of many other areas of multi-period decision analysis? Or is it a case of success in making a commitment by spending in advance to reduce the incentive to abandon the present promise? Perhaps equally arresting and insightful analogues await further study of the interactions between defense and national economies, defense and development, or other traditional subjects. With outbreak of major war between the superpowers now less an imminent threat, and its avoidance less preoccupying, numerous other "traditional" issues will come into stronger focus. For example, the relationships between defense and development, and the closely related questions of the impact of foreign aid on both. This nexus of problems promises to be of greater concern not only because the lapse of the Cold War has re-ordered our priorities as to which questions most deserve energetic study. The end of the Cold War has also produced changes in behavior which tend to elevate the importance of defense in developing countries. Thus, for example, ethnic violence, once suppressed under the monolith regime of East-West rivalry, has come to the fore. Clearer understanding of the effects of defense on the political economy of nation building may derive from new theoretical endeavors which focus on the relationships between defense spending, the form and durability of government, and its allocative behavior [Palda ( 1 993), Grossman ( 1 992)]. These studies - if synthesized with the burgeoning literature which concerns governmental form and development - promise

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significant new insights into the connections between development and defense. Related to the interconnected political economy of development and defense are recent analyses concerning the effects of foreign aid on the incentive structures of democratic versus autocratic regimes which illuminate unexpected relationships between economic or military assistance and regime durability. This approach could be merged with earlier work on aid, defense and development [Dudley ( 1 979), Smith, Humm and Fontanel ( 1 987), McGuire ( 1 9 87b)] to produce better understanding of the Third World as a new active player in the international security drama - no longer a passive stage for great power rivalry as in the Cold War (terminology due to economist Charles Wolf, Jr.). The spread of and potential for ethnic conflict suggests that the literature on development in conflict ridden contexts [Hendry ( 1962), Dacy ( 1 983)] will find renewed application. And though statistical evidence relating defense, development, and growth is ambiguous to muddled, these problems may yield to careful case study. Another of the traditional areas of Defense Economics to carry forward from the earlier era, and be an object of closer study must be the economics of international arms trade and arms transfer. Exponential growth in this sector would insure closer scrutiny [Levine, Sen and Smith ( 1 994)] . Moreover, the arms trade is of special interest for three trends which it embodies. ( 1 ) The increasing relevance of the decisions of non-governmental bodies and organizations to national/international security. Arms suppliers are often private firms, sometimes multinational corporations themselves. (2) The world's growing dependence on international economic integra­ tion. (3) The augmented arena for external economies/diseconomies as an international free rider issue. 4.2.

Normative issues arising from world economic change and the collapse of Communism

The traditional concerns of Defense Economics - some very few of which have been enumerated above - all must fit in with the exciting if confusing developments following the autumn of 1 989. More than this, the demise of the Cold War has ushered in a new range of normative issues sweeping in their scope with economics at their center. These issues can be usefully organized into several categories. 4. 2. 1.

Economics of transition

The primary security problem generated specifically by the end of the Cold War is that of a successful transition of East Bloc countries toward peaceful and stable growth. Inasmuch as such success is so largely economic, "Defense Economics" has a major input. Here one must include such issues as transition from command to market economies, the management of defense industries in economies under such stressful change, utilization of defense capital, labor, and technologies in economies under transition. Nor, of course, is it solely former Communist states which must manage transitional arms reduction and resource redirection challenges. The economics of

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defense reductions within the US and other NATO countries will continue to attract strong attention from economists [Fontanel ( 1 994), Seiglie (1992)]. 4.2.2.

New definition of national/international security

As the threat to territorial integrity of Great Powers has receded, the issue of what now constitutes security has risen to the fore and particularly whether national security is mostly just economic security plain and simple. Just as lessened threats of territorial war have allowed and encouraged greatly increased interdependence among economies of the world, the ever growing economic linkages make individual countries increasing vulnerable to unanticipated economic crises [Cooper ( 1 9 86)] . Such crises may stem from sudden monetary phenomena, including debt default and liquidity crises, exchange rate or other price catastrophes, or from slowly building decay of competitive institutions. They may originate in natural disasters such as famine, epidemic, overpopulation, or massive human migrations as examples; or from neglect or free riding behavior such as pollution and overexploitation of resources; and they might originate in deliberate economic acts of resource owners, or they might derive from deliberate political acts, possibly unanticipated effects of political realignments. All such interdependencies and their breakdowns will display complex components, such as unexpected institutional failures, technical unknowns, natural physical discontinuities, and/or abrupt divergences in individual human action and collective political behavior. It is not difficult to imagine threats deriving from religious fanaticisms which would combine all these components. Economists will also be alert to the likelihood that the definition of "security" should expand if the costs of controlling undesired developments has declined. That is, whereas it may once have been too expensive to undertake corrections of human rights abuse, excesses of religious fanaticism, or refugee starvation, now with the political costs of corrections diminished, new incentives may arise to include such mishaps under the aegis of security. But then this raises the question of how far to carry such extended definition: all the way to include world poverty, income inequality, health, and environmental safety? Encompassed in this category are crucial new questions of conditions under which conflicts within a country can reach a stage that international intervention is justified, even required; that is, norms for international interference in the "internal" affairs of a country [see Kaysen and Reed ( 1 993)]. Reevaluation of the acceptable limits of national sovereignty will ultimately rest upon economic concepts such as externalities, spillovers, public goods, private property rights, social and individual welfare, free riding, and transactions costs, as well as other criteria in the realm of the political, legal, moral, psychological, and purely pragmatic. 4. 2. 3.

New economic instruments for security

Greater interdependence among world economies implies an increase in the con­ sequences of economic mishap. Corresponding to the benefits from increased

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specialization and interdependence are increased risk of disruption. Accordingly, an important new goal for Defense Economics will be to further understanding of how economic instruments may be used to deal with such risks. Some of these risks may be common or collective, requiring extensions of models of insurance, and self-protection to the realm of collective action and the relations among states [see for example McGuire and Shibata ( 1 988), Ihori ( 1 994)]. Other types of economic instruments may be employed individually by specific countries or groups of countries and thus be "private" rather than public goods; for example stockpiling policy as an instrument to reduce effects of trade interruptions may be an example of a private response, while contingent agreements for multi-country energy sharing would represent a collective response. The uses of economic sanctions, and all other manner of economic policy instruments to achieve security or other political goals will deserve fresh re-examination. Of special interest here may be analysis of the relative impact of economic rewards versus punishments, the role of credit/debt policies and threat of default, new uses of economic and military aid, trade and factor migration controls broadly conceived. 4.2. 4.

New concepts of alliances and replacement for bi-polar world hegemony

The last sub-category under the umbrella title of "new issues post-Communism" concerns security management in a world of evolving great power coalitions. Can Defense Economics contribute to a resolution of the puzzle over what is to replace bi­ polar hegemony. Such an endeavor is by no means the exclusive realm of economics, but economists do have a special contribution to make especially insofar as the adhesive to bind alliances together may no longer be simply a common defense against conquest. Instead a complex web of exchanges of all types of property, including goods, services, people, capital, financial promises, physical externalities also binds "allies". These create mutual expectations of self and others, and complex agreements and practices to provide more or less common collective goods adds to the binding force. A major problem for economics is to understand how collective goods such as common defense protection, and individual goods such as benefits from specialization and exchange combine in producing incentives for alliance formation/functioning [see McGuire ( 1 989), Wong ( 1 99 1), Ihori ( 1 993)]. And because management of the free rider problem is so central to "alliance" effectiveness, the economics of voluntary behavior in small groups will itself continue to be central to security questions, and should illuminate such important issues as developing regional alliances, power balances, and conflicts. Such analysis might encompass applications of honest preference revealing techniques and self-enforcing commitment mechanisms to group adhesion in defense environments. 4.3.

Positive analysis of international power equilibria

Although the details of an ultimate positive understanding of defense are far from clear, and even the outlines obscure, one can see various micro-economic elements which

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will have to be integrated into an overall model. These micro-economic elements which must be combined, comprise at least the following: property rights and the underlying appropriability of "production", which is to say the technology of conflict versus peaceful competition; costs of politico-military conquest versus defense; institutions of collaboration and coalition formation; and principles of systems equilibrium. We can briefly describe each of these components in tum to obtain some small idea of how they might fit together. Property rights and appropriability: The centrality of the concept of property, property rights, rent seeking behavior and theft being stipulated, a most important component for positive understanding of Defense Economics concerns when and why one group or country finds it advantageous to conquer or otherwise expropriate the product of another group, and when it finds it more advantageous to save, invest, labor, and trade. In other words what determines the opportunity cost of expropriative activity. Part of the answer to this question will lie in the costs of political or military dominance compared with the costs of defending against such dominance. We will tum to these momentarily, but more fundamental may be the inherent availability or vulnerability of a country 's production to coerced seizure. This should depend upon a country's stage of economic and political development. Natural resources may be easy to seize and expensive to defend, while expropriation of sophisticated, knowledge intensive products far more difficult because their production or delivery requires willing cooperation of a myriad of technical specialists. And not only may technically advanced, highly networked economies be inherently less vulnerable to conquest, the same is likely to be true of politically advanced countries. It is one thing to seize control of a country from a dictator or oligarchy who already had established a system of expropriation from its own population; it is quite another to devise institutions which will effect such expropriations from a free market of a previously competitive population. Costs of conquest versus defense: The economic explanation of international structure centers on the notion that ultimately the organization of the world into nation-states is the result of struggle and eventually a balance between resources allocated to capture and resources devoted to defense. Such mutual neutralization of resource allocations is then a characteristic of an equilibrium configuration of nations. In this environment, the technology of offense versus defense with special reference to scale economies must be highly influential, so a significant part of the problem of understanding the equilibrium in the international system will be to understand those technologies of capture vs. protection. The forces of theft and protection play themselves out over geography, which thus mediates crucial components of the relevant technology. Original analysis of aspects of this geo-technology, are due to Friedman ( 1 977) indicating the effects of distance on market dominance, and by Boulding ( 1 962) of the effects of distance on military power projection as measured by a "loss of strength gradient". At the margin, however, wherever forces compete and the struggle between nations or coalitions is in balance, this will involve a sort of neutralization of defensive and offensive strength.

38

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Consequently, the geography over which to expect conquest to dominate defense must depend on the relative technical capabilities of the two activities, returns to scale (both geographic scale and resource input scale), resource availabilities of competitors and other factors. Suppose one could measure a country's vulnerability to or risk of being conquered, annexed, colonized, etc. This risk will depend on the weapons and forces threatening such a country and the defensive weapons it commands through resource allocations to defense and protection. Now consider the marginal ratio of defense forces to offensive forces which will just offset or neutralize each other, keeping the defender at the same level of vulnerability. Such a ratio is a measure of the relative efficacy of defense against offense. How does such a ratio depend on the absolute level of risk? Is it also a function of absolute resource levels? How does it depend on geography? Measures of defensive versus offensive effectiveness such as these have been an important element in strategic analysis and operations research analyses of missile duels and missile defense [Bailey ( 1 973)]. But now it appears that similar concepts would seem to have wider application to the entire problem of systems equilibrium of nations. Hirshleifer also has explored these tradeoffs at a theoretical level (Ch. 7 of this volume) and he argues more generally for a redirection of intellectual focus toward conflict ridden processes ("the dark side") throughout economic study. Other economists have delved more specifically into the micro-foundations of allocations between offense (property acquisition or conquest) activities and defensive ones (property protection, offensive weapon defeat). [see Grossman ( 1 99 1), Skaperdas and Syropoulos ( 1 994), and Garfinkel ( 1 990)] . Institutions of collaboration: The flourishing economic theory of games will doubtless be central to an evolving understanding of international security and its political economy. Game theory one might hope would provide insights into whether the system of interacting nations has a "core" and the implications of a positive or negative answer. Such conjectures will certainly build on knowledge which presently is accumulating with respect to how institutions influence warlike proclivities of nations. Evidence is growing as to institutional foundations for a peaceful world; first that the greater the volume of international trade between countries, the less likely are they to have recourse to war to settle disputes [Polachek ( 1 980)]. Second, democratic regimes are less likely to go to war with each other than either autocratic regimes with each other or with democracies. Future empirical and conceptual progress in understanding these issues may help in evaluating the present trend toward increased fragmentation of nation states. Is the monopolistic model of a single world government in effect to be rejected by a competitive system of hundreds and hundreds of countries? Or is an oligopolistic system of countries a possibility? Or consider the economic model of a price leadership in which one or a few big participants in a market interact so as to determine variables which are accepted as parameters by numerous smaller participants. Can this be transplanted into this environment where unlike the concentration of industry example, the goods provided to the market are not private goods but public?

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Princip les of system equilibrium: Thompson ( 1 974) first made a suggestion as to how the incentives which apply to countries individually would fit together in an international security equilibrium. In the tradition of general equilibrium in resource allocations his suggestion has great appeal. Thompson's conjecture was that a distribution of property among states must be such that when each country mounts its optimal defense, any other country after expending the resources necessary to overcome that optimal defense if possible, would find that conquest of the defending country cannot produce a net gain. Such an equilibrium condition would presumably determine the number of competing countries, every country's overall allocation between production and security, and within each country 's security budget its allocation between defense and offense. Further, the effects of technological change, increased wealth, capital and labor accumulation, and population change would seem in principle to be deducible from such condition. Thompson's equilibrium criterion may not be ultimately satisfactory. Possibly explicit inclusion of public good and externality effects would alter equilibria qualitatively. This criterion ignores asymmetries in information, and effects of expectational factors and commitment issues. A full application of the idea should require a multi time period context, and consideration of coalition possibilities, but the object of understanding the system-wide implications of these security and defense strivings will constitute a central goal of future research in Defense Economics. 5. Concluding remark

This essay has briefly surveyed the course of Defense Economics as a field of study in the post World War II era. The field has expanded continuously in the scope of the questions it addresses, in the economic tools employed in its analyses, and in the criteria of intellectual rigor and social usefulness by which it is to be judged. Amidst this surging growth in Defense Economics as a field of study, one trend stands out. Where the focus of study originated in normative concerns for national security within competing power blocks, the field has evolved as one of positive study of the individual elements within the international system, and with normative analysis increasingly reflective of a globalized point of view. References Bailey, M.J., 1 973, Strategic interaction in force structure planning, unpublished Working Paper (Carnegie­ Mellon University, Graduate School of Industrial Administration, Pittsburgh, PA). Benoit, E., 1 978, Growth and defense in developing countries, Economic Development and Cultural Change 26, 271-280. Boulding, K.E., 1962, Conflict and defense: A general theory (Harper and Row, New York). Brito, D.L., 1 972, A dynamic model of an armaments race, International Economic Review 13, 27 1-280. Brito, D.L., and M.D. Intriligator, 1985, Conflict war and redistribution, The American Political Science Review 79, 943-957.

40 Conybeare, J.A.C., J.C. Murdoch and T. Sandler, 1 994, Alternative collective-goods models of military alliances: Theory and empirics, Economic Inquiry 32, 525-542. Cooper, R., 1 986, Economic policy in an interdependent world (MIT Press, Cambridge, MA). Dacy, D.C., 1 983, Foreign aid, war, and economic development (Cambridge University Press, Cambridge). Deger, S., 1 986, Economic development and defense expenditure, Economic Development and Cultural Change 35, 1 79-196. Deger, S., and R. Smith, 1 983, Military expenditure and growth in less developed countries, Journal of Conflict Resolution 27, 335-353. Denoon, D.B.H., 1 985, Constraints on strategy (Pergamon-Brassey, Washington, DC). Dudley, L., 1 979, Foreign aid and the theory of alliances, Review of Economics and Statistics 6 1 , 564-57 1 . Ellsberg, D., 1 956, Theory of the reluctant duelist, American Economic Review 56, 909-923. Faini, R., P. Annez and L. Taylor, 1 984, Defense spending, economic structure and growth: Evidence among countries and over time, Economic Development and Cultural Change 32, 487-498. Fisher, A., 1 969, The cost of the draft and the cost of ending the draft, American Economic Review 59, 239-254. Fontanel, J., 1 994, The economics of disarmament: A survey, Defence and Peace Economics 5, 87-120. Friedman, D., 1 977, The size and shape of nations, Journal of Political Economy 85, 59-77. Garfinkel, M., 1 990, Arming as strategic investment in cooperative equilibrium, American Economic Review 80, 50--68. Grossman, H.!., 1 9 9 1 , A general equilibrium model of insurrections, American Economic Review 8 1 , 9 1 2-92 1 . Grossman, H.!., 1 992, Foreign aid and insurrection, Defence Economics 3 , 275-288. Hendry, J.B., 1 962, Economic development under conditions of guerilla warfare: The case of Vietnam, Pacific Affairs, 2, 275-288. Hirschman, A.O., 1 945, National power and the structure of foreign trade (University of California, Berkeley, CA). Hirshleifer, J., 1 987, Economic behaviour in adversity (University of Chicago Press, Chicago, IL). Hirshleifer, J., 1 9 9 1 , The paradox of power, Economics and Politics 3, 1 77-200. Hitch, C.J., 1 958, Economics and military operations research, Review of Economics and Statistics 40, 1 99-209. Hitch, C.J., and R.N. McKean, 1 960, Economics of defense in the nuclear age (Harvard University Press, Cambridge, MA). Hufbauer, G., and J. Schott, 1 985, Economic sanctions reconsidered (Institute of International Economics, Washington, DC). Ihori, T., I 993, International public goods and risks of emergency, unpublished mimeograph (Department of Economics, Tokyo University). Ihori, T., 1 994, Alliance protection against emergency and welfare, unpublished mimeograph (Department of Economics, Tokyo University). 1ntriligator, M.D., 1 975, Strategic considerations in the Richardson model of arms races, Journal of Political Economy 83, 339-353. Intriligator, M.D., 1 990, On the nature and scope of defence economics, Defence Economics I, 3-1 1 . lntriligator, M.D., and D.L. Brito, 1 98 1 , Nuclear proliferation and the probability of nuclear war, Public Choice 27, 247-260. Intriligator, M.D., and D.L. Brito, 1984, Can arms races lead to the outbreak of war? Journal of Conflict Resolution 28, 63-84. Jack, B., 1 99 1 , International public goods: The economics of their provision and cost-control under the Cournot-Nash hypothesis, unpublished dissertation (University of Maryland, College Park, MD). Kaysen, C., and L.W. Reed, eds., 1 993, Emerging norms of justified intervention (American Academy of Arts and Sciences, Cambridge).

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Kent, G.A., 1 964, Damage limiting: A rationale for the allocation of resources b y the U.S. and U.S.S.R. (US Department of Defense, Defense Research and Engineering, Washington, DC). Kent, G.A., and D.E. Thaler, 1 989, First strike stability and strategic defenses (The RAND Corporation, Santa Monica, CA). Klein, L.R., and K. Mori, 1 973, The impact of disarmament on aggregate economic activity, in: B. Udis, ed., The economic consequences of reduced military spending (Lexington Books, Lexington) 59-77. Knorr, K., 1 956, The war potential of nations (Princeton University Press, Princeton). Lanchester, F.W., 1 956, Aircraft in warfare: The dawn of the fourth arm, in: J. Newman, ed., The world of mathematics, Vol. 4 (Simon and Shuster, New York) 2 13 8-2148. Leontieff, W., and M. Hoffenberg, 1 96 1 , The economic effects of disarmament, Scientific American 204, 47-55. Levine, P., S. Sen and R. Smith, 1 994, A model of the international arms market, Defence and Peace Economics 5 , 1-18. Lincoln, G.A., 1 954, Economics of national security (Prentice Hall, Englewood Cliffs, NJ). Mayer, W., 1 977, The national defense tariff argument reconsidered, Journal of International Economics 7, 363-377. McGuire, M.C., 1 965, Secrecy and the arms race (Harvard University Press, Cambridge, MA). McGuire, M.C., 1 967, The structure of choice between deterrence and defense, in: R.N. McKean, ed., Issues in defense economics (National Bureau of Economic Research, New York) 1 29-149. McGuire, M.C., 1 977, A quantitative study of the strategic arms race in the missile age, Review of Economics and Statistics 59, 328-339. McGuire, M.C., 1 982, U.S. foreign assistance, Israeli resource allocation, and the arms race in the Middle East, Journal of Conflict Resolution 26, 1 99-235. McGuire, M.C., 1 987a, Economic considerations in the comparison between assured destruction and assured survival, in: C. Schmidt and F. Blackaby, eds., Peace, defense, and economic analysis (Macmillan, London) 1 22-1 50. McGuire, M.C., 1 987b, Foreign assistance, investment and defence: A methodological study with application to Israel, 1 960-1 979, Economic Development and Cultural Change 35, 847-873 . McGuire, M.C., 1 989, Alliance protection against national emergency: Prevention, preparedness, and insurance, Pew studies in international security (University of Maryland, College Park, MD). McGuire, M.C., 1 990a, Coping with foreign dependence: The simple analytics of stockpiling versus protection, Discussion paper 70 (Institute of Southeast Asian Studies, Singapore). McGuire, M.C., 1990b, Mixed public-private benefit and public good supply with an application to the NATO alliance, Defence Economics 1 , 1 7-36. McGuire, M.C., 1 992, The new strategic environment and economic factors in the future of nuclear defense, in: W. Isard and C. Anderton, eds., The economics of arms reduction and the peace process (North-Holland, Amsterdam) 143-157. McGuire, M.C., and C.H. Groth Jr, 1 985, A method for identifying the public good allocation process within a group, Quarterly Journal of Economics 1 00, 91 5-934. McGuire, M.C., and H. Shibata, 1 988, Protection of domestic industries versus defense against trade disruptions: Pew studies in international security (University of Maryland, College Park, MD). Murdoch, J.C., and T. Sandler, 1 982, A theoretical and empirical analysis of NATO, Journal of Conflict Resolution 26, 237-263. Murdoch, J.C., and T. Sandler, 1 984, Complementarity, free riding, and the military expenditures of NATO allies, Journal of Public Economics 25, 83-10 1 . Murdoch, J.C., T. Sandler and L . Hansen, 1 99 1 , An econometric technique for comparing median voter and oligarchy choice models of collective action: The case of the NATO alliance, Review of Economics and Statistics 73, 624-63 1 . Oi, W. , 1 967, The economic cost of the draft, American Economic Review 57, 39-62. Okamura, M., 1 9 9 1 , Estimating the impact of the Soviet Union's threat on the United States-Japan alliance: A demand systems approach, Review of Economics and Statistics 75, 624-63 1 .

42

M. C. McGuire

Olson, M., 1982, The rise and decline of nations (Yale University Press, New Haven). Olson, M., and R. Zeckhauser, 1 966, An economic theory of alliances, Review of Economics and Statistics 48, 266-79. Olvey, L.D., J. Golden and R. Kelly, 1 984, The economics of national security (Avery Publishing, Wayne, NJ). Palda, F., 1 993, Can repressive regimes be moderated through foreign aid? Public Choice 77, 535-550. Peck, M.J., and F.M. Scherer, 1 962, The weapons acquisition process: An economic analysis (Harvard Graduate School of Business Administration, Boston, MA). Polachek, S.W., 1 980, Conflict and trade, Journal of Conflict Resolution 24, 55-78. Reppy, J., 1991, On the nature and scope of defense economics: A comment, Defense Economics 2,

269-27 1 . Richardson, L.F., 1 960, Arms and insecurity: A mathematical study of the causes and origins of war (The Boxwood Press, Chicago, IL, and Quadrangle Books, Pittsburgh, PA). Rowen, H., and C. Wolf Jr, 1 990, The impoverished superpower: Perestroika and the Soviet military burden (ICS Press, San Francisco). Sandler, T., 1 977, Impurity of defense: An application to the economics of alliances, Kyklos 30, 443-

460. Sandler, T., 1992, On terrorism, guerilla warfare, and insurrections, Defence Economics 3, 259-262. Sandler, T., and J. Cauley, 1 975, On the economic theory of alliances, Journal of Conflict Resolution

19, 330-348. Sandler, T., and J.C. Murdoch, 1 990, Nash-Cournot or Lindahl behavior?: An empirical test for the NATO allies, Quarterly Journal of Economics 1 05, 875-894. Schelling, T.C., 1 960, The strategy of conflict (Harvard University Press, Cambridge, MA). Schelling, T.C., 1 966, Arms and influence (Yale University Press, New Haven, CT). Schelling, T.C., 1967, The strategy of inflicting costs, in: R.N. McKean, ed., Issues in defense economics (Columbia University Press, New York) 1 05-127. Seiglie, C., 1992, Determinants of military expenditures, in: W. lsard and C. Anderton, eds., Economics of arms reduction and the peace process (North-Holland, Amsterdam) 1 83-202. Shubik, M., 1 987, The uses, value and limitations of game theoretic methods in defense analysis, in: C. Schmidt and F. Blackaby, eds., Defense and economic analysis (St Martin's Press, New York)

53-84. Skaperdas, S., and C. Syropoulos, 1 994, Competing for claims to property, unpublished mimeograph (University of California-Irvine, CA). Smith, R., 1980, Military expenditure and investment in OECD countries, 1 954-1973, Journal of Comparative Economics 4, 1 9-32. Smith, R., A. Humm and J. Fontanel, 1 987, Capital labour substitution in defence provision, in: S. Deger and R. West, eds., Defence, security, and development (Frances Pinter, London) 69-80. Srinivasan, T.N., 1 987, The national defense argument for government intervention in foreign trade, in: R. Stern, ed., U.S. trade policies in a changing world economy (MIT Press, Cambridge, MA)

337-363. Thompson, E.A., 1 974, Taxation and national defense, Journal of Political Economy 82, 755-782. Tolley, G., and J. Wilman, 1 978, The foreign dependence question, Journal of Political Economy 85,

323-347. Tullock, G., 1 974, The social dilemma: Economics of war and revolution (Center for Study of Public Choice, University of Virginia, Charlottesville). US Strategic Bombing Survey, 1 945-46, The effects of strategic bombing on the German (Japan's) war economy (US Department of the Air Force, Washington, DC). Wan, H.Y., 1 961 , A Contribution to the Theory of Trade Warfare, unpublished dissertation (Massachusetts Institute of Technology, Cambridge, MA). Weidenbaum, M., 1 974, The Economics of Peacetime Defense (Praeger Publishers, New York).

Ch. 2: Defense Economics and International Security

43

Weidenbaum, M., 1 992, Small wars, big defense: Paying for the military after the Cold War (Oxford University Press, New York). Williamson, O.E., 1 967, The economics of defense contracting: Incentives and performance, in: R.N. McKean, ed., Issues in defence economics (Columbia University Press, New York) 21 7-278. Winter Jr, S., 1 963, Economic viability after thermonuclear war: RM-3436-PR (The RAND Corporation, Santa Monica, CA). Wittman, D., 1 99 1 , Nations and states: Mergers and acquisitions; dissolutions and divorce, American Economic Review Papers and Proceedings 8 1 , 126-129. Wolfson, M., 1 9 9 1 , Essays on the cold war (Macmillan, London). Wolfson, M., and J.P. Farrell, 1 987, Economic warfare between the superpowers, in: C. Schmidt and F. Blackaby, eds., Peace, defense and economic analysis (Macmillan, London) 1 55-1 84. Wong, K., 1 99 1 , Foreign trade, military alliance, and defence-burden sharing, Defence Economics 2, 83-103.

Chapter 3 W ORLD MILITA RY EXPENDITURES MICHAEL BRZOSKA

Bonn International Center for Conversion

Contents

Abstract Keywords 1 . Introduction 2. Concepts and definitions 2.1. 2.2. 2.3. 2.4.

Functional versus institutional approaches Direct, indirect and intangible costs and benefits Current versus comprehensive accounting Standard definitions

3 . Intertemporal consistency 4. International comparisons 5. Relative measures 6. Data sources 7. International arms transfers 8. Conclusion References

Handbook of Defense Economics, Volume I, Edited by K. Hartley and T. Sandler © 1995 Elsevier Science B. V All rights reserved

46 46 47 48 49 50 51 51 52 54 57 59 63 64 65

46

M. Brzoska

Abstract

Military expenditure is difficult to define. Major issues are functional versus institu­ tional approaches to defense, indirect and intangible costs and benefits and current versus comprehensive accounting. Authoritative institutions have adopted standard definitions but national governments are free to use their own definitions. Specific inflation pressures complicate the creation of real time series of military expenditures. International comparisons are influenced by the choice of exchange rates. For some countries, no credible data are available. Data series on military expenditures and arms transfers must be used with caution as the publishing institutions have only limited resources to deal with the numerous conceptual and practical problems.

Keywords

arms transfers, conscnptton, costs of wars, data limitations, data sources, deflators, exchange rates, indirect costs, inflation, international comparisons, military aid, military strength, national accounts, opportunity costs, productivity, purchasing power parity, secrecy, social benefits

Ch. 3: 1.

World Military Expenditures

47

Introduction

At first glance, military expenditures seem to be a straightforward measure: the costs of maintaining a military establishment in war and peace. But there are a number of conceptual problems with military expenditure data. In addition, data on military expenditures are of unequal quality and availability. Military expenditures are an overburdened concept both in academic analysis and in international politics. Military expenditures are basically an input measure: the aggregation of payments for soldiers and other persons concerned with the regular armed forces of a particular country, for goods purchased by the armed forces, and services bought from civilians, over a period of time, usually a year. Related to other economic aggregates, such as Gross Domestic or National Product (GDP; GNP) or the Central Government Expenditure (CGE) it is a measure of the relative burden of the military sector. The input costs of the military sector can also be thought of as their opportunity costs for expenditures in other, civilian, sectors. Similarly to other government expenditures whose productivity is difficult to measure, military expenditures are often used as an output measure. There is no readily available indicator of military strength, so military expenditures often serve this purpose. Of course, this is highly problematic. Strength is basically a stock measure, dependent on the military equipment available: for an effort to measure military capital see Hildebrandt ( 1 990). Fighting performance in war and the ability to prevent the out­ break of war are difficult to measure and depend on a number of non-pecuniary factors, such as training, motivation and leadership [Wiberg (1984), Goertz and Diehl ( 1 986)] . The use of military expenditures as a measure of military strength is especially numerous in international comparisons. Some methods have been developed to deal with the major deficiencies, e.g., the "building block" approach used to measure Soviet military expenditures during the Cold War. Another use of military expenditures occurs in military alliances in order to measure the "contribution" of members to the common cause. Again, the nature of military expenditures as an input measure requires interpre­ tation or corrective calculations, e.g. to deal with voluntary versus draft recruitment. The level and composition of military expenditures are often treated as state secrets, even in states with open political and parliamentary systems. Sizeable portions of the military budget, so called "black programmes" are not open to public scrutiny. The availability of military expenditures is low in states with highly autocratic regimes and in regions in conflict, for instance, the Middle East. Governments in Europe are required to reveal military expenditures to each other though not to the public - in the context of the Organization for Security and Cooperation in Europe (OSCE) 1 . A number of states report data to the UN on a

1 According to an agreement within the predecessing organization, the Conference on Security and Cooperation in Europe (CSCE), the Vienna Document 1990 of the Negotiations on Confidence and Security Building Measures convened in accordance with the relevant provisions of the Concluding Document of the Vienna Meeting of the CSCE. article I , paragraphs 14-1 6, reprinted in SIPRI Yearbook ( 1 99 1 , p. 476-477).

M. Brzoska

48

voluntary basis. Comprehensive worldwide statistics of military expenditures are not available from any authoritative source; instead there exists a number of interested institutional bodies that issue series of military expenditures. They are only capable of correcting some of the major deficiencies of military expenditure data.

2. Concepts and definitions

Governments are basically free to define military expenditures according to their own wishes and purposes. The chosen definition is reflected in the national budget or statement of expenditure. Sometimes the liberty to define is used for purposes of deception, or because of specific tradition. But there are serious issues where differing definitions can be justified (see also Table 1 ). Table I Definitions of military expenditures' Possible items of military expenditures

Expenditures for military forces and their support I.

Pay to soldiers, officers

2.

Salaries of technicians, bureaucrats etc. within armed forces or connected to military organization

3.

Medical services, tax benefits, social benefits to above (including relatives)

4. 5. 6.

7. 8. 9. 10.

Pensions Military schools, hospitals etc. Current procurement expenditures on weapons (incl. arms imports) Infrastructure construction, housing etc. Operation and maintenance Procurement of other goods Military research and development

Other expenditures with military/defense/strategic purpose I I.

Stockpiling of strategic goods

12. 13. 14. 15.

Mothballing of weapons, production lines, etc.

1 6.

Arms production subsidies/conversion subsidies Military aid to other countries Contributions to international organizations (military alliances, UN peacekeeping, etc.) Civil defense

Expenditures for past military forces/action 17. Veteran benefits, etc. 18. Service of war debts

Items b in definitions issued by IMF NATO UN

X

X

X

X

X

X

X

X

X X X X

X

X

X

X

X

X

X

X

X

X' X' X X

X

X

X

X X

X

X X

X X

X

X

X

X

Ch. 3:

49

World Military Expenditures

Expenditures on other forces 19.

Paramilitary/Gendarmery

20.

Border/Customs Guards

21.

Police

Chargeable to other accounts 22.

Humanitarian/disaster relief

23.

UN peacekeeping

Incomes from 24.

Military schools, hospitals, companies

25.

Civilian use of military infrastructure

26.

VIP transport

27.

Sale of patents, know-how

28.

Repayment of production subsidies

29.

Military aid from other countries

Obligations for future spending 30.

Procurements on credit

X

X

X

y

y

y

y

y

y

y y y

X

y y y

y y

y

X

' Sources: Ball ( 1 988, pp. 402-404), UN ( 1 977, 1 98 1 ), NATO DPQ(90)FIN&ECON, Part 1 (reprinted in Deutscher Bundestag, Drucksache 1 1/7373, 28). b Symbols: X, should be included in military expenditures; -, should not be included in military expenditures; Y, should be budgeted as income. ' If managed and financed by defense organization. d When judged to be trained, equipped and available for military operations. Double-counting has to be considered before aggregations.

e

2. 1.

Functional versus institutional approaches

Aggregation of expenditures belonging to military functions, such as military deterrence, defense and warfighting, is preferable. But government budgets are predominantly organized along bureaucratic lines. These may not coincide with functional purposes. For instance, paramilitary forces may come under the budget of the Ministry of Domestic Affairs, military aid under the budget of Foreign Affairs, and procurement under the budget of special "Ministries of Machinery". Especially for unstable developing countries it may be very misleading to equate military expenditures with the budget of the Ministry of Defense (or War, or the Armed Forces). In such cases expenditures for internal "regime security", for police and paramilitary organizations can be very large [Ball ( 1 988)] . Herrera ( 1 994, p. 42) gives data for the not untypical example of Tunisia. Between 1 985 and 1 99 1 , Ministry of Defense expenditures rose from 1 80 million to 224 million dinars. At the same time, expenditures for "public order and security", mostly contained in the budget of the Ministry of Interior, increased from 1 00 million to 238 million dinars. There are no clear limits to the functions of the military. Is civil defense such a function? Do pensions to veterans belong here? What is the difference between a

50

M. Brzoska

well-armed police force and lightly armed infantry? Is it the function of the military to provide for meteorological services, air traffic control, etc. as is the case in many countries? Is disaster relief something military? Is military aid to distant countries helpful fo� the national military purpose? In a number of countries, the armed forces run enterprises, often to produce weapons, but sometimes also to manufacture or sell civilian goods and services. There is no uniform way in which costs and incomes of such activities are budgeted. In the case of Indonesia, for instance, they seem to be fully outside the official budget [see e.g. Far Eastern Economic Review ( 1 994), June 9, p. 1 2]. A specific problem is presented by armed opposition groups. Their expenditures obviously are not part of the official state budget. Considering that in the early 1 990s more than 40 such groups were active the total expenditures of armed opposition groups may be quite substantive. Unfortunately, there are no data available. 2.2.

Direct, indirect and intangible costs and benefits

Budgets are basically statements of direct costs. Sometimes they include indirect costs, such as destruction during training exercises, when compensation is paid out by military departments. But often the use of civilian infrastructure etc. is not recorded. Environmental impacts of the activities of armed forces are seldom budgeted. Likewise there is often no attribution of costs to civilians even though they use military equipment, personnel or infrastructure. Thus, it is frequent practice that Air Forces provide VIP support out of the military budget. Armed forces are often exempted from indirect taxes and customs duties, sometimes even direct taxes. Different rules exist for the compensation of the armed forces for disaster relief, search and rescue operations, medical treatment and the like. A special case of indirect costs results from the practice of conscription. No country budgets the opportunity cost of using conscripts with low pay instead of professional soldiers. The argument is made frequently in international comparisons of military expenditures, especially for instance by governments within the North Atlantic Treaty Organization (NATO). Just to suggest orders of magnitude: the US government could save up to 25% of its military expenditure if it substituted conscripts for volunteers in the manner the German government does. Conscription, on the other hand, is an indirect cost to the economy since the supply of labor is reduced. The opportunity cost of a conscripted soldier is difficult to measure, especially in economies with high rates of unemployment in the relevant age groups. Another problem is presented by military aid. This can be given directly to the armed forces of another country or channelled through the budget of the recipient country. Practices differ. For instance, German assistance to foreign military forces is budgeted by the Foreign Office but administratively handled by the Ministry of Defense. US security assistance, which comes from the Pentagon's budget, consists of new weapon systems, surplus weapons of the US armed forces, training in the USA and in foreign countries, credits and cash to foreign governments.

Ch. 3: 2.3.

World Military Expenditures

51

Current versus comprehensive accounting

The functional approach generally excludes the consideration o f pensions, veteran benefits, etc. as well as debts incurred in prior wars. It can be argued that all social benefits should be excluded, as well as payments to children, relatives, etc. In practice, though, military bureaucracies often take care of such social benefits. In the other direction of time, a functional accounting of expenditures extending into the future, such as procurement on credit terms, would imply use of a depreciation stream. In budgetary practice this is not often found. Sometimes, actual expenditures are recorded for the years in which payments of interest and principal occurs. But in many cases debt service for procurement is aggregated with other debt service in a special budget account and not recognizable any more as expenditure connected with military activity. This is one of the reasons why detailed studies of military budgets in countries with resource gaps fail to find much expenditure on weapons [Ball (1984a, 1 98 8)]. Military expenditures are especially difficult to ascertain in times of war. Countries at war are notoriously missing from data series on military expenditures. Also, there are typical costs of wars that are of interest such as destruction of property, loss of lives or loss of output. While not military expenditures proper, they are part of the larger picture of the economic consequences ·of military activity. 2. 4.

Standard definitions

There may be good reasons for national practices of defining and budgeting military expenditures but they make international comparisons very difficult. Nicole Ball, who has made a detailed study of the budgets of a large number of developing countries has reported frequent changes in budgeting practices, so that intertemporal comparisons are also often very difficult [Ball ( 1 984a)]. Standard definitions of military expenditures have been proposed by international organizations involved in data collection (Table 1 ). Three definitions are widely used, namely those by NATO, the International Monetary Fund (IMF) and the United Nations (UN). The NATO definition is first and foremost for internal purposes, but has also been adopted as the basis of other data series, such as those of the Stockholm International Peace Research Institute (SIPRI) and the United States Arms Control and Disarmament Agency (US ACDA). The NATO definition is a fairly comprehensive measure of the financial burden of the operation of armed forces. The IMF definition provides the basis for various data products published by the World Bank (such as World Development Report, World Tables) and the IMF (such as Government Finance Statistics). It is an element in the IMF Government Finance Statistics and therefore less specifically oriented towards military considerations than the NATO definition. The UN definition was developed specifically for the purposes of international comparison. From the 1 970s, UN expert committees have worked on the problem of defining and reporting military expenditure. A detailed reporting scheme distinguishing major components of military expenditures and force groups (a total of 588 data entry

52

M. Brzoska

fields) was developed [UN ( 1 977, 1 98 1)] . The number of countries reporting data slowly increased, numbering close to 40 in the early 1 990s [US ACDA ( 1 993)]. The most detailed data have tended to come from the Western industrialized states for which disaggregated national data are publicly available anyway while only few Eastern or developing countries have reported even aggregate figures. The UN definition is also used in the OSCE framework. The UN definition is the most comprehensive of the definitions. In fact, it is so detailed that a number of governments justifY failure to report with the inability to conform to the UN framework. The differences between the three standard definitions do not look very striking (Ta­ ble 1 ) . Nevertheless, figures can be quite different in cases where there are large pension payments or "strategic" expenditures. Differences between national and standard definitions can be quite large. German military expenditures for 1 993 according to NATO criteria were put at DM mil­ lion 63 854 while the German Defense Budget was only DM million 49 602 Official Chinese defense expenditures for 1 993 amounted to 42.5 billion yuan or $7.3 billion. Adding such categories as production subsidies to defense industries and military research and development expenditures on People's Armed Police and militia brings the figure up to something like $34 billion. Pension and demobilization expenditures, which fall under the NATO, but not the IMF definition add another $2 billion or so. In addition, the People's Liberation Army has large incomes from arms sales and commercial enterprises. These may be as high as $9 billion. Most of this income is not budgeted centrally and spent by the unit which generated it [all estimates follow Shambaugh ( 1 994)]. In total, then, Chinese military expenditures following the NATO or UN definitions are something like six times the official figure. In addition to definitional differences, there are outright manipulations of data. It is widely assumed, though seldomly documented, that transactions are made outside of the budget, for instance through special accounts [Brzoska ( 1 982), Ball (1984b), Sen ( 1 992)]. The income for these funds usually comes from the exports of raw materials, as in the cases of Chile (copper) and Iran (oil) in the late 1 970s. Sometimes, budgetary control is in such a bad shape that it is impossible to establish military expenditure data, as was the case in Argentina in the early 1 980s. A World Bank team estimated that official data were underreporting true military expenditures by at least 50% in the 1 970s and early 1 980s [Herrera ( 1 994, p. 25)].

2.

3. Intertemporal consistency

Deflation is a major source of problems with international military expenditure data. There are only a few countries that have specific military price deflators [Skons ( 1 983), 2 Data from NATO Brief, April 1 994, p. 33 and Bundesministerium der Verteidigung, Weillbuch 1 994, Bonn 1 994, p. 76. Differences are due to payments from other budgets, such as contributions to the Gulf War, military aid and pensions.

Ch. 3:

World Military Expenditures

53

UN ( 1 986), Fontanel ( 1 982, 1 986)]. These are regularly larger than comparable civilian deflators. A major problem in the calculation of inflation in the military sector is the correction for increases in product quality. For some purposes, such as opportunity cost measurements, it is not necessary to have specific military deflators. No other country provides as many resources to the calculation of military deflators as the United States, at least if judged by what is known in the public sphere. The Pentagon publishes an annual series containing information on prices for weapons systems under procurement [DoD (annual)]; there are Pentagon aggregate estimates of deflators for weapon categories and force groups and there is a specific deflator for national account purposes, prepared from Pentagon raw data in the US Department of Commerce (monthly). Disaggregated military deflators are also available for a number of European NATO member states [Skons ( 1 983), UN (1 986)] . Two basic methods are used to construct these deflators. One is the use of weighted civilian deflators, such as labor costs, purchases of consumer goods, purchases of investment goods, etc. with weights corresponding to the composition of military expenditures. Another is to record the changes in input costs of specific military items, such as pay for soldiers and weapon systems, and to correct these for increases in productivity and product quality. In both cases, the correction of quality change is a major problem. Reported military deflators are usually larger than GDP or industrial production deflators but this may be due to insufficient calculation of quality improvement [Skons ( 1 983)]. On the other hand, there are some reasons for assuming that military inflation might be above average. For instance, military inputs tend to come overproportionally from sectors with above average inflation, such as high salary groups and high-technology industrial sectors. Also, there is a tendency for "gold-plating" weapons and the arms market is often monopsonistic or, at best, oligopolistic [Albrecht et al. ( 1 979), Albrecht ( 1 982), Smith (1 985)]. The rate of cost increase in reported military deflators - for military expenditures or weapon categories - above civilian inflation is sometimes called the "escalation rate". It is sometimes interpreted as a sign of secular overinflation in the military sector that has to be remedied through above average inflation compensation in military budgets. But it can also be argued that "escalation" reflects product improvement in the military sector above civilian average, otherwise the mix of inputs would not have been chosen [Smith ( 1 985)]. Going back to a well-known study from the early 1 970s comparing both inter- and intra-generational cost rises for a number of weapon systems, a "military escalation" rate of 4.5 per cent per annum is often quoted [US General Accounting Office ( 1 973)]. But given the difficulty of comparing weapons for their quality, any such number is arbitrary. Based on such escalation rates, Norman Augustine, later chairman of Martin Marietta, predicted in the mid 1970s that the entire US defense budget would only buy one ship, one tank and one aircraft by 2054 [Augustine ( 1 975)]. One additional problem with military deflators for weapon systems is that they tend to be distorted by procurement cycles. Unit weapon costs are often higher in

54

M. Brzoska

the early phases of procurement than in later phases. They also tend to vary with the number of items bought in a particular year, because of the high share of fixed costs. For aggregate measures, the usual quality correction problems of deflation arise. The quality of weapon systems of successive generations is notoriously difficult to value. Military deflators are of no relevance when the object is to measure the opportunity cost of military expenditures. Important here are the changes in the price levels of the goods and services foregone because of the allocation of expenditures to the military. Assumptions about the counter-factual have to be made: for instance that, if available for civilian purposes, resources would be spent on consumption, or in the same way as current GDP. In the first case, the consumer price deflator would be the proper one, in the second case, the GDP deflator. Inflation shapes another problem for international comparisons. Many countries have fiscal years that differ from financial years. With high rates of inflation, correct recalculations to a standard time frame, such as the calendar year, depend on some knowledge of the timing of expenditures within a fiscal year.

4 . International comparisons

Military expenditures are mostly expenditures in national currencies, for salaries and operation. Other parts, such as procurement of weapons, often are spent in international currencies, for instance US dollars. Basic data are reported in national budgets in national currencies. For purposes of international comparisons this presents problems of currency conversions. The most frequently used conversion rates for military expenditures - as for all other economic aggregates - are annual average market exchange rates as for instance regularly published in the IMF's International Financial Statistics. They basically reflect the comparative value of international economic transactions, such as trade, services, foreign investment and other capital transfers, but are also influenced by government interference in international transactions, expectations about future levels of interest rates and future political decisions. The more closed an economy, the higher is the probability that domestic prices diverge from international prices calculated with market exchange rates [Kravis et al. ( 1 978)]. For economies with highly regulated foreign exchange markets, market rates are misleading or not even available. This was, for instance, the case in the former socialist countries. For these cases, a wide spectrum of exchange rates can be used, ranging from official rates set by governments to experts' estimates. The latter are also often used to estimate exchange rates of economies with very high rates of inflation. There are various efforts to address some of the problems associated with market exchange rates. For instance, the UN's price adjusted rates of exchange (PARE) and the World Bank Atlas conversion rate are "corrected" market exchange rates. PARE uses a base year, judged to be reflective of relative prices, which is made current with GDP implicit price deflators. For many of the entries in the World Bank Atlas, an

Ch. 3:

World Military Expenditures

55

average of the current rate and two rates using earlier base years is calculated. Neither of these measures solves the structural problems of the comparability of relative price levels. A radical departure from the international transaction approach is the use of Purchasing Power Parities (PPPs). PPPs are usually calculated from the comparison of common baskets of goods and services of pairs of countries with the US dollar as the common currency. The most extensive effort to calculate PPPs for a large number of economies and to estimate real exchange rates for almost all countries has been the International Comparison Project (ICP) based at the University of Pennsylvania [Kravis et al. ( 1 978), Summers and Heston ( 1 988)]. Kravis, Heston, Summer and associates have developed PPPs for GDP and parts of GDP such as government expenditures. PPPs are also used for the World Economic Outlook published j ointly by the IMF and the World Bank, and by the OECD. The use of alternative currency conversion rates produces differing data sets of international military expenditures (Table 2). With exceptions, PPPs tend to value goods and services in poor countries higher than market exchange rates; therefore conversion of military expenditures with PPPs produces larger numbers for such countries [West ( 1 987), Sen ( 1 992)]. A rough estimate is that world military expenditures would be reported at about 1 25 per cent of their current level if converted with PPPs. The maj or increases in numbers are for countries such as India and China with large military expenditures and very low market exchange rates compared with PPPs. Such PPP conversions reflect opportunity cost measures of international military expenditures. For an output oriented measure of military expenditures, specific PPPs for the military sector have to be calculated. Some limited work has been done on specific military PPPs. A group of experts studied the issue in the framework of the UN Reduction of Military Expenditure exercise [UN ( 1 986), Fontanel ( 1 986), Cars and Fontanel ( 1 987)]. Sufficiently detailed data are only available for a few OECD member countries. Since these countries have fairly similar price structures, differences with figures calculated at market exchange rates are not very large [UN ( 1 986, Table 1 2)]. Building on a combination of the strictly military PPPs from the UN expert group and economic PPPs from the ICP project, Heston and Aten ( 1 993) have estimated real military expenditures for a large number of countries (excluding socialist countries). The base year was 1 980 with further estimations up to 1 985. They first estimated the shares of personnel, international procurement (arms imports) and other expenditures from a number of sources. They then applied differing PPPs to these categories. For some procurement items, such as food and construction, civilian PPPs were used. For purchases of military weapons and salaries of personnel specific PPPs based on the UN expert group's work were estimated. Since it makes a large difference whether there is draft or voluntary conscription of what military expenditures buy in terms of output, they estimated full opportunity cost salaries for conscripts. Heston and Aten's military PPP estimates are different from data based on market exchange rates as well as from GDP PPPs (Table 2). One problem with the data is that

M. Brzoska

56 Table 2 Comparison of military expenditures using alternative currency conversion methods Expenditures in local currencies Country Currency Amount Algeria Bolivia

m dinars m bolivanos

MER

a,

1 985

Expenditures in million US dollars b WBA RMP ppp PARE 141 1

4793

953

926

760

953

95

226

351

1 64

216

133

37700

752

n.a.

821

752

n.a.

Israel

m forint m new shekels

4055

3439

508 1

3465

3439

5028

Nigeria

m nairas

976

1 094

1 008

1091

1 160

Myanmar

m kyats

1 973

233

887

699 282

234

200

USA

b dollars

264

264

264

198

264

264

Hungary

Sources: SIPRI (1 989, appendix SA), UN (1 993, Table A2), Heston and Aten ( 1 993, Table 19.2). Abbreviations: MER, Market Exchange Rates [IMF according to UN ( 1 993)]; PPP, Purchasing Power Parities [ICP Project according to UN ( 1 993)]; PARE, Base Year 1 970 absolute pares [UN (1 993)]; WBA, World Bank atlas rates [World Bank according to UN ( 1 993)]; RMP, Real Military Expenditures [Heston and Aten ( 1 993)]; m, million; b, billion; n.a., not available. a

arms imports are a large component of military expenditures in the data Heston and Aten used 3 . Another is the number of data gaps that have to be filled with the help of regressions. Such data gaps are especially large and worrisome in the cases of East European and Middle Eastern countries and China, where more than 40% of global military expenditures occur. Until more data become available, military PPP estimates are not very reliable. Though they were not named this way, PPP type estimates of military expenditures were the predominant method to estimate data for East European socialist countries during the Cold War. The most important of these was the Central Intelligence Agency's (CIA) "building block method" for the Soviet Union. First, an extensive and labor intensive "count" of all physical items in the Soviet military was made. The physical numbers were than multiplied with prices for equipment and personnel. To these aggregates, cost estimates for other categories, such as research and development and operation and maintenance were added. US prices were used to produce a "dollar" estimate, rouble prices (from a variety of sources, including intelligence) for a "rouble" estimate. The CIA estimates were criticized for a variety of reasons. For instance, the use of either dollar or rouble estimates raises index number problems. Also, dollar and rouble estimates were surprisingly similar, given the large differences in pay for soldiers and workers in the arms industries in the Soviet Union and the USA [Holzman ( 1 982)]. 3 Most of these data are for industrialized countries. An extrapolation of these data to developing

countries is problematic, as Ball (1 984a, 1 988) has demonstrated.

Ch. 3:

World Military Expenditures

57

A number of alternative approaches were proposed and discussed [Jacobsen ( 1 987)]. This is now largely a matter of historical interest, although a lively debate continues [Gonchar ( 1 994)].

5. Relative measures

One way to avoid some of the mentioned problems of intertemporal and international comparisons is to use ratios of military expenditures in relation to other financial aggregates. Unfortunately, new problems arise. However, depending on the purpose for which military expenditure data are to be used, relative measures can be an attractive alternative to military expenditures in local or international currency. The most often used relation is military expenditures as a share of GNP or GDP. It is often called the "military burden measure" because it indicates the importance of the military sector in the spending of the national income. The "military burden" can be calculated without the use of deflators or currency conversion. It makes for easy comparisons between small and large countries as well as between rich and poor countries. As the name suggests, it is most useful for economic purposes. It has little relevance for purposes of measuring relative military strength and the like. The main problem with the "military burden" measure stems from the difficulties in establishing reliable data on national income. Especially in countries without developed markets, be they centrally planned or poor countries, there are large estimation problems. Since defense is a territorial concept, GDP, the production of goods and services in a territory, is preferable as a denominator over GNP, the income of the inhabitants of a territory. Another relative indicator based on a revision of GDP data has been proposed by Lock (1 979). He argued that the "burden measure" was skewed between rich and poor countries since in poor countries a larger share of GDP is subsistence production and can, or at least, should not be used to finance military expenditures. He attempted to calculate military expenditures as a share of Hypothetical Maximum Surplus (HMS). This is defined as national income beyond minimum expenditures necessary to satisfy the population's basic needs. It was calculated by subtracting from GDP the product of the population with the dollar value for the absolute poverty level. For developed countries there is no large difference between the "burden measure" and military expenditures as a share of HMS. For developing countries, especially very poor ones, the HMS based indicator shows much higher values. For Africa in 1 989, for instance, the share of military expenditures in HMS was 50% while it was only 4.4% of GDP [Brzoska ( 1 994b, p. 54)]. There are important conceptual problems with HMS. There is no guarantee that people will receive a minimum income that will cover their basic needs, especially in countries with authoritarian governments. HMS is thus truly hypothetical, though educational in highlighting differences between developing and developed countries. In addition, there are large conceptual and data problems in the calculation of absolute

58

M. Brzoska

poverty levels. There is no regular publication of military expenditures as a share of HMS. There are also relative measures designed to be more reflective of military strength, defense capability and the like. None of these have received much attention. Military expenditures per square kilometer, per kilometer of border line, per inhabitant, etc., can all provide some insight into specific aspects of international comparison, but none are capable of offsetting the basic problems of military expenditures as a measure of military strength mentioned above. Military expenditures as share of GDP may be a good measure of the "burden" for the economy but not of the priority given to the military sector in decision­ making over the use of available resources. Governments, as providers of resources for the military sector, only command part of the national income. If the purpose is to establish national political priorities, it makes more sense to use government expenditures as the denominator rather than the full national income. The share of military expenditures in government expenditures is a good indicator of the relative importance of the military sector in a given country. In practice, the value of this indicator is limited by conceptual and data problems for government expenditures. There are centralized and decentralized governments, governments that budget most expenditures for health, education and pensions directly and governments that leave such functions to private corporations, lean governments and governments that tax heavily and subsidize heavily, etc. The most often used denominator is the Central Government Expenditure series as provided by the IMF. Obviously, it is skewed in cases of very centralized, or decentralized, governments (compare France and Switzerland in Table 3). Recently, the United Nations Development Programme (UNDP) in its Human Development Report has highlighted another indicator, the relationship of military expenditures to expenditures on health and education. The indicator is not new: it can be found in early editions of US ACDA and in Sivard, and can easily be constructed from IMF data [IMF (annual); see also Abdallah ( 1 995)]; in fact, it provides much of the rationale of Sivard's publication 4 . UNDP puts additional emphasis on the indicator by declaring health and education expenditures a measure of priority on "human development". The comparison of military expenditures with human development expenditures was judged to be a good indicator of priorities. Although there are obvious problems with comparisons based on health and education expenditures - the shares of private and government provision differ, labor costs are very sensitive to specific labor supply curves, for instance for doctors and teachers, and the marginal costs of health and education tend to increase with national income - the UNDP data had a remarkable policy impact in the early 1 990s. Together with the burden measure it is, for instance, an important instrument in the discussion about economic aid [Ball ( 1 993)].

4 Sivard was in charge of the US ACDA data in the early 1 970s when it was decided to discontinue the publication of social data.

Ch. 3:

59

World Military Expenditures

Table 3 Military expenditures as share of GOP and Central Government Expenditures (CGE) and in relation to social expenditures' (selected countries, 1 99 1 or latest year available) Country GOP Algeria Bolivia Brazil China Colombia France Hungary Iran Iraq Israel India Nigeria Myanmar (Burma) Soviet Union/Russia Switzerland Uganda USA World average Developed Developing

Military expenditures in relation to (%) Social expenditures CGE

1 .8 2.4 1 .3 3.3 2.6 3.6 2.1 5.7 74.9 8.1 2.7 0.8 5.6 1 0.3 1 .9 2.6 4.9 4.2 4.1 4.5

' Sources: US ACDA ( 1 994), UNDP ( 1 994).

7.7 b 12.8 2.P 17.4 20.5 8.1 4.P 24.9 n.a.

20.5 16.4 2.8 b 1 3.8 43. 1 b 1 9.4 2 1 .8 1 9.6 15.0 14.2 1 8.3 b

11 57 23 1 14 57 29 18 38 27 1 1 06 65 33 222 132 14 18 46 37 33 60

Data for 1 990.

Table 3 illustrates some of the differences between named measures for selected examples. Developing countries generally have higher shares of military expenditures in relation to CGE than developed countries. Part of the difference comes from comparatively low spending on health and education expenditures in developing countries as highlighted by the data in the third column of Table 3. Obviously, the variances in the data series increase with the decreases in the values of the denominators relative to military expenditures. While the general trend in the three series is similar, there are important differences due to country specifics with respect to CGE and social expenditures.

6. Data sources

The general interest in military expenditures data, for whatever purpose, has impelled a number of institutions to publish such data series. Unfortunately, there is a large

60

M. Brzoska

amount of cross citation that is not always recognized by users. It is a time-consuming task to bring available data in line with a chosen definition and to fill in the gaps of poor or missing data. The UN military expenditure data exercise has already been mentioned. Unfortu­ nately, only a limited number of countries respond to the questionnaires sent out to them annually. There is no check to the data applied by the UN. The data are reported in annual publications by the UN in national currencies. The IMF sends out questionnaires to member countries for the purposes of its various statistical series. Following a review in the early 1 990s, questionnaires are now more specific and detailed. Member countries are under an obligation to provide statistics. The IMF provides governments with its definition of military expenditures but accepts the data sent in as long as it does not expressly conflict with the IMF definition or internal accounting logic. Because of bureaucratic practice in many countries, it is likely that the IMF under-represents expenditures outside of the budget of the Ministries of Defense. The data are published in a number of readily available IMF/World Bank sources, in most detail in the Government Finance Statistics Yearbook (GFSY). In 1 993, military expenditure was reported by 94 of the 1 79 IMF member countries. For those countries involved in extended credit programmes, IMF economists usually have a closer look at the statistics, including military expenditure data. Such data, often more conformant to the IMF definition, do not find their way into published statistics if they are not explicitly authorized by national governments. They have been used in an aggregated way in studies by IMF authors, and published in aggregated form in at least one instance in the World Economic Outlook [Arora and Bayoumi ( 1 993)] . In some of its standard series, such as UN National Account Statistics, the UN also publishes data supplied by national authorities. For special publications, such as the UNDP's Human Development Report, data are collected from a variety of sources, including IMF, Sivard and SIPRI. Agencies of the United States government collect, and for some countries of special interest, generate military expenditure data. The data are used for a number of purposes including Congressional requirements to report on countries receiving US aid. Agencies involved include US embassies around the world, the US Agency for International Development (AID) for developing countries, the CIA and the Defense Intelligence Agency (DIA) for countries such as the former Soviet Union, Russia and China. The data are published in a number of places, such as reports to Congress that are difficult to access. The most useful of the US government's publications is the annual World Miltary Expenditures and Arms Transfers prepared by the US ACDA. It is the most comprehensive of all available data sources. The data presented in this publication come from a number of sources within the US government but also from the IMF [Fei ( 1 979), Ball ( 1988)] . There are some peculiarities. For instance, for a number of countries arms imports, as estimated by US government sources, are added to estimates of military expenditures. Although it is probably true that a large number

Ch. 3:

World Military Expenditures

61

of governments do not record any expenditures on arms imports in official military expenditures, there is a danger of double counting for military aid and a mixture of actual and estimated expenditure [see below; for a similar procedure see Hewitt ( 1 993)] . Also, such procedures are not in line with the NATO definition that is reportedly chosen as the basis. Finally, the criteria for selection of countries for which the procedure is adopted are not clear. US ACDA reports data in current and constant US dollars. The constant dollar series is created by converting national data deflated with a CPI inflation index with market exchange rates for some base year. The current dollar series is calculated by applying the US CPI deflator. National and US deflators are thus mixed for the current dollar senes. At SIPRI information on military expenditures is collected from a large number of publicly available sources, such as newspapers, special military j ournals, government publications and budget data. The preferred definition is a simplified NATO definition but SIPRI only has very limited means to correct national data [Huisken (1973), Blackaby and Ohlson ( 1 9 82), Sen ( 1 992)]. For a number of countries, published IMF data are used, but still data have to be estimated for some countries. Because of misgivings about some of the data, estimation of a figure for the Soviet Union was discontinued in 1 987. The data are presented both in national currencies at current prices and at constant prices, using CPI deflators and market exchange rates. Ruth Sivard has for some time been publishing brochures including military expenditure data. Her data are mostly drawn from other sources, such as published IMF data, SIPRI and US ACDA, but for many countries, including the Soviet Union, estimates are made. Each publication includes aggregate data for a number of years and detailed data in US dollars for one year. The London based International Institute of Strategic Studies (IISS) presents data on military budgets in its Military Balance. The figures are usually projected budget expenditures for the current fiscal year as reported to the IISS by national governments. There is no effort to bring them to a common definitional standard or to check whether proj ections correspond with actual expenditures. Differences among the sources can be large in individual cases, as shown by a random sample in Table 4. Among the reasons for the differences are deflation methods, the use of currency conversion, the extent of data manipulation to reflect definitions, corrections for differences in fiscal and financial years and others. Rough trends, for instance for regional totals, are similar [Brzoska ( 1 982), Herrera (1994), Happe and Wakeman-Linn ( 1 993 , 1 994)]. But rankings of individual countries, growth rates of military expenditures for individual countries and levels of military expenditures are source dependent. An example is the number for global military expenditures (Table 5). The main reason for the difference between US ACDA and Sivard is the valuations of Soviet/Russian and Chinese military expenditures. US ACDA, based on CIA estimates, puts very high values on these, while Sivard reports very low numbers.

62

M. Brzoska

Table 4 Military expenditures - differences among international sources • (millions constant US dollars of 1 988) Country

Year

SIPRI

Algeria

1 989 1 991 1989 1991 1 989 1 99 1 1 989 1991 1 989 1 99 1 1 989 1991 1989 1 99 1 1 989 1991 1 989 1 99 1 1 989 1991

1 045 1 1 77 181 1 78

Bolivia China Hungary Israel India Nigeria Myanmar (Burma) Soviet Union/Russia USA Totals, 1 989 Totals, 1 99 1 Number of countries in source

1 989 1 99 1

US ACDA

1 084 644 145 1 03 42 900 43 500 3888 1 1 12 5975 4402 641 2 6129 1 13 215 754 1 129 288 000 221 000 290 938 247 1 97 I 023 445 9 1 5 500 1 22 1 15

n.a. n.a.

1 944 1354 3830 3909 9609 9033 247 275 292 429 n.a. n.a.

290 593 264 383 628 1 89 671 805 Ill

81

GFSY

Sivard'

929 734

n.a. n.a.

1 1 84

n.a.

80 1 03

1 24

n.a. n.a.

1 3 1 40

582

556

IISS

139 6350 1 6 200 792b 660 4961 ' 4543 d 8500 6970 264 208 325 338 I l l 500 1 14 700 277 898 ' 247 146' 744 628 825 727 1 16 1 03

n.a.

5429

5630 4302 8353 6 1 00

9905

n.a. n.a.

258

266 820

539

n.a. n.a.

78 300

278 440 248 220 496 887 423 456 72 45

295 770 706 088 1 32

Sources: SIPRI ( 1 992), US ACDA ( 1 994), Sivard ( 1 993), IMF GFSY ( 1 994), IISS ( 1991-1 993), Happe and Wakeman-Linn ( 1 994); deflation rate: US ACDA ( 1 994). Abbreviations: US ACDA, US Arms Control and Disarmament Agency; SIPRI, Stockholm International Peace Research Institute; IISS, International Institute for Strategic Studies; GFSY, International Monetary Fund - Government Finance Statistics Yearbook. b As announced by government. ct Fiscal Year, including US military aid. ' Fiscal Year. ' 1 990 or earlier, as available. a

Table 5 World military expenditures Billion US dollars, 1 987 prices

Data source• Sivard US ACDA SIPRI

1 980

1 989

1 990

1 99 1

549 850 777

690 986

676 960

655 882

Sources: Sivard ( 1 993, p. 42), US ACDA ( 1 994, Table 1 ), SIPRI ( 1 986, p. 23 1). b No world total estimated after 1 986.

a

Ch. 3:

World Military Expenditures

63

Table 6 World military spending relative to GDP, 1991 • (in percent of GDP, averages over countries in source b) Region/country World total Western industrial countries Eastern Europe Soviet Union/Russia Developing countries Asia Middle East North Africa Sub-Saharan Africa Western Hemisphere

US ACDA

4.9 2.7 4.6 1 0.3 5.6 3.4 18.8 4.3 3.3 1 .8

SIPRI

nss

3.3 2.7

4.1 2.4

GFSY

WEO

3.1 2.9

3.4' 3.3 3.8 6.3 2.6 2.4 7.2 2.2d

1 .6

3.6

3.3

n.a.

n.a.

n.a.

3.8 3.2 1 0.0 3.6 1 .8 1 .6

4.8 3.8 12 4.4 3 .7 2.5

3 .2 2.5 8.4 2.0 2.7 1 .3

1.1

' Sources: Arora and B ayoumi ( 1 993), Happe and Wakeman-Linn ( 1 993). Abbreviations: US ACDA, US Arms Control and Disarmament Agency; SIPRI, Stockholm International Peace Research Institute; !ISS, International Institute for Strategic Studies; GFSY, International Monetary Fund-Government Finance Statistics Yearbook; WEO, International Monetary Fund/World Bank, World Economic Outlook. b Data for WEO are for 1 992. ' Own estimate including Russia. d Africa total.

Large differences are also visible in the data o f military expenditures as share in GDP (Table 6). The relations between the various world regions are similar, though not identical. Available data sources have to be used with great caution. 7. International arms transfers For developing countries, more than half of the value of procurement is the import of weapons and other military goods. As mentioned earlier, the treatment of arms imports in many countries' military expenditures is difficult to track, leading some experts into the practice of adding arms imports to military expenditures [US ACDA, Hewitt ( 1 993)] . Unfortunately, available data on the arms trade are not well suited for such correction of military expenditure data, even in cases where national budgeting practice would allow such adjustment. Available data - from SIPRI, US government and the UN are output oriented. They are constructed with the primary goal of measuring the transfer of military power [Brzoska ( 1 9 8 1 )] . SIPRI researchers collect public information on transfers of maj or weapons 5 and then multiply them with a price (called SIPRI unit -

5

Aircraft, armored vehicles and artillery, ships, missiles and stand-alone radar and guidance systems.

64

M. Brzoska

value) that is considered to reflect values regardless of whether this price is actually paid or not. The US government collects data on individual arms transfer deals, recording the number of items transferred and prices paid. But if actual prices seem to diverge from imputed values or no money is paid, average prices from similar deals are imputed. The data are regularly published in the reports by US ACDA and the Congressional Research Service [Grimmett (annually)]. At the UN, a voluntary arms transfer register has been in operation since 1 993 . A large percentage of exporters and a fair amount of importers report transfers of maj or weapons. Some cross-checking is therefore possible. No financial data are published [Laurance, Wulf and Wezeman ( 1 993)]. Especially during the Cold War, when large numbers of weapons were transferred for free or at subsidized prices, there were large discrepancies between arms transfer data as published by international sources and what was actually paid for imported weapons. In the case of the Soviet Union, for instance, less than one third of income from arms sales reported in standard sources actually occurred. The rest was delivery on credit terms where repayment was insecure or not expected at all [Brzoska ( 1 983, 1 994a)]. On the other hand, because of the widespread practice of purchasing weapons on credit, a sizeable amount of military induced debt was accumulated in the late 1 970s and 1980s. Debt service on weapomy imported earlier may be higher since the late 1 980s than the cost of current arms transfers [Brzoska ( 1 992)]. These costs are regularly not part of reported military expenditures. If they were included, arms transfer data would be increased by one fourth to one third [Brzoska ( 1 994a)].

8. Conclusion

For academic analysis, military expenditures may be the best indicator of military activity but available data have to be used with a great deal of caution, for instance in regression analysis [Goertz and Diehl (1 986)]. For interpretation of all kinds it has to be taken into account that there is no general agreement on the concept nor its translation into definitions. Data accuracy and validity is not sufficient to support weak statistical results. Exceptions from this statement are only acceptable in the case of OECD countries. The data are good for some countries outside of the OECD, such as India, but very poor for a large number of others. The ready availability of data in some well-known sources should not detract from the numerous data problems. None of the institutions collecting and openly publishing data are able to put much effort into correcting military expenditures data. Compared with the resources available to national or international statistical offices, the labor input is marginal. At SIPRI, Sivard, and US ACDA, timely publication of the series depends on the initiatives of single persons. Unfortunately, the UN has not succeeded in bringing a sufficient number of countries to report detailed data and the IMF does not publish its more standardized series.

Ch. 3:

World Military Expenditures

65

The available data are more suited for trend analysis than for international comparisons. The range of definitions is large, and corrections according to a standard definition are limited. Currency conversion problems are serious. Deflation is another large problem. Above all, for the maj ority of countries, the availability of data remains as the outstanding issue. Military expenditures are still a highly political issue in many countries, although the most controversial case, Soviet military expenditures, has lost its relevance. Many governments continue to treat military expenditures as a national secret even if they do not engage in manipulation of such data. It is to be hoped that the end of the Cold War will allow a continuation of the UN's efforts at reporting military expenditures or another maj or effort by another international organization. The success of the arms transfer register is a good sign. More transparency of military expenditures is also one of the goals of recent activities by donors of development aid [Ball ( 1 993), Kan ( 1 993)] .

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66

DoD (US Department of Defense), annual, Programme acquisition costs by weapon system (US Department of Defense, Washington, DC). Fei, E.T., 1 979, Understanding arms transfer and military expenditure data problems, in: S.G. Neumann and R.E. Harkavy, eds., Arms transfers in the modem world (Praeger, New York) 37--46. Fontanel, J., 1 982, La comparaison de depense militaire, Defense Nationale, 38, 1 07-1 2 1 . Fontanel, J., 1 986, A note on the international comparison o f military expenditures, in: C . Schmidt, ed., The economics of military expenditures (Macmillan, London) 29--46. Goertz, G., and P.F. Diehl, 1 986, Measuring military allocations: A comparison of different approaches, Journal of Conflict Resolution, 30, 553-5 8 1 . Gonchar, K., 1 994, Military spending i n the USSR: A reconsideraton, Journal o f Peace Research, 3 1 ,

2 1 9-228. Grimmett, R., annual, Conventional arms transfers to the Third World (Library ofCongress, Congressional Research Service, Washington, DC). Happe, N., and J. Wakeman-Linn, 1 993, Military expenditure and arms Trade: Alternative data sources, Part I, Peace Economics, Peace Science and Public Policy 1, 3-38. Happe, N., and J. Wakeman-Linn, 1 994, Military expenditure and arms trade: Alternative data sources, Part II, Peace Economics, Peace Science and Public Policy 2, 1 0-23. Herrera, R., 1994, Statistics on military expenditure in developing countries: Concepts, methodological problems and sources (OECD Development Centre, Paris). Heston, A., and B. Aten, 1993, Real world military expenditures, in: J. Brauer and M. Chatterji, eds., Economic issues of disarmament (New York University Press, New York) 257-287. Hewitt, D.P., 1 993, Military expenditures worldwide: Determinants and trends, Journal of Public Policy

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1 76. Holzman, F.D., 1 982, Soviet military spending: Assessing the numbers game, International Security 6,

78-1 0 1 . Huisken, R., 1973, The meaning and measurement o f military expenditure (SIPRI Research Report, Stockholm). IISS (International Institute for Strategic Studies), annual, Military Balance (IISS, London). IMF (International Monetary Fund), monthly, International financial statistics (IMF, Washington, DC). IMF (International Monetary Fund) GFSY, annual, Government finance statistics yearbook (IMF, Washington, DC). Jacobsen, C.G., ed., 1 987, The Soviet defence enigma. Estimating costs and burdens (Oxford University Press, London). Kan, S., 1 993, Military expenditures by developing countries: Foreign aid policy issues, Report 93-999F (US Library of Congress, Congessional Research Service, Washington, DC). Kravis, LB., et a!., 1 978, International comparisons of real product and purchasing power (The Johns Hopkins University Press, Baltimore, MD). Laurance, E.J., H. Wulf and S. Wezeman, 1 993, Arms watch (Oxford University Press, London). Lock, P., 1 979, New international order and armaments, Vierteljahresberichte der Friedrich-Ebert-Stiftung,

77, 14-28. Sen, S., 1 992, Military expenditure data for developing countries: Methods and measurement, in: G. Lamb and V. Kallab, eds., Military expenditure and economic development. A symposium on research issues (World Bank Discussion Papers 1 85, Washington, DC) 1-18. Shambaugh, D., 1 994, World military expenditures, China, in: SIPRI yearbook 1 994, 441--448. SIPRI (Stockholm International Peace Research Institute), annual, SIPRI yearbook (Oxford University Press, London). Sivard, R.L., annual, World military and social expenditures (World Priorities, Leesburg, VA). Skons, E., 1 983, Military prices, in: SIPRI yearbook 1 983 (SIPRI, Stockholm) 1 95-21 1 .

Ch. 3:

World Military Expenditures

67

Smith, R., 1 985, Defence costs, in: J. Roper, ed., The future of British defence policy (Gower, London) 143-158. Summers, R., and A. Heston, 1 988, A new set of international comparsions of real products and prices: Estimates for 1 30 countries, The Review of Income and Wealth 34, 1-25. UN (United Nations), 1 977, Reduction of military budgets: Measurement and international reporting of military expenditures, Report of the Secretary-General, A/31/222/Rev. l (UN Centre for Disarmament, New York) . U N (United Nations), 1 9 8 1 , Reduction of military budgets. International reporting o f military expenditures, Report of the Secretary-General, A/35/479 (UN Centre for Disarmament, New York). UN (United Nations), 1 986, Reduction of military budgets. Construction of military price indexes and purchasing power parities for comparison of military expenditures, Report of the Secretary-General, A/40/421 (UN Department for Disarmament Affairs, New York). UN (United Nations), 1 993, Trends in international distribution of gross world product (Department for Economic and Social Information and Policy Analysis, Statistical Division, New York, Special Issue of National Accounts Statistics, ST/ESA/STAT/SER.X/ 1 8. UNDP (United Nations Development Programme), annual, Human development report (Oxford University Press, London). US ACDA (US Arms Control and Disarmament Agency), annual, World military expenditures and arms transfers (US Government Printing Office, Washington, DC). US Department of Commerce, monthly, Bureau of Economic Analysis, Survey of current business (US Department of Commerce, Washington, DC). US General Accounting Office (GAO), 1 973, Cost growth in major weapon systems (US General Accounting Office, Washington, DC). West, R., 1 987, Improved measures of the defense burden in developing countries, in: S. Deger and R. West, eds., Defense, security and development (Francis Pinter, London) 1 9-48. Wiberg, H., 1 984, Measuring military expenditures: Purposes, methods, sources, Cooperation and Conflict, 1 8, 1 6 1-177. World Bank, annual, World development report (Oxford University Press, London).

Chapter 4 THE DEMAND FOR MILITARY EXPENDITURE RON SMITH

Birkbeck College, London

Contents

Abstract Keywords 1 . Introduction 2. The framework 3. Interpretation 4. Theoretical specification 5. Data 6. Econometric issues 7. Some examples 8. Conclusion References

Handbook of Defense Economics, Volume I, Edited by K. Hartley and T Sandler © 1 995 Elsevier Science B. V. All rights reserved

70 70 71 71 74 76 78 80 83 84 85

70

R. Smith

Abstract

This chapter provides an analytical survey of models explaining the level of military expenditure, emphasizing empirical econometric models based on optimizing behavior. After setting out the standard neo-classical model in which nation states are represented as rational agents maximizing a welfare function depending on security and economic variables subject to a budget constraint, the chapter considers: criticisms of this model, alternative theoretical specifications, data and measurement issues, alternative econometric approaches and reviews selected studies.

Keywords

demand, military expenditures, econometric methods, optimizing models

Ch. 4:

The Demand for Military Expenditure

71

1 . Introduction

This chapter provides an analytical survey of the large literature on models which attempt to explain the level of military expenditure. It emphasizes empirical econo­ metric models based on optimizing behavior, but tries to confront some of the more fundamental methodological issues raised by these models. Section 2 sets out the standard neo-classical model in which nation states are represented as rational agents who maximise a welfare function depending on security and economic variables, subject to a budget constraint which includes military spending, and a function which determines its security in terms of its own and other countries military forces. The state then balances the welfare benefits of extra security derived from military expenditure against its opportunity costs in terms of foregone civilian output, and solves this optimization problem to give a derived demand for military spending. Section 3 considers the fundamental questions about this approach. Firstly, who (median voter or rational state) is maximizing what and why? Secondly, can this model be regarded as a plausible or useful summary of the political and bureaucratic process actually generating military spending. Third, is the fundamental assumption of this framework that military expenditure is motivated by security, rather than domestic political or economic concerns, justified? Section 4 considers the detailed theoretical specification of such models. The issues discussed include the choice of welfare function, budget constraint, and functional forms; the role of prices; the form of any dynamics and the arguments of the security function. These issues are also discussed in the arms-race and alliance chapters. Section 5 examines the data and measurement issues. Section 6 examines alternative econometric approaches used to model military spending. In particular, it contrasts theory based with data based models and single equation with systems estimators. Section 7 reviews selected studies and Section 8 draws some conclusions. Many of the issues discussed in this chapter are also covered in chapter 3 of Sandler and Hartley ( 1 995).

2. The framework

The standard neo-classical model of the demand for military expenditure assumes that there is a national state which maximizes welfare W, which is a function of security S, economic variables such as total consumption C, population N, and other variables, say ZW, which parameterize shifts in the welfare function (e.g. the politics of the party in power). For instance: W = W(S, C,N, ZW).

(l)

Population is included because while defense may be a public good, consumption probably is not, so it is per capita consumption that matters for welfare. This

R. Smith

72

maximization is subj ect to a budget constraint and a security function. The simplest budget constraint is

Y = pcC + pmM,

(2)

where Y is nominal aggregate income and Pm and Pc are the prices of real military spending M and consumption C. Security can be thought of as perceived freedom from threat of attack. Like utility or welfare, security is unobservable to the econometrician and is replaced by some set of quantifiable variables, such as the military forces of the country and other countries, together with other strategic variables, ZS, which parameterize shifts in the security environment S

=

S(M M 1 , . . , Mn , ZS). ,

.

(3)

Some of the other countries may be allies in which case there is a "spillin" from their expenditure which raises your security, others may be potentially hostile in which case their forces pose a threat to your security. There are a variety of ways that the forces of the allies may be aggregated: for instance total alliance military effectiveness may depend on the sum of the forces; the minimum force (the "weakest link in the chain" determines effectiveness) or the maximum force (the "best shot" determines effectiveness). Conybeare, Murdoch and Sandler ( 1 994) test between alternative models of the aggregation technology. The forces of each country will be determined in a similar way. This j oint determination of the set of forces is the focus of much arms race and alliance literature. Here we will focus on the partial equilibrium determination of one country's forces, given those of the others. This optimization problem is then solved to give a derived demand for the level of military spending: (4) For estimation, this demand function will need to be supplemented by auxiliary assumptions about the appropriate forms of the functions. To be more specific, consider a very simple example in which we ignore N, ZW and ZS and assume that the welfare function is of the Stone-Geary form: W

=

a log(C) + (1 - a) log(S).

(5)

A minimum level of consumption is often allowed for C*, with C - C* appearing instead of C in the welfare function. Let us suppose that the state is not aggressive but faces one threatening neighbor, with military forces M 1 , and neither has allies. Its security is given by: (6) where M* is the forces the country would need to resist an attack by its neighbor. M* is determined partly by fixed elements unrelated to the opponents forces (for instance, if

Ch. 4:

73

The Demand for Military Expenditure

there are natural strategic defenses {30 would be negative; if surprise attack would give the neighbor an advantage {30 would be positive) and partly by the size of the opponents forces with {3 1 , the Lanchester coefficient, measuring the relative effectiveness of the forces in combat [see, for instance, Anderton ( 1 990)]. Using the budget constraint above, the Lagrangean is then:

L = a log( C) + ( 1 - a) log(M - M*) + A.(Y -Pc C - PmM).

(7)

The first order conditions are: I. e.

8L aM

a C = ­' p A c

1-a - APm = 0; M - M*

I.e.

M=

(8) 1-a

--

APm

+ M* '

8L - = Y -- pc C - pm M = 0. 8A.

(9) ( 1 0)

Eliminating the Lagrange multiplier using ( 1 1) gives the two demand equations of the Linear Expenditure System (LES) M=

1-a

--

Pm

Y + a(f3o + f3rMr),

( 1 2)

and ( 1 3) which determine real consumption and military spending as a function of income, prices, preference parameters (a), strategic parameters ({3;) and the other countries military spending. This system satisfies the usual requirements of adding up, homo­ geneity, symmetry and negativity of the Slutsky matrix. Much of the interest in demand systems has focussed on testing these implications of theory [see, for instance, Chapter 3 of Deaton and Muellbauer ( 1 980)]. Dunne, Pashardes and Smith ( 1 9 84) show that a complete dynamic demand system for four categories of UK government consumption including military spending does satisfy homogeneity and symmetry. However, such testing is quite rare, partly because of the lack of data on military prices. The model can be easily generalized to allow for the more realistic assumption that security depends on stocks of military forces, rather than flows of military

R. Smith

74

expenditures. The stock of military forces (equipment plus the human capital embodied in experienced personnel) can be defined as the depreciated sum of past expenditures ( 1 4)

where o is the depreciation rate, a parameter to be estimated. Depreciation here is a peace-time concept, not destruction during war. If there is a similar stock measure for the other country, security is then given by ( 1 5)

where M7 = f3o + f3 I [Mit + ( 1 -- o)Klt-d - ( 1 - o)Kt+

( 1 6)

This gives a demand function M1

=

( 1 - a)

( ) �

Pm 1

( 1 7)

+ aM ; .

If stocks are not observed, which is the usual case, they can be substituted out using _

Kt -

Mt 1 - c 1 - o)L '

( 1 8)

where L is the lag operator such that Lx1 = x1-1 - Multiplying through by (1-( 1 - o)L) and rearranging gives Mt

=

af3o o + ( 1 - a)

( ) :!..._

Pm t

[

+ af31Mu + ( 1 - a) ( 1 -

Equation (23) can be written

M, = a( l - p) + f3'x, + PYr-! - pf3'xr-! + u,

(24)

which is a special case of the dynamic linear regression model (25) subject to the k (common factor) restrictions (26) These restrictions, which are imposed by Cochrane-Orcutt, are rarely tested. If the residual serial correlation is an indicator of dynamic misspecification (the common factor restrictions are not true) Cochrane-Orcutt type estimators will be biased and inconsistent. While static models are implausible in that they imply that short and

R. Smith

82 Table I Autoregressions explaining log of real military expenditure 1 960� 1 985 Quantity

constant lnM(� l )

us

0.94 (2.02)' 1 .47 (8.59)

Country France

UK

Germany

0.47 ( 1 .82)

1 .20 (3.05)

1.19 (6.36)

0.56 (2.78)

0.59 ( 1 .07) 0.84 (3.92)

lnM(�2)

�0.66 (3.69)

�0.36 ( 1 .92)

0.04 (0.37)

�0.05 (0. 1 9)

t ( x l OO)

0.25 (1 .58)

0.40 ( 1 . 84)

0.55 ( 1 .86)

0.33 (1 .52)

R2 for level of M

R2 for change in M

SC p b

ADF( 1 ) '

0.89

0.98

0.89

0.89

0.42 0.51

0.20

0.33

0.1 1

0.3 1

0.12

0.30

�2.03

� 1 .79

�2.92

�1 .07

' Figures in parentheses are absolute t ratios. b SC p is the p value of the F version of an LM test for first order serial correlation. ' ADF(1) is the Augmented Dickey Fuller Statistic including one lagged change, its critical value �3.59.

long-run effects are the same, they can provide estimates of the long-run effects if the variables are 1( 1 ) (integrated of order one, i.e. stationary after being differenced once) and cointegrated. In fact, both the theory discussed above and the data strongly suggest that the dynamics are important. Table 1 gives estimates of the following simple model for the four largest NATO countries 1 960-- 1 985 (27) The data, which are in 1 980 US $ bn, were taken from Table A7. 1 of Murdoch and Sandler (1 990). In the case of a random walk, p1 = 1 and p2 0; a first order autoregression in the growth rates is the special case where p 1 + p2 1 . In either case there is a unit root in the process. In all four cases, the first order augmented Dickey Fuller statistic, ADF(1 ), does not reject the unit root hypothesis that the series is I( 1). None of the equations shows significant serial correlation and they indicate that at least 89% of the variation in real military expenditure can be explained "atheoretically", purely from univariate dynamics. Of course, this high R2 is misleading as is indicated by the much lower value for the proportion of the change in M explained. In fact, for France and Britain, the hypothesis that real military expenditure is just a random walk with drift, cannot be rejected. Given the importance of both theory and dynamics, integrating the theoretical static and atheoretical dynamic approaches is an important avenue for future research. This is, of course, also a major research agenda in mainstream economics. =

=

Ch. 4:

The Demand for Military Expenditure

83

In many cases demand equations for military expenditure have been estimated as components of complete systems. The systems may include the other components of demand in a particular country (as in traditional complete demand systems) or the demand equations for other countries as in alliance or arms race models. As an example, Hilton and Vu ( 1 99 1) estimate a 3 equation demand system for each of a set of NATO allies by Full Information Maximum Likelihood. There are three main reasons for using systems estimators. Firstly, systems allow cross-equation restrictions to be imposed (e.g. symmetry in complete demand system) which increases estimation efficiency and permits hypothesis testing. Secondly, systems can allow for cross­ equation disturbance covariances, also improving efficiency. Thirdly, systems can allow for simultaneity, where explanatory and dependent variables are j ointly determined; enabling consistent estimates of the structural parameters to be obtained when the system is identified. Simultaneous systems arise in alliance or arms race models when the military expenditures of sets of countries are jointly determined and in macro­ economic models where the main focus of the exercise is to estimate the economic effects of military spending but equations for military expenditure are included to deal with potential simultaneity biases.

7.

Some examples

One of the most striking features of this literature is its variety. This is well illustrated by the studies in Hartley and Sandler ( 1 990). The authors of this collection were asked to estimate their country's demand for military expenditure, using a standard model in which military expenditure was determined by GDP, the threat, spillins from allies and other variables such as governing party or a change in strategy. Despite being provided with a standard framework, the authors managed to produce a wide range of equations. In many cases the final equation was the result of a specification search. Looney and Mehay ( 1 990) regressed US real defense spending ( 1 965-1 985) on its lagged value, anticipated and unanticipated Soviet defense spending, inflation, deviation from trend in federal revenues, lagged federal deficit, a Vietnam dummy, deviations from trend in other NATO spending and a detente dummy, correcting for AR 1 serial correlation, by Cochrane-Orcutt. In a number of their specifications the coefficient of the lagged dependent variable was very close to unity. Smith ( 1 990) regressed the change in the UK share of military spending ( 1 9491 987) on the change in the US share, the difference between the UK share and the Soviet share in the previous period and dummies for the Korean War, defense reviews, and the NATO 3 % commitment, using OLS. Schmidt, Pilandon and Aben ( 1 990) regressed the SIPRI measure of French defense spending in constant dollars (1 9651 978) on GDP, Soviet military spending, other NATO expenditures, Allied African expenditures correcting for AR2 serial correlation. They also discuss using French measures (which do not correspond to the NATO definition used by SIPRI).

84

R. Smith

Fritz-ABmus and Zimmermann ( 1 990) regress German defense spending in constant dollars ( 1 961-1 987) on GDP (which had a negative sign), the lagged level in French and other NATO countries defense spending, lagged Soviet defense spending, and a dummy for government composition, where the coefficients of the spillin terms were allowed to shift with the change in NATO strategy in 1 974. Murdoch and Sandler ( 1 990) use a log-log equation to explain real Swedish military expenditure in US dollars (1958- 1 985) by GDP, population, the lagged real military expenditures of Norway, lagged Soviet spending (which was negative but insignificant) and a fiscal dummy; allowing coefficients of the Norwegian spillin terms to shift with the change in NATO strategy. They experimented with a variety of other spillin measures. Deger and Sen ( 1990) estimate equations explaining India and Pakistan's real military spending by their own lagged spending, current or lagged values of the others spending, GDP, arms imports, arms production and the ratio of government spending to output. A priori, it seems unlikely that the structure of the processes generating military expenditure are so different in each of these countries. It seems more likely that the differences are the products of the prior beliefs and the modelling techniques of the authors. Such proliferation of competing models is not uncommon in applied econometrics and there is considerable methodological dispute as to what the appropriate response should be. The issues being very similar to that within the military literature: the relative weight to be given to firm theoretical foundations or an adequate representation of the data.

8. Conclusion

The studies discussed in this chapter indicate that it is possible to achieve equations that explain military expenditure reasonably well in terms of R2 and significant t statistics. However, for integrated time-series subj ect to the danger of spurious regression these may not be very stringent criteria. In a regression with two unrelated integrated series, R2 goes to unity and the t statistics to non-zero values as the sample size increases. This suggests that more demanding statistical criteria are required: tests for cointegration, lack of serial correlation, functional form, normality, and heteroskedasticity are now standard in econometrics packages and may help in distinguishing between models. In addition, tests for structural stability, whether the parameters are constant over time, should also be informative in future work given the large changes in the strategic environment over the last few years. It would also be useful if authors could make their data sets more widely available, so that the performance of different models on the same data could be compared. There is also scope for improving the theory. There are a range of theoretical arms­ race models which treat countries as strategically interacting, forward-looking agents maximizing inter-temporal welfare functions subject to constraints. However, these have not yet been widely used in empirical work and there is scope to investigate the

Ch. 4: The Demandfor Military Expenditure

85

empirical implications of such models. Ideally, one would like a generally accepted dynamic inter-temporal optimizing model which nested the variety of theoretical and atheoretical forms for the demand for military expenditure. This model could then be used as a framework to assess the theoretical consistency and statistical adequacy of the competing equations. While this seems unlikely to be achieved, it does provide an interesting research agenda. References Alogoskoufis , G., and R. Smith, 1 99 1 , On error correction models: Specification, interpretation, estimation, Journal of Economic Surveys 5, 97-128. Anderton, C.H., 1 990, The inherent propensity towards peace or war embodied in weaponry, Defence Economics I , 1 97-220. Chan, M.W.L., C. Hsiao and C.W.K. Keng, 1 982, Defence expenditures and economic growth in developing countries: A temporal cross-sectional analysis, in: O.D. Anderson and M.R. Perryman, eds., Applied time series analysis (North-Holland, Amsterdam) 53-64. Chowdhury, A.R., 1 9 9 1 , A causal analysis of defence spending and economic growth, Journal of Conflict Resolution 35, 80-97. Conybeare, J.A.C., J.C. Murdoch and T. Sandler, 1 994, Alternative collective-goods models of military alliances: Theory and empirics, Economic Inquiry 32, 525-542. Cusack, T.R., and M.D. Ward, 1 9 8 1 , Military spending in the United States, Soviet Union and the People's Republic of China, Journal of Conflict Resolution 25, 429--469. Cypher, J., 1 987, Military spending, technical change, and economic growth: A disguised form of industrial policy? Journal of Economic Issues 2 1 , 33-59. Deaton, A., and J. Muellbauer, 1 980, Economics and consumer behaviour (Cambridge University Press, Cambridge). Deger, S., and S. Sen, 1 990, Military security and the economy: defence expenditure in India and Pakistan, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London) 1 89-227. Dudley, L., and C. Montrnarquette, 1 98 1 , The demand for military expenditures: An international comparison, Public Choice 37, 5-3 1 . Dunne, J.P., and R . Smith, 1 990, Military expenditure and unemployment i n the OECD, Defence Economics 1 , 57-73. Dunne, J.P, P Pashardes and R. Smith, 1 984, Needs, costs and bureaucracy: The allocation of public consumption in the UK, Economic Journal 94, 1 - 1 5. Fontanel, J., and R. Smith, 1 990, The impact of strategy and measurement on models of French military expenditure, Defence Economics I , 261 -273. Fritz-ABmus, D., and K. Zimmermann, 1 990, West German demand for defence spending, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London)

1 1 8-147. Georgiou, G., and R. Smith, 1 983, Assessing the effect of military expenditure on OECD countries, Arms Control 4, 3-1 5. Gleditsch, N.P, and 0. Njolstad, eds., 1 990, Arms races: Technological and political dynamics (Sage Publications, London). Granger, C. W.J., 1 969, Investigating causal relations by econometric models and cross-spectral models, Econometrica 37, 424--438. Greenwood, D., 1 987, Note on the impact of military expenditure on economic growth and performance, in: C. Schmidt, ed., The economics of military expenditures (Macmillan for the International Economic Association, London) 98-1 03.

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86

Griffin, L.J., M. Wallace and J. Devine, 1 982, The political economy of military spending: Evidence from the United States, Cambridge Journal of Economics 6, 1-14. Hartley, K., and T. Sandler, eds., 1 990, The economics of defence spending: An international survey (Routledge, London). Hilton, B., and A. Vu, 1991, The McGuire model and the economics of the NATO alliance, Defence Economics 2, 105-2 1 . Karnlet, M.S., and D.C. Mowery, 1987, Influences o n Executive and Congressional budgetary priorities 1 955-1 9 8 1 , American Political Science Review, 8 1 , 1 55-178. Levine, P., and R. Smith, 1 995, The arms trade and arms control, Economic Journal 1 05, 471-484. Looney, R.E., and S.L. Mehay, 1 990, United States defence expenditures: trends and analysis, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London) 13-40. Maizels, A., and M.K. Nissanke, 1986, Determinants of military expenditures in developing countries, World Development 14, 1 125-1 140. McGuire, M.C., 1982, U.S. foreign assistance, Israeli resource allocation, and the arms race in the Middle East, Journal of Conflict Resolution 26, 199-235. McGuire, M.C., 1987, US foreign assistance, Israeli resource allocation and the arms race in the Middle East, in: C. Schmidt, ed., The economics of military expenditures (Macmillan for the International Economic Association, London) 1 97-238. Mintz, A., ed., 1992, The political economy of military spending in the United States (Routledge, London). Murdoch, J.C., and T. Sandler, 1984, Complementarity, free riding and the military expenditure of NATO allies, Journal of Public Economics 25, 83-1 0 1 . Murdoch, J.C., and T. Sandler, 1 986, The political economy o f Scandinavian neutrality, Scandinavian Journal of Economics 88, 583-603. Murdoch, J.C., and T. Sandler, 1 990, Swedish military expenditure and armed neutrality, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London)

148-176.

Murdoch, J.C., T. Sandler and L. Hansen, 199 1 , An econometric technique for comparing median voter and oligarchy choice models of collective action: The case of the NATO alliance, Review of Economics and Statistics 63, 624-63 1 . Nickell, S., 1 985, Error Correction, partial adjustment and all that: an expository note, Oxford Bulletin of Economics and Statistics 47, 1 19-129. Okamura, M., 1991, Estimating the impact of the Soviet Union's threat on the United States-Japan alliance: A demand system approach, Review of Economics and Statistics 73, 200-207. Ostrom Jr, C. W., 1 978, A reactive linkage model of the US defence expenditure policy-making process, American Political Science Review 72, 941-957. Ostrom Jr, C.W., and R.F. Marra, 1 986, US defence spending and the Soviet estimate, American Political Science Review 80, 8 1 9-842. Payne, J.E., and K.L. Ross, 1 992, Defense spending and the macroeconomy, Defence Economics 3,

1 6 1-168. Pivetti, M., 1 992, Military spending as a burden on growth: An "underconsumptionist" critique, Cambridge Journal of Economics 1 6, 373-384. Rattinger, H., 1 975, Armaments detente and bureaucracy: The case of the arms race in Europe, Journal of Conflict Resolution 1 9, 571-595. Sandler, T., and K. Hartley, 1995, The economics of defense (Cambridge University Press, Cambridge). Sandler, T., and J.C. Murdoch, 1 990, Nash-Cournot or Lindahl behaviour: An empirical test for the NATO allies, Quarterly Journal of Economics 105 , 875-94. Schmidt, C., L. Pilandon and J. Aben, 1 990, Defence spending in France: the price of independence, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London) 93-1 17.

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87

Smith, R., 1 977, Military expenditure and capitalism, Cambridge Journal of Economics 1, 6 1 -76. Smith, R., 1 978, Military expenditure and capitalism: a reply, Cambridge Journal of Economics 2, 299-304. Smith, R., 1 980, The demand for military expenditure, Economic Journal 90, 8 1 1-820. Smith, R., 1 987, The demand for military expenditure: A correction, Economic Journal 97, 989-90. Smith, R., 1 989, Models of military expenditure, Journal of Applied Econometrics 4, 345-359. Smith, R., 1 990, Defence spending in the United Kingdom, in: K. Hartley and T. Sandler, eds., The economics of defence spending: An international survey (Routledge, London) 76-92. Smith, R., 1 994, Measuring the effects of military spending: Cross-sections or time-series? in: M. Chatterji, H. Jager and A. Rima, eds., The economics of international security (Macmillan, Basingstoke) 232-244. Smith, R., and J.P. Dunne, 1 994, Is military spending a burden? A marxo-marginalist response to Pivetti, Cambridge Journal of Economics 1 8, 5 1 5-521 . Smith, R., A . Humm and J. Fontanel, 1 987, Capital labour substitution in defence provision, in: S . Deger and R. West, eds., Defence, security and development (Frances Pinter, London) 69-80. Stoll, R.J., 1 992, Steaming in the dark? Rules, rivals and the British Navy 1 860-1 9 1 3, Journal of Conflict Resolution 36, 263-283. Tait, A.A., and P.S. Heller, 1 982, International comparisons of government expenditure, Occasional Paper No. 1 0 (International Monetary Fund, Washington, DC). Williams, J.T., and M.D. McGinnis, 1 992a, Expectations and the dynamics of US defense budgets: A critique of organisational reaction models, in: A. Mintz, ed., The political economy of military spending in the United States (Routledge, London) 282-304. Williams, J.T., and M.D. McGinnis, 1 992b, The dimension of superpower rivalry: A dynamic factor analysis, Journal of Conflict Resolution 36, 86-98.

Chapter 5 MILITA RY ALLIA NCES: THEORY A ND EMPIRICS JAMES C. MURDOCH

University of Texas at Dallas Contents

Abstract Keywords 1. Introduction 2. Theoretical contributions 2. 1 . The pure public good model 2.2. The joint product model 2.3. Other contributions 2.3 . 1 . Technology of supply 2.3.2. The allocation process

3 . Empirical contributions 3 . 1 . Tests based on the pure public good model 3.2. Tests based on the joint product model 3.3. Other empirical contributions

4. Conclusion References

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T. Sandler © 1 995 Elsevier Science B. V. All rights reserved

90 90 91 91 92 95 98 98 99 1 00 1 00 1 03 1 04 1 06 1 07

90

J. C. Murdoch

Abstract

This chapter provides an overview of the main theoretical and empirical findings in the economics of military alliances. The pure public and j oint product models are presented along with the empirical methods used to test them. Issues concerning burden sharing and strategic doctrine in the NATO alliance are discussed. Comparisons between the Nash and Lindahl allocation processes are made by presenting the empirical work that has attempted to distinguish between them. Attention is also given to the median-voter model and to alternative technologies of public good supply.

Keywords

alliance, best shot, burden sharing, collective action, joint-product model, Lindahl equilibrium, median-voter model, military alliance, NATO, Nash equilibrium, Nash reaction paths, pure public good, strategic doctrine, weakest link

Ch. 5: Military Alliances: Theory and Empirics

91

1 . Introduction

Since the seminal study of Olson and Zeckhauser ( 1 966), economists and political scientists have applied the tools of public economics to the study of military alliances. In this chapter, a survey of these studies is presented with particular emphasis on the theoretical and empirical behavior of individual nations that belong to a military alliance. By definition, a military alliance is a group of nations that are bound to provide protection to all members from aggression by common enemies [Olson and Zeckhauser ( 1 966)]. From the perspective of the individual ally, the level of protection, which is also called security or deterrence, is a public good. Regardless of whether defense is purely or impurely public, the nonexclusion and nonrivalry properties generate several testable hypotheses about the behavior of the individual allies. The purpose of this chapter is to highlight these hypotheses and indicate the empirical methods used to test them. Much of the literature follows in the tradition of Olson and Zeckhauser ( 1 966) and concerns burden sharing and allocative efficiency. With respect to burden sharing, the discussion begins with an "exploitation hypothesis" [Olson (1 965)], in which the burdens for defending the alliance will be shared unequally, with the large wealthier allies contributing relatively more to the defense. Empirical tests of this hypothesis generally study the association between measures of burden and measures of wealth. While related to burden sharing, the analysis of allocative efficiency generally concerns the behavioral assumptions for the allies. If the allies follow Nash behavior, then we can expect some free riding and a sub-optimal level of provision when compared to the Pareto-optimal standard. Over time, however, the allies may adopt cooperative behavior by, for example, bargaining [Palmer ( 1 990)], and we may see a reduction in free riding and improved allocative efficiency. The empirical tests regarding allocative efficiency depend on measuring the extent of free riding and distinguishing Nash behavior from cooperative behavior. The primary body of this chapter is organized into two sections - theoretical and empirical contributions. Within each of these sections, I address the literature relating to (i) the pure public good model, (ii) the joint product model, and (iii) other perspectives. The final section of the paper offers some summary remarks.

2. Theoretical contributions

There is a close relationship between the theoretical literature addressing military alliances and the private provision of public goods literature [e.g., Warr (1983)]. This relationship is interesting primarily because the origin of some models is unclear. For example, the joint product model appears to have its roots in military alliances. It was then ported to other applications in public sector economics. In this chapter, I am not concerned with these issues and, therefore, attribute the theoretical arguments primarily to the military alliances literature.

92 2. 1.

J. C. Murdoch

The pure public good model n­

The pure public good model characterizes the behavior of an ally who belongs to an country alliance. The ith ally is assumed to allocate its national income, between a military activity, and a private nondefense numeraire good, The military activity produces a pure public good for all allies, which I call deterrence, The production relationship is governed by

q; ,

f dq; =f'

yi.

Ji,

zi.

(1)

d2f dq;2 f" :::;;

where d I > 0 and 0 . Alternative specifications of Equa­ I tion ( 1 ) are employed in the literature. The most common is to simply set [Sandler ( 1 993)]. The qualitative conclusions of the model are basically unaffected by these restrictions and we maintain Equation ( 1 ) for more generality and to set up the j oint product model. Total deterrence, Z, is nonrival and nonexcludable; thus, all allies receive Z regard­ less of how much they contribute. The in the basic, pure public good model is additive with unit weights on contributions: =

zi =q;

technology ofpublic supply

(2)

zi

This simple aggregation implies perfect substitutability of among allies. As discussed below, this technology may not be appropriate for some alliances. From the ith country's perspective, total deterrence is (3)

zi qi's: z = J 0 and :::;; 0. The budget constraint for ally i is ;

,

(5)

where is the price per unit of the military activity and the price of the numeraire has been normalized to one. The preferences of the ith ally are assumed to be represented by an unspecified agent with a utility function, (6)

£i

where represents (possibly) a vector of exogenous environmental influences that shift the utility function. In many treatments, represents, in part, the military strength

1

£i

We are implicitly asswning a functional form for the f(-) function such that h(Q') = '£1 ,J(qi).

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Ch. 5: Military Alliances: Theory and Empirics

of the alliance's common enemies, referred to as threat. Other influences included in may be the price of oil or periods of time. Rather than denoting the preferences of an agent for the entire nation, the utility function may represent other decision makers. For example, Dudley and Montmarquette ( 1 9 8 1 ) and Murdoch, Sandler and Hansen ( 1 99 1 ) test the median voter hypothesis by redefining Equation (5) to reflect the budget of the median voter. In this case, the optimal choice of the median voter is assumed to be translated into national action. Substituting Equation (4) into (6), we specify the Nash problem for ally i as

Ei

max y, ql

{

Ui(/,J(qi) + h((/),Ei) I f = yi + pqi } . (qh,. qn* )

(7)

(yh, . . . ,yM)

such , A Nash equilibrium requires a vector q* = and y* = that Equation (7) is simultaneously satisfied for every ally. The first-order conditions require satisfaction of the budget constraint and _ .

f' MRS;Zy = p ,

(8)

where MRSZy denotes the marginal rate of substitution of deterrence for the private good. Equation (8) illustrates that each ally will provide until their marginal valuation of deterrence, weighted by the productivity of in producing deterrence, is equal to the marginal cost of q'". The allocative inefficiency of the Nash equilibrium is evident in Equation (8), since a Pareto optimal level of Z would require that The Nash solution generates a provision level that is less than the f' L; MRSkY Pareto level, because each ally does not consider the marginal valuation of the other allies that its defense provision conveys. At a Nash equilibrium, the first-order conditions of Equation (7) imply a set of "demand" equations for the military activity:

qi qi

=

p.

(9) illustrating that the demand for military activity depends on the national income, price per unit of activity, the total military activity of a nation's allies, and various shift measures. The demand equations facilitate hypotheses about the relationships between and the exogenous variables. For example, comparative static results suggest a direct relationship between and and an inverse relationship between and assuming that the military activity is a normal good [Murdoch and Sandler ( 1 984)]. Moreover, the comparative static relationship between and is expected to be negative and is called the slope of the "reaction path". Much of what distinguishes the alliance literature concerns this reaction path; i.e., how one ally responds to the actions of the other allies. In contrast, arms-race models concern how an ally responds to the actions of an enemy over time; hence the analysis focuses on in a dynamic model. 2

qi

qi Ji

qi p,

qi Qi, (iJqiJiJQi),

iJqiJiJEi

2 Smith's Chapter

4 reviews the alternative empirical forms of equations like (9).

J. C. Murdoch

94

One way to see the burden sharing and efficiency implications of the pure public good model is to analyze an algebraic example [see Comes and Sandler ( 1 986) and Sandler ( 1 993) for geometric treatments] . Consider a 3-country alliance, where each ally differs only by income; e.g., let / 1 > 12 > /3 . If the utility functions are identical and of the Cobb-Douglas family ( U = y0 Q/3 , Q = q1 + q2 + q3) and f' = 1 , then the demand equations are

ql = a(II/p) - b(l + l),

( l Oa)

l = a(I2/p) - b(ql + q3),

( l Ob)

q3 = a(J3/p) - b(ql + q2 ),

( l Oc)

E;

where a = {31(a + {3), b = a!(a + {3), and is dropped to simplify the presentation. This particular example nicely illustrates the hypothesized relationships between income, price, the spillins and the military activity. Moreover, the parameters of the model are easily identified in an empirical exercise. The Nash equilibrium is the simultaneous solution to the demand equations. In this example, the Nash or "subscription equilibrium" [Warr (1 983)] solution is

ql* = a[I I + b(/ 1 _ 12 _ !3)]/c,

( I I a)

l* = a[I2 + b(/2 - I I - !3)]/c,

( l i b)

q3* = a[/3 + b(/3 _ / 2 _ II )]/c.

( l i e)

In Equations ( 1 1 a)-( 1 1 c), each q i• _:;?: 0 and c = ( I + b - 2b2 )p. An important result of the pure public good model is that the provision level depends on the relative size of income. For example, let ! 1 = 1 00, !2 = 90, !3 = 80 and a = b = 0.5. Additionally, assume that the defense price equals one, giving c = 1 . Then, ally 3 will make a contribution because its income is almost as large as ally 1 and 2. The equilibrium ally provisions are q 1 * = 32.5, q2 * = 22. 5, and q3* = 12. 5 for a total provision level of 67.5. On the other hand, if ! 1 = 1 00, !2 = 60, and !3 = 40, ally 3 will not make a contribution. The equilibrium values are qh = 46.67, q2 * = 6.67, and q3* = 0 for a total provision of 53.33. Bergstrom, Blume and Varian ( 1 986) and Andreoni and McGuire (1 993) discuss more general procedures for identifying the group of contributors when incomes differ. Both numerical examples illustrate the exploitation hypothesis. In the first example, the burdens (calculated as q iJJi) are 0.325, 0.25, and 0. 1 56, respectively for allies 1 , 2 , and 3 . Similarly, i n the second example, the burdens are 0.466, 0.066, and 0.0, respectively. In either case, the larger allies shoulder larger burdens and we see a high correlation between economic size and military burden. The exploitation is more pronounced in the second example where the income differences are greater. This fact is the basis for the interest in the relative income differentials in NATO discussed in Section 3, below [see Olson ( 1 986) and Oneal and Elrod ( 1 989).]

Ch. 5: Military Alliances: Theory and Empirics

95

The inefficiency of the Nash solution is also readily apparent in these numerical examples. When I 1 = 1 00, 12 = 90 and /3 = 80, the Pareto optimal levels of provision are q 1 = 55 , q2 = 45, and q3 = 35 for a total of 1 3 5 . Alternatively, under the second income distribution, the optimal levels are q 1 = 66.67, q2 = 26.67 and q3 = 6.67 for a total of 1 00 3 . In either case, we see that the Nash levels are less than the Pareto optimal levels. 2. 2.

The joint product model

The pure public good paradigm of Olson and Zeckhauser ( 1 966) is the seminal economic model for understanding military alliances. However, it does not explain certain observable facts. In particular, Russett ( 1 970) noted that by the late 1 960s, the correlation between economic size and defense burden for a sample of NATO allies was essentially insignificant. This fact was counter to the main hypothesis of the pure public good model and contrary to the correlations of just a few years earlier. What could explain this result? A partial answer was proposed by van Ypersele de Strihou ( 1 967), who argued that defense burden sharing must be influenced by the "private benefits" of defense 4 . B y private, h e meant that some defense activities, for example, protection o f colonial interests and drug traffic interdiction, provide benefits to the nation undertaking such activities, but not to the other members of the alliance. The benefits may be purely public to the citizens of the providing nation, but they can be withheld from the citizens of the other nations in the alliance. van Ypersele de Strihou ( 1 967) concluded that the burden sharing is more likely to reflect the benefits-received principle when private benefits are a significant proportion of the defense benefits received by allies. Sandler ( 1 977) extended the analysis by proposing a joint product model, for which the defense activity of an ally jointly produces a vector of outputs that may be purely public (e.g., deterrence), impurely public (e.g., damage limitation), and private (e.g., policing terrorist activities at home). The model is a straightforward extension of the pure public good model and facilitates modelling the complexity of modem military arsenals. A nation like the USA, for example, maintains an arsenal of nuclear and conventional forces that may be used to produce a host of various public and private benefits 5 .

3

These calculations are very simple, given the assumptions of the example. One way to find the optimal levels is to recognize that the MRSiY = y/Z V i. Because the sum of the MRS's must equal 1 , we can set each equal to l/3. Then, with the three budget constraints, we have six equations in six unknowns. Alternatively, we can recognize that the Pareto optimal level must be 50% of the total income of the group because of homothetic preferences and unit prices, because a = f3. 4 See Knorr ( 1 985), Oneal ( 1 990a,b), Russett ( 1 970), and Sandler ( 1 977). 5 The joint product model has many applications in public economics [See Comes and Sandler ( 1 986, 1994)]. A formal derivation of the primary results of the model as they apply to ally behavior first appeared in Murdoch and Sandler (1 984).

J.C. Murdoch

96

In the basic j oint product model, the military activity, q i , produces the pure public good (zi ) , as described above, and a private good xi , which enters the ally's utility function. The joint product relationships are ( 1 2, 1 3) while the utility function is ( 1 4) '

"

where g > 0, g � 0, and/ is as described above. Substituting Equations ( 1 2) and (4) into ( 1 4), we derive the Nash problem for the ith ally as ( 1 5) which is the same as Equation (7) except for the addition of the private defense output, xi . Once again, the Nash equilibrium requires vectors q * and y* such that Equation ( 1 5) is simultaneously satisfied for all allies. The first-order conditions imply that g

'

MRS�y +f 'MRSh

=

p.

( 1 6)

Hence, each ally equates the weighted sum of its MRS for the private defense good and the MRS for the public defense good to the price, where the weights are the marginal products of the defense activity in producing the defense outputs. As in the pure public good model, the equilibrium is still suboptimal in a Pareto sense, because each ally only considers its MRSb in the provision decision; Pareto optimality would require a summing over all MRSZy 's. The j oint product model provides a plausible explanation to the phenomenon noted by Russett ( 1 970): if the military activities of individual nations generate more private benefits, then the level of qi must increase to satisfy Equation ( 16), making the burdens more equitably shared. The j oint product model implies a demand equation that appears the same as that implied by the pure public good model. Thus, the first-order conditions of Equation ( 1 5) (by the implicit function theorem) imply ( 1 7) However, the relationship between qi and Qi in Equation ( 1 7) is potentially quite different when compared to the same relationship in Equation (9). Murdoch and Sandler ( 1 984) noted that aqifa(ji may be positive or negative in the j oint product model; a key determinant in signing this derivative is the complementarity of the j oint products. When the j oint products are Hicksian complements, the derivative may be

Ch. 5: Military Alliances: Theory and Empirics

97

positive - the opposite of the predicted sign in the pure public good model 6. Murdoch and Sandler argued that the different theoretical results have important implications for understanding NATO because the alliance switched from providing protection via a nuclear deterrent (the doctrine of mutually assured destruction) to protection via a doctrine of flexible response. According to the flexible response doctrine, NATO should respond to external threats in a variety of ways; e.g., conventional ground forces, air power, or limited nuclear strikes. Hence, the latter doctrine enhanced the complementarity of the private and public defense goods 7 . The result of this effect, over time, is to generate the more equalized burdens in NATO. Because the reduced-form demand equations (9) and ( 1 7) look identical, it is not obvious how to distinguish between the pure public good model and the joint product model. One means is to simply estimate an equation with data on qi , Ji , p, Q i , and Ei and examine the estimated relationship between qi and Qi . A positive relationship would certainly be evidence against the pure public good model, but a negative sign is not inconsistent with either model. This approach is, consequently, weak because the two models are not measured against each other. Sandler and Murdoch ( 1 990) found that by expressing the demand equations in their "full income" form, a simple nested test could be derived to distinguish between the models. The full income is the sum of an ally's income (Ji) and the value of the spillins (pQi) [Bergstrom, Blume and Varian ( 1 986)]. Adding pQi to each side of Equation (4) we get pi =

( 1 8) Ii + p(l = / + pQi , l in which pqi + p( = pQi . In the full income model, the choice is over/ and Qi , rather than / and qi . The utility function in the pure public good model becomes ( 1 9) Ui (yi ,f(qi) + h(( i), Ei) = Vi (yi , qi , {]i , Ei),

while in the j oint product model we have

Ui (yi , g(Qi - (i) J(Qi - (]i) + h((i), Ei) = Vi ( / , (l , Qi , Ei).

(20)

Qi = Qi (Fi ,p, Ei )

(2 1 )

For the pure public good model, the full income demand equation is when Equation ( 1 9) is maximized subject to Equation ( 1 8), while, for the joint product model, the full income demand equation is (22) when Equation (20) is maximized subject to Equation ( 1 8). In both models, a Nash equilibrium requires that Q i = Qi for every i *j. Equations (2 1) and (22) provide a 6 See Comes and Sandler ( 1994) for an extensive treatment of the comparative statics of the joint product model. Also, the neutrality results are quite different in the joint product model, see Sandler ( 1993). 7 This argument is challenged by Oneal and Elrod ( 1 989) and defended by Murdoch and Sandler (1991 ).

J. C. Murdoch

98

theoretical distinction between the two models that is empirically testable: the joint product model can be estimated and then the significance of the {? effect can be tested. If this effect is restricted to zero, the pure public good model results. 2.3.

Other contributions Technology of supply

2. 3. 1.

Until recently, the theoretical literature assumed a simple summation technology, such as that displayed in Equation (2), for the total supply of the public good 8 . Hirshleifer (1 983) and McGuire (1 990) offer alternative technologies that are particularly relevant to the economics of military alliances. Hirshleifer suggested the "weakest-link" and "best-shot" technologies. Under the weakest-link, Z = min(z 1 , . . , zn ), (23) .

=

while under the best-shot, Z max(z 1 , . . . , zn ).

(24) The weakest-link supply equation may apply, for example, to an alliance that fortifies a perimeter in order to keep the enemy from breaking through, so that the security of the nations within the perimeter is determined by the strength of the weakest-link nation. The best-shot technology, on the other hand, may apply to an alliance wherein the security is provided by the nuclear deterrent of a single nation, so that the level of provision is determined by the contribution of the strongest nation. For both the best-shot and weakest-link models, the efficiency and burden sharing implications are different when compared to the summation technology. These differences are discussed by Conybeare, Murdoch and Sandler ( 1 994), who derive the demand and efficiency conditions under both the best-shot and weakest-link technologies for a pure public good and j oint product model. An interesting finding is that, in a j oint product model, the demand equations differ depending on the supply technology and the identification of the best shooter or weakest-link. To see this, assume that the supply is weakest-link and that country 1 is the weak-link nation, making the demand for the military activity in 1

ql =

(25)

qi qi(Ji,p , qt , Ei).

(26)

q i (J I ,p, £ 1 ). For the other allies (j = 2, . . . , n), the demand is =

The demand equations are similar for a best-shot alliance, except for the interpretation of ally 1 . In the best-shot alliance, let ally 1 denote the best shooter; then Equations 8 This section only covers a small subset of the theoretical literature. See Sandler ( 1 993) and Sandler and Hartley ( 1 995) for more exhaustive surveys.

99

Ch. 5: Military Alliances: Theory and Empirics

(25) and (26) will represent the reduced-form demand equations. The identification of these equations enabled Conybeare, Murdoch and Sandler ( 1994) to devise a testing procedure for identifying the actual supply technology. McGuire ( 1990) offered a generalization of the summation technology. In his model, the aggregation technology is

Q i qi + L w�qi ,

(27)

=

j .c i

where the weights (w�) are all positive. An interesting feature of the model is that the weights reflect the consumer (i.e., receiving nation) and the producer nation. Thus, wi , for example, is the spillover from ally 4 to ally 2. McGuire defines several specific cases with restrictions on Equation (27). He also derives the basic efficiency and burden­ sharing implications of his model. 2. 3.2.

The allocation process

The pure public and joint product models assume a noncooperative Nash allocation mechanism, which is a natural point of departure for modelling the behavior of agents who contribute to the supply of a public good. However, it is conceivable that a relatively small military alliance will behave cooperatively, especially over time as political pressure to contribute comes to bear on the free riders. Unfortunately, as outside observers, we have no way of knowing the "true" allocation process - we only observe the data generated from the process. McGuire and Groth ( 1985) speculated that the data patterns would be different under a Nash allocation scheme when compared to a Lindahl process. In particular, with unit prices and Cobb-Douglas utility functions, the relationship between wealth and defense expenditures should lie on a ray out of the origin under a Lindahl model. Under the Nash model, in contrast, the relationship should lie on a straight line with a negative y-intercept. McGuire and Groth went on to derive several econometric specifications for testing the underlying allocation process with observed data. Sandler and Murdoch ( 1 990) operationalized the McQuire-Groth approach in order to test the allocation mechanism using NATO data. The essential theoretical contribution of Sandler and Murdoch was to derive reduced-form demand equations under the Lindahl and Nash hypotheses that are comparable empirically. Let e1 denote the Lindahl cost share for ally then

i,

(28) is the ith ally's demand for the total military activity in the alliance. Note that a Lindahl equilibrium requires a set of cost shares that fully finance a level of Q Q * such that Q; Q* The Lindahl Equation (28) differs from the Nash pure public good model, =

=

Vi.

J. C. Murdoch

1 00

Equation (2 1), and from the Nash joint product model presented in Equation (22), illustrating that it is theoretically possible to identify the allocation mechanism. 3. Empirical contributions

The earliest empirical studies focused on the relationship between measures of burden and economic size, using cross-sectional data from members of the NATO alliance. These studies sought primarily to investigate the inequality of defense burdens among allies at a particular point in time. In the 1 960s when Olson and Zeckhauser ( 1 966) proposed their theory of alliances, there were too few annual observations to consider a time-series methodology. In the latter half of the 1 970s, however, the empirical methods switched so as to take advantage of the time-series variation in data from the individual NATO allies. The object of the analysis also changed from the burden sharing question to estimating demand equations like those presented in Equations (9), ( 1 7) and (22). This new focus facilitated an investigation into the sharing of the burdens of defense might change as well as several direct tests of the public goods models. There are numerous empirical studies on military alliances [see Sandler (1 993)] and just as many ways to categorize their results. Below, a small subset of the empirical findings are presented that, hopefully, represent the range of empirical issues and methods addressed in this literature. To organize the findings, I have categorized empirical exercises according to their antecedent paradigm, making three subsections ­ tests derived from either the pure public good or the joint product model, and other interesting empirical tests. The scope of the presentation is limited in order to complement other chapters in this volume, especially Chapter 4, by Smith.

why

3. 1.

Tests based on the pure public good model

Olson and Zeckhauser ( 1966, p. 274) hypothesized that within an alliance and all else equal, larger nations, in terms of economic size, should "devote larger percentages of their national incomes to defense than do the smaller nations." To test this hypothesis, they examined the Spearman rank correlation coefficient between GNP and the defense budget as a percent of GNP in 1 964 for fourteen NATO nations. The null hypothesis of no association was rejected in favor of the hypothesis of positive association. This simple test provided strong evidence to support the pure public good model; i.e., it appeared as though the small NATO allies were able to exploit the larger allies. Interestingly, Olson and Zeckhauser's definition of defense burden (i.e., the percentage of national income devoted to defense) became the definition for future research, and little attention was paid to alternative measures of burden until the 1 980s [Sandler and Forbes ( 1 980)]. 9

de facto

9 Russett ( 1 970) and Oneal and Elrod ( 1 989) noted that the military budgets across nations may not be comparable, owing to the conscription practices of different nations. Oneal and Elrod provide some corrected defense burden measures but they do not affect the basic conclusion of Olson and Zeckhauser.

Ch. 5: Military Alliances: Theory and Empirics

101

Olson and Zeckhauser were reluctant to take a parametric approach by, for example, regressing national income on defense burden. The primary problem with regression methods is that within an alliance there are typically some very large (USA) and small (Luxembourg) nations, meaning that a fitting technique that weights observations according to squared deviations from the mean, such as ordinary least squares (OLS), gives misleading parameter estimates. OLS gives so much weight to the very large nation that the fitted line is forced through that point regardless of the general pattern of the other data points. Dudley and Montmarquette (1981) circumvented this problem by formulating a median-voter model. Their approach allowed them to pool countries from NATO and other alliances into one cross-sectional sample. To summarize the median-voter model estimated by Dudley and Montmarquette, define the following notation where all expenditures are in real terms 1 0 : military expenditures in nation i, ME; population in nation i,

GNP;

gross national product in nation i,

SPILL;

sum of the ME; of nation i's allies that are in the sample,

OSPILL;

sum of the ME; of nation i's allies that are not in the sample,

auxiliary variables that may shift the relationship. Then, using a Stone-Geary utility function, they derive an empirical approximation to the demand for defense as

E;

ME; -- - f3o + f3 1 N; _

( GNP; ) + f32 ( 1 ) --

N;

--

N}-a

f3

+ 3

( SPILL; + OSPJLL; ) N;

+ f34E · + t:>

'

"

(29)

where the f3's are unknown parameters and £; is a random disturbance term. The inverse population measure ( l /N 1 -a) facilitates a test of the publicness of defense in consumption, since as a approaches zero, defense approaches a pure public good in the model 1 1 . Dudley and Montmarquette ( 1981) used data from 3 8 countries and several alliances. The parameters were estimated with data from 1960, 1970, and 1975 using a full­ information maximum likelihood (FIML) routine. The FIML estimator was necessary because of the simultaneity between the ME; and SPILL; . The results generally supported the pure public good model with the median-voter as the decision maker; i.e., /3 1 was positive and significant, /33 was negative and significant, and a was not significantly different from zero. Moreover, the Stone-Geary utility function setup allowed Dudley and Montmarquette to solve for the underlying parameters of the 10 Some studies presented in this section use gross domestic product (GDP) to measure national income. In those cases, I will use GDP, to denote the variable. 11 The linearity of the form and the test for publicness are artifacts of the Stone-Geary utility function. In ageneral model, it is difficult to identify the a parameter.

J C. Murdoch

1 02

model. They found that defense was a superior good (income elasticity greater than one) and that the elasticity with respect to the tax price of defense was somewhat elastic. As noted in Section 2, the equalizing of the defense burdens in NATO resulted in the formulation of the joint product model. In a series of empirical papers, Oneal ( 1 990a, 1 990b) and Oneal and Elrod ( 1 989) argued that, with respect to NATO, the basic predictions of the pure public good model held true well into the 1980s. Additionally, they argued that the potential for complementarity between the joint products, owing to the doctrine of flexible response, was actually quite limited 1 2 . Thus, NATO even in the 1 980s looked much like a "uniquely privileged group" with the USA shouldering the bulk of the defense for the alliance. There are many dimensions to their argument; however, the essential empirical evidence in its favor is that, after appropriate controls, the estimated relationship between measures of defense burden and measures of economic size is positive and significant. The problem with the simple rank correlations, which, as indicated above, showed that the relationship was not significant after the mid- 1 960s, is that they do not hold the other influences constant. Oneal ( 1 990a) used data from 1 5 NATO countries for the years 1 950-1984 to estimate the following relationship: 2 GDPit MEi (30) f3o + /3 1 + {3 2E it.

= GDP· If

(

""""' �i

GDP·l(

)

Thus, the economic size variable is stated relative to the total economic size of NATO, where size is gross domestic product (GDP). Oneal includes a measure of Soviet defense burdens, European interdependence, and two dummy variables, one indicating Greece, Turkey, and Portugal and one indicating the other European nations. The parameters are estimated using a pooled, time-series, cross-sectional estimator. The estimate on {3 1 is positive and significant and robust to alternative samples and transformations of the size measure. Okamura (1 991) provided a unique and interesting application of the pure public good model to the USA-Japan alliance. Okamura employed a Linear Logarithmic Expenditure System (LLES) to derive the Nash reaction functions for the USA and Japan. The real defense expenditures of the Soviet Union ( THREAT) entered both reaction functions, while the defense expenditures of the NATO allies, excluding the USA (MEN), entered the US equation. For the USA, the reaction function was ME = PM ( YMo + YM 1 THREAT) +[GDP - P M (YMo + YM 1 THREAT) - Pc(Yco + YCJ THREAT)]

[a 1 + /3 1 ln(PM) + f32 ln(Pc)] + [a! + {3 1 ln(PM) + f32 !n(Pc) - I ] x

X

(3 1)

(ME; + MEN ) ,

where PM and Pc denote the price deflators of military expenditures and consumption expenditures, respectively, and ME; denotes the military expenditures of Japan. The 12 See Murdoch and Sandler ( 1 9 9 1 ) for critical comments on this point.

Ch. 5: Military Alliances: Theory and Empirics

103

equation for Japan was similar except that MEN did not enter the model. The parameters of the two-equation system (y's, a's, and /3's) were estimated using the expenditure share equations. The LLES estimates were generally consistent with the pure public good model. Both nations responded positively to GDP and Soviet defense expenditures. The USA responded negatively to Japan's defense expenditures, while Japan responded negatively to the defense spending in the USA. Okamura reported a stable Nash equi­ librium with the USA spending $ 1 50.79 billion and Japan spending $5 1 .64 billion in 1 982 dollars. Despite the fact that the price term did not perform in the expected fashion in Japan's equation, the study stands out for including measures of the price of defense in the equation.

3.2.

Tests based on the joint product model

Sandler and Forbes ( 1980) extended the empirical methodology of Olson and Zeckhauser to test the pure public good model and some predictions from the joint product model using data from NATO allies. Their first test was to compute year-by­ year Kendall rank correlation statistics (r) between GDPi and ME/GDPi . As expected, they found generally significant correlations before 1967 but insignificant correlations afterwards. They then computed the first- and second-order partial r's in an attempt to hold constant the private benefits of defense. In the first-order r, the GDP per capita was held constant, while in the second-order r, both GDP per capita and exposed border were held constant. Even the higher-order statistics were generally insignificant after 1967, suggesting that the pure public good model must be rejected. Sandler and Forbes next looked for evidence in favor of the joint product model. They argued that, under the joint product model, the private benefits of defense should predict the defense burden sharing; i.e., relative economic size is not the only predictor. Thus, they compared the relative defense burdens (ME/ Li MEi) to a private benefit measure, finding that by 1 975 the private benefits did in fact predict the defense burdens better, when compared to 1960. The private benefit measure was an average of the GDP share, the exposed border share, and the population share. It is interesting to note that the questions addressed by Oneal ( l 990a) and Sandler and Forbes are similar. However, the two studies used quite different statistical methods and drew essentially opposite conclusions. As discussed below, the weight of the evidence now favors the conclusions drawn by Sandler and Forbes. Two papers by Murdoch and Sandler (1 982, 1984) changed the empirical methods of alliance studies from cross-sectional to time series and emphasized country-by-country comparisons ofthe "demand for military expenditures". The demand interpretation was derived from the reduced-form demand equation [e.g., Equation (1 7)] . With the price of the military activity set equal to 1 , the military expenditures are the best measure of qi.

J. C. Murdoch

1 04

The Murdoch-Sandler approach involved estimating MEit = /3;o + f3n GDPit + f3i2SPILLit-i

+ f3i3 Eit + Eit

(32)

for each i in an alliance. Thus, they generally presented an estimated equation for each ally that was based on the time-series variation in the data. Various measures have been

considered in Eit, including the ratio of the USA's strategic defense force to that of the Soviet Union's, force thinning, the price of oil, a dummy variable for the Viet Nam war, and Soviet defense expenditures. The simultaneity between ME; and SPILL; was addressed by lagging the spillin measure. Murdoch and Sandler ( 1984) found that for some of the NATO allies, the response to spillins (/3i2 ) was positive (5 out of 1 0), while for others it was negative. The negative response is not inconsistent with the pure public good or joint product model. However, the positive responses suggest rejecting the pure public good model. To devise a cleaner test of the joint product model, they argued that the doctrine of flexible response resulted in increased complementarity between the joint products and, therefore, a shift in the /3;2 coefficients toward the positive direction. Their estimates of Equation (32) with a slope-shifter on SPILLit after 1 974 indicated that f3i2 was more positive after the doctrine of flexible response in 7 out of the 1 0 allies in their sample. Hence, the evidence seemed to favor the joint product model. Two other tests of the applicability of the joint product model to the NATO alliance are worthy of mention. The first is by Hansen, Murdoch and Sandler ( 1 990) who disaggregated the military expenditures in NATO into expenditures on conventional forces and strategic forces. This disaggregation allowed them to identify complementarity between conventional forces and substitutability between conventional forces and strategic forces. Thus, free riding in NATO was only possible on the strategic forces provided by the nuclear allies. The second test of the joint product model was the implementation of Equation (22) by Sandler and Murdoch ( 1 990). Using time-series data for NATO allies, they estimated

L MEit

=

/3;o + f3n (GDPit + SPILLit) + f3i2 SPILLit + f3i3 Eit + Eit.

(33)

Note that in Equation (33) the dependent variable is the same for each ally. From Equation (2 1 ), the pure public good model implies f3i2 0. Using data from 1956 to 1 987 and a two-stage least squares estimator, Sandler and Murdoch rejected this restriction for all 1 0 of the allies in their study. These parametric results, coupled with the nonparametric findings by Sandler and Forbes ( 1980), provide convincing evidence in favor of the joint product model. =

3.3.

Other empirical contributions

In this section, three studies that offer unusually interesting empirical contributions are reviewed. These studies are chosen not so much for their insights into military

Ch. 5: Military Alliances: Theory and Empirics

1 05

alliances, but because they illustrate how the study of military alliances has generated empirical techniques that may be useful for a host of public economic questions. The first study is by Murdoch, Sandler and Hansen ( 1991) who used data on the NATO allies to test between the "oligarchy" and the median-voter model. In the oligarchy model, the budget set constrains the choices of a decision-making body that acts on behalf of the entire nation, while under the median-voter model, the defense allocation decision is made by the median voter; hence, the appropriate budget constraint is that of the median voter's. With the exception of Dudley and Montmarquette (1981 ), most military alliance studies have implicitly or explicitly assumed an oligarchy choice perspective. Murdoch, Sandler and Hansen ( 1 99 1 ) showed that restrictions on MEit = /3;o + f3il

(

(- )

)

1 GDPit + {3;3 SPILLit + Eit ff + f3i2 A, 1t L it

(34)

are consistent with the oligarchy or median-voter model. Hence, the specification provides an empirical method for discriminating between the two models. In Equation (34), Lit represents the employed labor force, but in another application it could be equal to Nit · For A. = 1 , the specification is consistent with the median-voter model, while for A; = 0 and f3i l 0, the specification is consistent with the oligarchy choice model. Interestingly, these authors found that some of the NATO allies generate median-voter-like data, while others appear to follow the oligarchy choice or neither paradigm. Specifically, the median-voter model could not be rejected for Belgium, the Netherlands and the United Kingdom, while the oligarchy model fitted the data from West Germany, France, Italy, and the USA. Neither model appeared correct for Canada, Denmark, and Norway. The second study is by Sandler and Murdoch ( 1 990) who tested the Nash allocation mechanism against the Lindahl mechanism, again using data from the NATO allies. The question of which allocation mechanism is an important one because it addresses the efficiency question; i.e., a Lindahl allocation implies Pareto efficiency. The Sandler-Murdoch test requires estimates from four equations for each nation. The first is derived from the Nash j oint product model: =

(35) while the second represents Lindahl � MEit �

;

=

(

MEit {3;o + f3il (GDPit ) + f3i2 .2:.:: ; MEit

)

+ {3;3 Eit + t:it.

(36)

The third and fourth equations are "joint" or combinations of Equations (35) and (36) that serve as auxiliary equations in order to implement the J test developed

1 06

JC. Murdoch

by MacKinnon, White and Davidson (1 983). The J tests computed by Sandler and Murdoch provided some evidence to support the Nash assumption in five of the smaller allies, while the five largest allies could not be classified. Because no support for the Lindahl model was found, the authors suggested that NATO provided a suboptimal level of defense over the time period under investigation. The last study addresses the technology of public supply. Conybeare, Murdoch and Sandler ( 1994) tested the best-shot and weakest-link models in four military alliances - the Triple Alliance (1 880-1914), the Triple Entente ( 1 880-1914), the Warsaw Pact ( 1 963-1987), and NATO ( 1 961-1987). The authors show, assuming the existence of joint products, that the technology of public supply can be empirically determined by a recursive system of equations. They find support for the best-shot technology in the Triple Alliance, limited support for the weakest-link technology in the Triple Entente, and generally inconclusive findings in the Warsaw Pact and NATO.

4. Conclusion

Theoretical research in military alliances closely parallels research in the theory of public goods. For over twenty-five years, economists have made significant contributions to our understanding of military alliances by modelling the behavior of individual allies as rational members of a collective that provides a public good. In addition to insights concerning burden sharing and allocative efficiency, our ability to explain and predict changes in ally behavior has increased over time. Probably the most important theoretical paradigm to date has been the development and application of the joint product model, which repeatedly appears to explain actual data better than the pure public good model. Perhaps the most important empirical development has been the application of annual time-series data to test the theoretical propositions. The gain in flexibility from having individual country data has, unquestionably, led to several creative tests, some of which have been applied to other public good problems. Future research should concentrate in three areas. First, methods must be engineered to test allocative processes other than Nash and Lindahl. One possibility is to extend the hybrid models suggested by McGuire and Groth ( 1 985), so that they could be estimated with time-series data. Alternatively, a repeated game structure might facilitate other allocation mechanisms and provide some structure for modelling actions between alliances. The second area of future research concerns membership size, which, especially with respect to NATO, has been ignored. However, recent political events indicate that NATO will soon need to decide if some of the Eastern European nations should be admitted to the alliance. Lastly, more research must be done on the technology of public supply. The techniques developed by Conybeare, Murdoch and Sandler ( 1994) should be extended to other alliances and supply functions. It may prove particularly fruitful to integrate a geographic approach to the technology of public supply by modelling the spatial interaction between allies.

Ch. 5: Military Alliances: Theory and Empirics

1 07

References Andreoni, J., and M.C. McGuire, 1 993, IdentifYing the free riders: A simple algorithm for determining who will contribute to a public good, Journal of Public Economics 5 1 , 447-454. Bergstrom, T.C., L. Blume and H. Varian, 1 986, On the private provision of public goods, Journal of Public Economics 29, 25-49. Conybeare, J.A.C., J.C. Murdoch and T. Sandler, 1 994, Alternative collective-goods models of military alliances: Theory and empirics, Economic Inquiry 32, 525-542. Comes, R., and T. Sandler, 1 986, The theory of externalities, public goods, and club goods (Cambridge University Press, New York). Comes, R., and T. Sandler, 1 994, The comparative static properties of the impure public good model, Journal of Public Economics 54, 403-421 . Dudley, L., and C . Montrnarquette, 1 98 1 , The demand for military expenditures: An international comparison, Public Choice 37, 5-3 1 . Hansen, L., J.C. Murdoch and T. Sandler, 1 990, On distinguishing the behavior o fnuclear and non-nuclear allies in NATO, Defence Economics I , 37-56. Hirshleifer, J., 1 983, From weakest-link to best-shot: The voluntary provision of public goods, Public Choice 4 1 , 3 7 1-386. Knorr, K., 1 985, Burden-sharing in NATO: Aspects of U.S. policy, Orbis 29, 5 1 7-36. MacKinnon, J.G., H. White and R. Davidson, 1 983, Tests for model specification in the presence of alternative hypotheses: Some further results, Journal of Econometrics 2 1 , 53-70. McGuire, M.C., ! 990, Mixed public-private benefit and public good supply, with an application to the NATO alliance, Defence Economics I , 17-35. McGuire, M.C., and C.H. Groth Jr, 1 985, A method for identifying the public good allocation process within a group, Quarterly Journal of Economics 1 00, 9 1 5-934. Murdoch, J.C., and T. Sandler, 1 982, A theoretical and empirical analysis of NATO, Journal of Conflict Resolution 26, 237-263. Murdoch, J.C., and T. Sandler, 1 984, Complementarity, free riding, and the military expenditure of NATO allies, Journal of Public Economics 25, 83-1 0 1 . Murdoch, J.C., and T. Sandler, 1 99 1 , NATO burden sharing and the forces o f change: Further observations, International Studies Quarterly 35, 1 09-1 1 4. Murdoch, J.C., T. Sandler and L. Hansen, 1 99 1 , An econometric technique for comparing median voter and oligarchy choice models of collective action: The case of the NATO alliance, Review of Economics and Statistics 73, 624-63 1 . Okamura, M., 1 9 9 1 , Estimating the impact of the Soviet Union's threat on the United States-Japan alliance: A demand system approach, Review of Economics and Statistics 73, 200-207. Olson, M., 1 965, The logic of collective action: Public goods and the theory of groups (Harvard University Press, Cambridge, MA). Olson, M., 1 986, A theory of the incentives facing political organizations, International Political Science Review 7, 1 65-179. Olson, M., and R. Zeckhauser, 1 966, An economic theory of alliances, Review of Economics and Statistics 48, 266--2 79. Oneal, J.R., 1 990a, Testing the theory of collective action: Defense burdens, 1 950-1984, Journal of Conflict Resolution 34, 426-448. Oneal, J.R., 1990b, The theory of collective action and burden sharing in NATO, International Organization 44, 379-402. Oneal, J.R., and M.A. Elrod, 1 989, NATO burden sharing and the forces of change, International Studies Quarterly 33, 435-456. Palmer, G., 1 990, Corralling the free rider: Deterrence and the Western alliance, International Studies Quarterly 34, 147-164.

1 08

J. C. Murdoch

Russett, B.M., 1970, What price vigilance? The burdens of national defense (Yale University Press, New Haven, CT). Sandler, T., 1977, Impurity of defense: An application to the economics of alliances, Kyklos 30, 443-

460.

Sandler, T., 1 993, The economics theory of alliances: A survey, Journal of Conflict Resolution 37,

446-483.

Sandler, T., and J.F. Forbes, 1980, Burden sharing, strategy, and the design of NATO, Economic Inquiry

1 8, 425-444. Sandler, T., and K. Hartley, 1995, The economics of defense (Cambridge University Press, Cambridge). Sandler, T., and J.C. Murdoch, 1 990, Nash-Cournot or Lindahl behavior?: An empirical test for the NATO allies, Quarterly Journal of Economics 1 05, 875-894. van Ypersele de Strihou, 1., 1 967, Sharing the defense burden among Western allies, Review of Economics and Statistics 49, 527-536. Warr, P.G., 1983, The private provision of a public good is independent of the distribution of income, Economics Letters 13, 207-21 1 .

Chapter 6 A RMS RACES A ND PROLIFERATION * DAGOBERT L. BRITO

Rice University MICHAEL D. INTRILIGATOR

University of California, Los Angeles Contents

Abstract Keywords 1 . Introduction and overview of arms races, proliferation, and the outbreak of war 2. The Richardson model of the arms race 3. The dynamics of arms accumulation: the rational actor model 4. The dynamics of nuclear war: strategy and outcomes 5. Arms races and stability 6. A general model of an arms race 7. Power, bargaining, and war 8. The role of nuclear weapons 9. Nuclear weapons in a formal model of bargaining 1 0. Nuclear proliferation 1 1 . Proliferation and the probability of war 1 2. The future of the arms race and of proliferation 1 3 . Appendix 13.1. 1 3.2. 1 3.3. 13.4.

Proof of proposition 1 Proof of proposition 2 Proof of proposition 4 Proof of proposition 7

References

1 10 1 10 111 1 14 1 17 121 1 26 1 28 130 144 146 150 151 1 55 1 60 1 60 160 1 60 161 161

* Our work was supported by the Baker Institute at Rice University, The Center for International and Strategic Affairs at UCLA, the Ford Foundation, The Mershon Center at The Ohio State University, and the National Science Foundation. We would like to thank Radu Filimon, Jonathan Hamilton, Jack Hirshleifer, Steven Slutsky, Erica Worth, and Dina Zinnes for their help over the years. Todd Sandler and Keith Hartley made invaluable contributions as editors to this chapter.

Handbook of Defense Economics, Volume I, Edited by K. Hartley and T. Sandler © 1995 Elsevier Science B. V All rights reserved

1 10

D.L. Brito and M.D. Intriligator

Abstract

Previous analyses of arms races and proliferation are integrated and extended, building from a treatment of the behavioral foundations of weapons acquisitions to a general theory of arms races, with implications for the role of negotiations, the balance of power, the timing of crises, and nuclear proliferation. Recent developments in economic theory are also applied here to the problems of the arms race, nuclear proliferation, and the outbreak of war, yielding a deeper treatment of these phenomena by directly or indirectly treating asymmetric information in bargaining, repeated games that involve threats, and principal-agent problems in decisions on technology and weapons accumulation. Keywords

accidental nuclear war, arms races, asymmetric information, bargaining, crisis stability, deterrence, equilibrium, nuclear proliferation, nuclear war model, outbreak of war, precommitment, probability of war, repeated games, rational choice models, reaction curves, Richardson model, stability, stock adjustment model, timing of crises, warfighting

Ch. 6: Arms Races and Proliferation 1.

Ill

Introduction and overview of arms races, proliferation, and the outbreak of war

In the nuclear era the potential implications of arms races and the proliferation of weapons of mass destruction for life and death are staggering. Their political implications in terms of power and influence and their economic implications in terms of resources mobilized for weapons production are of overwhelming importance. Nevertheless, arms races have received relatively little attention from social scientists, particularly economists, in recent years. The interpretive guide to the literature on conflict theory in Intriligator ( 1 982), which organizes the literature by eight analytic approaches and eight areas of application, shows that most of the work in this field has been conducted by political scientists and that there tends to be a clustering of work on certain key approaches and models, such as the Richardson model of arms races, neglecting many important areas of potential inquiry and many possible alternative methodologies. While economists did some fundamental and relatively early work on these and related topics, as in Morgenstern ( 1 959), Schelling ( 1960, 1 966), and McGuire ( 1 965), relatively few economists have conducted research in this area. This neglect by economists is both surprising and unfortunate because many of the essential features of arms races, proliferation, and related phenomena, such as arms control and strategic choices in warfare, involve resource allocation, oligopolistic interactions, the production of public goods, bureaucratic and organizational behavior, and externalities, which are subjects of central concern to economists. The purpose of this chapter is to integrate and to extend previous analyses of arms races and proliferation, building from a treatment of the behavioral foundations of weapons acquisition to a general theory of arms races. Some recent developments in economic theory are also applied here to the problems of the arms race, nuclear proliferation, and the outbreak of war. These new approaches yield a deeper treatment of these phenomena by directly or indirectly treating such salient aspects of an arms race as asymmetric information in bargaining, repeated games that involve threats, and principal-agent problems in decisions on technology and weapons accumulation. Various approaches have been used to study arms races, including the Richardson model, as discussed in the next section, and models based on dynamic optimization 1 . Much of the previous theoretical work on the arms race is in the Richardson ( 1 960) tradition, which explains the arms race descriptively and mechanically. The Richardson model uses a coupled pair of differential equations to explain the change in levels of weapons in each of two nations as a function of the weapons held by both sides. More recent work in this area, by contrast, has used rational choice models to explain the arms race in terms of the behavior of decision makers, making use of the postulates of rationality and maximizing behavior. In our prior separate work, for example, in Brito 1 For a survey of the arms race literature see the book edited by Gleditsch and Nj0lstad ( 1 990). See also Sandler and Hartley ( 1 995).

1 12

D.L. Brito and M.D. Intriligator

( 1 972) and in Intriligator ( 1 97 5), we used an optimal control approach of optimization in a dynamic setting to explain choices of arms acquisitions over time. We each obtained a general set of equations describing an arms race of which the Richardson model is one special case. The value of arms in such a framework is a consequence of the behavioral decisions of defense decision makers on both sides in seeking either to deter or to attack the other side. As in the case of general equilibrium theory, a common denominator in much of the literature on arms races is concern over the existence and stability of equilibrium. Equilibrium, in the case of an arms race, as elsewhere, refers to a situation in which there is no change over time in certain variables characterizing the system. From a behavioral standpoint, an equilibrium is a Nash equilibrium in which none of the decision makers has an incentive to change their decisions, given the choices of the other decision makers. In certain cases it is possible to obtain functional dependencies giving the equilibrium levels of weapons on each side as functions of technical and strategic parameters. Another common denominator in much of this chapter is the concept of stability, which is an essential ingredient in any study of arms races and related phenomena. Stability is a concept that occurs in various and often conflicting guises in this chapter. First, there is the conventional notion of the stability of the quantitative arms race, involving determining whether nations will engage in the proverbial behavior of piling arms upon arms or whether this process will stop at some stable equilibrium, as in the Richardson model with certain restrictions on its parameters. Second, there is the stability of the qualitative arms race, involving determining whether nations engage in competitive research and development to acquire a technological advantage. Another concept of stability is that of crisis stability: under what circumstances will a crisis between rival nations, such as the Cuban missile crisis of 1962 between the United States and the Soviet Union, lead not to the outbreak of war but rather to some type of peaceful resolution? This is a fundamental question of international relations that has been only partly answered by political theorists. Some wars have occurred due to irrational behavior, accidents, or imperfections in the process of decision making. In such cases, paradoxically, the stability of the arms race in the conventional sense of low levels of weapon accumulations may be inconsistent with crisis stability. Low levels of weapons accumulations may in some cases even increase the probability of war. All of these aspects of stability must be treated when considering arms races that involve multiple countries and thereby nuclear proliferation, referring to the possibility of their acquiring nuclear weapons, other weapons of mass destruction, and delivery systems 2 . As other nations acquired nuclear weapons, such as the United Kingdom, France, and China, it was necessary to treat them as additional participants. Regional conflicts have also involved the acquisition or potential acquisition of nuclear weapons, including the Arab-Israeli conflict, the conflict between India and Pakistan, 2 For a survey of the proliferation literature see the book edited by Davis and Frankel ( 1 993 ).

Ch. 6:

Arms Races and Proliferation

1 13

that between Iran and Iraq, that between North and South Korea, and others. The possibility of such nuclear proliferation can imply that the results about equilibrium and the various stability properties of the bipolar arms race may no longer be valid. Most previous work on proliferation has assumed, explicitly or implicitly, that additional nuclear powers would be destabilizing in the sense of increasing the probability of war. By contrast, Waltz (198 1 , 1 983) concluded that more nations with nuclear weapons would reduce the chance of conflict. In lntriligator and Brito (1981) and Brito and Intriligator ( 1983) we analyzed the consequences of additional nuclear weapons states on crisis stability. We concluded that nuclear proliferation may have different qualitative effects on the probability of nuclear war depending on the number of existing nuclear nations and the level of weapons held by the various countries involved. We found that, in certain circumstances, but not universally, in contrast to Waltz, having an additional nuclear power in the system may reduce rather than increase the probability of deliberate nuclear war. This effect occurs when the restraining influence of the additional nuclear weapon state on the prior states with nuclear weapons offsets the destabilizing influence of there being an additional state able to start a nuclear war. However, this whole line of research is open to question since we have been able to show (see below) that qualitative predictions about the change in the probability that individual nations will initiate a nuclear war as the number of nuclear powers increases are not sufficient to make predictions about the change in the aggregate probability of a nuclear war. A third influence that is always destabilizing is that of the potential for accidental nuclear war, implying the value of introducing safeguards against accidental or inadvertent use of nuclear weapons. In the absence of such safeguards in the new nuclear nations, the probability of an accidental nuclear war will increase and, as a result, the aggregate probability of war will likely increase. The explicit treatment of these three different ways in which proliferation may change the probability of war outbreak is more useful in analyzing or formulating policy in this area than either implicitly assuming that proliferation is always destabilizing, as in the traditional approaches, or explicitly assuming that it is always stabilizing, as in the Waltz approach. A fundamental question of international relations that has been only partly answered by political theorists is that of when and under what circumstances conflict between nations leads to the outbreak of war. Some wars have occurred due to irrational behavior, accidents, or imperfections in the process of decision making. Other wars have occurred due to the use of force in an attempt to change the allocation of rights between nations, such as the Iraqi invasion of Kuwait in 1990 and the subsequent Gulf War to restore the previous situation. If countries are in conflict over the rights to an asset, such as land, population, or oil, then war can occur as a result of an attempted redistribution of such rights. Thus, yet another aspect of stability in an arms race is that of a stable distribution of wealth and power. Some of the models that we have developed provide a way of analyzing this type of war. There are three factors that are clearly relevant to the outbreak of war. The first is imperfect information, where the

1 14

D.L. Brito and M.D. lntriligator

relevant decision makers may be uninformed about salient aspects of the problem. The second is the redistribution ofresources, that can act as an equilibrating mechanism and thus reduce the likelihood of war. The third is risk taking, in which nations may engage in a game of brinkmanship in order to gain or to avoid losing resources. The history of war suggests that all three factors have played important and, in some instances, crucial roles in explaining why wars did - or did not - occur. The important idea is that there is a relationship between the distribution of power and the distribution of wealth. Conflict can occur if these two relationships are not in equilibrium. We have studied war outbreak and related topics, such as the influence of an arms race on the likelihood ofwar, using a two-period model in Brito and Intriligator ( 1 985). In the first period the two countries choose between consumption and investment in arms, so this period involves a potential arms race. In the second period, the countries bargain over the reallocation of resources, possibly using force or the threat of force to attain their goals, so this period involves a potential war. Our model builds on recent work on bargaining with asymmetric information and employs some recent developments in models of sequential equilibria. The model implies that if both countries are fully informed as to the parameters of the problem, then there will be no war but rather a voluntary redistribution of resources. If, however, there is a situation of asymmetric information in which one of the countries is informed about all parameters of the problem but the other is not so informed, then war can occur if the uninformed country adopts a strategy in which it precommits itself to a positive probability of war in order to prevent bluffing by the informed country. There would be no conflict if the uninformed country finds it optimal not to attempt to prevent such bluffing or, alternatively, if either country has very few resources and thus chooses not to participate. If each of the countries is fully informed about the characteristics of the other country, then when transfers occur, there is no conflict. There exists an initial distribution of resources that leads to no transfers and the two countries would invest in weapons to deter rather than to engage in a war. A surprising result is that a Nash equilibrium in pure strategies does not exist in the fully informed case. However, a Nash equilibrium in the space of mixed strategies does exist, where some of the realizations of the mixed strategies might lead to a crisis. Deterrence requires the use of mixed strategies, with countries choosing positive probabilities of both a war-deterring strategy and a war-fighting strategy. A model in which nations are rational actors and in which threats and deterrence play a major role in the distribution of resources yields significant insights into why deterrence may fail in the real world. Nations are not single rational actors, however, and rational behavior within a bureaucratic and hierarchical organization may lead to undesired consequences. 2. The Richardson model of the arms race

The Richardson arms race model constitutes one of the best known models of arms race phenomena and, at the same time, one of the most influential formal models

Ch. 6: Arms Races and Proliferation

115

in all of the international relations literature 3 . Different types of models have been used in the study of arms races, including descriptive and normative models. The Richardson model is an example of a descriptive model, one with neither an explicit objective nor an assumption of maximizing behavior. Another such descriptive model of an arms race is the stock adjustment model. Both of these models are intended primarily to describe arms race phenomena. Another type of model is the normative model, with an explicit goal and the assumption of maximizing behavior. This type of model is intended to explain the underlying motivations for arms races in terms of goal-directed behavior. One such normative model is the optimal resource allocation model of Brito ( 1972). Another is the differential game model developed by Simaan and Cruz ( 1 975, 1 976), which applies the Nash solution to the basic resource allocation model proposed by Brito. We begin by defining our terms and assumptions. By an arms race we mean the dynamic process of interaction between countries in their acquisitions of weapons. Like Richardson, we treat only two countries, labeled 1 and 2, thus avoiding such issues as proliferation, alliance formation, multicountry stability, etc. From an empirical standpoint, much of the observed interaction in arms races is in fact between two countries or two alliances. In nuclear weapons, there was the US-USSR superpower arms race interaction (or, more broadly, NATO vs. Warsaw Pact) with only relatively insignificant impacts of other nuclear powers. Conventional weapons arms races include the Arab-Israeli arms race, the Iran-Iraq arms race, and many others. We also assume, again as in Richardson, that there is a single homogeneous weapon, where country 1 has w1 weapons and country 2 has w2 weapons. The Richardson model can be extended to the more complex case of several weapons types, but both theoretical and empirical arguments justify this assumption. A model with several types of weapons would considerably complicate the basic theory as it would be necessary to address the problem of portfolio selection. It is important to start with the simpler analysis of a single type of weapon. It is possible, from an empirical standpoint, to aggregate either nuclear weapons or conventional weapons (but not the two together) into an overall measure of military capability. The theory to be developed can be considered applicable to one of these aggregates. The Richardson model is summarized by two differential equations describing the rate of change over time of weapon stocks in each of the two countries. For country 1 , i f w1 (t) i s the stock of weapons at time, then t h = dw 1 /d t i s the rate of change of weapon stocks in country 1 at time t. According to the Richardson model, this change is described as the sum of three separate influences. The first is the defense term, where the accumulation of weapons is influenced positively by the stock of 3

Basic references for the Richardson model are Richardson ( 1 939, 1 9 5 1 , 1 960) and Rapoport ( 1 957, 1 960). Lewis Fry Richardson's seminal work became available in 1 947-1949 in microfilm and was published in book form in 1 960, as Richardson ( 1960). Rapoport ( 1 957, 1 960) provides a review and appreciation of this work. See Intriligator and Brito ( 1 976b) and Isard and Anderton ( 1 985); see Anderton ( 1 985) for an extensive survey and bibliography.

D.L. Brito and M.D. Intriligator

1 16

Figure

I.

weapons of the opponent w2, representing the need to defend oneself against the opponent. The second is the fatigue term, where the accumulation of weapons is influenced negatively by one's own stock of weapons, representing the economic and administrative burden of the arms race. The third is the grievance term, representing all other factors influencing the arms race, whether historical, institutional, cultural, or others. In the Richardson model these tetms are independent, additive, and linear, resulting in the two coupled linear differential equations: ( 1) (2) Equation (1) for country 1 determines weapons acquisitions as a function of the constants a 1 , a2, a3, and the weapons stocks in both countries. According to the theory, a 1 and b1 are positive since the two countries are opponents. Also according to the theory, a2 and b2 are positive since maintaining weapons reduces the ability to acquire additional weapons. The grievance terms a3 and b3 can be positive or negative. At an equilibrium point of the dynamic process there is no change in weapon stocks, w1 = 0 and w2 = 0, yielding the reaction functions

Wz = wz =

a2w, - a3 a, b 1 w 1 + b3 bz

for country 1,

(3)

for country 2.

(4)

These reaction functions, illustrated in Figure 1 , give the number of weapons each country holds as a (linear) function of the number held by the opponent, i.e., how each country reacts to weapons stockpiles of the other for an equilibrium to be attained. If the grievance terms a3 , b3 are positive and the stability condition a2b2 - a 1 b 1 > 0 holds, then an equilibrium exists. This condition guarantees that the reaction functions

Ch. 6: Arms Races and Proliferation

1 17

will cross and that the resulting equilibrium will be stable. The equilibrium stockpile of weapons for country 1 is then given by

,

WJ =

a3b2 + a1b3 a2b2 - a 1 b 1 '

(5)

and a symmetric equation exists for w2 . If the stocks on both sides exceed the equilibrium then the force of the fatigue terms would offset the defense (and grievance) terms to reduce stocks on both sides to the equilibrium level. If, conversely, the stocks on both sides were below their equilibrium levels then the defense terms would offset the others to raise stocks on both sides. In the case where W J is "too large" and w2 is "too small" relative to the equilibrium, the force of the fatigue term for 1 and that of the defense term for 2 would reduce w 1 and increase w2 , restoring the equilibrium. While the Richardson model is the most influential model of an arms race, it is not the only such model. Another descriptive model is the stock adjustment model, such as those of Boulding ( 1 962), Intriligator ( 1964), and McGuire ( 1 977). Each country determines a desired stock of weapons, WJ and w2, and the rate of change of weapon stocks is assumed to be proportional to the discrepancy between desired and actual weapon stocks, as in the two differential equations:

a4 (ti'J - W I ) , w2 = b4 (w2 - wz ) .

ti�J =

(6) (7)

Thus, each side acquires additional stockpiles in order to overcome a perceived deficiency in its stockpiles of weapons, the deficiency given by the gap between the desired and actual levels of weapons, for example, w 1 - w for country 1 . In general, the desired stocks of weapons depend on the level of weapons in both countries. If, for example, each country desires to have a certain base level of weapons and to match increments of the other side's levels according to a fixed ratio then the desired stocks are linear functions of the levels of weapons held by the other side: (8) (9) where a5 and b5 are the base levels and a6 and b6 are the fixed ratio of increments of one country's stocks relative to those of the opponent's. Inserting these in Equations (6) and (7) yields the Richardson model. Conversely, any Richardson model, as in Equations ( 1) and (2), can be interpreted as a stock adjustment model with the desired stocks linear functions of the weapons held by the opponent. 3. The dynamics of arms accumulation: the rational actor model

Our goal in this section is to explain the arms race in terms of the behavior of decision makers using the postulates of rationality and maximizing behavior. In particular, we

D.L. Brito and M.D. Jntriligator

1 18

derive the dynamics of arms accumulation in a model based on the axioms of rational choice, where it is assumed that each country can be modeled as a single rational actor. There are several schools of thought about the· stability of armament races. One is that arms races must have a stable equilibrium. This result comes either from a static model that treats an arms race as a game similar to "Prisoner's Dilemma" or from a dynamic model such as those of Richardson ( 1960), Saaty ( 1968), and Smoker ( 1 965), which assume the equations of motion. A second school of thought is that arms races are unstable. This theory, often seen in the popular press, holds that, unless some agreement is reached, weapon stocks will increase in an ever-increasing spiral that must ultimately lead to bankruptcy or war. A third view is that a stable equilibrium may exist but that stability may only be a local property. Thus, a large disturbance of the system such as the introduction of a new weapons system may lead to an arms race. Here we will formulate a model that will permit us either to reconcile or to discriminate among these apparently conflicting viewpoints. Again consider a system with two nations. Each nation can use its production for either consumption or investment in its weapons stock. Each nation is trying to maximize a utility function over time whose arguments are consumption and defense. We address three questions: 1 ) Does there exist an equilibrium level of armaments? 2) If such an equilibrium exists, under what conditions will it be stable? 3) Under what conditions will a stable equilibrium occur at zero weapon stocks? We show, under very general assumptions given in Brito ( 1972), that there exists an equilibrium level of armaments. Further, we give some sufficient conditions for the equilibrium to be stable. Finally, we show that in a dynamic economic model total disarmament is unstable except under very special circumstances and that behavior very similar to that of the "Prisoner's Dilemma" game will be observed. We assume that: 1) Welfare in each country can be represented by a strictly concave twice­ differentiable concave utility function U(c;, D(w;, w1)) where c; is the consumption of the ith country and D(w;, w1) is a public good which will be called defense. We assume that at zero level of consumption the marginal utility of consumption is infinite. 2) The level of defense D(w;, w1) is given by the value function associated with a potential war or conflict that depends on the weapon stocks in each country, where w; is the weapons stock of the ith country. We assume that an increase in the weapons stocks of a country will increase its level of defense and that an increase in the weapons stocks of its rival will decrease its level of defense: 8D; (w;, wJ) ( 1 0) ____:, ____:..:.._ � 0, _

8w;

8D; (w;, w1 ) 8wj

�

0.

( 1 1)

The exact dynamic game that defines the value function will not be specified for the moment, but it suffices to think of this function, associated with the outcome of a potential war, as a primitive construct, such as a production function.

1 19

Ch. 6: Arms Races and Proliferation

3) To reduce the dimensionality of the problem we assume that both countries are at an equilibrium capital-labor ratio and that they invest sufficiently to maintain their capital stocks. Further, we assume that the population is constant. The problem of the effect of armaments on growth and vice versa is important, but here we ignore it. Letting Yj(t) be the net national product of the ith country and z;(t) be the expenditure on weapons at time t, the resource constraint is given by ( 1 2) Let b;w; be the resources necessary to maintain and operate weapon stock w;. Then ( 1 3) stating that net investment in weapons is gross expenditure less depreciation and operating expenses. 4) Finally, given the discount rate r;, we assume that at any point in time r, the ith country seeks to maximize welfare given by the present discounted value of utility, J;(r)

=

100

e-r,(H)

U (c;, D; (w;, w1)) dt

( 1 4)

subject to the constraints given by Equations ( 1 2) and ( 1 3 ) and the jth country's reactions. Since this optimization depends only on the initial conditions, we can simplify notation by assuming that r 0. Assume initially that the parties t o an arms race are Coumot-Nash players i n that they are myopic with respect to the behavior of the other party, taking the behavior of the other party as given. We show that the dynamic equations for the arms race are given by general Richardson-type differential equations =

w; R; (w;, w1) , w1 R1 (w;, w1) , =

( 1 5)

=

( 1 6)

and that this dynamic system has a stable equilibrium at w; and w1. The Coumot­ Nash assumption of myopic behavior will be relaxed in subsequent sections, however it is useful to explore the implications of such simple strategic behavior. It provides a benchmark against which other strategic assumptions can be j udged. Since the actual mechanism involved in the allocation of resources in the countries involved is a complex combination of political and bureaucratic behavior, there is some virtue in simplicity. The assumption of Coumot-Nash behavior implies that the level of the jth country's weapons stock w1 is constant and parametric to the ith country's optimization. The current value Hamiltonian for the ith country's optimization is given by ( 1 7)

where !;; is the costate variable associated with the ith country's weapon stocks and A; is the Lagrange multiplier associated with the resource constraint. According to

1 20

D.L. Brito and M.D. Intriligator

the Pontryagin Maximum Principle the ith country would choose optimal paths c7(t) and z7(t) (where * denotes the optimal solution) so as to maximize the Hamiltonian at each point in time for the l;7(t) which is the solution to the costate differential equation given below as well as the w7 (t) which is the solution for the state differential equation for the appropriate boundary conditions [Intriligator (1971)]. It follows from the Berge Maximum Theorem and the strict concavity of the Hamiltonian in c; that solution of the optimization c; (!;;, w;, w1 ) and z7 (!;;, w;, w1 ) are both continuous functions of l;; , w;, and w1. The assumption that the utility function is differentiable implies that A.7(l;;, w;, w1) is also continuous. For a given wh the dynamics of the ith country's accumulation of arms is then given by the autonomous (time independent) differential equation system for the state and costate variables

( 1 8) (19) Since the differential equation system is autonomous, Equations ( 1 8) and (19) can be combined to yield a differential equation in phase space, which, together with the boundary conditions, can be integrated with respect to w; to yield the optimal costate

!;7 if>(w7 , wJ)-

(20)

=

Equation (20) can then be substituted into Equation (18), resulting in

(21) and a similar equation can be derived for the jth country:

(22) Together, Equations (2 1) and (22) provide the rolling plan for both countries at time t. Implementation of the plan gives the dynamics of an arms race when the principals behave as Cournot-Nash players. This is a general nonlinear version of Richardson's equations as given by Equations ( 1 5) and (16). Letting w; be the solution of R; (w;, w1 ) = 0, it is clear from Equation (20) that w7 = 0 implies that l;7 = 0 and that from Equation (19),

8U; (c7 , D; (w;, w1 )) 8D; (w;, w1 ) aD;

Ow;

- (r; + 8;) if>; ( W;, Wj ) . _

,

(23)

This is a standard result in capital theory, stating that the marginal product of capital is equal to the cost of capital. Furthermore, solving the equations for w1 as functions of w1 yields i = 1,2 j

=

1 , 2,

(24)

representing a general non-linear version of the reaction curves of the Richardson model.

Ch. 6: Arms Races and Proliferation

121

Proposition 1 .

Given the assumptions we have made, if /5i > 0 then there exists an equilibrium level of armaments, where the equilibrium is characterized by 4

=

o

(25)

R2('-h , w2) = o.

(26)

R 1 (w ! , w2)

We have demonstrated the existence of a resource-constrained equilibrium. The assumption that the utility function satisfies the condition that the marginal utility of zero consumption is infinite implies that this equilibrium is always in the interior of the feasible set. If we assume that /5i 0, then we can still prove that an equilibrium exists if we assume decreasing returns to scale in arms as this would imply that Equation (24) is a contraction mapping, as discussed in Brito ( 1 972).

=

4.

The dynamics of nuclear war: strategy and outcomes

A criticism that can be lodged against all the models introduced so far is that they treat an arms race from the outside, in terms of a mechanistic model, rather than from the inside, in terms of the decisions of defense planners, as discussed in Intriligator (1967). They all ignore strategic considerations, in particular, the roles of weapons in both deterring and conducting a war. Intriligator ( 1 975) developed a model that took such factors into account, connecting the acquisition of weapons to their use in both peace (deterrence) and war (warfighting). This section connects this model that treats strategic considerations as perceived by defense planners to the arms race. In both country 1 and 2, at any time t, the political authorities will generally require the military authorities to justify their proposed budgets, in particular, any request for an increase in the level of weapons, here called "missiles". They may also question the existing levels of missiles in terms of their danger and/or expense. The military authorities would typically seek to justify both their budgetary requests for missile acquisitions zi(t) and their current inventories of missiles wi (t) in terms of national security considerations by showing their potential for deterrence or warfighting. Both the deterrence and the warfighting roles of weapons can be addressed via considering a hypothetical missile war, such as in war gaming or in computer simulation. The simulation of a missile war can be described by the time paths for missiles in both countries w 1 (r), w2 ( r) and for casualties in both countries x 1 (r), x2 ( r), where is an index of time during the simulated war which starts at the present time t. These time paths can be considered the solutions to the following coupled system of

T=

T

4

Proof in Appendix.

122

D.L. Brito and M.D. lntriligator

differential equations and the associated boundary conditions at time t for the four state variables w1 , w2, x � . and x2 , which provide a dynamic model representation of the hypothetical or simulated missile war5. (27) (28) (29) (30)

In Equation (27), the stock of country 1 's missiles starts at w1 (t), its current level, and, assuming the hypothetical war begins at time t, the stock declines for two reasons. First, country 1 fires its missiles at the rate v1" so -v1,w1 represents the decline in country 1 missiles due to its own firing decisions. Second, country 1 missiles are destroyed due to country 2's missiles launched against them. Of the v2,w2 missiles launched at time t, as shown in Equation (28), the proportion v2s is launched counterforce against country 1 missiles. Thus, v2, v2sw2 missiles are launched and targeted at country 1 missiles at time r. If each destroys, on average, e2w of country 1 's missiles, then e2w v2, v2sw2 of country 1 missiles are destroyed at time r, as shown in Equation (27). The remaining country 2 missiles launched at time r, given as v2,(1-v2s)w2, are targeted countervalue, at country 1 's cities, and they inflict e2xv2,(1-v2s)w2 casualties in country 1 , as shown in Equation (29), where e2x is the average casualty inflicted per countervalue weapon of country 2. Equations (28) and (30) represent similar processes for country 2. The evolution of the simulated war described by Equations (27) to (30) is determined by the initial weapons stocks; the strategic decisions, over time, of rates of fire and targets; and the technical parameters determining the effectiveness of weapons against enemy weapons and their effectiveness against enemy cities. It should be emphasized that this is a planning model of a hypothetical war, e.g., in a war game or a computer simulation, which can be used by the military authorities to justify current budgetary requests and force levels. In particular, it can be used to justify the force levels and weapons acquisitions needed to deter an actual war. (It should also be emphasized that this differential equation model of a simulated war should not be confused with the earlier differential equation models of an arms race, such as the Richardson model.) Deterrence, in this context, refers primarily to the ability to keep the opponent from initiating a war, so consider what happens in the hypothetical war if the enemy initiates the war at the present time t. The value function of the associated optimization problem can be thought of as the D;(w;, wj) term from the last section. If the planners 5

See Intriligator ( 1967, 1 975), Saaty ( 1 968), Brito and Intriligator ( 1 972-1 974, 1 977), and Intriligator and Brito ( 1 976a). For a related model see Kupperman and Smith (1 972, 1 976).

Ch. 6: Arms Races and Proliferation

1 23

in country 1 have the objective function J 1 [w 1 (T), w2(T), x 1 (T), x2(T)] , defined on the terminal stage of a hypothetical war to be maximized, then (3 1) where the choice variables in the maximization are strategic variables, here the rates of fire and the target selection during the war. If the objective of the military authorities in country 1 is to deter country 2 from striking by threatening to inflict upon it an unacceptable level of damage on a potential retaliatory second strike, then they should have enough missiles to inflict at least such a level of casualties. It is then possible to solve for the minimum level of missiles required for country 1 to deter country 2 by inflicting this level of casualties. The result is a linear reaction function, as in the Richardson model, but one which can be solved as an explicit function of certain underlying strategic, technical, timing, and social/psychological factors, such as in the example below. Thus, the Richardson model coefficients in Equations (1) and (2) can be interpreted as consequences of underlying strategic and related factors. In the case of each country acting so as to deter one another, a stable equilibrium for the resulting arms race exists if certain stability conditions are met. To give a numerical example, consider the symmetrical case, where the parameters are the same on both sides and where the maximum rate of fire is 1 0 percent per minute, it takes two weapons to destroy one enemy missile, one missile inflicts 250 000 casualties, the first strike initiation interval is 15 minutes, the second strike retaliation interval is 1 0 minutes, and the minimum number of casualties required for deterring the other side is 40 million. Then the solution for the equilibrium level of weapons held by each side (where the linear reaction functions cross) is 414, that is, with 414 weapons each side has enough to deter the other side. At this level on both sides, either side can absorb the 1 5 minute first strike of the other and still have enough weapons left to inflict the required number of 40 million casualties on the other in the 1 0 minute retaliatory second strike 6 . Geometrically, in the case of the two countries each trying to deter the other, these two reaction curves are shown in Figure 2 as the lines marked "country 1 deters", and the comparable line for country 2, marked "country 2 deters". At points to the right of the a, a, line country 1 has a sufficient number of missiles to deter country 2, while at points above the a2 a2 line country 2 has sufficient missiles to deter country 1 . The two reaction curves intersect at E, which is the equilibrium level of missiles, e.g., 414 on both sides in the above numerical example. The shaded upper cone of mutual deterrence represents the region of mutual deterrence, where each deters the other. As long as the levels of missiles remain in this cone, each side deters the other and the 6 For a discussion of the sensitivity of the equilibrium levels of missiles to changes in the strategic, technical, timing, and social/psychological parameters see Jntriligator (1 975).

D.L. Brito and M.D. Intriligator

124

country 2 attacks

country I attacks

Figure

2.

situation will be relatively stable against the outbreak of war. Arms control through arms limitations or reductions is feasible as long as the situation remains in the cone of mutual deterrence. Another goal of military authorities could be to avoid a preemptive strike by having enough missiles relative to those on the other side that it will not appear to the other side that an attack could be successfully implemented. If the other side believes that such an attack could be carried out then it might be forced to make its own preemptive strike in order to take advantage of being the first to move, using the element of surprise. If the number of casualties inflicted on country 2 in retaliation for its initiating the war were sufficiently large then country 1 would not fear an attack by country 2 and thus country 2 would avoid a preemptive strike. In Figure 2 the shaded cone of mutual deterrence is included in the area of the larger cone with vertex at E', for which both sides avoid preemption. At points to the right of the line b 1 b 1 country 1 attacks, while at points to the left of the line b2 b2 country 2 attacks. Thus, in the cone with the vertex at E' both sides avoid preemption. This figure also shows the regions of initiation as the lower shaded sawtooth-shaped region in which one side, both, or neither avoids preemption nor deters the other side. For example, in region I 1 country 1 can attack since it has enough missiles to attack country 2, but neither has enough missiles to deter the other. Thus country 1 will be forced to attack or country 2 will be forced to preempt, in either case leading to war. Region I 2 is the obverse case in which either country 2 attacks or country 1 preempts. Region I 12 near the disarmed state, is the most dangerous region of all since each side

Ch. 6: Arms Races and Proliferation

1 25

can successfully attack the other, neither can avoid preemption, and neither can deter the other. Each is forced to initiate the war in order to take advantage of striking first. Bilateral disarmament, interpreted geometrically as a movement to the origin in Figure 2, inevitably entails movement through the region of initiation. While the movement to the disarmed state need not necessarily lead to initiation, the movement from the disarmed state may be highly explosive. In such a situation, either country could acquire a small inventory of missiles which could enable it to attack the other with impunity. In fact, the danger of war may be greatest if one side detected that the other was starting to rearm. In such a situation the missile levels move through the regions of initiation in a crisis atmosphere. Figure 2 can also be used to study the effects of the arms race on the outbreak of war 7 . Arms races are, in terms of Figure 2, movements in the weapons plane, representing changes in the weapons levels of both sides. An arms race in the usual sense of increasing levels of weapons on both sides would be represented by a movement up and to the right, while a disarming race would be represented by the reverse type of movement, that is, down and to the left. Other types of races can also be represented, for example, one in which one country is increasing while the other is decreasing its levels of weapons. The shaded areas indicate the likely effect of an arms race on the outbreak of war. For example, a movement from the disarmed state at the origin up into the region of initiation, such as to points in I 1 2 , would represent an arms race that is likely to lead to war. It results in an explosive situation in which neither country can deter and both can preempt. It is precisely this potential arms race that shows the danger of a completely disarmed situation, where rearming in a crisis atmosphere without the stabilizing influence of mutual deterrence could lead to the outbreak of war. Not all arms races, however, lead to the outbreak of war. Consider, for example, an arms race that starts in one of the regions of initiation, say in I 1 • If both countries increase their levels of weapons via an arms race from a point in I 1 to a point in the cone of mutual deterrence then the arms race has the effect of reducing the chance of war by the stabilizing influence of mutual deterrence. In fact, this type of increase may be one interpretation of the United States-Soviet Union nuclear arms race. The late 1950s and early 1 960s were characterized by the instability of relatively low numbers of missiles, which were not sufficient to deter either side. There was, furthermore, asymmetry in the situation in that the United States, country 1 in the diagram, could attack, while the Soviet Union, country 2 in the diagram, could not. Thus, the situation was in region I 1 , one of initiation. The fundamental instability in the situation was shown by repeated crises, culminating in the 1 962 Cuban missile crisis, perhaps the time the world has come closest to nuclear war. In the mid- and late 1960s, however, there was a considerable buildup of Soviet weapons, substantially increasing w2 , and 7 See Intriligator and Brito ( 1 984-1986). See also Huntington (1 958), Gray ( 1 9 7 1 , 1 976), Lambelet

(1 975, 1985), Smith ( 1 980), and Mayer ( 1 986).

1 26

D.L. Brito and M.D. Intriligator

some buildup in US weapons, increasing w1 . The result was that by the 1 970s there was a situation of mutual deterrence, which represented a more stable situation. Thus, the arms race resulted in movement from regions of initiation to those in the cone of mutual deterrence. Such an arms race had the effect of reducing the chance of war. Once mutual deterrence was achieved there were no crises comparable to the Cuban missile crisis or to the other crises of the late 1 950s and early 1 960s. Both sides had become, by necessity, more restrained and less willing to "go to the brink" due to their mutual deterrence relationship. 5. Arms races and stability

The existence of an equilibrium is important, but its implications depend crucially on whether the equilibrium is stable. In this section we will investigate sufficient conditions for an equilibrium to be stable. It is necessary to specify how each of the two countries will react when the weapon stocks are not in equilibrium. The simplest assumption we can make is that of myopic behavior, where each country behaves in a myopic manner, reacting only to the current level of the weapons stock of the opponent and disregarding information about the history of the levels of weapon stocks and the opponent's current rate of investment in weapons. This assumption was used by Richardson and others, and it is similar to the assumption used in the Coumot­ Nash solution of the duopoly problem. Under this assumption we have the following proposition: Proposition 2. An

equilibrium point of an arms race is stable if each country behaues in a myopically optimal manner.

Proposition 2 can be established by examining the phase diagram in Figure 3 8 . This result, that the equilibrium o f an arms race i s stable i f the countries involved act in a myopic manner, also depends on the assumption made in the model that the utility function is of the form U ( c;, D( w;, w1)) , where c; is the consumption of the ith country and D(w;, w1 ) is the public good, defense. Brito and Intriligator ( 1 987) treat a more general problem using a utility function of the form u(c;, x;, z;) where x; is the level of defense and z; is the investment in weapons as before. If the preferences satisfy the condition that, on an indifference curve, !/x; � > 0, then for a wide range of strategic behavior the resulting equilibrium is unstable. A necessary and sufficient condition for stability is that the elasticity of Z; with respect to x; be less than 1 . Thus, if expenditure on arms enters the utility function, then the problem becomes more complicated. The assumption that both countries behave in a myopic manner makes it very easy to analyze the stability of the equilibrium. This assumption, however, is very unrealistic. 8

The phase diagram is derived in the Appendix.

Ch. 6: Arms Races and Proliferation

127 w1

=

o

r

0

�----�------------�._----------w

wl

Figure

l

3.

Clearly, military expenditures are based not only on the current arms level of the potential enemy, but also on its projected levels. A more realistic assumption is to assume that each country uses information about current arms levels and the rate of change in arms levels to predict future arms levels. This projection, which is revised periodically or continuously, is then used to plan current investment. Thus, the most realistic assumption to make about an arms race is that the participants monitor the behavior of the other parties and thereby learn about their characteristics. Such a formulation was attempted by Brito ( 1972) in an ad hoc fashion. Recent results on rational learning in games by Kalai and Lehrer ( 1993a,b, 1 995) now enable us to address this problem in a very general fashion. The principal change in the model is that the choice set of the players must be discrete. In the context of the arms race, this assumption is, in fact, more realistic than the previous assumption that the choice set is the bounded interval which defines the budget set, given that warships, bombers, and missiles all come in discrete units. Letting 1/(1 + r) be the discount factor and recalling that, without loss of generality, we can choose the planning time as t = 0, the objective function for country i in the discrete case can be written as the sum of discounted expected utility

p

=

E(� p1 U; (cit, Xit)) ,

(32)

cit

is the level of consumption and xu is the level of defense in country i at where time t, and the expectation is taken with respect to the probability distribution induced by the ith country's predictions of the other country's behavior. The objective function given by Equation (32) is maximized subject to the equation that gives the dynamics of weapons accumulation (33)

D.L. Brito and M.D. Intriligator

1 28

a discrete version of Equation ( 1 3), where Zif is gross expenditures on arms zit in Z;, with Z; a finite set, and 0; is the rate of depreciation or cost of maintaining weapons. The budget set as in Equation ( 1 2), is given by Yu = C;t + zu,

(34)

the level of defense associated with weapons accumulation is given as (35) and the ith country's forecast of the jth country's strategies for t as

=

1

·

·

·

oo

is given (36)

/)1

.. .

where Wjt is a random variable with a probability distribution for t = 1 , 2, , oo, and lu is the information available to the ith country at time t, which is revised by Bayesian updating. The optimal return function can be written V; (w;o, Wjo, l;o)

=

max

{ E (�

p1 U; ( cit , Xit)

)}.

(37)

The solution to the problem is characterized by the choice of weapons stocks by country i at time 1 , given as w71 , and a sequence of contingent plans and forecasts Wif for t 2, 3, . . . , oo and Wjt for t 1 , 2, . . . , oo. The function V;(w;o, Wjo, l;o) in Equation (3 7) is the value function of a dynamic programming problem. From Bellman's Principle of Optimality, =

=

V;(w;o, Wjo, l;o) = max { U; (c;o, x;o) + p; V; ( wn , Wj i , ln ) } ,

(38)

which is the Bellman equation for this dynamic programming problem. The Kalai­ Lehrer theorem states that if the players use Bayesian updating of their beliefs and certain technical restrictions are satisfied then the game will converge to an equilibrium. 6. A general model of an arms race

Most of the early models of the arms race were heavily influenced by the Richardson model and, as a result, were formulated in continuous time. The goal of most of these models was often a derivation of the Richardson equations from more fundamental principles. Inasmuch as one of the objectives of these studies was an analysis of the stability of the arms race, continuous time models were convenient. The use of

Ch. 6: Arms Races and Proliferation

1 29

continuous time models was unfortunate, however, because continuous time makes it very difficult to model other essential features of an arms race, such as learning, strategic behavior, uncertainty, budgetary cycles, and lags in a continuous time model. All of these are important features of an arms race which need to be studied. A general model of an arms race which would encompass the many previous models can be formulated in discrete time. This general model has four components: a technology that describes the economic constraints faced by the country, a defense technology, an information or learning technology, and a choice function that characterizes the choices made by the country, given the technology and information available to them. Again assuming two countries, 1 and 2, at discrete points in time each country faces the economic constraints defined by

Yit = F (cit, zit) ,

(39)

Wit+I = Zit + (1 - and is finite 1 3 . Since there is no conflict in the first period and preferences are assumed to be the same in both periods, utility in the first period is given by For simplicity we assume that the decision makers in each country believe that the parameter, n ; , characterizing the other country's disutility of war takes one of two values: a with probability p or f3 with probability 1 p 1 4 . Without loss of generality a < {3, so the disutility of war is greater for an a country than it is for an f3 country as measured by the amount of utility of consumption needed to offset a particular level of the externality. In the first period each country faces a resource constraint of the usual form

8u(cit , x)/8cit 0 8u(O, 0)/8cit u(ci !,O).

u(·12•, ·)

-

(47) as in Equations (12) or (34), where Y; 1 represents the total goods available to the ith country in the first period, and w; is the ith country's investment in weapons. We assume that total resources Y = Y;1 + lj1 are fixed; thus, Y;1 is sufficient to describe the initial allocation of wealth. 12 This assumption is made so that the game is such that an agent has the option of not participating. The utility level of u(O, 0) can be thought of as the utility of staying home as opposed to engaging in adventures abroad in order to acquire a right to a share of total goods available Y, which, in turn , could be thought of as representing gains from international trade and diplomacy. 13 The assumption that x is public bad common to both countries is made to facilitate the graphical representation of the model. The formal mathematics do not change if we assume that x, is a public bad that is specific to the ith country. 14 This particular basis for uncertainty is not crucial to the properties of the model. For example, we could have modeled the problem as one of uncertainty in the technology of conflict, where the jth agent is uncertain as to the ith agent's effectiveness. What is crucial is that there is uncertainty for the jth agent about the cost and/or outcome of conflict. Also we could have formulated the uncertainty in other ways, for example, a continuous distribution over the parameter n,, reflecting the beliefs of agent j.

DL Brito and M.D. Intriligator

1 34

By the second period, both countries have chosen weapon stocks w; and w1, respectively, and there are then three possibilities. First, both countries could choose to behave passively and preserve the status quo. Second, one country could propose a redistribution agreed to by the second country. Third, one or both countries could propose a redistribution not agreed to by the other side that could lead to conflict and possibly to the outbreak of war. The first stage of the game involves the choice of the weapon stocks W; and w1. These weapon stocks in tum establish the parameters of the second stage of the game. Define as the war allocation the distribution of resources and the externality that results from the maximization of second period utility by the two countries subject to the constraints

(48) (49) V;

� W;,

(50) (5 1)

where V; is the amount of fighting by the ith country, as measured by the amount of weapons each of the countries commits to the war. We assume that committing more weapons shifts the redistribution, as measured in Equation (49) by lJf;(v;, v1), in that country's favor, so that 8 1Jf;(v;, v1)!8v; > 0 and 8 1Jf;(v;, v1)!8v1 < 0. The redistribution function lJf ;( v;, v1) plays a role here similar to that of the threat point in the Nash bargaining problem. The amount of fighting the ith country is able to do is limited by its level of weapons, which was determined, in part, by the initial distribution of resources in the first period and the redistribution is from one to the other so lJf;(v;, v1) - 1Jfj(v1, v;). The war allocation defines the threat point of the second period bargaining game. The properties of this game can be illustrated in Figure 4. In this figure, the vertical axis represents second-period consumption for both countries and the horizontal axis is the level of the externality caused by war. The private consumption of country 1 is measured upwards from point 0, and the private consumption of country 2 is measured downwards from point Y0. Country 1 has indifference curves that slope upward since x is the public bad; similarly, country 2 has indifference curves that slope downwards. If the initial allocation is at point a0, then, in the second period there are two possibilities: the war allocation could either be at a point like a1 or it could be at a point like a2. If the war allocation is a1, both countries prefer the allocation at a0 to the allocation at a1 . If, however, the war allocation is at a point like a2, then country 1 would prefer the allocation at a2 and thus has an incentive to initiate a war. However, both countries would prefer an allocation like a3 that is feasible and dominates a2• Rather than fight, country 2 should rationally negotiate and reach a settlement in the interval [a3 , a4 ], representing the set of points that Pareto dominate a2 for both countries and do not

=

Ch. 6: Arms Races and Proliferation

135

r:.--

_ _ _

o �------�x�==��--­ Figure 4.

involve conflict 15 . If such voluntary transfers are possible and if each party knows the other's preferences, then war is not consistent with rationality since the set of points that Pareto dominate a2 is well defined. We assume that a threat cannot be rationally implemented by a party if it prefers the initial allocation to the threat allocation, and define an allocation to be stable if the initial allocation Pareto dominates the threat allocation. Classical bargaining theory assumes individual rationality, meaning that a rational individual would not agree to an allocation that is dominated by the threat point, and also assumes joint rationality, meaning that two rational individuals would not agree to an allocation if there exists an alternative feasible outcome that will make them both better off. Since any outcome in the interior of the feasible set is Pareto dominated, the final outcome must lie on the boundary of the feasible set and must consist of points that dominate the threat point. Defining N (a3 ) { f;z, l}z l Yi2 ;? a4 , Yo ;? lfz a5 }, this is the set of points that Pareto dominate a3 and represents the negotiation set. There are several solution concepts that assign an allocation in the negotiation set as a function of the threat point 1 6 . For the purpose of this section, however, it is only necessary to assume that the outcome of a negotiation will result in an allocation in the negotiation set. The cooperative allocation in the second period is described as follows: if the conflict allocation is not Pareto dominated by the initial allocation then the second period

=

-

15 The standard Nash solution of the bargaining game leaves open the question as to why the threat point is ever implemented given that it is Pareto dominated by the negotiation set. See Nalebuff ( 1 982, 1 984). 16 See Nash (1 950), Kalai and Smorodinsky ( 1 975), and Brito, Buoncristiani and Intriligator ( 1977).

D.L. Brito and M.D. Intriligator

136

allocation is given by the outcome of a cooperative game that allocates the surplus. However, if the conflict allocation is Pareto dominated by the initial allocation then the initial allocation is the outcome. With this formulation of the two-period model it is possible to show that there always exists a set of initial allocations of wealth that are stable and that do not lead to war since those initial allocations Pareto dominate any possible war allocation, as in

There exists a set of positive measure, S0, the stable set, in the interval [0, Yo ] such that allocations in S0 will Pareto dominate any allocation that results from war 17. Proposition 4.

In the first period countries can choose two possible strategies for investing in weapons. First, they can adopt a war arms investment strategy in which they invest in weapons as if they planned to engage in fighting in the second period. Second, they can adopt a deterrence arms investment strategy in which they invest in a sufficient level of weapons so as to deter the other country from initiating a war in the second period. In the example illustrated by Figure 4, country l can choose to invest in weapons in the first period so that the resulting allocation is a5 , making it better off since it would then have more first-period consumption and the allocation in the first period would still be ao . If the countries adopt a war arms investment strategy, the ith country chooses w; in the first period and, in the second period, maximizes, by choice of its level of fighting V;, its second period utility, given as:

(52) subject to Equations (48)-(5 1), where it is assumed that v1 is chosen rationally by the jth country in response to the ith country's actions. An alternative to the war arms investment strategy is a deterrence arms investment strategy. Define T; as a voluntary transfer from the ith country to the jth country in the second period. Another way to formulate the problem is for the ith country to maximize total utility of consumption over both periods:

u (ci l , 0) + u (ci2 , 0)

(53)

subject to the incentive constraint that the jth country be no worse off after the transfer than the utility level it could have achieved by war, namely

(54) 17 Proof in Appendix.

Ch. 6: Arms Races and Proliferation

137

Here T; is the transfer in the second period, given w1 as well as the resource constraints for the ith country in both periods:

Yi l Ci! W I 0, liz T; ci2 = 0. -

-

-

-

=

(55) (56)

The incentive constraint in Equation (54) requires that the ith country define the feasible set of the jth country such that the jth country weakly prefers the nonwar allocation with the transfer to the war allocation 1 8 . The resource constraint in Equation (55) states that the ith country's total resources in the first period are divided between weapons and consumption while that in Equation (56) states that total resources in the second period are divided between consumption and transfers to the jth country. The solution to this problem represents the maximum consumption that the ith country can achieve while still guaranteeing that it would not be optimal for the jth country to engage in war given that it has w1 weapons.

5. If the transfer T; > 0 then an equilibrium level of weapons exists and the allocation that results from the ith country adopting a deterrence arms investment strategy and the jth country adopting a war arms investment strategy is a Nash equilibrium. Proposition

Note that if the ith country adopts a war investment strategy then the solution for the ith country strategy depends on its own parameter, n;, while if it is adopting a deterrence investment strategy, the solution depends on the other country's parameter, n1. This point is important in understanding why deterrence may lead to higher arms levels. If a country believes that the other country is tough, it may feel that it is necessary to invest in high weapon levels in order to deter. If, on the other hand, the ith country is adopting a war investment strategy, then it will choose a level of weapons, and thus a level of fighting, at which the marginal benefits from fighting are equated to the marginal costs of fighting. This apparent anomaly is due to the fact that in the deterrence arms investment strategy the level of arms acquired by the ith country is independent of n; but does depend on ni. Thus, if n1 is much greater than n; then the deterrence arms investment strategy may have an equilibrium with a higher level of arms than the war arms investment strategy.

6. If the transfer T; = 0 and if both countries adopt a deterrence arms investment strategy then the resulting arms investment strategy is not a pure Nash equilibrium.

Proposition

18 The problem of determining how the surplus created by not fighting is distributed in a bargaining situation is not addressed. For the sake of simplicity, we are assigning the entire surplus to the party making the transfer. Clearly any rule from axiomatic bargaining theory could also be used. See the references in footnote 1 6.

D.L. Brito and M.D. lntriligator

138

B

l

ci2

A

L-------�xx---::::�--�--�0� Figure 5.

In Figure 5, point a 1 is the allocation associated with the war arms investment strategy for both countries. This is Pareto dominated by a0 so there will not be a war if both sides adopt investment strategies that result in a1 . Each country, however, can unilaterally adopt strategies that result in points like a2 and a3 • These are the allocations that would result if one country adopts the war arms investment strategy and the other adopts a deterrence arms investment strategy. Again, these are Pareto dominated by a0 so there will not be a war, but they are also Pareto dominated by a4 , the allocation that results if both countries adopt the deterrence arms investment strategy, each assuming that the other is using a war arms investment strategy. This point, however, is unstable, since it is Pareto dominated by a5 and a6 , which are the allocations that result if either country adopts a deterrence arms investment strategy, each assuming that the other is using a deterrence arms investment strategy. This process results in a sequence of weapon stocks that converges to the disarmed state, but the allocation associated with this state is not stable since either country would find it advantageous to switch to a war arms investment strategy. The resulting allocation will be a0 which is unstable. A mixed strategy, however, will lead to a Nash equilibrium 1 9. Consider now the asymmetric information case in which only one country knows the utility function of the other. In this case, both informed and uninformed countries maximize expected utility. The informed country has the option of bluffing so as to increase the transfer made to it by the uninformed country. The uninformed country may call the bluff by offering the informed country a choice that involves a nonzero probability of war, a separating equilibrium. Alternatively, it can simply assume that the other country is not bluffing and not run the risk of war, a pooling equilibrium. Whatever equilibrium is chosen depends on the relative wealth of the two countries and the underlying distribution of types. 19 This follows from the standard result that all finite two-person games have an equilibrium in the space of mixed strategies [Nash (1 950)].

139

Ch. 6: Arms Races and Proliferation

Figure 6.

Without loss of generality, we assume that thejth country is informed and knows the value of the war aversion parameter, n;, of the ith country. However, n1 is not known to the ith country, which knows only that n1 is a with probability p and f3 with probability 1 -p, where a < /3. In Figure 6, if the strategies of both countries result in a war allocation at a point like a 1 , then a 1 would be preferred to a0 by the jth country if it were of type f3 but not if it were of type a. Thus, it would be efficient for the ith country to make a positive transfer to the jth country if it were of type f3 but not if it were of type a. In general there are two transfer allocations, T;a if the jth country is of type a and T;[J if the jth country is of type f3 that will make the jth country indifferent to the conflict allocation. Further, there is no reason why the transfers cannot be negative, resulting in a transfer from j to i. The uninformed country's problem is to choose both a level of investment in weapons in the first period and a transfer in the second period that will maximize its expected utility, given its prior belief p concerning the informed country's utility function and its wealth lj 1 • If war occurs, the outcome for the jth country is defined as:

(57) so the first period maximization for the jth country if it plans to fight is given by m;x { U J

(lj 1 - Wj , 0)

+

fj (w; , Wj , n; )

}

(58)

The solution to this problem is

(59) where w1{3(w;) is the choice made by the jth country if it is of type {3. (The choice made by the jth country if it is of type a, w1a , will be defined later.)

D.L. Brito and M.D. Intriligator

140

The ith country, knowing that w113(w;) is optimal if the jth country is of type {3, will propose a lottery such that it will give the jth country T;13 with probability 1 - q and fight with probability q if the jth country chooses w113(w;). Alternatively, it can choose T;0 if it is of type a. The lottery is chosen such that for a f3 country,

(60) where for an

a country, (6 1)

If the jth country is of type f3 it will choose the lottery, while if it is of type will optimally choose w10. This is possible because

a

it

(62) The expected outcome for the ith country is then given by the compound lottery:

A; =

{

( 1 - p)

[

(

q u Yi2 + lV(w; , w113),

+p u( Yiz - T;a, 0)

}

D;(w; , w113) n;

)+

( 1 - q)

]

u(Yi2 - T;13 , 0)

(63)

The ith country wants to maximize expected utility, that is, the utility of first-period consumption plus that of the lottery given by Equation (63). Let cp(Y; 1 , n;, a, f3,p) be the value of the solution of the problem (64) subject to the incentive constraints given by Equations (60) and (6 1 ) and the resource constraints given by Equations (55) and (56). This problem can be solved recursively as a dynamic program, where the second-stage problem is given by

V; =

max

q, Tia,T;·/3

A; + Aa (u( ljz + T;0 , 0) - (q � (w; , w1f3, a) + ( l - q) u( ljz + T;f3, 0)) )

+ Af3 { u( ljz + T;13 , 0) - �(w; , Wif3,

/3)} .

(65) The first-order conditions for the problem are standard, and the process is illustrated in Figure 7. The point a0 is the initial allocation, the point a 1 is the conflict allocation, the point a2 is the allocation that results from the transfer T;13 , and the point a3 is the allocation that results from the transfer T; 0• The ith country chooses T;13 and w; such that if the jth country is of type f3 it is indifferent between the conflict allocation. Note that the jth country is indifferent between a1 and a2 • Thus the ith country picks

141

Ch. 6: Arms Races and Proliferation

Figure

7.

'La and q such that if the jth country is of type

a it is indifferent between a 4 with with probability (1 q). Then. it is optimal for the jth country probability q and a2 to reveal that it is of type a. An alternative equilibrium that has been treated in the literature on sequential games is a pooling equilibrium, where the ith country will choose a strategy that does not attempt to discriminate between the two types. This will happen if the optimal solution results in q 0. We can characterize the configuration of possible equilibria. The important first-order condition is with respect to q. First, we can use the first-order condition with respect to 'La to solve for Aa in Equation (65), yielding: =

Aa =

&u (Y;z - 'La, 0) /8T;a &u (lJz - T;a , 0) 18T;a '

while the first-order condition with respect to

(66)

q is

(67)

The first term in Equation (67) is negative since the ith country prefers to make a transfer rather than have a war, while the second term in Equation (67) is positive since the jth country prefers a transfer to having a war if it is of type a, so the term in parenthesis is negative and the multiplier is positive if p > 0. If p = 0 then the second term will be negative. In that case the ith country would choose q = 0, and the equilibrium will be pooling for all Y;1 along the locus of points such that p 0. Ifp = 1

=

D.L. Brito and M.D. Intriligator

142 probability of war

p* Figure

p

8.

then the first-order condition becomes positive as the term that is multiplied by ( 1 - p) drops out and the optimal solution is q = 1 , yielding a "separating equilibrium". The probability of a war for a given distribution of wealth is illustrated in Figure 8 where the probability increases linearly until it reaches some critical level p* and then drops discontinuously to zero. While this result is, to some extent, an artifact of the linearity of the model, wars occur in the model as a result of rational choice and they are associated with uncertainty, as suggested by the earlier cited empirical work on war initiation. Further results are available if we are willing to assume that the ith country is willing to make a transfer to an a country but not to a f3 country. This could be considered as the case in which a status quo power is challenged. It might be willing to make concessions to a strong challenger but not to a weak challenger. For most fixed levels of p n, + 1 ) < 1 represents the increase in the danger of an accidental or inadvertent nuclear war as a result of the entry of a new nuclear power. The overall effect of added nuclear nations on the probability of nuclear war is given as the product of three factors in Equation (70). This overall effect can be positive or negative, depending on the relative magnitudes of these three factors. Gallois, Tullock, Wentz, and Waltz concentrate on the first two factors and make the implicit assumption that p;(n) > p;(n + 1) ;;:;: 0 implies that the sequence rr� l pf(n) will converge to 1 , that is to say, that the probability of a deliberate nuclear war will go to zero. Unfortunately, this does not necessarily hold and it is possible to prove:

necessary condition for any model to predict that an increase in the number of nuclear powers will decrease the probability of a deliberate nuclear war is it must be able to predict the cardinality of the terms p'j(n) and p'j(n + 1 )/p'f(n) as n increases 25. Proposition 7. A

Thus, while it may be possible to construct theoretical arguments that imply that 1), it may not be possible to show that the rate at which the term decreases is sufficiently high so that the probability of a deliberate nuclear war will decrease. As long as the economic and political models are only able to establish qualitative results about these terms we cannot make any statements about the change in the probability of deliberate nuclear war as the number of nuclear powers increases. Further, the risk of a nuclear war due to accidents, irrationality, or political instability is likely to be the dominant effect of proliferation, highlighting the importance of actions to reduce such risks.

p;(n) > p;(n +

12. The future of the arms race and of proliferation

This final section considers the future of the arms race and of proliferation, including their implications for stability and for policy [Intriligator and Brito (1990)). The "new" arms races will probably differ from the "old" arms race in several ways. In the past the 25 Proof in Appendix.

156

D.L. Brito and M.D. Intriligator

arms race was dominated by the superpower competition between the United States and the Soviet Union, it was characterized by the use of high technology, and it resulted in the stability of a mutual deterrence regime. Future aims races, by contrast, will proba­ bly have radically different characteristics, with multiple races among the medium and smaller powers; with these races characterized by the use of medium and low technol­ ogy; and with potential instabilities becoming manifest in regional conflicts and wars. The superpower arms race between the United States and the Soviet Union lasted from 1 94 7 to the dissolution of the Soviet Union in December 1 99 1 . The United States and Western arms buildup was stimulated in part by the Soviet takeover of Czechoslovakia in 1 948 and its invasions of Hungary in 1 956, of Czechoslovakia in 1 968, and of Afghanistan in 1 979. Of key importance, however, were the 1 949 Soviet first atomic bomb explosion, demonstrating its nuclear capabilities; the 1 953 Moscow flyby of Soviet long-range bombers, showing its delivery capabilities; and the 1 957 Sputnik launch, showing its ICBM capabilities. Each of these demonstrated to the United States its vulnerabilities and led to the mobilization of its political, scientific, and military communities. On the other side, the Soviet and Eastern arms buildup was stimulated in part by the Truman Doctrine in the Balkans in 1 94 7, the formation of NATO in 1 949, and the outbreak of the Korean War in 1 950. Of key importance, however, were the 1 950s buildup of United States bomber capabilities, the 1 962 Cuban missile crisis, and China's first atomic bomb explosion in 1 964. Each demonstrated Soviet vulnerabilities and led to the mobilization of the Soviet political, scientific, and military communities. The result of these events was a change on the part of both superpowers in their perception of the capabilities and the intentions of the potential enemy, leading to an enormous acquisition of arms by both the United States and the Soviet Union. This arms race resulted by the 1 970s in huge and unprecedented arsenals on both sides, of not only strategic long-range capabilities (a frequent measure of armament), but also of other military capabilities - tactical, conventional, chemical, etc. This arms race has been characterized by both a quantitative and a qualitative dimension, as both sides not only added numbers of missiles, warheads, etc., to their arsenals but also used newer technologies for weapons, their means of delivery, and their control. At the same time, as arms buildups were occurring on both sides, steps were taken in the area of arms control. These included the Austrian State Treaty in 1 95 5 and the Antarctica Treaty i n 1 959 t o keep nuclear weapons out of these areas and later agreements to keep nuclear weapons out of the seabeds and space; the Limited Test Ban Treaty in 1 963 to stop atmospheric testing of nuclear weapons and later agreements to limit yields on such tests; the Treaty on the Non-Proliferation of Nuclear Weapons (NPT) in 1 968 to prevent nuclear proliferation, with later measures to strengthen the non-proliferation regime; the Strategic Arms Limitation Treaties (SALT) in 1 972 and 1 979 to limit strategic weapons; the Anti-Ballistic Missiles (ABM) Treaty in 1 972 to limit such missile deployments; and the Intermediate Nuclear Forces (INF) Treaty in 1 987 to eliminate intermediate and shorter-range missiles.

Ch. 6: Arms Races and Proliferation

157

The result of both these arms deployments and these arms control measures was that, probably by 1 970 and certainly by 1 980, there existed a regime of mutual deterrence, with each side restrained not only from attacking the other but even from seriously provoking the other for fear of the consequences. In that sense, the superpower arms race and the arms control agreements resulted in a more stable world than that of the earlier period. It is not by accident that the later period did not see crises comparable to those of the late 1 950s and early 1 960s, especially the 1 962 Cuban missile crisis. By establishing a mutual deterrence regime, the arms race and arms control jointly contributed to strategic stability. While the superpower arms race has ended with the end of the Cold War and the dissolution of the Warsaw Pact and the Soviet Union, there is a substantial likelihood that other nations will accelerate their arms acquisitions. The result will be a new set of arms races, which are new in terms of the nations involved, in terms of the types of arms acquired, and in terms of their implications for conflict and war. One important set of nations involved in the new arms races is the Soviet successor states, other than Russia, that have nuclear weapons on their soil. While Russia has inherited much of the capabilities and the international status of the Soviet Union, including its permanent seat on the United Nations Security Council, the other three former Soviet republics with nuclear weapons on their territory, Ukraine, Kazakhstan, and Belarus have suddenly been thrust in a new situation. While they have stated that they plan to eliminate these strategic nuclear weapons, there is a strong sentiment, particularly in Ukraine and Kazakhstan, which each have over 1 000 nuclear warheads, to retain at least some of them and to obtain control over them. The issue, in terms of the arms race, is not that of acquiring weapons but rather that of gaining the technical capabilities to use them. This is an important issue, and its resolution will play an influential role in the future of the former Soviet Union and the rest of the world. Another set of nations involved in the new arms races is the smaller nuclear powers of the United Kingdom, France, and China, which are engaged in major deployments and which are upgrading their weapons, both nuclear and conventional. Past acquisitions of weapons by these three nuclear powers have generally been ignored, as analysts and policy-makers had concentrated on the superpower arms race. Past arguments have been that Britain was so closely tied to the United States that it could be treated as a minor addition to the United States capabilities and that French and Chinese capabilities were negligible. Now, however, France and China each have a complete triad of bomber, missile, and submarine based nuclear weapons and they are both improving them and building them to up to higher levels. The result of this arms race is to accelerate the shift to a multipolar world with additional potential initiators of a conflict or a war, shifting coalitions of major nations, an increase in global uncertainty, and thus a more dangerous world than the earlier bipolar one. A third set of nations consists of the potential proliferators, nations with the potential of building nuclear weapons. Apart from the five great power nuclear weapons

158

D.L. Brito and M.D. Intriligator

states, only India has detonated a single nuclear device, but it is widely suspected that certain nations have a covert stockpile of untested nuclear weapons. These nations with "bombs in the basement" have followed the alleged Israeli pattern of covert nuclear weapons development, no weapons tests, secret weapons production and stockpiling, and a stated policy of denial or ambiguity. There may, in fact, be several covert nuclear weapons nations today, including possibly Israel, India (which switched to a covert program after its one nuclear test), Pakistan, South Korea, and Taiwan, with South Africa already having admitted to having had a small and unannounced stockpile of nuclear weapons, which have been destroyed. In the future these states may possibly be engaged in a covert nuclear arms race, adding to and modernizing their secret stockpiles. Other nations may follow this route. Meanwhile the other highly industrialized nations, including many in Europe, have the technology and the infrastructure to acquire or to develop nuclear weapons whenever they want in a very short period of time, but they have chosen not to do so. The presence of these nations, including Germany, Japan, Switzerland, Sweden, Italy, Spain, Canada, and others has created the potential for a cascading instability if there were indications that any one of these were, in fact, acquiring or developing nuclear weapons. A fourth set of nations consists of the newly industrialized countries. These include South Korea, Taiwan, and Brazil which, in addition to having a nuclear weapons potential, could be building conventional capabilities due to the combination of a perceived security threat from their regional rivals, greater recent capabilities to acquire weapons, the perceived status conveyed by weapons, and the desire to keep the current political and military leaders in power. In fact, the East Asian newly industrialized countries of South Korea, Taiwan, Malaysia, and others, along with China, are currently engaged in some of the largest increases in arms expenditures of any region in the world. Yet another factor affecting nuclear proliferation is the advent of second-tier nuclear supplier states among the newly industrialized countries. These nations were believed to be nuclear importing states at the time of the signing of the NPT in 1 968 but, over time, have become current or potential future nuclear exporting states. Included are Brazil, Argentina, India, and Pakistan, none of which is a participant in the nuclear non-proliferation regime. In addition, Brazil, some other Latin American nations, several central and east European nations, and North Korea have established large arms industries aimed at exporting conventional weapons. Such exports play an important role in earning foreign exchange and thus paying their foreign debt. A fifth set of nations consists of the Third World nations. Civil wars and international wars are being fought in Africa, Asia, the Middle East, and elsewhere, and additional such wars may occur in the future. Such wars and the potential for additional wars provide a strong incentive for Third World nations to acquire nuclear weapons as well as other weapons of mass destruction, whether for defensive or offensive purposes. The Iran-Iraq War, the Gulf War, and the wars in Angola and other African nations have provided important lessons for Third World nations,

Ch. 6: Arms Races and Proliferation

! 59

showing that wars can occur in these regions. They have demonstrated that these nations will have to rely on their own arms capabilities or imported weapons for defense and that they cannot rely upon external protectors. The likely result will be an acceleration of the arms race in these nations, leading to instabilities in these regions. Finally, there are the non-nation state actors, including various subnational groups of liberation fronts, terrorist organizations, and private armies, as well as various supranational groups of international drug organizations and crime syndicates. These actors will probably play an increasingly important role in seeking and obtaining arms or even manufacturing their own arms to advance their own causes or interests. The new arms races, involving newer nations acquiring conventional weapons, chemical weapons, biological/bacteriological weapons, and covert nuclear weapons, have ominous implications. The "old" arms race of the superpowers, while perhaps a waste of resources, at least had the advantage of contributing to stability through the establishment of a mutual deterrence regime. By contrast, the "new" arms races will probably not have this redeeming feature. The acquisition of weapons, particularly by nations in the Third World, is likely to contribute to the outbreak of war, with such nations acquiring enough weapons to strike their regional rivals but not enough to deter them. Thus, the new arms races could be qualitatively of a different and much more dangerous type than the superpower arms race. Nuclear proliferation, whether overt or covert, could be particularly destabilizing. Nations with nuclear weapons could use nuclear threats or even nuclear strikes in extreme situations, particularly when their survival is at stake. Subnational groups or even terrorist organizations might also acquire nuclear weapons by theft or other means and use nuclear threats or strikes to promote their own goals. The circumstance when nuclear weapons are probably most likely to be used, as already noted, is when one nation in a conflict or war has a nuclear weapons monopoly. Such a situation could occur in several regions of the world as a result of the new arms races and proliferation. Furthermore, with more overt or covert nuclear weapons states there is a growing probability of inadvertent or accidental nuclear war due to human error, technical failure, or terrorist action. In addition to adverse consequences for strategic stability, increasing the chance of conflict or war, the new arms races will have adverse consequences for arms race stability. If one nation were to begin to acquire weapons, that, by itself, would likely incite similar acquisitions by other nations in that region or elsewhere, triggering an arms race. The large number of nations with a nuclear weapons potential suggests that the acquisition of such weapons by one country or by a non-nation actor could trigger the acquisition by others, continuing the historical chain of proliferation from the United States to the Soviet Union to the United Kingdom, France, and China, then to India and to Pakistan then to . . . Thus, while the East-West arms race that had been dominant for over forty years is over, the problem of the arms race and proliferation remain important, with potential adverse consequences for the stability of the international order.

160

D.L. Brito and M.D. Intriligator

13. Appendix 13. 1 .

Proof ofproposition

1

Let Q be the feasible set of weapons stocks for the two countries,

and g(w) be a mapping from the feasible set onto itself. Thus,

g(w)

(w) ) = ( ggz1 (w) '

where g : Q --+ Q. Using the Brouwer Fixed Point Theorem, a fixed point exists if g(w) is continuous, yielding the equilibrium lh , w2 •

13.2. Proof ofproposition 2 Suppose w; > g;(wi) ofEquation (24). If ?;7(w;, wi) is a solution to the differential equa­ tion for the costate variable given by Equation ( 1 9), then ?;7(w;, w1) < ?;7(g;(w1), w1) implying c7(?;7(w;, w1), w;, w1) > c7(?;7(g;(wi), wi), w;, w1) and thus that w 1 (w;, w1) > 0 if w; > g;(w1). The resulting phase diagram for w 1 and w2 in Figure 3 shows that the equilibrium point is stable.

13.3.

Proof ofproposition 4

The conditions of the Berge Maximum Theorem are satisfied since w; and w1 are continuous functions of Y; 1 , while ci2 and c12 are continuous functions of w; and w1. It follows that they are continuous functions of Y; 1 . Maximization therefore defines a continuous mapping from first-period allocations to second-period allocations. This mapping is defined on a compact set and thus has a fixed point. At the fixed point, the initial allocation is strictly preferred to the conflict allocation since it avoids the conflict externality without any change in the allocation of the private good. Thus, there exists a neighborhood of the fixed point for which the initial allocation is strictly preferred to the conflict allocation.

Ch. 6: Arms Races and Proliferation 13.4.

Proof ofproposition

161

7

To prove that the entry of a new nuclear power will decrease the probability of a deliberate nuclear war it is necessary to show that

which requires information about the magnitude of pf(n + 1 ) and

pf (n + 1 ) pf(n)

-p;) = 1 - p [p2,2! _ p33,! ]

Since p; (n) < 1 , exp (

;

+

+·· ·+

[p2�2k! - p�k!2k+ ] + · · · > 1 -p;, I

the terms in brackets are all positive, so

g pf(n) = g ( 1 - p;(n)) � g exp (-p;(n)) n

n

n

= exp

(- �n p;(n)) .

Since p;(n) > 0, a sufficient condition for IT:, p'f(n) to be an decreasing function of n is that the series 2:::: , p;(n) diverge as n ---+ oo. The condition p;(n + 1)-p;(n) < 0 is not sufficient. For example the series IT7� 1 i+Jin , satisfies this condition, but will diverge as n ---+ oo.

References Anderton, C.H., 1985, A selected bibliography of arms race models and related subjects, Conflict Management and Peace Science 8, 99-122. Boulding, K.E., 1 962, Conflict and defense: A general theory (Harper and Row, New York). Brito, D.L., 1 972, A dynamic model of an armaments race, International Economic Review 13, 359-375. Brito, D.L., and M.D. Intriligator, 1 972, A general equilibrium model of the stability of an armaments race, Proceedings of the sixth Asilomar conference on circuits and systems (Western Periodicals Co., North Hollywood, CA) 355-360. Brito, D.L., and M.D. Intriligator, 1 973, Some applications of the maximum principle to the problem of an armaments race, Modeling and Simulation 4, 140-144. Brito, D.L., and M.D. 1ntriligator, 1 974, Uncertainty and the stability of the armaments race, Anuals of Economic and Social Measurement 3, 279-292. Brito, D.L., and M.D. Intriligator, 1 977, Strategic weapons and the allocation of international rights, in: J.V: Gillespie and D.A. Zinnes, eds., Mathematical systems in international relations research (Praeger, New York) 1 99-2 1 5 .

1 62

D.L. Brito and M.D. Intriligator

Brito, D.L., and M.D. Intriligator, 1 983, Proliferation and the probability of war, global and regional issues, in: D.L. Brito, M.D. Intriligator and A.E. Wick, eds., Strategies for managing nuclear proliferation economic and political issues (Lexington Books, Lexington, MA) 1 3 5-144. Brito, D.L., and M.D. Intriligator, 1 985, Conflict, war, and redistribution, American Political Science Review 79, 943-957. Brito, D.L., and M.D. Intriligator, 1 987, Stock externalities, Pigovian taxation and dynamic stability, Journal of Public Economics 33, 59-72. Brito, D.L., and M.D. Intriligator, 1 993, The economic and political incentives to acquire nuclear weapons, Security Studies 2, 287-3 1 0. Brito, D.L., A.M. Buoncristiani and M.D. Intriligator, 1 977, A new approach to the Nash bargaining problem, Econometrica 45, 1 1 63-1 1 72. Bueno de Mesquita, B., 1 98 1 , The war trap (Yale University Press, New Haven, CT). Bueno de Mesquita, B., and W. Riker, 1 982, Assessing the merits of selective nuclear proliferation, Journal of Conflict Resolution 26, 283-306. Davis, Z.S., and B. Frankel, eds., 1 993, The proliferation puzzle (Frank Cass, London/Portland). Deutsch, K.W., and J.D. Singer, 1 964, Multipolar systems and international stability, World Politics 1 6, 390-406. Evron, Y., 1 994, Israel's nuclear dilemma (Cornell University Press, Ithaca, NY). Frankel, B., ed., 1 99 1 , Opaque nuclear proliferation: Methodology and policy implications (Frank Cass, London/Portland). Fudenberg, D., and J. Tirole, 1 99 1 , Game theory (MIT Press, Cambriq�e, MA). Gallois, P., 1 96 1 , The balance of terror (Houghton Mifflin, Boston, MA). Gleditsch, N.P., and 0. Njolstad, eds., 1 990, Arms races; technological and political dynamics (Sage Publications, London). Gray, C., 1 97 1 , The arms race phenomenon, World Politics 24, 39-79. Gray, C., 1 976, The Soviet-American arms race (Lexington Books, Lexington, MA). Hersh, S.M., 1 99 1 , The Samson option: Israel's nuclear arsenal and American foreign policy (Random House, New York). Huntington, S., 1958, Arms races: prerequisites and results, Public Policy 1 8, 4 1 -86. Intriligator, M.D., 1 964, Some simple models of arms races, General Systems 9, 143-164. Intriligator, M.D., 1 967, Strategy in a missile war: Targets and rates of fire (Security Studies Project, University of California, Los Angeles, CA). Intriligator, M.D., 1 97 1 , Mathematical optimization and economic theory (Prentice-Hall, Inc., Englewood Cliffs, N J). Intriligator, M.D., 1 975, Strategic considerations in the Richardson model of arms races, Journal of Political Economy 83, 339-353. Intriligator, M.D., 1 982, Research on conflict theory: analytic approaches and areas of application, Journal of Conflict Resolution 26, 307-327. Intriligator, M.D., and D.L. Brito, 1 976a, Strategy, arms races, and arms control, in: J.V Gillespie and D.A. Zinnes, eds., Mathematical systems in international relations research (Praeger, New York) 1 73-1 89. Intriligator, M.D., and D.L. Brito, 1 976b, Formal models of arms races, Journal of Peace Science 2, 77-88. Intriligator, M.D., and D.L. Brito, 1 98 1 , Nuclear proliferation and the probability of nuclear war, Public Choice 37, 41-59. Intriligator, M.D., and D.L. Brito, 1 984, Can arms races lead to the outbreak of war?, Journal of Conflict Resolution 28, 63-84. Intriligator, M.D., and D.L. Brito, 1 985, Heuristic decision rules, the dynamics of an arms race, and war initiation, in: U. Luterbacher and M.D. Ward, eds., Dynamic models of international conflict (Lynne Rienner Publishers, Boulder, CO) 1 33-160.

Ch. 6: Arms Races and Proliferation

1 63

Intriligator, M.D., and D.L. Brito, 1 986, Arms races and instability, Journal of Strategic Studies 9, 1 1 3-1 3 1 . Intriligator, M.D., and D.L. Brito, 1 990, A possible future for the arms race, in: N.P. Gleditsch and 0. Njolstad, eds., Arms races: Technological and political dynamics (Sage Publications, London) 376-383. Isard, W., and C.H. Anderton, 1 985, Arms race models, a survey and synthesis, Conflict Management and Peace Science 8, 27-98. Kahn, H., 1 962, Thinking about the unthinkable (Horizon Books, New York). Kalai, E., and E. Lehrer, 1 993a, Rational learning leads to Nash equilibrium, Econometrica 6 1 , 1 0 1 91 045. Kalai, E., and E. Lehrer, 1 993b, Subjective equilibrium in repeated games, Econometrica 61, 1 23 1 - 1 240. Kalai, E., and E. Lehrer, 1 995, Subjective games and equilibria, Games and Economic Behavior 8, 1 23-1 63. Kalai, E., and M. Smorodinsky, 1 975, Other solutions to the Nash bargaining problem, Econometrica 43, 5 1 3-5 1 8. Kaplan, M.A., 1 966, Some problems of international systems research: International political communities: An anthology (Doubleday, New York). Kupperman, R., and H. Smith, 1 972, Strategies of mutual deterrence, Science 1 76, 1 8-23. Kupperman, R., and H. Smith, 1 976, Deterrent stability and strategic warfare, in: J.V. Gillespie and D.A. Zinnes, eds., Mathematical systems in international relations research (Praeger, New York) 1 3 9-1 66. Lambelet, J.C., 1 975, Do arms races lead to war? Journal of Peace Research 1 2, 1 23-128. Lambelet, J.C., 1 985, Arms races as good things? in: U. Luterbacher and M.D. Ward, eds., Dynamic models of international conflict (Lynne Rienner Publishers, Boulder, CO) 1 61 - 1 74. Mayer, T., 1 986, Arms races and war initiation: Some alternatives to the Intriligator-Brito model, Journal of Conflict Resolution 30, 3-28. McGuire, M.C., 1 965, Secrecy and the arms race (Harvard University Press, Cambridge, MA). McGuire, M.C., 1 977, A quantitative study of the strategic arms race in the missile age, Review of Economics and Statistics 59, 328-339. Morgenstern, 0., 1 959, The question of national defense (Random House, New York). Morgenthau, H.J., 1 965, Politics among nations: The struggle for power and peace (Knopf, New York). Nalebuff, B.J., 1 982, Prizes and incentives (Oxford Nuffield College, D.Phil. thesis). Nalebuff, B.J., 1 984, A question of balance (Harvard Institute of Economic Research, Cambridge, MA). Nash, J.F., 1 950, The bargaining problem, Econometrica 1 8, 1 55-162. Rapoport, A., 1 957, Lewis F. Richardson's mathematical theory of war, Journal of Conflict Resolution I , 249-304. Rapoport, A., 1 960, Fights, games, and debates (University of Michigan Press, Ann Arbor, MI). Richardson, L.F., 1 939, Generalized foreign politics, British Journal of Psychology, Monographs Supplement 23. Richardson, L.F., 1 95 1 , Could an arms race end without fighting? Nature 4274 (September 29). Richardson, L.F., 1 960, Arms and insecurity (Boxwoqd Press, Pittsburgh, PA). Rosecrance, R.N., 1 966, Bipolarity, multipolarity, and the future, Journal of Conflict Resolution 1 0 , 3 1 4-383. Russett, B.M., 1 983, Away from nuclear mythology, in: D.L. Brito, M.D. Intriligator and A.E. Wick, eds., Strategies for managing nuclear proliferation - economic and political issues (Lexington Books, Lexington, MA) 145-155. Saaty, T., 1 968, Mathematical models of arms control and disarmament (John Wiley, New York). Sandler, T., and K. Hartley, 1 995, The economics of defense (Cambridge University Press, Cambridge). Sandler, T., J. Cauley and J.F. Forbes, 1 980, In defense of collective goods theory of alliances, Journal of Conflict Resolution 24, 537-547. Schelling, T.C., 1 960, The strategy of conflict (Harvard University Press, Cambridge, MA).

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Schelling, T.C., 1 966, Arms and influence (Yale University Press, New Haven, CT). Simaan, M., and J. Cruz, 1 975, Formulation of Richardson 's model of arms race from a differential game viewpoint, Review of Economic Studies 42, 67-77. Simaan, M., and J. Cruz, 1 976, Equilibrimn concepts for arms race problems, in: J.V Gillespie and D.A. Zinnes, eds., Mathematical systems in international relations research (Praeger, New York)

342-356. Siverson, R., and M. Tennefoss, 1 983, Power, alliances, and international conflict, 1 8 1 5-1 965, American Political Science Review 77, 1057-1 069. Smith, T.C., 1980, Arms race instability and war, Journal of Conflict Resolution 24, 253-284. Smoker, P., 1965, On mathematical models in arms races, Journal of Peace Research 2, 94-95. Tsipis, K., 1 983, Arsenal: Understanding weapons in the nuclear age (Simon and Schuster, New York). Tullock, G., 1 974, The social dilemma (University Publications, Blacksburg, VA). Wallace, M.D., 1979, Arms races and escalation: some new evidence in explaining war, in: J.D. Singer, ed., Explaining war: Selected papers from the Correlates of War project (Sage, Beverly Hills, CA)

240-252. Wallace, M.D., 1 98 1 , New nails in old coffins: the para bellmn hypothesis revisited, Journal of Peace Research 18, 91-96. Waltz, K.N., 1964, The stability of a multipolar world, Daedalus 93, 8 8 1 -909. Waltz, K.N., 1981, The spread of nuclear weapons: more may be better, Adelphi Papers, no. 171 (International Institute for Strategic Studies, London). Waltz, K.N., 1 983, Toward nuclear peace, in: D.L. Brito, M.D. Intriligator and A.E. Wick, eds., Strategies for managing nuclear proliferation - economic and political issues (Lexington Books, Lexington, MA)

1 17-134. Wentz, WB., 1 968, Nuclear proliferation (Public Affairs Press, Washington, DC).

Chapter 7 THEORIZING A BOUT CONFLICT JACK HIRSHLEIFER

University of California, Los Angeles

Contents

Abstract Keywords 1. Introduction 2. Analytic choices in modelling conflict 2.1. 2.2. 2.3. 2.4. 2.5. 2.6.

3. 4. 5.

Conflict versus settlement: Dichotomy or continuum? Plays, rounds, and moves Binding agreements possible? Limited stakes? Restricted means? Varying the number of contenders Actual versus threatened conflict

Sources of conflict The technology of conflict A first illustrative model - does conflict promote equality? 5 . I . Elements of an economic model of conflict 5.2. Optimization and Coumot equilibrium 5.3. Resource disparities: The paradox of power

5.4. When conflict becomes more decisive

A second illustrative model: armed settlement under threat Concluding remarks References

6. 7.

Handbook of Defense Economics, Volume I, Edited by K Hartley and T. Sandler © 1995 Elsevier Science B. V. All rights reserved

166 166 1 67 168 1 68 168 169 169 1 70 171 1 72 1 75 179 1 79 1 80 182 1 83 1 84 1 87 1 88

1 66

J. Hirshleifer

Abstract

The category of conflict encompasses not only war but also crime, litigation, strikes and lockouts, and redistributive politics. Exchange theory and conflict theory constitute two coequal branches of economic analysis, the first based upon contract and mutual gain, the second upon contest for asymmetric advantage. A number of the analytic options for modelling conflict are reviewed. Preferences, opportunities, and perceptions are shown to determine the choice between conflict and settlement. The technology of conflict as an economic activity is surveyed. Two illustrative models are presented, the first involving actual fighting and the other armed peace.

Keywords

conflict, settlement, competition, war, redistribution, politics, deterrence, threats, Nash equilibrium, technology of struggle, contests

Ch. 7: 1.

Theorizing about Conflict

1 67

Introduction

Living beings everywhere compete for the means of existence. Competition takes the more intense form we call conflict when, instead of merely utilizing available resources for productive or consumptive purposes, contenders try to hamper, disable, or destroy rivals. Conflict theory has to deal not only with the standard technology of production, but also with the technology ofstruggle. There is a technology for tilling the land, and quite a different technology for capturing land and defending it. [While I will be using military terms like "capturing" and "fighting", these are to be understood as metaphors. Conflict encompasses not only warfare but also activities that do not necessarily involve physical violence, e.g., litigation. Commercial competition becomes conflict when, instead of merely vying for consumers' favor, firms act to raise rivals' costs or hinder their market access.] Among the different modes of social interaction, economists of course emphasize market exchange. But all exchange, all cooperation, all compromise take place in the shadow of conflict [Cooter, Marks and Mnookin ( 1 982)]. What a nation can achieve by diplomacy depends upon the damage it could inflict should war occur. What a person has to pay for a piece of property depends upon the chances of seizing it without paying. More generally, decision-makers accede to others' wishes to the extent that they fear the consequences of failing to do so. While economists have devoted attention to a number of topics in the conflict domain - among them crime, litigation, strikes and lockouts, rent-seeking, warfare, and redistributive politics - it is remarkable that these literatures within economics have remained almost entirely disjointed. Specialists in one or another of these branches have hardly been cognizant of the logical parallels among them, and even less aware that there are general underlying principles applicable to all conflictual interactions. Imagine that international trade, industrial organization, resource economics, public finance, etc., had all developed as entirely separate fields with no recognition of their intellectual resemblances or of their common foundation in microeconomics. A failing of exactly this type has occurred here. A first aim of conflict analysis is therefore to pro­ vide an underlying microtheory that would be applicable to all the topical areas of ap­ plication such as warfare, litigation, etc. More sweepingly, exchange theory and conflict theory constitute two coequal branches of economic analysis: the former based upon two-sided advantage and contract, the latter upon one-sided advantage and struggle. Section 2 below examines some of the analytic distinctions that need to be made in modelling conflict. Section 3 more explicitly addresses the choices between conflict and settlement, while Section 4 surveys the technology of conflict. Sections 5 and 6 describe two illustrative models of conflictual equilibrium, the first involving actual fighting and the other armed peace. Section 7 concludes briefly.

J Hirshleifer

1 68

2. Analytic choices in modelling conflict 2. 1.

Conflict versus settlement: Dichotomy or continuum?

Conflict and settlement are usually interpreted as dichotomous. Rival nations are said to be at war or else at peace; a trade union may call a strike or else sign a collective­ bargaining contract; a lawsuit may be settled or else litigated in court. Alternatively, we might think in terms of a continuum. Very often what looks like a dichotomous decision on a small time-scale becomes a continuous choice taking a longer time-perspective. A primitive tribe may alternate between peace and war, but over the long term its actions can be interpreted as a steady-state division of its efforts between productive exploitation of its own territory versus appropriative struggles against other tribes. Thinking in dichotomy terms suggests searching for special causes of war. Continuum thinking suggests instead that conflict and settlement are equally normal and coexistent; the analytic question is the balance between the two. In dichotomy models, the guns versus butter decisions on both sides typically determine a yes/no (peace/war) outcome together with an estimate of the respective chances of victory. In continuum models the same choice variables determine the intensity of conflict and the proportionate division of the stakes. An awkward modelling problem arises in dichotomy models: once war has occurred, what next? In such models the advent of war means "the end of history". But wars, not to mention other forms of conflict, only rarely have such drastic consequences. Continuum models, by way of contrast, imply ongoing histories: persisting interactions in which the parties remain balanced between cooperative and conflictual activities. 2.2.

Plays, rounds, and moues

In strategic interactions it is important to distinguish among moues, rounds, and plays of the game. Think of an auction. A play corresponds to sale of a single item in the auction catalog. Within a given play, each round of bidding allows every participant to make an offer. And of course a moue is a single player's bid-or-pass choice. Completion of a play generates payoffs. A multiple-play game therefore entails a series of payoff disbursements. (Successive plays might all possibly have the same payoff structure, as in the repeated Prisoner's Dilemma, but that would be a special case.) Within a given play there may be a succession of rounds, consisting of bargaining or negotiation moves by the players. But moves and rounds do not generate payoffs until the play is completed. Players may move either sequentially or simultaneously. Simultaneity refers to the state of knowledge rather than clock time: a move later in time, but in ignorance of the opponent's choice, is considered simultaneous with the latter. In a sequential­ move situation, the last-mover necessarily has an informational advantage. But the first-mover's choices can constrain the options available, so whether or not there is

Ch. 7:

Theorizing about Conflict

169

on balance a first-move or last-move advantage (or neither) depends upon the detailed structure of the game [see, e.g., Dixit (1987), Baik and Shogren (1992)]. In some cases the sequence of moves is exogenously determined. In the American political system, for example, only the Congress can initiate legislation, which the President may or may not then veto. But the sequence of moves might also be determined endogenously. One interesting possibility would be a "pre-play" interaction in which the players simultaneously indicate a preference for moving first or last. If these preferences match up, the sequence is determined accordingly. In the event of a mismatch, e.g., if both sides seek to move first, then they must move simultaneously instead 1 . Finally, there has to be a termination rule closing the rounds of negotiations and allowing payoffs to be made. Again there are quite a number of modelling options. There might be a fixed number of rounds (in the simplest case, only a single round) or perhaps bargaining ends at some pre-set hour of the clock. In an auction, rounds of bidding continue until "naturally" terminated when no-one chooses to raise the last bid made. And finally, it may be that certain types of move serve to terminate play. Think of a crisis in which nations are negotiating by successive rounds of threats. This negotiation game terminates, among other ways, whenever some nation chooses to declare war. 2.3.

Binding agreements possible?

Since fighting is essentially always Pareto-inefficient 2 , settlement remains an attractive alternative. But settlement agreements are of no use unless fulfillment can be guaranteed. Binding agreements normally require a third party to serve as enforcer 3 . Absent such an enforcement authority, as for example in territorial struggles among animals or international contentions among major powers, the chances of peace are considerably less. Yet the availability of binding agreements does not suffice to rule out conflict. Litigation remains a big industry even where the judicial system stands ready to enforce negotiated settlements. 2. 4.

Limited stakes? Restricted means?

Conflict may be to the death, or for a narrowly circumscribed prize. The aim of a war may be extermination of the opponent, or a mere border adjustment. Paralleling the 1 Baik and Shogren (1 994) have conducted an experimental investigation of such an "endogenous timing" modeL 2 Though some people may enjoy bar-room brawls for their own sake. 3 As a major exception, the prospect of a continuing mutually advantageous association between the parties does provide a motive for not defecting from a current agreement. But this mutual forbearance is subject to the well-known last-period problem, and even on other grounds tends to be rather fragile. See, e.g., Telser (1 980).

170

J Hirshleifer

possible limits upon the magnitude of the stakes are restrictions upon the means or instruments of conflict. In both dimensions, the limits may be externally imposed. In litigation, a plaintiff can normally claim reimbursement only for damages actually incurred (limited stakes), and cannot lawfully bribe judge and jurors (restricted means). In electoral struggles, the victorious majority is checked by constitutional protections for the minority (limited stakes), while campaign efforts may be subject to legal restrictions like caps on aggregate expenditures. But sometimes the limitations may be the result of an explicit or implicit agreement among the parties, in which case the constraint is subject to reneging. A contestant dissatisfied by the outcome in a limited conflict may be tempted to escalate to a level where its chances are better [Kahn ( 1 965)]. In the Vietnam war, the US long refrained from bombing North Vietnam, but eventually decided to do so in the hope of forcing a more favorable settlement. (This represented an escalation both of stakes and of means.)

2.5.

Varying the number of contenders

In traditional microtheory, perfect competition involves many buyers and many sellers. At the opposite extreme is bilateral monopoly: one buyer, one seller. Ordinary monopoly is a one seller/many buyers situation. Then there are duopoly (two sellers, many buyers), monopoly with a fringe of smaller sellers, and other interesting combinations. All of these have analogs in conflict theory. One-on-one warfare corresponds to bilateral monopoly. A tyrant-versus-subjects situation corresponds to ordinary monopoly: while the tyrant's decisions can influence citizens' choices (e.g., whether or not to rebel), no single citizen can expect to influence the overlord's choice - how much he invests in repression. (Yet the citizens are not "price-takers"; there is no exchange in a pure conflict model.) The struggle between Bolsheviks and Czarists in revolutionary Russia - or, to take a more limited conflict, between Republicans and Democrats in the US - are analogs of market duopoly. In such cases the ordinary citizenry correspond to the passive buyers of standard duopoly theory, i.e., they are "non-strategic" players. It may sometimes be useful to think of each side as divided between an activist leader and a passive body of followers. Then there would be two strategic players (the leaders) and two distinct groups of non-strategic players. In wartime, for example, political leaders on each side have to balance between fighting the enemy versus countering internal dissension. With two or more strategic players, alliances become possible [Sandler ( 1 993)]. One major type is an alliance of the strategic against the passive players. It is not too difficult to imagine Republican and Democratic leaders conspiring to pass legislation against the interests of the general citizenry. Or, a leader on one side may "sell out" his non-activist constituency. But more familiarly, alliances are combinations of some strategic players against others. Since an ally today may be an enemy tomorrow, such combinations are often fragile. Alliance games are played not only in warfare and

Ch. 7:

Theorizing about Conflict

171

politics but in all the competitions o f everyday life, e.g., promotion ladders in business hierarchies. 2. 6.

Actual versus threatened conflict

Since all settlement takes place in the shadow of conflict, threats may have a vital role in the preservation of peace. It will be useful to distinguish between "profitable threats" and "unprofitable threats". In either case a threat aims to force the opponent to comply with the threatener's desires. If executing a threat would be profitable for the threatener, in comparison with the status quo, the opponent need have no doubt that it will be carried out. The range of possible profitable threats on each side define the "threat point" of cooperative game theory [Friedman (1 986, p. 1 53 )] . Any achieved agreement has to be Pareto-preferred to the threat point, else one or the other side could issue a profitable threat to go its own way instead. "Unprofitable threats" are more puzzling. Here the threat is to do something to the disadvantage not only of the threatened party but of the threatener as well. The classic example is the MAD ("mutual assured destruction") strategy intended to deter nuclear war. Once a nation has suffered nuclear attack, it might be thought there is little to be gained by retaliating. While unprofitable threats fail the test of sequential rationality, in some circumstances they might have a degree of credibility. To mention just a few: (i) It may be possible to make an irrevocable commitment ("burning your bridges behind you"); (ii) if the present interaction is linked to future possibilities, concern for reputation may make it costly not to retaliate; (iii) a contender may pretend to be, or actually be, sufficiently irrational as to retaliate regardless of profitability considerations. Indeed, any positive perceived probability of such irrationality may suffice to deter attack 4 . I have by no means surveyed the entire range of analytic categories that may be important in designing conflict models 5 . Others that might have been mentioned include: (i) the effects of geography and distance [Boulding ( 1 962, Ch. 1 2)] ; (ii) allowing for economic growth and other changes over time, and the implications thereof for economic warfare and the sustainability of arms races [Wolfson (1 985), and see Chapter 6 of this Handbook] ; (iii) complementarities in production and consumption between the contending parties (which serve to increase the payoff from peaceful settlement); and, a truly huge topic, (iv) the informational assumptions (are both sides fully informed, or perhaps symmetrically though not fully informed, or are there informational asymmetries?).

4

For a related idea in a more general context, see Kreps et a!. ( 1 982). lntriligator ( 1 982) attempts to provide a systematic survey, though limited to war, threatened war, and preparation for war. 5

J. Hirshleifer

172

Q ()) E 0 0 I; V>

'o

()) 0::

Q Blue's Income

Figure I a. Large potential settlement region (PSR).

3. Sources of conftict 6

While failure to come to agreement does not necessarily imply actual fighting the parties could simply go their own separate ways - it is certainly a precondition for conflict. Why do parties fail to agree, and how does the conflict option affect the prospects of settlement? I shall consider three interacting determinants: preferences, opportunities, and perceptions. These correspond to traditional issues debated by historians and political scientists as to the causes of war: Is war mainly due to hatred and ingrained pugnacity (preferences)? Or to the prospects for gain at the expense of weaker victims (opportunities)? Or is war mainly due to mistakes in evaluating others' motives and capacities (perceptions) 7? The two panels of Figure 1 illustrate how these elements come together. On axes I 8 and I R representing Blue's income and Red's income, the curve QQ bounds the "settlement opportunity set" - what the parties can j ointly attain by peaceful agreement or compromise. The points P8 and PR indicate, in contrast, the parties' separate perceptions of the income distribution that would result if they fail to agree, i.e., if they come to blows. (P8 and PR correspond to the "threat point" referred to earlier, but note that the parties' estimates thereof may differ.) In each diagram the curve U8 6 This discussion expands upon portions of Hirshleifer ( 1 9 87). 7 While my terminology suggests a dichotomy between conflict and settlement (see Section 2), this is only an expository short-cut. In a continuum model, the chosen intensities of fighting etTorts would similarly be determined by the parties' preferences, opportunities, and perceptions.

Ch. 7:

1 73

Theorizing about Conflict

Q

(])

E 0 u c

Q

=... --- ---�

-- --------

Blue's Income

IB

Figure 1 b. Small potential settlement region (PSR).

is a member ofBlue's family of indifference curves, and similarly for UR. The shaded area in each diagram is the Potential Settlement Region (PSR). Figure l a shows a relatively benign situation. Opportunities: the shape of the QQ boundary indicates that the parties' settlement opportunities are complementary and harmonious: both sides can gain by working together, and the largest aggregate of income is achieved when the parties have relatively equal shares. Preferences: the negatively-sloped indifference curves reveal a degree of benevolence on each side; Blue, for example, regards not only his own income as a good but Red's income as well. Perceptions: the perceived incomes in the event of failure to settle are relatively small, and also agreed (PB and PR coincide). These considerations combine to form a large settlement region PSR, which plausibly implies a high probability of agreement. Figure 1 b shows a less pleasant situation. The settlement opportunities are disharmonious, since relatively equal distributions of income aggregate to a smaller total than unequal distributions. (While ex-post transfers could conceivably share out the aggregate more equally, any such possibilities will already have been incorporated into the shape of the settlement opportunity set bounded by QQ.) Second, the positively-sloped indifference curves indicate malevolent preferences (the other party's income enters utility functions as a bad rather than a good). Third, the two sides have discordant and optimistic perceptions of the outcome from non-settlement; in the event of failure to agree, each believes he will do relatively better. The overall effect is to shrink the Potential Settlement Region, making the prospects for settlement poor. (In fact, worsening on any of the three scores could eliminate the PSR completely.

J. Hirshleifer

1 74

Settlement opportunities a bit more disharmonious, preferences a bit more malevolent, perceptions a bit more divergently optimistic - or some combination of the three would make rational agreement impossible.) Going a bit more deeply, let us start with preferences. Economists have noto­ riously taken "tastes" as arbitrary data. But preferences, and in particular benev­ olence or malevolence toward specified others, are not totally incapable of ex­ planation. As determinant of an individual's willingness to sacrifice for others, evolutionary biologists have emphasized genetic relatedness r - measured by the proportions of shared genes. (For siblings r 112, for half-siblings 1/4, for first cousins 1 /8, etc.) So, it has been said, an individual "should" be willing to sacrifice his life to save 2 siblings, 4 half-siblings, or 8 cousins! More generally, Hamilton's rule [Hamilton ( 1 964)] says that evolution will select for actions such that =

c r, b where b is the


0

(5. 1)

or that G is maximized with dG op (5.2) = - f tLa - y :( 0 and I = 0. d/ o Conditions (5 . 1 ) and (5.2) say that, if the potential insurgent leader chooses a positive value for I that is, if he decides to organize an insurrection - then I is such that the marginal contribution of insurgents to the expected net income of the insurgent leader's clientele equals the expected compensation rate required by insurgents, y. Alternatively, if the potential insurgent leader decides not to organize an insurrection, then at I equal to zero the marginal contribution of insurgents to the expected net income of the potential insurgent leader's clientele would be less than or equal to y. In addition, if l is positive, the compensation schedule for insurgents must be such that whatever the outcome of the insurrection the realized net income of the insurgent leader's clientele is nonnegative. Suppose that the insurgent leader captures all of tL a with probability 1 - p and captures none of tL a with probability p. Then, to satisfy this constraint, as well as the constraint Wi = y, the leader would offer the insurgents compensation at rate y/(1 -p) to be paid if and only if the insurrection succeeds. Substituting for op/81, calculated from Equation (4), conditions (5. 1 ) and (5.2) imply that -

I=

V Tr

{ rw;_� 0

e

for

S


!

0�!

( 1 0) ·

Equation ( 1 0) says that, if 0 > l /2, then I is proportionate to tLaly. The maximum value of the ratio yl!tLa is l /4, which obtains at 0 = l . Substituting Equations (9) and ( 1 0) into Equation (4) gives the equilibrium value for p,

(l l)

-

Equation ( l l ) says that the fraction o f the gross income of the ruler's clientele that the insurgent leader expects to capture, 1 p, depends only on 0, the measure of the effectiveness of insurgents relative to soldiers. If 0 is less than or equal to 112, then there is no insurrection and 1 - p equals zero. Alternatively, if 0 exceeds l /2, then the potential insurgent leader organizes an insurrection and l - p is positive and is an increasing function of e. Note that, although an increase in y would increase the cost of recruiting insurgents, it also would increase the cost of recruiting soldiers. Moreover, because both S and I, as given by Equations (9) and ( 1 0), are proportionate to y, a change in y would not affect either the ratio /IS or the expected compensation bill for soldiers, yS. Similarly, although an increase in tLa would increase the return to recruiting insurgents, it also would increase the return to recruiting soldiers and it also would not affect liS.

H.!. Grossman

202

Accordingly, because p is a zero degree homogeneous function of I and S, with I and S chosen, respectively, to maximize the expected net incomes of the insurgent leader's clientele and the ruler's clientele, the equilibrium value of p is independent of both y and tL a . Importantly, the only effect of an change in y on the expected net income of the ruler's clientele would be through the negative effect of y on market production, La, and thereby on ptLa .

3. 4. The ruler 's tax policy To complete the analysis, consider the ruler's choice of t, the fraction of market production taken by the ruler's clientele. In choosing t, the ruler takes into account how this choice will affect the choice of L by the peasant or worker families. The ruler also takes into account the effect of his choice of t on the passive support that an insurrection would receive from noncombatants. The extent of passive support for an insurrection is reflected positively in the value of e, the measure of the effectiveness of insurgents relative to soldiers. The key assumption is that the amount of passive support for an insurrection is inversely related to the ruler's popularity, which, in turn, is an increasing function of t. To make this story operational in a tractable way, the model assumes that e=

{�

exp[¢>(t - z)] >

�

1 - � exp[¢>(z - t)] �

�

for t


> 0 and ¢>z � ln 2. In Equation ( 1 2), z and ¢> are the deep parameters of the technology of insurrection. The parameter z, which is the value of t for which 8 equals �, indexes the technology. For any value of t a decrease in z would increase 8 and would represent an unambiguous improvement in the technology of insurrection from the perspective of the potential insurgent leader. The parameter ¢> determines the sensitivity of 8 to the difference between t and z. Equation ( 1 2) implies for t > z for t � z. With the ruler choosing S to maximize R, and given this assumed dependence of e on t, how does R depend on t? Substituting Equations (9) and ( 1 1 ) into Equation (7) gives

{

R=

tLa

48 ( l - O) tLa

� for e � � · for e >

( 1 3)

Equation (13) says that, for all values of 8, R is positively related to tLa and negatively related to 8. For 8 > �, the negative relation between R and 8 obtains because the

203

Insurrections

Ch. 8:

negative effect of e on p outweighs the negative effect of e on S. For e � negative relation between R and e reflects the positive effect of 8 on S. Using Equation (2) to relate La to t , Equation ( 1 3) implies

dR = dt

{

a t t de La (1 ) 1 - a 1 - t B dt 4e a t t de ( 1 - e) La ( 1 - - - - - - ) 1 - a 1 - t 1 - e dt

for e > for e �

t t

i,

the

( 1 4)

Then, substituting for de/dt, as calculated from Equation (12), and setting dR/dt equal to zero, we find that the ruler chooses the value of t that satisfies t a ( 1 5) 1 - - - - cpt = O ' 1-a 1 -t Equation ( 1 5) implies that, in equilibrium, the fraction of market production taken by the ruler's clientele is negatively related to the parameters a and cp. In the limit as cp approaches zero, t approaches 1 - a, which is the value of t that maximizes tLa, given the response of the peasant or worker families to t. But, as long as cp is positive, the ruler sets t less than 1 - a in order to dissuade noncombatants from passively supporting an insurrection. More importantly, Equation ( 1 5) implies that if a, cp and z are sufficiently small, then the ruler sets t larger than z, with the result that e is larger than i· In this case, the potential insurgent leader chooses to organize an insurrection and the equilibrium value of p equals 1 12e, which is less than unity. Also, substituting for t from Equation ( 1 5) into Equation ( 1 2) reveals that in this case the equilibrium value of e is negatively related to a and z, and, unless t is much larger than z, is also negatively related to cp. Equation ( 1 5) also implies that, if a, cp and z are sufficiently large, then the ruler does not set t larger than z and, hence, e is not larger than i. In this case, it is not profitable for the potential insurgent leader to organize an insurrection, with the result that the equilibrium value of p equals unity.

3.5. Income Given the equilibrium choices of the peasant or worker families, the potential insurgent leader, and the ruler, we can calculate from Equations ( 1), (3), and (7) that equilibrium expected incomes are as follows:

{�

( 1 6)

E = ( 1 - t) La + y(1 - L), G

�

1 - � ) ' tL" 2

for t > z for t

( 1 7)

� z,

tLa ( 1 8) R= 4e ' where Equations (2), ( 1 2), and ( 1 5) give L, e, and t. Equations ( 1 6), ( 1 7), and ( 1 8) reveal how total income and its distribution depend on the parameters of the technology

204

H.I. Grossman

of insurrection, z and ¢. Recall that the smaller is z, the better is the technology of insurrection and that the larger is ¢ the more sensitive is passive support for an insurrection to the fraction of market production taken by the ruler's clientele. The most interesting implications are the following: First, the expected income of the peasant or worker families is positively related to ¢. This result obtains because the expected income of the peasant or worker families depends negatively on t and the ruler's choice of t, in turn, is negatively related to ¢. Second, the expected income of the ruler's clientele is positively related to z . This result reflects the negative relation between f) and z. Moreover, this result obtains even if there is no insurrection because deterring an insurrection requires the ruler to deploy S soldiers and the smaller is f) the smaller is S. Third, if the potential insurgent leader organizes an insurrection, then the expected income of his clientele is negatively related to z. Finally, aggregating Equations ( 1 6), ( 1 7) and ( 1 8) reveals that, as long as f) is not larger than �, consumable product is positively related to z. [If an insurrection were sufficiently destructive of market production, then consumable product would be positively related to z for all values of t and z.]

4. Revolutions

We have been analyzing an insurrection that attempts only to appropriate the current income of the ruler's clientele, who are either the property owners or the ruling class. In this case, the insurgents were, as noted above, indistinguishable from bandits or pirates. The present section extends the theory to analyze insurrections whose goal is permanent change - either an alteration of property rights and associated claims to income or the overthrow of the ruling class. Because both the establishment of property rights and the collection of taxes are functions of sovereign power, as also noted above, an insurrection that attempts to establish a new system of property rights or to enthrone a new ruling class is also an attempt to appropriate sovereign power. In this case, an insurrection becomes a revolution and the insurgents are revolutionaries, rather than bandits or pirates. 4. 1. A

revolution?

A potential revolutionary leader wants to appropriate sovereign power and to replace the current incumbent ruler. His objective is to maximize the expected wealth of his clientele. In the example of the Tsar and Lenin, the ruler's clientele includes both owners of property and a parasitic ruling class, and the revolutionary leader's clientele is a clique of ambitious intellectuals. Another historically relevant possibility is that the ruler's clientele is a parasitic ruling class and that the potential revolutionary leader's clientele is the owners of property, or vice versa. In this case, a revolution would involve what the economic historian E.L. Jones ( 1 98 1 , p. 1 32) has described as "a struggle between taxes and rents." In both of these examples, the ruler and the

Ch. 8: Insurrections

205

revolutionary leader, as Jones puts it, are "fighting . . . for the right to commandeer from the peasantry" (p. 1 28). Assume, for simplicity, that only one potential revolutionary leader exists in each period and that he has only one opportunity to organize a successful revolution on behalf of his clientele. If there is a successful revolution, then the revolutionary leader and his clientele not only capture the current gross income of the incumbent ruler's clientele, but the revolutionary leader also becomes the ruler in the next period. Accordingly, the expected wealth of the current potential revolutionary leader's clientele, denoted by J, is J = ( l - p)(tLa + V) - wJ.

( 1 9)

The new variable V represents the value to the potential revolutionary leader's clientele of having the revolutionary leader become the ruler. It seems reasonable to assume that V is also the value to the incumbent ruler's clientele of having the incumbent remain as the ruler. In other words, V is the present value of the expected net income of the ruler's clientele, whoever the ruler may be, beginning one period hence. Also, 1 - p now represents the probability that there is a successful revolution, with p being the probability that there is not a successful revolution. Note that J differs from G, as given by Equation (3 ), only in that tLa + V replaces tLa . As before, the potential revolutionary leader takes as given tLa , S, Wi = y, the technology of insurrection, and 8. Also, the potential revolutionary leader now takes V as given. He selects a nonnegative value of I to maximize J . The solution to this problem is again given by Equation (6) above, but with tLa + V replacing tLa .

4.2. The incumbent ruler In a revolutionary situation, the objective of the incumbent ruler is to max1m1ze the expected wealth of his clientele. Assume, for simplicity, that, if there were a successful revolution, the incumbent ruler would be permanently removed and, hence, the income of his clientele would be zero forever after. This assumption abstracts from any possibility of a successful counterrevolution. Accordingly, the expected wealth of the incumbent ruler's clientele, denoted by Q, is Q

=

p(tLa + V) - W8S.

(20)

Note that Q differs from R, as given by Equation (7), only in that tLa + V replaces tLa . As before, the incumbent ruler takes W8 = y as given. The incumbent ruler now also takes V as given. He selects nonnegative values for t and S to maximize Q. In choosing t and S, the ruler again takes into account how his policies affect the decisions of the other agents. The solution to this problem for S again satisfies Equation (9) above, but with tLa + V replacing tLa . Consequently, the revolutionary leader's choice of I again

HI. Grossman

206

satisfies Equation (10) above, but with tU + V replacing tLa , and the equilibrium value of p again satisfies Equation ( 1 1). In other words, the probability of a successful revolution depends only on e, the measure of the effectiveness of insurgents relative to soldiers. Moreover, substituting Equations (9) and ( 1 1 ) as amended into Equation (20) gives

{

tLa + V for e > ! 4e ( l - e)(tLa + V) for e ::;; ! -

Q=

(2 1 )

Note that Q , as given by Equation (2 1), differs from R, as given by Equation ( 1 3), only in that tLa + V replaces tLa . Using Equation (2) to relate La to t, Equation (2 1 ) implies

dQ

=

dt

{

[ (

a

t tLa + V de e dt 1 a 1-t 4e tLa + V d e a t_ ( l - e) L a l 1 a1 t 1 - e dt l

La l -

[ (

)

]

-

__ _ -

)

_

]

-

for e >

�

for e ::;;

�-

(22)

Assume, for simplicity, that whoever i s the ruler i n any future period, whether he is the current incumbent ruler, the current potential revolutionary leader, or a future potential revolutionary leader, will face a constant threat of revolution. [This assumption implies that a new potential revolutionary leader is born in each period.] Given this assumption, the present value of the expected net income of the ruler's clientele beginning one period hence, V, equals the expected wealth of the current incumbent ruler's clientele discounted by one period. In other words, we have V = AQ,

0 ::;; A < 1 ,

(23)

where A is the one-period discount factor and is common to the clienteles of the incumbent ruler and all potential revolutionary leaders. Substituting Equation (2 1) into Equation (23) gives

V=

{ MU

4e - A A(l - e) tU 1 - A( 1 - e)

for e >

�

for e ::;;

!-

(24)

Substituting for V from Equation (24), Equation (22) becomes

dQ

dt

=

{

La 4e

a

t 1 t de e (fdt - 1 - a 1 - t 1 - A/4 a t 1 t de ( l - e) La 1 1 a 1 - t 1 - A(l e) 1 - e dt

(1

(

)

- -

-

)

for e >

�

for e ::;;

!

-

207

Ch. 8: Insurrections

Then, substituting for e and d e!dt, as calculated from Equation ( 1 2), and setting dQ!dt equal to zero, we find that the incumbent ruler chooses the value of t that satisfies 1

_

a

t_ 1 -a 1-t

_ _ _

_

¢t

1 - A ! exp [¢(z - t)]

=

O.

(25)

Note that, in the limit as A --+ 0, the value of t that satisfies Equation (25) approaches the value of t given by Equation ( 1 5) above. Equation (25) implies that, if there is a potential for revolution, then the chosen value of t is negatively related to the discount factor, A. (The proof of this result involves the assumption that the second-order condition d2 Q/ d t2 < 0 is satisfied.) Thus, the larger is A the greater the range of values for the other parameters for which the incumbent ruler would set t not larger than z and, hence, for which no revolution occurs. Moreover, even if A, a, ¢ and z are sufficiently small that the incumbent ruler sets t larger than z, with the result that a revolution occurs, the larger is A the smaller are the values of t and e and the smaller is the resulting probability that the revolution succeeds. Equation (25) also implies that, if there is a potential for revolution, then the chosen value of t is negatively related to z . These results obtain for the following reason: Equations ( 1 2) and (24) imply that the larger is either A or z the larger is V, and Equation (21 ) implies that the larger is V the larger is the negative effect of e on the expected wealth of the ruler's clientele, Q . Consequently, because e is positively related to t, the larger is either A or z the more reason the ruler has to reduce t, in order to reduce e, and, hence, the smaller is the chosen value of t. Thus, if there is a potential for revolution, because t is negatively related to A and z, the expected income of the peasant or worker families is positively related to A and z, as well as positively related to ¢.

4.3. Income and wealth Given the equilibrium choices of the peasant or worker families, the potential insurgent leader, and the incumbent ruler, we can calculate from Equations ( 1 ), (19), and (20) that the expected income of a peasant or worker family is

E = ( I - t)L0 + y( l - L),

(26)

that the expected wealth of the potential revolutionary leader's clientele is for t > for

z

t :( z,

(27)

and that the expected wealth of the incumbent ruler's clientele is Q=

tL0 4e - A '

(28)

where Equations (2), ( 1 2), and (25) give L, e and t. Equations (26), (27), and (28) reveal how expected income and wealth depend on the parameters of the technology

208

H.!. Grossman

of revolution, z and ifJ, and on the discount factor, A. Recall that the smaller is z, the larger is 8 - that is, more effective are insurgents relative to soldiers - and that the larger is ifJ the more sensitive is the incumbent ruler's popularity to t, the fraction of market production taken by the incumbent ruler's clientele. The most interesting implications are the following: First, the expected income of the peasant or worker families is positively related to z, ifJ and A. This result obtains because the expected income of the peasant or worker families depends negatively on t and the ruler's choice of t, in tum, is negatively related to z, ifJ and A. Second, the expected wealth of the ruler's clientele is positively related to z. This result reflects the negative relation between 8 and z. Moreover, this result obtains even if there is no revolution, because deterring a revolution requires the ruler to deploy s soldiers and the smaller is 8 the smaller is s. Third, for the expected wealth of the potential revolutionary leader's clientele to be positive, z must be small enough that the incumbent ruler sets t larger than z. Moreover, for values of z such that the chosen value of t is larger than z, the value of z affects the expected wealth of the revolutionary leader's clientele in three ways. Because the smaller is z the larger is 8 and p, the smaller is z the higher is the probability that the current revolution will succeed, but also the higher is the probability that a subsequent revolution will overthrow the current insurgent leader. The first of these two effects outweighs the second. In addition, because the smaller is z the larger is t and tL the smaller is z the larger is the income of the ruler's clientele that a successful revolution captures. In sum, for values of z such that the chosen value of t is larger than z, the expected wealth the revolutionary leader's clientele is negatively related to z .

a,

4.4. Economic welfare The equilibrium choices of the peasant or worker families, the potential revolutionary leader, and the incumbent ruler imply that consumable product per family is L

a

+

yH =

{a L

+

y( 1 - L) - y(S + I) ,

La + y(1 - L) - yS

for t > z for t

(29)

� z,

where, from Equations (6), (9), ( 1 0) as amended, and (24), we calculate that y(S + I) =

(

1 8

3- -

) -tLa

48 - A '

,

Ys -

----

8tLa 1 - A ( l - 8) '

La+

and where L satisfies Equation (2), 8 satisfies Equation ( 1 3), and t satisfies Equation (25). The main effects of the parameters z, ifJ and A on yH are as follows: For t > z and, hence, 8 > �, S + I is positively related to A. For t � z and, hence, 8 � �' S is positively related to A. In other words, the larger is the discount factor, A, the larger is either the number of soldiers and insurgents deployed in a revolution

Ch. 8:

209

Insurrections

or the number of soldiers necessary to deter a revolution. Thus, the larger is the discount factor - that is, the more value the current incumbent ruler and the potential revolutionary leader attach to being the future ruler - the more resources are allocated either to revolutionary activity and its suppression or to deterrence of revolutionary activity, and the smaller is home production and consumable product. [The negative relation between t and A produces an offsetting effect on La + yH, but, unless ¢ is large, A does not have a large effect on t. Powell ( 1 993) derives a similar result about the positive effect of the discount factor on military expenditures in a model of international appropriative interactions.] For t > z , but

8� t+

Vb

-

f2,

the partial derivative of La + yH with respect to

8 is negative. This result obtains because for 8 > i, as long as 8 is not too large, the larger is e the larger is the total number of soldiers and insurgents deployed in a revolution. Also, for t � z and, hence, e � i, the partial derivative of U + yH with respect to 8 again is negative. The result obtains because, for 8 � t, the larger is 8 the larger is the number of soldiers necessary to deter a revolution. Accordingly, because e is negatively related to z, the smaller is z the smaller is consumable product. [The negative relation between t and z reinforces this effect of z on La + yH, but, unless ¢ is large, z does not have a large effect on t.] The partial derivative of U + yH with respect to t, holding 8 fixed, is negative. This result obtains because t acts as a tax on market production that distorts resource allocation. Accordingly, because t is negatively related to ¢, the smaller is ¢ the smaller is total consumable product. [The effect of ¢ on 8 can either offset or reinforce this effect of ¢ on La + yH, but, unless the difference between t and z is large, ¢ does not have a large effect on e.] 5.

Summary

This essay has developed an economic theory of insurrections. The decision-making agents in this theory are an incumbent ruler, a potential leader of an insurrection, and a large number of peasant or worker families. The incumbent ruler maximizes the expected income or wealth of his clientele, who can be either the property owners or a ruling class. The potential insurgent leader maximizes the expected income or wealth of his clientele. The incumbent ruler establishes property rights, levies taxes, and acts to deter or to suppress insurrectionary activity. His counterinsurgency strategies include both internal security measures - specifically, the deployment of soldiers and a tax and income-distribution policy designed to dissuade noncombatants from passively supporting an insurrection. Given the incumbent ruler's policies, the potential insurgent leader decides whether or not to organize an insurrection. The role of the insurgent leader in organizing an insurrection is to recruit, compensate, and deploy the insurgents. The peasant or worker families divide their time among market production, soldiering, insurgency, and home production. Market production is subject to the extraction of land or capital rents and/or taxation.

210

H.!. Grossman

The essay initially considered an insurrection that attempts to appropriate only the current income of the ruler's clientele. In this case, two structural parameters of the technology of revolution are critical. One of these parameters indexes the technology and directly influences the effectiveness of insurgents relative to soldiers. The other parameter determines the sensitivity of the incumbent ruler's popularity, and the resulting passive support for an insurrection, to the fraction of market production taken by the incumbent ruler's clientele. The theory implies that, for the potential insurgent leader in equilibrium to decide to organize an insurrection, two conditions must be satisfied: First, the technology of insurrection must be sufficiently good. Second, passive support for an insurrection must not be too sensitive to the fraction of output taken by the ruler's clientele. The worse is the technology of insurrection and the more sensitive is passive support for an insurrection to the fraction of market production taken by the ruler's clientele, the easier it is for the ruler to deter an insurrection. Moreover, if the potential insurgent leader decides to organize an insurrection, then the fraction of the income of the ruler's clientele that the insurgent leader expects to capture is larger the better is the technology of insurrection and the less sensitive is passive support for a revolution to the fraction of output taken by the ruler's clientele. In addition, the theory has the following implications for the equilibrium con­ figuration of expected income and for economic welfare: ( 1 ) If the technology of revolution is better, then either the number of soldiers and insurgents deployed in an insurrection or the number of soldiers necessary to deter an insurrection is larger and consumable product, which is an index of current aggregate economic welfare, is smaller. Also, the expected income of the incumbent ruler's clientele is smaller and, if there is an insurrection, the expected income of the insurgent leader's clientele is larger. (2) If passive support for an insurrection is more sensitive to the fraction of market production taken by the ruler's clientele, then the fraction of market production taken by the incumbent ruler's clientele is smaller, the expected income of the representative peasant or worker family is larger, and consumable product is larger. The essay went on to extend the theory to analyze revolutions, which are insurrections whose goal is permanent change - either an alteration of property rights or the overthrow of the ruling class. A revolutionary leader wants to replace the current incumbent ruler. His clientele is an alternative set of property owners or an alternative ruling class. In a theory of revolution, the discount factor, which helps to determine the value that the incumbent ruler and the potential insurgent leader attach to being the future ruler, is an additional important structural parameter. For a potential revolutionary leader to decide to organize a revolution, the discount factor cannot be too large, because the larger the discount factor the more willing is the ruler to forego current income for his clientele in order to deter a revolution. Moreover, if the potential revolutionary leader decides to organize a revolution, then the equilibrium probability that the revolution will succeed is larger the smaller is the discount factor. In addition, if the discount factor is larger, then the fraction of market production taken by the ruler's clientele

211

Ch. 8: Insurrections

is smaller and the expected income o f the representative peasant or worker family is larger. But, either the number of soldiers and insurgents deployed in a revolution or the number of soldiers necessary to deter a revolution also is larger and consumable product, which is an index of current aggregate economic welfare, is smaller. Also, in a revolution, if the technology of revolution is better, then the fraction of market production taken by the ruler's clientele is larger and the expected income of the representative peasant of worker family is smaller. These results reveal that in equilibrium the likelihood of a successful revolution and the expected income of the representative peasant or worker family are negatively related, but the likelihood of a successful revolution can be either positively or negatively related to an index of current aggregate economic welfare. If either the technology of revolution is better or passive support for a revolution is less sensitive to the fraction of market production taken by the ruler's clientele, then a successful revolution is more likely and both the expected income of the representative peasant or worker family and current aggregate economic welfare are smaller. But, if the discount factor is larger, although the expected income of the representative peasant or worker family is larger, a successful revolution is less likely and current aggregate economic welfare is smaller, because more resources are devoted to either deterring or suppressing a revolution.

References Brito, D.L., and M.D. Intriligator,

1 990, An economic model of guerrilla warfare, International Interactions

1 5, 3 1 9-329. Grossman, H.l.,

1 99 1 ,

A general equilibrium model of insurrections, American Economic Review

81,

9 1 2-92 1 . Grossman, H.l., Grossman, H . I . ,

1 992, Foreign aid and insurrection, Defence Economics 3 , 275-288. 1 994, Production, appropriation, and land reform, American Economic

Review

84,

705-7 1 2. Grossman, H.I.,

1 995,

Robin Hood and the redistribution of property income, European Journal of

Political Economy, forthcoming.

1 994, Population increase and the end of colonialism, unpublished. 1 995, Swords or plowshares? A theory of the security of claims to property,

Grossman, H.I., and M. Iyigun, Grossman, H.l., and M. Kim,

Journal of Political Economy, forthcoming. Grossman, H.l., and S.J. Noh, Economics

1 990,

A theory of kleptocracy with probabilistic survival and reputation,

& Politics 2, 1 5 7-17 1 .

1 994, Proprietary public finance and economic welfare, Journal of Public 53, 1 87-204. Haavelmo, T., 1 954, A study in the theory of economic evolution (North-Holland, Amsterdam). Hirshleifer, J., 1 988, The analytics of continuing conflict, Synthese 76, 201 -233. Hirshleifer, J., 1991, The paradox of power, Economics & Politics 3, 177-200. Hirshleifer, J., 1995, Anarchy and its breakdown, Journal of Political Economy 1 03, 26-52. Jones, E.L., 1 98 1 , The European miracle (Cambridge University Press, New York). Kuran, T., 1 989, Sparks and prairie fires: A theory of unanticipated political revolution, Public Choice 61, 41-74. Grossman, H.I., and S.J. Noh, Economics

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Popkin, S.L.,

1 988,

Political entrepreneurs and peasant movements in Vietnam, in: M. Taylor, ed.,

9-62. 1 993, Guns, butter, and anarchy, American Political Science Review 87, 1 1 5-132. Roemer, J.E., 1 985, Rationalizing revolutionary ideology, Econometrica 53, 85-108. Roemer, J.E., 1 988, Rationalizing revolutionary ideology: A tale o f Lenin and the Tsar, in : Michael Taylor, ed., Rationality and revolution (Cambridge University Press, New York) 229-244. Skaperdas, S., 1 992, Cooperation, conflict, and power in the absence of property rights, American Economic Review 82, 720-739. Tullock, G., 1 974, The social dilemma: The economics of war and revolution (Center for the Study of Rationality and revolution (Cambridge University Press, New York)

Powell, R.,

Public Choice, Fairfax, VA). Usher, D.,

1 989,

The dynastic cycle and the stationary state, American Economic Review

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The distribution of income in a despotic society, Public Choice

54,

Chapter 9 TERRORISM: THEORY A ND A PPLICATIONS WALTER ENDERS and TODD SANDLER

Iowa State University

Contents

Abstract Keywords 1 . Introduction 2. Data and trends 3 . Game theoretic analysis 1 : Treaty formation and negotiations

4. 5. 6. 7.

A Prisoner's Dilemma scenario

3.1. 3.2.

To bargain or not to bargain

7I 7 .2.

The Libyan raid and other retaliations

Game theoretic analysis 2 : Terrorists' choice of targets Further game analyses Choice-theoretic models of terrorism Intervention analysis .

.

Other interventions: Increased embassy security

8. Vector autoregression models of terrorism 9. Concluding remarks References

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T. Sandler © 1 995 Elsevier Science B. V. All rights reserved

214 214 215 216 221 221 224 228 233 23 5 237 239 239 24 1 247 247

214

W. Enders and T. Sandler

Abstract

This chapter reviews game-theoretic and choice-theoretic depictions of terrorist behavior. A simple game-theoretic framework is presented to ascertain under what circumstances a government would want to precommit itself to a no-negotiation strategy. In another game model, we analyze whether two governments (nations) that are targeted by the same terrorist group would overdeter or underdeter terrorist attacks. Moreover, we demonstrate that piecemeal policy, which allows the governments to share intelligence but not deterrence decisions, can be worse than no coordination. Choice-theoretic models identify substitution and complementarity possibilities among diverse modes of terrorist attacks as terrorists respond optimally to government actions. A host of time-series techniques are used to study the effectiveness of alternative antiterrorism policies. Vector-autoregression intervention procedures are particularly suited. Time-series analyses are also used to identify cycles, trends, and irregular components for forecasting purposes.

Keywords

antiterrorism policies: embassy security, Libyan retaliatory raid of 1 986, metal detectors; asymmetric information; game theory: dominant strategy, Nash equilibrium, perfect Bayesian equilibrium, Prisoner's Dilemma, signalling game; international terrorism, definition of; rational-actor model; reputation effects; Spanish tourism and terrorism; state-sponsored terrorism; terrorism, definition of; terrorism data: cycles, data sources, ITERATE; trends; terrorist attack modes: assassinations, bombings, hostage taking, skyjackings, threats and hoaxes; time­ series analysis: ARMA, Granger causality, intervention analysis, spectral analysis, stationarity, VAR; transboundary externality

Ch. 9:

Terrorism: Theory and Applications

215

1 . Introduction

Terrorism is an activity that has probably characterized modem civilization from its inception. Nonetheless, terrorism has increased in importance and visibility as a means of conflict during the past quarter century as terrorists have taken advantage of advancements in communication, transportation, and technology to intimidate a global community with threats of violence unless political demands are conceded. As a general concept, we define terrorism as the premeditated use, or threat of use, of extra-normal violence or brutality to obtain a political objective through intimidation or fear directed at a large audience. The presence of a political objective is crucial; thus, threats of violence used to extort money with no underlying political motive do not constitute acts of terrorism. The political objectives of terrorists vary and include the promotion of religious freedoms, economic equality, income redistribution, nationalism, separatism, ideological ends, nihilism, and issue-specific goals. Terrorists often direct their violence and threats towards a vulnerable target group, not immediately involved in the political decision-making process that they seek to influence. Thus, terrorist incidents may injure pedestrians along a crowded marketplace (e.g., Tamil separatists bombings in Sri Lanka) or murder passengers waiting to check in at an airline counter (e.g., armed attacks in the Rome and Vienna airports on December 27, 1 985). When a terrorist incident in one country involves victims, targets, institutions, governments, or citizens of another country, terrorism assumes a transnational char­ acter. A skyjacking that originates in country A, but that terminates in country B is transnational, as is a kidnapping in country A that places demands on individuals or institutions in another country. If a terrorist group launches its operation from a second country, then the incident is a transnational event. Transnational events are examples of transboundary externalities, since actions conducted in one country may impose uncompensated costs or benefits on the people or property of another country. Since 1 967 and the Arab-Israeli Wars, transnational terrorism has plagued many countries. The end to the cold war and the breakup of the former Soviet Union and other Eastern European states increases the risks of transnational terrorism as regions seek autonomy. Furthermore, the dismantling of the superpowers' nuclear arsenal could place enriched nuclear materials in the hands of terrorists. The study of terrorism in economics is a relatively new endeavor originating with papers by Landes ( 1 978) and Sandler, Tschirhart and Cauley ( 1983). A vast literature on terrorism has been written in political science [see Crenshaw ( 1 992) for recent surveys] and differs in some fundamental ways from the economic approaches reviewed in this chapter. Although both literatures tend to be policy oriented, the economic studies attempt to construct a theoretical model upon which empirical hypotheses are formulated and tested. Many of the economics papers rely on statistical inference, while the bulk of the political science literature depends on informed observation, case studies, institutional details, and taxonomy [examples can be found in Wilkinson and Stewart ( 1 987), and Alexander, Carlton and Wilkinson

216

W. Enders and T. Sandler

( 1 979)]. These latter exercises are extremely useful and complementary to those in economics. Because the economic papers are interested in predicting behavior, economic studies employ rational-actor representations that depict an individual or collective (e.g., terrorist group or government negotiators) as optimizing some goal, usually that of utility or net benefits, subject to a set of constraints. Game-theoretic models are used when strategic interactions oftwo or more sets of optimizing agents are considered, and each set engages in actions that alter the choices of the other set of agents. The primary purpose of this chapter is to survey the theoretical and empirical approaches used in the economic literature to investigate aspects of terrorism. To date, studies have examined negotiation strategies for managing hostage-taking missions, terrorists' choice of targets, retaliation decisions against state sponsors, the effectiveness of alternative antiterrorist policies, and the process of treaty formation. Essentially, economic studies have evaluated policies directed at thwarting terrorism. Such policies are of two basic types: passive or defensive (e.g., installation of metal detectors at airports, fortification of embassies, institution of stiffer penalties) and active or offensive (e.g., retaliatory raids, preemptive strikes, group infiltration). A secondary purpose is to display some of the theoretical approaches used. A third purpose is to put forward alternative time­ series methods that can be used in a wide range of defense economics studies to ascertain the effectiveness of government interventions. A particularly useful approach is that of vector-autoregression (VAR) intervention analysis.

2. Data and trends

Economic studies of terrorism have been either purely theoretical [e.g., Selten ( 1 988), Shahin and Islam ( 1 992)] or empirical [e.g., Cauley and Im ( 1 988)]. The latter studies have relied on data sets containing events data in which various aspects of a terrorist incident are recorded. Aspects include the location, the type of incident, the number of victims, the fate of the terrorists, the type of target, negotiations (if any), and so on. Since the late 1 960s, a number of data sets have been compiled concerning transnational terrorism. For domestic terrorism, data sets have been assembled for the United States, Israel, Germany and elsewhere. The most complete data set on transnational terrorism is that of the US State Department [see, e.g., US Department of State ( 1 986, 1 993)]; but, it is not available for researchers. RAND also maintains data on significant transnational terrorist incidents and has made it publicly available in recent years. Edward Mickolus ( 1980, 1982) developed a data set, International Terrorism: Attributes of Terrorist Events (ITERATE) for 1 9681 977. This data set was extended to cover 1 97 8-1987 by Mickolus, Sandler, Murdock and Fleming (1989b). More recent updates by Mickolus and Fleming have included 1 988- 1 99 1 . The working definition of transnational terrorism used by ITERATE is the use, or threat of use, of anxiety-inducing extranormal violence for political purposes by any individual or group, whether acting for or in opposition to established

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217

governmental authority, when such action is intended to influence the attitudes and behavior of a target group wider than the immediate victims and when, through the nationality or foreign ties of the perpetrators, through its location, through the nature of its institutional or human victims, or through the mechanics of its resolution, its ramifications transcend national boundaries [Mickolus, Sandler and Murdock ( 1 989a, Vol. 1, p. xii)]. The data sets suffer from a number of problems. First, most data sets rely on newspaper accounts and, thus, exclude incidents that are either not newsworthy or not reported. Second, the data sets do not contain much information about the governments' strategies or behavior within an incident. Thus, these sets tend to be more useful for analyzing terrorists' responses rather than government actions. Third, even the best data set has lots of missing values. Researchers must be cautious when using the data sets. ITERATE is, however, especially appropriate for time-series studies owing to the large number of periods included. It is particularly useful for studying how various series respond to government policies. As rational actors, terrorists can be characterized as choosing between illegal and legal activities to promote their political goals. Illegal actions include violence or its threatened use, while legal activities involve running for office or advertising the cause. If legal activities are made expensive by government repression, then a corner solution may result with the terrorists choosing just illegal actions [Lichbach ( 1 987)]. Ironically, repression may work against government's interests in reducing the relative cost of violent dissent. Within the category of illegal terrorist activities, terrorists must allocate resources among alternative modes of attack. As many as 24 separate attack modes have been characterized; these fall into four primary categories: bombings, hostage­ taking missions, assassinations, and threats and hoaxes. The choice of modes could be modeled in terms of a utility tree, where terrorists first allocate resources between terrorist and nonterrorist activities, and then among alternatives within each class of activities. For terrorist activities, this latter choice is dependent on the shadow prices for each type of action, which, in turn, depends on time, other resource requirements, and risk considerations [Sandler, Tschirhart and Cauley ( 1 983)). Events that are logistically complex (e.g., skyj ackings, kidnappings) and/or more risky have higher per-unit prices. Government policies can alter these prices by making one type of event more difficult than another. Thus, the installation of metal detectors at airports on January 5, 1 973 made skyjackings more difficult. In Figure 1 the number of transnational terrorist events per quarter is displayed for 1 968- 1 99 1 , using the ITERATE data. The lower time-series in this same figure depicts the quarterly totals of bombings, which include explosive bombs, incendiary bombs, mortars, grenades, letter bombs, and car bombs. A number of features of these two time series are worth highlighting. First, the shape of the bombing series is a prime determinant of the appearance of the time series for all events. Bombings are the favorite operating mode of terrorists and account for over half of all incidents. Second, both time series appear to display cycles. Third, a small upward trend may be present in the all-incidents series. Fourth, peaks in both series often correspond to

W. Enders and T Sandler

218 400 ,----

300

�

"' ::>

0

� -E!Ql

200

-

:2

"

=

100

1 968

1 976

1972

•

Figure

1.

1 980

All Incidents

1 984

1 988

1 992

- Bombings

All incidents and bombings: Quarterly

1 968-199 1 .

significant international events; the peak in 1 972 came after a war between Israel and its neighbors, while the peak in 1 99 1 coincided with the Gulf War. In Figure 2, the quarterly time series for hostage-taking events - kidnappings, skyjackings, and barricade and hostage taking - is depicted. Hostage events occur much less frequently than bombings, which are logistically less complex and less risky. A comparison of Figures l and 2 suggests that terrorists appear aware of risks and engage in more risky, higher-payoff modes of attacks less often. In a hostage-taking event, the terrorists often make demands of government, business, or family members. These demands involve ransom, the release of prisoners, political concessions, or media exposure. As in the case of two earlier series, cycles appear to characterize the hostage-taking series. Quantification is important if researchers are interested in using time-series properties of terrorism events for forecasting purposes. Given that daily time series have been accumulated for transnational incidents for 24 years, from the start of 1 968 to the end of 1 99 1 (e.g., ITERATE), there is sufficient data to conduct sophisticated time-series studies. Moreover, various time-series techniques [vector autoregression (VAR)] can be combined with intervention analysis, where discrete policy changes are allowed, to investigate policy effectiveness.

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219

Terrorism : Theory and Applications

40 ,-------�

30

�

20

10

1 96B

1 976

1 972

Figure

2.

1 9BO

Hostage incidents: Quarterly

1 984

1 9BB

1 992

1 968-199 1 .

Enders, Parise and Sandler ( 1 992a) tested the time series displayed in Figures 1 , 2 as well as those of assassinations and threats and hoaxes for a deterministic trend that takes the general polynomial form: m

z1 =

L i� J

a;t;

(1)

in which z 1 i s the trend, the a;'s are coefficients, and t i s time. These authors found that all time series, except bombings, displayed a significant trend component. In general, a time series can be expressed as the sum of a trend, cyclical, and irregular component. Letting y1 denote any of the incident series, we can write Yt = Zt + Xt + Ut,

(2)

where z1 is the trend component, x1 is the cyclical component, and u1 is the irregular component. Each of these components has a unique effect on the time series. The trend component is associated with permanent movements in the observed series and, as opposed to Equation ( 1 ), can be deterministic or stochastic. The existence of trend implies that y1 is nonstationary. For the cyclical component, a sinusoidal or "wavelike" pattern characterizes the time series. Once the trend has been purged, spectral analysis can be used to identify cycles [Gottman ( 1 98 1)]. The Spectral Decomposition Theorem states that the variance of a time series can be broken down into the contributions of statistically independent oscillations of different frequencies. Finally, the irregular component is the result of all other influences of behavior of y1 •

W. Enders and T. Sandler

220

In general, the three components need to be estimated from the data. First, consider a time series suspected of containing a nonstationary component owing to a stochastic trend. Write the series as �Yt

= + Et,

(3)

f3oYt-!

where E1 is a white noise term. Wheny1 is stationary, the true value of the coefficient {30 will differ from zero and fulfill the stability condition that -2 < {30 < 0. If f3o is exactly zero, then the series has a unit root and is nonstationary. All shocks are then permanent by changing the mean of the series. A unit root process has a stochastic trend; the unconditional variance of such a series is infinite. A modification of (3) allows us to account for the presence of autoregressive (AR) terms, drift, and a deterministic trend. Consider �Yt =

+ + +L n

ao

Zt

f3oYt- !

i�!

{3;�Yt-i

+

Et ,

(4)

where the first right-hand side (RHS) expression is the intercept, the second is the deterministic trend from ( 1 ), the third and fourth are autoregressive components, and the fifth is the irregular component. If, again, y1 is stationary around a deterministic trend, the coefficient {30 will be such that -2 < {30 < 0. When y1 is trend stationary and the order of the polynomial trend has been ascertained, the y1 series can be made stationary by filtering. With ordinary least squares (OLS), y1 can be regressed on z1, and the residuals from the regression will contain only the cyclical and irregular components. Equation (4) can be estimated using OLS, but traditional t-tests are not appropriate to test the null hypothesis that {30 0. To determine whether {y1} contains a stochastic trend, one uses a Dickey-Fuller table for the appropriate confidence interval surrounding {30 [Dickey and Fuller ( 1 979, 1 9 8 1 )] . Enders, Parise and Sandler ( 1 992a) examined the five basic time series of transnational terrorist events for cycles and uncovered the following results 1 : (i) All five series displayed regular cycles. (ii) Logistical complexity was positively associated with the length of the cycles: hostage-taking events and assassinations had cycles of 1 8 quarters, while threats and hoaxes had the shortest cycles of 3.6 quarters. (iii) Bombings were associated with a 7.2 quarter cycle. (iv) The all-events series displayed periodicities of 1 8 and 7.2 quarters. Obviously, the cycle for bombings carried over to the all-events series, since the former composed a large part of the latter series. The cyclical nature of the time series led these authors to conclude that the downturn in transnational terrorist incidents in 1 989 and 1 990 would not foretell a

=

1

Somewhat similar results were found in an earlier study by Im, Cauley and Sandler (I 987).

Ch. 9:

221

Terrorism: Theory and Applications Table I Trend estimates for five incident series, 1 968-1 9 9 1

t2

Constant•

Series All Hostage taking

5 1 .360

1 .796

(4.38)

(3.2 1 )

4.843 (2.75)

Bombings

0.2972 (3.54)

-0. 1 248

t'

F -statistics b

ADF(4) '

1 1 .50

-3.97

1 2.06

-4.73

(-2.24) -0.002 (-2.60) NA

50.786

-3 .43

(8.61) Threats & hoaxes

3 .502 ( 1 .62)

Assassinations

-2.838 (- 1 .94)

a

0.1767

20.96

-2.8 1

37.05

-4.30

(4.57) 0.5036 (7.21 )

-0.0041 (-5.83)

Numbers i n parentheses are /-statistics.

b NA denotes not applicable. ' ADF(4) lists the augmented Dickey-Fuller test statistic (with 4 lags) for a null hypothesis that the residual of the filtered series has a unit root. Since the critical value at the 95% significance level is -2.89, we can reject the null of a unit root for all but the threats and hoaxes residual series.

permanent curtailment of transnational terrorism. Figure 1 indicates that a resurgence of terrorist activities followed in 199 1 . In Table 1 , we update the study of trend and stationarity to the 1968- 1991 period. Regressing the y1 series on the polynomial z1 [in Equation (1)] allows us to obtain estimates of a;. For a given series, the degree of the polynomial is obtained once an additional term (i.e., power of the time trend) is statistically insignificant. Only the statistically significant powers of the time trend are reported in Table 1 . Four of the five series have significant trend; the sole exception is the series for bombings. The threats and hoaxes series displays a linear trend, while the all-incidents, hostage-taking, and assassinations series display a quadratic trend. Formal tests using the Dickey-Fuller procedure (with a constant but without a deterministic trend) indicate a rejection of a unit root for four of the series. Nonstationarity characterizes the threats and hoaxes series at the 95% level of significance. 3. Game theoretic analysis 1 : Treaty formation and negotiations 3. 1. A

Prisoner 's Dilemma scenario

Whether one is analyzing the interaction of terrorists and the authorities, or the interaction among different nations' governments faced with a common terrorist threat, game theory is an appropriate tool, because each agent's optimizing choices may be dependent on the choices of its counterparts. We first focus on some strategic choices made by governments confronted by transnational terrorism. In particular, we are

222

W Enders and T Sandler Nation 2

Abide

Nation 1:

Abide Does Not Abide

a c

2,2 5 ,-3

Does Not Abide b

d

-3,5 0,0

a. Two-Nation Prisoners' Dilemma

Other Four Nations' Strategies 2 Others Abide 1 Other Abides 3 Others Abide 4 0thers Other 4 Nations Abide 1 Does Not Abide 2 Do Not Abide 3 Do Not Abide Do Not Abide

Abide

Nation i: Does

Not Abide

17

12

7

2

-3

20

15

10

5

0

b. Five-Nation Prisoners' Dilemma

Figure 3. (a) Two-nation Prisoner's Dilemma; (b) five-nation Prisoner's Dilemma.

interested in a dilemma that treaty formation might pose. For illustration, we consider a two-nation treaty to retaliate against a known sponsor of terrorism. For this case, the associated payoffs often imply a Prisoner's Dilemma. In the top matrix ofFigure 3, a typical scenario is displayed with a 2 x 2 game matrix in normal form, which indicates the players, their strategies, and their payoffs. This matrix refers to a situation in which two nations sign an agreement pledging to punish state sponsors of terrorism. Once the treaty is signed, each nation has two strategies or choices: to abide or not to abide by the agreement. These choices are exercised when a state-sponsored incident occurs that requires a response. The game matrix indicates hypothetical payoffs for four strategy combinations or cells: (i) both nations abide, (ii) nation 1 abides, while nation 2 does not, (iii) nation 2 abides, while nation 1 does not, and (iv) neither nation abides. In the top matrix, the rows indicate the two strategies of nation 1, whereas the columns depict those of nation 2. The first number in each cell is the payoff to nation 1 , while the second is the payoff to nation 2. The payoffs depicted are based on the following scenario: Each nation that abides by the treaty confers benefits of 5 on itself and on the other nation, but at costs of 8 to itself. The costs arise from engaging in the retaliation, while the benefits stem from the deterrence accomplished and the destruction of terrorists ' resources. Benefits have the properties of a public good - i.e., nonrivalry and nonexcludability. If, therefore, both nations abide, then each receives a net benefit of 2 - the difference between benefits of

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223

10 ( 2 x 5) minus the private costs of 8. When, however, only one nation abides, the abider receives a net benefit of -3 (= 5 - 8) and the nonabider receives a free ride of 5 in benefit s. Net benefits are 0 when neither abides. The pattern of payoffs that results is a Prisoner's Dilemma. If given the choice between mutual cooperation and mutual defection, the payoffs in the top matrix clearly indicate that mutual cooperation is in everyone's interest - i.e., this strategic combination Pareto dominates mutual defection. A dilemma results, because rational self-interested players are predicted to not abide by the treaty when required. To display the dilemma, we must introduce the concept of a dominant strategy that provides a greater payoff to the player regardless of the other player's action. In the top matrix, not abiding is dominant for nation i, since its payoffs of 5 and 0 exceed the corresponding payoffs of 2 and -3 . As the players exercise their dominant strategies, they both renege on their pledge and end up in cell d. This cell represents a Nash equilibrium, which corresponds to a strategy combination from which neither nation would unilaterally want to alter its strategic choice if given the opportunity. Once at cell d, each nation would lose 3 by acting unilaterally to abide by the treaty. In the bottom matrix of Figure 3, the same scenario is extended to five nations. Each abider to the treaty confers a benefit of 5, from deterrence, to itself and to the other nations in the agreement. As before, a nation pays costs of 8 from carrying out the treaty's conditions. If, say, all five nations abide, each receiues net benefits of 1 7 equal to gross benefits o f 2 5 (5 times the number of abiders) minus costs o f 8 . In the bottom matrix, we list the payoffs to nation i based on its strategy and those of the other four nations. If, for example, nation i and three others abide, then nation i receives a net benefit of 1 2 (= 4 x 5 - 8). The other payoffs are computed in a similar fashion. For nation i, the dominant strategy is to not abide, since the payoffs in the bottom row exceed those in the top row regardless of the other nations' actions. Because all nations view the game as does nation i, none abides when needed. The resulting Nash equilibrium gives each nation a 0 payoff rather than a benefit of 1 7 from mutual cooperation. Lee ( 1 988) and Lee and Sandler ( 1 989) introduced a notion of paid riding when examining whether nations are willing to retaliate against a state sponsor. In Lee (1 988), nations have the option of actually selling or reducing the public good of retaliatory deterrence, provided through the efforts of others, by offering safe havens to terrorists in return for the terrorists' pledge to attack elsewhere. When an agent sells or undoes the deterrence provided by others, the agent is termed a paid rider. In fact, Lee's ( 1 988) analysis is completely consistent with a standard Prisoner's Dilemma representation, because the third strategy of negative deterrence (paid riding) now dominates the other two strategies of abiding or not abiding (zero deterrence). Obvious caveats apply to our one-shot Prisoner's Dilemma analysis. First, the game can be placed in an infinite repeated game framework, where the short-run gains from not abiding in some period must be weighed against the discounted long-run losses stemming from the other nations as they punish the defector's actions. A host of Nash equilibria result that are consistent with individual rational responses [ Sandler ( 1 992, =

W Enders and T. Sandler

224

pp. 79-89)]; mutual cooperation is among these Nash outcomes. Second, infinitely repeated games must be contrasted with those containing a finite (known) number of periods. For the latter games, backward induction would identify mutual defection as the subgame perfect equilibrium (i.e., the Nash equilibrium for all constituent subgames). Because governments may have known endpoints to their terms (e.g., President Reagan prior to the Irangate scandal), the mutual defection outcome may be expected. Nations have not been consistent in following through with their tough talk regarding terrorism. This failure makes pledges less credible. Third, the underlying game may be something other than the Prisoner's Dilemma. 3.2.

To bargain or not to bargain

Game theory is a particularly appropriate tool for analyzing the interaction between a terrorist group and a targeted government. This interaction may occur during hostage­ taking missions, because the terrorists often make demands on the government. We briefly sketch a game representation that can be used to examine whether it is in a government's interest to precommit itself to a no-negotiation strategy 2 . From the government's viewpoint, two choices must be examined: the choice of deterrence expenditures, and whether to capitulate or not when hostages are taken. The first choice involves the expense incurred by the authorities to reduce terrorists' logistical success (i.e., their ability to apprehend hostages); the second choice arises once hostages are secured by terrorists. It is conventionally believed that if a government precommits never to capitulate, then potential hostage takers will have nothing to gain from holding hostages. Consequently, no hostages will be taken. This conventional wisdom rests on a number of implicit assumptions: (i) the government's pledge is fully credible to would-be hostage takers; (ii) there is no uncertainty concerning payoffs; (iii) the terrorists' gains from hostage taking only derive from the fulfillment of their demands; and (iv) the government's expenditures on deterrence will stop all attacks. Each of these assumptions may be suspect in practice. For our purposes, we investigate the game in a single period or stage and then suggest a multiperiod extension. There are two agents in the game - the terrorist group and the government; hostages are treated as exogenous agents. In Figure 4, the extensive form for this one-period game is displayed with the payoffs. First the government chooses its expenditures, D, to deter an attack; second, the terrorists decide whether to attack; and third, the government determines whether to capitulate when the terrorists attack successfully. The optimal strategy for each agent depends on its payoffs in each state and the beliefs that it holds as to the likelihood attached to each state. The

2

This section draws from Lapan and Sandler ( 1 988). For a nongame theory approach to negotiations, see Islam and Shahin ( 1 989) and Shahin and Islam ( 1 992). This latter approach, while interesting, ignores crucial strategic interactions.

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225

Government chooses deterrence

D(e)

Terrorists decide whether to attack -). On each branch, the likelihood that is attached to a state is given. We first consider the terrorists' options. An unsuccessful attack is assumed to give the terrorists a net cost of -c < 0, whereas a successful attack and successful negotiation is assumed to yield the terrorists a payoff of m > 0. Finally, a successful attack with negotiation failure gives the terrorist m, which might be positive or negative. If the event leads to extensive media exposure for the terrorists' cause, then m can be positive but less than m. The expected payoff, Z, to the terrorists from an attack also depends on the probability 6> that they associate with a logistical failure and the probability, p, that they attach to the government capitulation. From the game tree, we have Z

=

(1 - 6>)

·

[pm + (1

- p)m] - Be,

(5)

W Enders and T Sandler

226

, where m > m > -c and m > 0. It is in the terrorists interest to attack provided that expected payoffs are positive, so that c < c*

=

[(1 - ] EJ)

-----e-

·

[pm +

(1-

p)m].

(6)

The likelihood of an attack, Q, increases with the perceived probability of success, the perceived probability of capitulation, and the benefit of a successful operation, m. By Equation (6), we see that even a credible policy of precommitment never to negotiate, which implies that p = 0, may be insufficient to deter an attack if the terrorists derive net benefits from logistical success despite negotiation failure, so that m > 0. Additionally, the no-negotiation policy may be insufficient to deter an attack when the costs associated with failure are low or even negative. In fact, a fanatical group may perceive benefits from logistical failure, so that m > -c > 0. Clearly, the conventional wisdom hinges, in part, on a group being solely motivated by concessions. Next, we turn to the government, which expends D in deterrence regardless of the outcome. This expenditure determines, along with nature (chance), the terrorists ' perceived probability of logistical failure. From Figure 4, we see that the government only incurs D if no attack occurs. If an attack occurs and fails, then the government incurs a (� 0) in addition to D; if, however, an attack succeeds then the government incurs an additional cost of h for capitulating and n for not capitulating. These additional costs involve crisis management and political fallout. At this juncture reputation costs are ignored. The government influences the terrorists' perceived failure rate through its expen­ ditures on deterrence, in which EJ = K(D)

(7)

or

where D(O) = 0, D' > 0, D" > 0. We further assume that the government does not know the resolve of the terrorists so that c � 0 is a random variable with probability density functionf(c). For the government, the likelihood of an attack is prob {c < c*} = Q =

l

c*

f(c) dc.

(8)

By Equation (6), we have that c * and, hence, Q depends on terrorists' beliefs concerning the likelihood of logistical success and government capitulation - i.e., Q = Q(EJ,p). Partial differentiation of Equation (8) gives the following results: increased deterrence reduces the likelihood of an attack, and an increase in p (i.e., the perceived negotiation weakness of the government) encourages terrorist strikes. For simplicity, the two agents are assumed to have identical beliefs of the likelihood of attack.

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Terrorism: Theory and Applications

When the decision to capitulate is made ex post, the government would concede whenever n > h, or capitulation is less costly. Following a hostage incident, ex post cost is min(n, h). From an ex ante perspective, the expected cost to the government is

E[TC] = D(8) + Q8a + Q( l - 8) E[min(n,

h)],

(9)

where n is a random variable with density function g(n), and E[ · ] is the expectations operator. To determine its optimal deterrence, the government chooses 8 to minimize Equation (9). We denote 8* as the argmin E[TC] and TC* as minimized expected cost. Comparative statics applied to the resulting first-order conditions would show that 8* increases as (i) the likelihood of attack goes up, (ii) the expected cost of successful attacks rises, and (iii) the ability to deter attacks increases (i.e., BQ/88 rises). Desirability of precommitment never to negotiate can be examined by comparing the cost associated with such a policy with TC* . Let Q denote the ex ante probability of an attack when precommitment is credible, so that Q = Q( 8, 0). The government's expected cost is then

T C = D(8) + Q 8a + Q(l - 8)E(n),

( 1 0)

where E(n) is the expected cost of a successful attack. If a policy of precommitment eliminates all attacks (i.e., Q = 0 when evaluated at 8*), then precommitment dominates the ex post decision when Equation (9) is compared with ( 1 0). When, however, all attacks are not eliminated, precommitment may prove more costly ex post for those incidents where E(n) > E[min(n, h)] or capitulation is less costly. Credibility is not sufficient to make precommitment the optimizing policy, especially when the cost of holding firm cannot be known in advance. In essence, precommitment can lead to a time consistency problem if the game is extended to multiple periods, since a government may come to regret its pledge to hold firm once the actual cost of doing so is revealed. The analysis can be made more realistic by allowing multiple periods and reputation cost. The latter arises when concessions in one period make the terrorists raise their beliefs about future concessions. As p increases, more hostage taking will occur. Loss of reputation for the government raises the cost associated with capitulating and should curb, but not eliminate, such behavior [see Lapan and Sandler ( 1 988) for further details] . Reputation cost arises because capitulation in any period of a multi­ period scenario augments the terrorists' perceived likelihood of future capitulations (i.e., Pt+ 1 > p1 if capitulation occurs in period t). An increase in p then augments the likelihood of an attack and, consequently, raises expected cost to the government. With reputation cost (R), the government will negotiate ex post only if n > h + R. Such cost decreases the likelihood of negotiation, but it does not necessarily eliminate the possibility unless h + R exceeds n for all realizations of n. The institution of a constitutional amendment that inhibits capitulation by imposing severe penalties may achieve this result.

228

W. Enders and T. Sandler

There are a number of aspects of the above representation that require future work. First, the analysis does not contain learning on the part of the two sets of agents. In the case of the terrorists, the model does not explicitly allow the terrorists to alter their beliefs with respect to p, based on the past behavior of the government. The same is true about the government's belief concerning p and other key variables. We return to this problem in Section 5. Second, the model permits an examination of a single incident and its ramification, but does not provide a theory of terrorists' campaigns, where the strategic choice for combining incidents over time is investigated. Third, the intertemporal aspects can be pursued to a greater extent. An optimal control framework, whereby terrorists are concerned about recruitment and resources over time, while the government is concerned about limiting these resources, may be required to study intertemporal aspects. This is an important direction for future work. The random nature of the government cost associated with not capitulating and the randomness of -c are important to the modeling. If all of the payoffs were deterministic, then one need only work backwards to ascertain with certainty whether the government will capitulate or whether the terrorists will attack [see, e.g., Lapan and Sandler ( 1 993) and Selten ( 1 988)]. The appearance of some randomness is crucial to making the problem interesting.

4. Game theoretic analysis 2 : Terrorists' choice of targets

In this section, we set up a simple one-period game in which two governments (targets) must determine deterrence expenditures when confronting the same terrorist group 3 . This exercise allows us to show the presence of a transnational transferable externality between the governments as they decide deterrence expense. Increased deterrence in one nation augments the probability that the attack will be in the other nation. Second­ best aspects arise when two or more choice variables are considered and cooperation extends to just one. We consider a case where a single terrorist group targets one of two nations, denoted by nation i, i = 1 , 2. When nation i increases its deterrence expenditure, D( B;), the other target (nation}) experiences two "spillovers" or external effects: (i) By increasing the likelihood of terrorist failure, e; , in attacks against nation i, nation i's actions increase the likelihood of attacks, n1, against nation}. (ii) By increasing the likelihood of terrorist failure against nation i, nation i 's actions reduce the expected cost to citizens (or property) of nation} visiting (or present) in nation i. The first externality is negative, while the second is positive. Clearly, the net outcome depends on the relative strengths of the opposing externalities. In a given period, we assume that the terrorist group can attack, at most, one country. Figure 5 depicts the corresponding game tree for a symmetric game in which each

3

This section draws, in part, from Sandler and Lapan ( 1 988).

Ch. 9:

229

Terrorism: Theory and Applications Governments choose deterrence

��0(\ �0 �or:)l-

> �'

p� � )

( �cD(E\� �

a +

D(0,)

/

Terrorists decide whether to attack

\

n,

z 0 )>

()

g:

-'1ttoC'k l\t, l"J. Ofi01) '
(z(c, e)).

(9)

Rather than work directly with effort, it is more convenient to simply view the agent as choosing c at a disutility cost of cS(c, e). Thus the effort variable is suppressed entirely 1 0 . Assumptions made previously that effort decreases cost and effort induces disutility cre < 0, ¢' > 0), and that higher values of e mean that costs are higher (r e > 0) immediately imply that disutility both decreases in cost and increases in e, i.e., and

be > 0.

( 1 0)

The regularity assumption will be made that (1 1 ) This means that the marginal disutility from lowering costs becomes greater as e increases. Thus increases in e mean that both the disutility from lowering costs and the marginal disutility from lowering costs increase. This is equivalent to the property that the efficient or first-best cost level increases in e, which is also equivalent to the property that if the agent was given a fixed-price contract, the agent would choose a higher cost if his type was higher. This is of course a very intuitive requirement. We interpret higher values of e as meaning that the type is "worse". The assumption in Equation ( 1 1 ) states that as e becomes higher, we would observe the same contract resulting in higher costs. Therefore, Equation ( 1 1 ) simply formalizes what we intuitively mean by a worse-cost situation, and is a very natural assumption. This is an important point, because the main qualitative results depend on this assumption. For example, if cS was additively separable in c and e, this would imply that all types would choose the same cost. In this case, a fixed-price contract would 10

All of the early analyses of the pure self selection problem followed this practice of suppressing the effort variable. This led to the inaccurate impression that the distinction between the pure moral hazard and pure self selection models is whether an effort variable exists. This is not true. In the pure self selection model, the agent makes a decision that affects his unobservable utility and this can always be thought of as an effort choice. The distinction between the two models is whether the uncertainty over cost is symmetric or asymmetric.

W.P. Rogerson

328

extract all the rent from every type and this would be the optimal contract for the principal to offer. If Dee < 0, then worse (i.e., higher) types choose higher costs. Thus, offering a price high enough to attract the high types leaves the low types earning rent. Recall from the above discussion of the intuition of the pure self selection problem, that this was the reason that a non-trivial contracting problem exists. One more regularity assumption will be made. For any type 8, the total disutility of the agent is given by the sum of production cost, c, and the disutility of effort, b(c, 8), ( 1 2)

c + b(c, 8). It will be assumed that

( 1 3) and that for every order condition

8 there exists

a unique value of c, cF ( 8), which satisfies the first­ ( 1 4)

Therefore CF ( 8) is the unique first-best or efficient-cost choice for type e, in the sense that it minimizes total disutility of c. Total differentiation of Equation ( 1 4) yields ( 1 5) By Equations ( 1 1 ) and (1 3), this is positive, i.e., higher types should optimally produce at higher cost. Laffont and Tirole (1 986) consider an example satisfying properties ( 1 0)-( 1 4). The exampie is created by assuming that

T(e, 8) = 8 - e

( 1 6)

and that ¢>(e) is strictly increasing and strictly convex. The agent's type is therefore the value of cost if no effort is exerted. Exertion of effort results in cost reductions below 8. If r is defined by Eqation ( 1 6), then,

b(c, 8) = ¢>(8 - c).

( 1 7)

It is easy to verify that (j satisfies the assumptions stated in Equations ( 1 0)-( 1 4) . The principal's contractual design problem can now b e formally described. Gov­ ernment considers a contract, p(c). Given this contract, the principal predicts for each type of firm, e, whether that type will participate, and what cost that type will choose to produce at, if it does participate. Among the contracts that cause all types

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to participate 1 1 , the principal picks the one that minimizes his expected cost. Let c(e) denote the cost chosen by type e. Then, formally, the principal can be viewed as solving the following program: Minimize

c( ), p( )

j p(c(e)) g(e) de

subj ect to

c(e) E argmax{p(c) - c - O(c, e)} p(c( e)) - c( e) - 6(c( e), e) ;;,: 0

for every e,

for every e.

( 1 8) ( 1 9) (20)

This problem can be transformed into a well-behaved optimal control problem under various regularity assumptions. The main result is to show that a unique solution c * (e) and p * (e) exists with the following three characteristics: (i) Higher types choose strictly higher costs,

c*'(8)

>

0.

(2 1)

(ii) The lowest type, emin, chooses the first-best cost. All other types choose a cost strictly greater than the first best,

c* ( emin) = CF ( 8min) c*(8) > cF(e) for every 8 E (emin , emaxl

(22) (23)

(iii) The highest type, emax , earns zero expected utility. All other types earn positive expected utility and expected utility is strictly decreasing in type:

u*(emax) = 0,

u* ' (e)


0 and equal to the first best iff p' (c* ( 8)) = 0. That is,

(29) Let [cmin• Cmax] be the interval of costs over which p*(c) is defined. The cost Cmin is chosen by type Bmin and the cost Cmax is chosen by Bmax· Then it follows immediately that

p ' (cmin) = 0 p '(c)

>

0

for c E (cmin, Cmax l

(30) (3 1 )

That i s , the slope of p(c) equals 0 at Cmin and is strictly positive elsewhere. This is the only property of the function p(c) that fol lows from the general analysis. A fixed-price contract is one where p'(c) is identically equal to zero. Therefore, the general result is that it is optimal for the principal to offer a cost-sharing contract, in the sense that prices increase with cost. Since p*'(c) equals zero at Cmin and is strictly positive for larger values of c, the function p*(c) cannot be globally concave. However, it is possible that it may be globally convex. This possibility is illustrated in Figure 1 . The contract p*(c) is the convex function defined over [cmin• Cmaxl Each type of agent chooses a (p, c) combination off this curve to maximize his expected utility. Utility is increasing in price and decreasing in cost. Let 81 and 82 be two types with 81 < 82 . The best indifference curve which can be achieved by each type is drawn in. The key geometric

Ch. I2:

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331

property illustrated by this graph is that higher types have flatter indifference curves 1 2 . This follows from assumption ( 1 1) and is often referred to as the single crossing condition. This property is why higher types locate a tangency at a higher cost. An interesting result of Laffont and Tirole ( 1 986) and McAfee and McMillan (1 987a) is that if p*(c) is convex as drawn, it would be possible to replace the contract p*(c) with a menu of linear contracts. Consider the menu of linear contracts formed by all tangent lines to p* (c) over the interval [Cmin , Cmax l . Suppose the principal initially offered the agent this menu. It is geometrically clear that each type () would choose the tangent line at c* ( fJ) and would then choose the cost c* ( fJ). Thus, the nonlinear contract p* (c) could be implemented by offering a menu of linear contracts. Furthermore, it is straightforward to show that one can add back some symmetric additive noise to the model, E, and the menu of linear contracts continues to be optimal 13 . This result is interesting for three reasons. First, it provides a formal theoretical model consistent with the observation of only linear contracts. Second, it extends the pure self selection model to cases including a symmetric noise term, E. Third, it suggests the general idea that government should structure bargaining so that firms claiming to be lower cost select themselves into contracts where they bear a higher share of the risk. This qualitative insight is potentially quite applicable in a wide variety of situations. It turns out that it is difficult to identify broad classes of cases where p*(c) can be shown to be globally convex. In the case considered by Laffont and Tirole ( 1 986), for example, one must assume that the third derivative of the disutility function is positive in order to guarantee that p* (c) is globally convex [Rogerson ( 1 987)] . However, while this is unfortunate, it is not a "fatal flaw" of the model. In some over-all sense, p* (c) must be "generally convex" in the sense that its slope equals zero at Cmin and is positive elsewhere. Thus in many practical applications, the intuition that lower cost types should self select themselves into contracts where they bear a greater responsibility for cost overruns and underruns may turn out to be correct. More research is required on this point. Another interesting line of research explores how auditing should optimally be used in the pure self selection model [Baron and Besanko ( 1 984)].

3. 6. Pure self selection: Discussion Just as for the pure moral hazard model, the pure self selection model obviously makes a significant contribution at the level of logical foundations. It clearly and 1 2 In Figure 1, I (1 ) is an indifference curve belonging to a low (high) type. The single crossing 1 2 property means that I2 is flatter than I1 at the point where they intersect. If this property holds for all indifference curves, the tangency for type 1 must occur to the left of the tangency for type 2. 1 3 See Rogerson ( 1 987) for a thorough discussion of this geometric interpretation of the menu of linear contracts result.

332

WP. Rogerson

explicitly describes the basic idea that incentive contracting may involve a trade-off between effort inducement and rent extraction, and thus supplies a theory of incentive contracting. Unfortunately, the same basic criticism also applies to this model. Namely, the technical analysis is surprisingly delicate and complex, and the general nature of the optimal contract varies tremendously depending upon the precise functional forms one assumes. Just as for the pure moral hazard model, it is possible to derive various versions of TR # 1 . Once again, the problem is that it is difficult to actually test this result. Furthermore, since both theories predict the same result, it does not help distinguish between them. Five additional remarks should be noted about the pure self selection model. First, the basic idea underlying the pure self selection model is more complex and subtle than the basic idea underlying the moral hazard model. Thus, it is probably fair to say that the basic idea was not well understood by economists even on an intuitive basis prior to the creation of the formal models. Second, it may be that the pure self selection model is focussing on the more fundamental or important phenomenon. Asymmetric information at the time of contracting may tum out to be a more important explanation for various contracting practices than risk aversion. If all firms were risk neutral, it is not clear that contracting practices and institutions would necessarily be much different. However, if no firms had private information, there would be clearly be large differences. Third, the "linear menus" result for the pure self selection model possibly creates another testable result which will be called testable result number two (TR #2). Under the optimal menu, higher-type firms select a linear contract with a higher value of f3 and earn lower rents. The term "rent" refers to the agent's total utility including the unobservable part. Therefore, if we observed the same contracting problem played out n times, where nature drew an independent identically distributed (iid) value of e each time, we would observe a negative correlation between f3 and total utility. This is TR #2. Testable Result #2: Firms operating under linear contracts with higher values of f3 should earn lower rents. It is a well-accepted stylized fact that the measured ex-post rate of accounting profit earned by firms on fixed-price contracts is greater than the measure ex-post rate of accounting profit earned by firms on cost-reimbursement contracts. One might interpret this as supporting TR #2; however, this argument is problematic. The model predicts a correlation between unmeasurable total utility, p(c) - c - c5(c, 8), and {3; it does not predict a relationship between measured profit, p(c) - c , and {3. Since the key feature of the model that generates all of the results is that there is unmeasurable utility, abstracting away from this for the purposes of creating testable predictions is clearly inappropriate. This stylized fact is most straightforwardly explained by some sort of risk/expected return relationship. Therefore, although testable results may flow from the linear menus analysis, TR #2 is not such a result.

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Fourth, it may be that the linear menus analysis may help government to create better negotiation strategies with firms by explicitly offering them menu choices [see Reichelstein ( 1 992) for a very interesting analysis along these lines] . Fifth, the SPP proceeds under the relatively artificial bargaining structure that government makes a single take-it-or-leave-it offer. In the moral hazard model, where information is symmetric at the time of contracting, this assumption is no great cause for concern; but, in the pure self selection model, where information is asymmetric, this assumption is much less palatable. Institutions that affect negotiations and the government's ability to commit may play a much more important role in determining contracting outcomes in this case. In support of this point, it is interesting to note that the pure self selection model has had its greatest success in explaining behavior, precisely in situations where commitment is not an issue. This is in models of a monopoly practicing price discrimination in a market with large number of anonymous consumers. A firm facing a large anonymous market of consumers truly does make a take-it-or-leave-it offer when it publishes a price schedule 1 4 .

3. 7. The general model A general model would allow both types of cost uncertainty to exist simultaneously, and would allow the agent to be risk averse. This model would contain elements of both the pure moral hazard and pure self selection model, but has not yet been extensively analyzed [see Baron and Besanko (1 987b, 1 988) and McAfee and McMillan ( 1 986)] . One way that some of these papers make progress is by exogenously restricting themselves to linear contracts and making other simplifying assumptions. This is a good strategy given the complexities of the general model. 4. The simple procurement problem with multiple agents

A natural way to generalize the SPP of the preceding section would be to assume that there are initially n agents capable of producing the commodity, where n is greater than one. The principal only needs to hire one agent. If there is no asymmetric information, nothing fundamental changes. The principal would face n different pure moral hazard problems. He would calculate the optimal contract for each problem and the resulting expected payment. He would then simply choose the agent to minimize his expected wage payment. If there is asymmetric information, however, the introduction of multiple potential agents creates a fundamental change. In this case, the principal can conduct some type of auction in an attempt to extract more rent from the agents. Thus the question of how the principal should design auctions to produce the lowest expected payment arises.

14 The extra structure created by observable demand curves also make the models potentially more empirically relevant.

334

W.P. Rogerson

The auctions literature has concentrated on the case where it is assumed that the principal does not measure any production costs at all, so only fixed-price contracts are possible. Of course, if there is a single agent this problem is trivial from an analytic point of view 1 5 . The pure self selection literature in a sense creates an interesting problem out of the single-agent case by assuming that some costs can be measured and that an effort variable exists which affects both measurable and unmeasurable cost. This creates a trade-off between rent extraction and effort inducement. When there are multiple agents, a non-trivial problem exists even when costs cannot be measured. There are many different ways to run a fixed-price auction for producing a commodity. Which will minimize the principal's expected procurement cost and why? The auctions literature has been one of the most successful literatures in information economics. A large number of sharp and interesting results have been derived. This literature is too voluminous to attempt to survey here [see the excellent survey by McAfee and McMillan ( 1 987b)] . This literature is mentioned simply to place it in the context of the models described in this chapter. The auctions literature simplifies the SPP by assuming that costs are unobservable so that only fixed-price contracts can be signed. Thus the issue of effort becomes irrelevant and we can simply assume that each agent has an unobservable cost of production drawn from some distribution. Anton and Yao ( 1 989, 1 992) have analyzed a number of models of "share auctions" where two firms bid prices for various shares of the total buy. This is a particularly interesting type of auction from the perspective of defense procurement because it resembles the DoD practice of dual sourcing [Anton and Yao (1 990)]. One of the main insights from these models is that, in a one-period model, it would generally be highly undesirable to conduct a share auction. The principal would almost always be better off by conducting a winner-take-all auction, because it induces more competitive behavior. Therefore, the value of dual sourcing must be that it preserves competition for the future. A number of papers have considered two-agent self selection models where extra structure is added by distinguishing between a low-cost incumbent and a higher-cost potential entrant [Anton and Yao ( 1 987), Demski, Sappington and Spiller ( 1 987), Stole ( 1 994)] . The general flavor of the results is that it may be desirable for government to commit ex-ante to use the potential entrant in circumstances where it would be cheaper to use the incumbent, ex-post. This threat can force the incumbent to bid lower. Recently, a number of papers have begun to generalize the general n-person auction model to consider cases where there is unobservable effort, measurable cost, unmeasurable disutility, and effort affects both measurable cost and unmeasurable disutility [Laffont and Tirole ( 1 9 87), McAfee and McMillan ( 1 987a), Riordan and 15 In the formal model of the previous section, it was assumed that the principal places infinite value on consuming the good. Therefore the principal would offer a fixed price equal to the lowest price the agent would accept with certainty. In a more realistic case where the principal places a finite value on consuming the good, the optimal price would generally be one where the agent refuses the contract with positive probability. Calculation of the optimal price is analytically straightforward.

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Sappington ( 1 987)]. These papers generalize the pure self selection model to the case where there are n agents. The general flavor of the result is that, in cases where it would have been optimal for the principal to offer a menu of linear contracts with a single agent, it is now optimal for the principal to announce a menu of linear contracts and a preference ordering over them, and then to have agents bid a linear contract from the menu. The agent bidding the most preferred linear contract wins the auction. An interesting technical feature of these models is that there is often a sort of "separability" between the effort-inducement problem and the rent-extraction problem. Adding more agents does not change the relationship between type and effort for the winning bidder. It only changes the amount of rent extracted. Another interesting line of research has investigated how government should run auctions where firms bid both price and quality, in situations where quality can vary and some aspects of it can be objectively measured [Che ( 1 993)]. In such cases government announces a "scoring rule" that it uses to compare bids with different prices and qualities.

5. Research and development

As discussed in Section 2, innovation is a major product of the procurement process. Producing innovation quite clearly requires unobservable "effort" on the part of defense firms. Therefore government faces an incentive problem. A natural first approach to modeling this would be to attempt to use the models developed in Sections 3 and 4. In the SPP of Sections 3 and 4, the agent exerted unobservable effort to produce units of "output". We chose to interpret units of output as units of "cost reduction", but the same mathematics would still apply if we chose another interpretation for output. In fact, most of the incentives literature does choose other interpretations. Why then, don't the models of Sections 3 and 4 describe the government's problem of inducing firms to perform R&D? To be more concrete, suppose that the value of consuming a weapons program to government is given by u and the cost of producing the program is given by c . Both of these are affected by R&D work at the design stage. Finding a better design increases u and finding a cheaper way to produce the same design decreases c. The net value or surplus from producing the program is u - c, which I will denote by s. Why can't the models of Sections 3 and 4 be applied by assuming that the agent exerts effort to produce units of s? The answer is that the models of Sections 3 and 4 assume that units of output can be objectively measured for purposes of contracting upon. For the R&D case, this would amount to assuming that government can describe all possible designs in an objectively verifiable fashion, and specify the reward that the firm will be paid depending upon what design it comes up with. Generally speaking this is not possible. There are too many possible designs and no way of objectively measuring their surplus to government. Of course the ex-post cost of production can be measured

336

WP. Rogerson

to some extent, and this is one of the factors that determines s. However, so long as the performance of the weapon cannot be completely specified at the beginning of the design phase, attempting to write contracts which rewarded the firm if the ex­ post production cost turned out to be low would create serious incentive problems. Namely, a firm could always reduce production costs by settling on a design which offered less performance. Therefore, from a modelling standpoint, the distinguishing feature of the R&D phase is that it is a principal agent problem where the agent's output cannot be objectively measured for purposes of contracting upon. Therefore the solution of signing explicit incentive contracts as modelled in Sections 3 and 4 cannot be followed. In purely commercial markets where there are generally fairly large numbers of consumers for a product, incentives for innovation are created by the patent system. A firm which invents a new idea is allowed to be the owner of it for a number of years and charge "whatever the market will bear". Thus the prospect of earning monopoly profit at the production stage gives firms the incentive to innovate. In the case of defense procurement, the policy of telling firms to invest their own money in R&D and then to charge government "whatever the market will bear" would create severe problems. Firms would generally be unwilling to invest in any R&D because there would be no guarantee of recovering any investment at the production stage, due to the hold-up problem. At a minimum, allowing prices at the production stage to be determined by "free and unfettered" bargaining would create enormous uncertainties and bargaining costs. As discussed in Section 2, one of government's main responses to this has been to directly fund a large share of R&D itself. That is, unlike most purely commercial markets, government directly buys the intermediate product R&D, as well as buying the products that incorporate this R&D. However, this does not create any incentives for firms to exert effort at the R&D stage. How does government create incentives for firms to exert effort at the design phase? The method that government appears to use is a "prize" system. Suppose that multiple firms are creating different designs at the R&D phase. Although there is no objectively verifiable signal of the value of s that each firm comes up with, there is an obj ectively verifiable signal of which firm comes up with the highest s. That is, government will choose the design with the highest value of s to enter production. Therefore, government could create incentives for innovation by committing to a set of regulatory institutions that guaranteed that firms which generate ideas good enough to be adopted by government would receive prizes in the form of economic profit on the production phase of the system. Furthermore, if profit was awarded approximately as a percentage of cost, this might also tend to award larger prizes to more important innovations, at least in a rough sense. It appears that government has followed this strategy [see Rogerson ( 1 989, 1 994) for a more extensive discussion] . The basic idea that offering a prize to the winner of a contest will create incentives for contestants to work hard, is simple and clear enough that perhaps no formal modelling is required to elucidate it. However, three more complex and

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subtle issues related to this do require modelling, and have been considered in the incentives literature. First, R&D is not simply a one-shot process where a number of firms simultaneously spend money and then each receives a design. R&D is a sequential process, where one can begin with many possible design approaches and narrow the field gradually as intermediate results become known. Taylor ( 1 995) explicitly analyzes how a prize system should be organized in light of the fact that R&D is sequential. Second, the main focus of the incentives literature has been on the role of asymmetric information at the sole source selection phase in allowing government to make credible commitments to give prizes for innovation. The issue is "How does government credibly commit to award prizes?" Suppose, as was done in Sections 3 and 4, that the principal has all the bargaining power at the source selection phase, in the sense that the principal can make a take-it-or-leave-it offer. If there is no asymmetric information at the source selection phase then, in the absence of any other commitments on the part of the principal, the agents know that they will earn no surplus at the source selection phase regardless of how good their design is. Working backwards, they will therefore have no incentive to perform R&D at the design phase. However, now suppose that there is asymmetric information at the source selection phase. Then agents will expect to earn positive rents at the source selection phase, and in many plausible situations agents will perceive that their expected rents are increasing in R&D effort, so this creates an incentive for R&D. Therefore asymmetric information at the source selection phase may be desirable because it creates a credible commitment on the part of government not to expropriate all the benefits of firms ' R&D. This then suggests that government might be able to influence the amount and quality of R&D that firms perform by committing to institutional procedures that affect its ability to extract rent at the source selection phase. In particular, by committing to procedures that reduce competition or reduce the amount of information that government has available at the source selection phase, it may be that firms' incentives to perform R&D would increase [see Laffont and Tirole ( 1 988b), Piccione and Tan ( 1 993), Riordan and Sappington ( 1 989), Tan ( 1 992), Tirole ( 1 986a), and Sappington ( 1 986) for models that explore aspects of this issue] . The third subject investigated by formal models is the "franchise bidding" aspect of the problem that is created by the fact that multiple firms typically perform R&D and then a sole source is selected for production. For a moment, ignore the effects of source selection procedures and pricing procedures in the sole source phase on firms' incentives to perform R&D this was described above. Even if firms' R&D efforts can be directly controlled by government, the fact that multiple firms bid for the sole source franchise creates some interesting questions. In particular, it is reasonable to expect that much of the profit earned at the sole source production stage will be bid away at the source selection phase. If this is true, there is no reason to necessarily insist on using regulatory institutions at the sole source production stage that extract all the rent at that stage. In particular, one could allow rents to be earned at this stage if this would create some other benefit. Two possible benefits that have -

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been discussed are creating better incentives for the sole source to lower production costs [Riordan ( 1 993), Rogerson ( 1 994)] and creating incentives for more competitive bidding at the source selection phase [Bower and Osband ( 1 99 1)]. Bower and Osband's argument is particularly clever. They build a model where allowing higher profit rates on sole source production contracts actually reduces over-all expected contractor profits and increases government's welfare. The intuition for their result is that the differential subsidization created by profit policy at the sole source phase (higher­ cost producers receive higher markups) encourages more aggressive competition at the source selection phase. This paper very strikingly illustrates the general idea that the procurement stages are interrelated and that policy instruments applied at one stage may have quite surprising and unintended consequences for behavior at other stages. Many more insights remain to be gleaned from procurement models that explicitly model procurement as occurring over three stages - design, source selection, and production - and consider the interlinkages between stages.

6.

Multiple periods of production, regulatory lag, and the ratchet effect

An important facet of many real procurement situations that the SPP abstracts away from is the fact that DoD often purchases the same product or closely related versions of the same product over a number of years. Because the design continues to evolve in difficult-to-anticipate ways, and because of uncertainty regarding future demand, long­ term contracts cannot be signed. In such situations, even if the firm is initially better informed than government, we might expect much of the firm's private information to be revealed over time as costs of production for each year are observed. One focus of the theoretical literature has been to highlight the crucial role of commitment ability in such situations. Consider the pure self selection model with a single agent from Section 3 . Now, however, assume that the procurement will occur twice and that the agent's type remains the same over both procurements. Such a model has been considered by Laffont and Tirole ( 1 988a). Let p * (c) denote the optimal contract to offer in the one-period version. It is straightforward to show that, if the principal can make a long-term commitment, the best policy for the principal is to commit to offer p * (c) both times. However, now consider what happens if the principal cannot make a binding commitment to the period-2 contact. Suppose, for the sake of argument, that the principal initially promises to offer p * (c) both periods and the agent initially believes him. Then, in period 1 , the agent will choose a cost according to his type as described in Section 3. In particular, the principal will be able to precisely infer the agent's type, since higher types choose strictly higher costs. This means that, at the start of period 2, the principal knows the agent's type. Since the principal now knows the agent's type, he will of course no longer want to offer p * (c). Realizing this at stage 1 , the agent will alter his selection of c to take into account the effects of this on the principal's period-2 choice. Laffont and Tirole ( 1 988a) solve for equilibrium behavior in this model. The general flavor of the results is that the inability to commit

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may make the principal significantly worse off, and that the formal analysis becomes much more complicated than for the one-period case, because the incentive constraints are not as well-behaved. Laffont and Tirole ( 1 990) and Baron and Besanko ( 1 987a) consider the effect of allowing government certain types of commitment ability. In reality, the most overwhelming stylized fact related to the repeat nature of procurement is that a type of simple regulatory lag behavior seems to occur [Rogerson ( 1 994)]. Each annual procurement occurs under a fixed-price procurement and this year's price is determined largely by last year's cost. This creates a distinct incentive for firms to find ways to lower costs. Namely, if they find a way to lower cost, they can "keep" the savings on the current contract. It is not completely clear how to square this observation with the theoretical models described above. Should regulatory lag be modelled as the result of government commitment or is it what we would observe when government can make no commitments? The topic of using formal incentive models to normatively and positively analyze the observed behavior of regulatory lag is an interesting subject for future research.

7.

Incentives within government 16

7.1. Introduction To focus attention on the incentive problem between government and defense firms, the discussion to this point has implicitly viewed government as a single rational actor. But DoD's budget is the size of a small country's GNP and decision­ making must necessarily be decentralized among thousands of individuals with potentially conflicting obj ectives. The way that government organizes its decision­ making procedures, and the incentives faced by individual acting in their own self­ interest, will affect how these decisions are made. Thus, government faces a massive planning, organizational, and incentive problem of its own, independent of any problems it faces with defense firms [Baron ( 1 993), Leitzel ( 1 993)]. Three underlying factors characterize the defense decision-making process. First, since final decision-making authority rests with Congress and the President, there is no single rational actor with well-defined preferences in control of defense procurement. However, this chapter will set aside political aspects of the procurement process [Mayer ( 1 990)], and instead describe the organizational problem that remains even if a single rational principal - call it "Congress" - pursued the goal of adequate defense at minimum cost. Second, the defense decision making process is enormous and complex. This means that Congress must delegate substantial decision-making authority to lower levels. Within DoD, this delegation has taken the form of individual military services 16

This section draws from Rogerson ( 1 994).

340

WP. Rogerson

essentially choosing their own weapons, while the Office of the Secretary of Defense and Congress play a supervisory role. Third, many aspects of DoD's performance like "preparedness", and whether it was accomplished at minimum cost - are very difficult to measure objectively. In the absence of convenient bottom-line measures of defense performance, it becomes harder to delegate, and more necessary for Congress to control and manage the process. Thus, while the technical complexity and sheer magnitude of the procurement process make delegation of decision-making authority necessary and desirable, the lack of objective overall performance measures limits its value. An analogy to the organizational problem of a profit-maximizing firm is illuminat­ ing. When a board of directors of a large firm delegates authority to management, it can monitor the results by using (admittedly imperfect) objective performance measures like profits and stock-market value. But there is no analog to profit or stock-market value in the Congress/DoD relationship, which is what makes the delegation problem more difficult.

7.2. Two-level models There are two different types of principal agent models that can be used to capture different aspects of the problem. One type of model is the normal two-level principal agent model where the principal is interpreted as Congress and the agents are interpreted to be the military services or other agencies within DoD. This type of model therefore completely abstracts away from the incentive problem between government and defense firms. One interesting conclusion that has emerged from this type of model is that the military services may derive some of their power to affect policy through strategically controlling program decisions made early in a program's life. A theme of the literature on government decision-making dating back to Niskanen ( 1 97 1 ) is that a goal of government bureaucrats may be to maximize the size of their own budget. It is well-accepted that military services act as though this is one of their primary goals [Fox (1 988), McNaugher ( 1 989), Stubbing (1 986)]. In Niskanen's ( 1 97 1 ) theory, bureaucrats are assumed to be able to maximize their budget by exercising a sort of monopoly power. He assumes that an individual government bureau is the only possible supplier of a particular product and is able to make Congress a take-it-or-leave-it offer. Rather than offer Congress the first-best quantity (where marginal cost equals marginal benefit), the bureau offers Congress the largest quantity that Congress would prefer to having nothing (where total cost equals total benefit). Faced with the offered quantity or nothing, Congress chooses the offered quantity. The bureau then receives a budget sufficient to produce this quantity. A problem with this theory is explaining why bureaucrats have monopoly power. Why can't Congress simply choose the quantity it wants to? In the case of defense procurement, a different, though somewhat related, theory which does not exhibit this problem can be created to explain how bureaucrats are able to increase their budget. The key fact which this theory is based on is that defense programs are executed over

Ch. 12: Incentive Models of the Defense Procurement Process

341

many years. Congress exercises budget authority and thus decides how many units to purchase each year. However, many relatively complex and technical decisions made early in the program's life affect the marginal benefits and marginal costs that Congress will face when it makes annual quantity decisions. In many cases, these early decisions are delegated to the military services and Congress has a difficult time evaluating the technical merits or consequences of these decisions. This means the military services can strategically manipulate Congress's future decisions through their decisions made early in the program's life which affect future marginal benefits and marginal costs. In this theory, the source of the bureau's power to influence its budget is its informational advantage. Congress can still be viewed as "moving first" or as designing the over-all mechanism that is played. At the outset, Congress has two choices. If it delegates certain decisions to the military, better decisions will be made in a variety of technical dimensions because of the military's greater technical expertise. However, the military may also purposely distort its decisions to alter future marginal benefits and marginal costs of the program and thus manipulate Congress's future decisions over quantities to procure. Congress must weigh the benefits and costs of delegation and then determine how much authority to delegate. Two examples of such decisions will now be described. The first example concerns the trade-off between quality and quantity. Many institutional analyses of defense procurement have argued that the same expenditures would produce a more effective defense if larger numbers of less elaborate and less technically sophisticated weapons were purchased [Gansler ( 1 980, pp. 1 5-2 1), Peck and Scherer ( 1 962, ch. 1 3) , Stubbing ( 1 986, ch. 8)]. This outcome can also be seen as the result of an agency problem between Congress and the military. Rogerson ( 1 990) describes a simple framework where the military chooses the quality of weapons, and then Congress chooses quantity. In this model, the military's goal is to maximize the benefits of military preparedness, while Congress's goal is to maximize the benefits of military preparedness minus the costs. The major result is that when quality and quantity are not good substitutes, that the military will purposely choose a quality higher than the efficient level. The intuition behind this result is that the military can increase military preparedness by purposely increasing quality above the efficient level because this induces a relatively small decrease in Congress's quantity choice. An interesting feature of this model is that the military is assumed to be as good an agent as one could realistically hope for. The military agrees with Congress's definition of military preparedness and makes a good-faith effort to maximize this. If given a fixed budget, the military in this model would always choose quality and quantity to maximize military preparedness. The distortion arises because the military is able to manipulate Congress into increasing the budget by increasing quality. In this model, budget-maximizing behavior on the part of defense bureaucrats is caused by the relatively idealistic goal of maximizing the bureau's production of social benefits. A second example concerns the decision of what scale of production facility to build. In a model related to the above quality vs. quantity model, Rogerson ( 1991 b) shows that the military can induce Congress to increase the quantity purchased of a weapon

342

W.P. Rogerson

by purposely selecting a production technology of too high a scale. The underlying insight is that higher-scale technologies exhibit higher fixed costs, but lower marginal costs. Thus, so long as Congress does not cancel the program, it will buy more when faced with a higher scale technology. This model explains the well-accepted stylized fact that weapons production systematically occurs in production facilities designed to produce at much higher rates than they are actually operated at [CBO ( 1 987), Gansler (1 989), Rogerson ( l 99 1 a)] .

7.3. Three-level models The other type of model to build is a three-level model with a principal, a supervisor, and an agent. In this model, the principal is interpreted as Congress, the supervisor as the military service, and the agent as the defense contractor. The focus of this type of model is to explicitly analyze the hierarchical nature of control within defense procurement. The study of such models is in its infancy, and a large literature on such models addressing the structure of control and authority in organizations is likely to develop over the next few years. One of the most interesting qualitative insights explored by this literature is the idea that control problems within government may affect the type of incentive arrangements that government is able to offer defense firms. In particular, Congress may limit the type of contractual arrangements that the military services have with defense contractors, because Congress is worried about being strategically manipulated by the military services. Kelman ( 1 990) argues that this explains why Congress delegates so little discretion to DoD officials. Laffont and Tirole ( 1 99 1 ) and Marshall, Meurer and Richard ( 1 994a) have built formal models that exhibit this phenomenon. Marshall, Meurer and Richard ( 1 99 1 , 1 994b) have analyzed models where the bid protest process is modelled as a device to help Congress monitor and control defense bureaucrats. An interesting issue that arises in this type of model, is modelling the possibility of collusion between the supervisor and the agent. See Tirole ( 1 986b) and Campbell ( 1 994) for some approaches to this. Tirole ( 1 986b) calculates the optimal "collusion­ proof" contract in a model where collusion occurs through legally binding contracts between the supervisor and employee. Campbell ( 1994) expands upon this line of research by modelling collusion as occurring through non-binding agreements.

8. Conclusion

Formal models of incentive contracting have contributed to our understanding of defense procurement by forcing us to think more explicitly (and thus more clearly) about the nature of the incentive and information problems that affect defense procurement. Much of the modelling thus far has been devoted to the necessary first step of considering fairly simple stylized principal agent problems. Research that builds upon these efforts, to develop models with more institutional and empirical content and

Ch. 12: Incentive Models of the Defense Procurement Process

343

models which capture aspects of the multi-stage nature of defense procurement, will surely yield many new insights over the next decade.

References Anton, J.J., and D.A. Yao, 1 987, Second sourcing and the experience curve: Price competition in defense procurement, Rand Journal of Economics 1 8, 57-76. Anton, J.J., and D.A. Yao, 1 989, Split awards, procurement and innovation, Rand Journal of Economics 20, 538-552. Anton, J.J., and D.A. Yao, 1 990, Measuring the effectiveness of competition in defense procurement: a survey of the empirical literature, Journal of Policy Analysis and Management 9, 60-79. Anton, J.J., and D.A. Yao, 1 992, Coordination in split award auctions, Quarterly Journal of Economics 1 07, 681-707. Baron, D.P., 1 989, Design of regulatory mechanisms and institutions, in: R. Schmalensee and R.D. Willig, eds., Handbook of industrial organization, Volume II (North-Holland, Amsterdam) 1 347-1447. Baron, D.P., 1 993, Defense procurement: politics, management, and incentives, in: J. Leitzel and J. Tirole, eds., Incentives and procurement contracting (Westview Press, Boulder, CO) 7-24. Baron, D.P., and D.E. Besanko, 1 984, Regulation, asymmetric information, and auditing, Rand Journal of Economics 1 5 , 447-470. Baron, D.P., and D.E. Besanko, 1 9 87a, Commitment and fairness in a dynamic regulatory relationship, Review of Economic Studies 54, 41 3-436. Baron, D.P., and D.E. Besanko, 1 987b, Monitoring, moral hazard, asymmetric information, and risk sharing in procurement contracting, Rand Journal of Economics 1 8 , 509-532. Baron, D.P., and D.E. Besanko, 1 988, Monitoring of performance in organizational contracting: The case of defense procurement, Scandinavian Journal of Economics 90, 329-356. Baron, D.P., and R.B. Myerson, 1 982, Regulating a monopolist with unknown costs, Econometrica 50, 9 1 1-930. Besanko, D.E., and D.E.M. Sappington, 1 987, Designing regulatory policy with limited information (Harwood Academic Press, London). Bower, A. G., and K. Osband, 1 99 1 , When more is less: Defense profit policy in a competitive environment, Rand Journal of Economics 22, 1 07-1 1 9. Burnett, WB., and F.M. Scherer, 1 990, The weapons industry, in: W. Adams, ed., The structure of American industry (Macmillan, New York) 289-3 17. Caillaud, B., R. Guesnerie, P. Rey and J. Tirole, 1 988, Government intervention in production and incentives theory: A review of recent contributions, Rand Journal of Economics 1 9, 1-26. Campbell, Colin, 1 994, Collusion within hierarchies, mimeograph (Northwestern University, Evanston, IL). CBO (US Congressional Budget Office), 1 987, Effects of weapons procurement stretchouts on costs and schedules (Congressional Budget Office, Washington, DC). Che, Y.-K., 1 993, Design competition through multidimensional auctions, Rand Journal of Economics 24, 668-680. Crocker, K.J., and K.J. Reynolds, 1 993, The efficiency of incomplete contracts: An empirical analysis of Air Force engine procurement, Rand Journal of Economics 24, 1 26-146. Demski, J.S., D.E.M. Sappington and P.T. Spiller, 1 987, Managing supplier switching, Rand Journal of Economics 1 8, 77-97. Fox, J.R., 1 988, The Defense management challenge (Harvard Business School Press, Boston, MA). Gansler, J.S., 1 980, The defense industry (MIT Press, Cambridge). Gansler, J.S., 1 989, Affording defense (MIT Press, Cambridge). Goldberg, VP., 1 976, Regulation and administered contracts, Bell Journal of Economics 7, 426-448.

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Grossman, S.J., and O.D. Hart, 1 983, An analysis of the principal-agent problem, Econometrica 5 1 , 7-46. Guesnerie, R., and J.-J. Laffont, 1 984, A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm, Journal or Public Economics 25, 329-369. Holmstrom, B., 1 979, Moral hazard and observability, Bell Journal of Economics 19, 74-9 1 . Kelman, S., 1 990, Procurement and public management (AEI Press, Washington, DC). Kovacic, W.E., 1 99 1 , Commitment in regulation: Defense contracting and extensions to price caps, Journal of Regulatory Economics 3, 2 19-240. Laffont, J.-J., and J. Tirole, 1 986, Using cost observation to regulate firms, Journal of Political Economy 94, 6 1 4-641 . Laffont, J.-J., and J. Tirole, 1 987, Auctioning incentive contracts, Journal of Political Economy 95, 921-937. Laffont, J.-J., and J. Tirole, 1 988a, The dynamics of incentive contracts, Econometrica 56, 1 1 53-1 175. Laffont, J.-J., and J. Tirole, 1 988b, Repeated auctions of incentive contracts, investment and bidding parity, Rand Journal of Economics 1 9, 5 1 6-537. Laffont, J.-J., and J. Tirole, 1 990, Adverse selection and renegotiation in procurement, Review of Economic Studies 75, 597-626. Laffont, J.-J., and J. Tirole, 1 9 9 1 , The politics of government decisionmaking: A theory of regulatory capture, Quarterly Journal of Economics 1 06, 1 089-1 1 27. Laffont, J.-J., and J. Tirole, 1 993, A theory of incentives in procurement and regulation (MIT Press, Cambridge, MA). Leitzel, J., 1 993, The choice of what to procure, in: J. Leitzel and J. Tirole, eds., Incentives in procurement contracting (Westview Press, Boulder, CO) 9 1 -99. Lichtenberg, F.R., 1988, The private R&D investment response to federal design and technical competitions, American Economic Review 78, 550-559. Marshall, R.C., M.J. Meurer and J.-F. Richard, 1 99 1 , The private attorney general meets public contract law: Procurement oversight by protest, Hofstra Law Review 20, 1-7 1 . Marshall, R.C., M.J. Meurer and J.-F. Richard, 1994a, Unwarranted bidder exclusions and biased bid evaluations in federal procurements, mimeograph (Duke University). Marshall, R.C., M.J. Meurer and J.-F. Richard, 1 994b, Curbing agency problems in the procurement process by protest oversight, Rand Journal of Economics 25, 297-3 1 8 . Mayer, K.R., 1 990, Patterns of congressional influence in defense spending, in: R . Higgs, ed., Arms politics and the economy (Holmes and Meier, New York) 202-235. McAfee, R.P., and J. McMillan, 1 986, Bidding for contracts: A principal agent analysis, Rand Journal of Economics 17, 326-338. McAfee, R.P., and J. McMillan, 1987a, Competition for agency contracts, Rand Journal of Economics 1 8 , 296-307. McAfee, R.P., and J. McMillan, 1 987b, Auctions and bidding, Journal of Economic Literature 25, 699-738. McNaugher, T.L., 1 989, New weapons, old politics: America's military procurement muddle (Brookings Institution, Washington, DC). Mirrlees, J., 1 985, Optimal taxation, in: K. Arrow and M. lntriligator, eds., Handbook of Mathematical Economics, vol. 3 (North-Holland, Amsterdam). Monteverde, K., and D.J. Teece, 1 982, Supplier switching costs and vertical integration in the automobile industry, Bell Journal of Economics 1 3 , 206-2 1 3 . Musa, M . , and S. Rosen, 1 978, Monopoly and product quality, Journal o f Economic Theory 1 8 , 3 0 1 3 17. Niskanen, W.A., 1971, Bureaucracy and representative government (Adeline-Atherton, Chicago, IL). Peck, M.J., and F.M. Scherer, 1 962, The weapons acquisition process: An economic analysis (Graduate School of Business, Harvard University, Cambridge, MA).

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Piccione, M., and G. Tan, 1 993, Cost-reducing investment, incentives, and procurement contracts, mimeograph (University of British Columbia). Reichelstein, S., 1 992, Constructing incentive schemes for government contracts: An application of agency theory, The Accounting Review 67, 7 1 2-73 1 . Riordan, M.H., 1993, Incentives for cost reduction in defense procurement, in: J. Leitzel and J. Tirole, eds., Incentives in Procurement Contracting (Westview Press, Boulder, CO) 1 35-146. Riordan, M.H., and D.E.M. Sappington, 1 987, Awarding monopoly franchises, American Economic Review 77, 375-387. Riordan, M.H., and D.E.M. Sappington, 1 989, Second sourcing, Rand Journal of Economics 20, 41-58. Rogerson, W.P., 1 985, The first-order approach to principal agent problems, Econometrica 53, 1 3571 367. Rogerson, W.P., 1 987, On the optimality of menus of linear contracts, Discussion Paper 7 14R (Northwestern University Center for Mathematical Studies in Economics and Management Sciences). Rogerson, W.P., 1989, Profit regulation of defense contractors and prizes for innovation, Journal of Political Economy 97, 1 284-1 305. Rogerson, W.P., 1 990, Quality vs. quantity in military procurement, American Economic Review 80, 83-92. Rogerson, W.P., 1 9 9 1 a, Excess capacity in weapons production: An empirical analysis, Defence Economics 2, 235-250. Rogerson, W.P., 1 99 1 b, Incentives, the budgetary process, and inefficiently low production rates in defense procurement, Defence Economics 3, 1-18. Rogerson, W.P., 1 99 1 c, Profit regulation of defense contractors and prizes for innovation, R-3635-PA&E (RAND Corporation, Santa Monica, CA). Rogerson, W.P., I 992a, Overhead allocation and incentives for cost minimization in defense procurement, R-401 3-PA&E (RAND Corporation, Santa Monica, CA). Rogerson, W.P., 1 992b, Overhead allocation and incentives for cost minimization in defense procurement, The Accounting Review 67, 671-690. Rogerson, W.P., 1992c, An economics framework for analyzing DoD profit policy, R-3860-PA&E (RAND Corporation, Santa Monica, CA). Rogerson, W.P., 1 994, Economic incentives and the defense procurement process, Journal of Economic Perspectives 8, 65-90. Sandler, T., and K. Hartley, 1 995, The economics of defense (Cambridge University Press, Cambridge). Sappington, D.E.M., 1 983, Limited liability contracts between pricipal and agent, Journal of Economic Theory 29, 1 -2 1 . Sappington, D.E.M., 1 986, Commitment t o regulatory bureaucracy, Information Economics and Policy 2, 243-258. Sappington, D.E.M., 1 99 1 , Incentives in principal-agent relationships, Journal of Economic Perspectives 5, 45-66. Scherer, F.M., 1964, The weapons acquisition process: Economic incentives (Graduate School of Business, Harvard University, Cambridge, MA). Shavell, S., 1 979, Risk sharing and incentives in the principal agent relationship, Bell Journal of Economics 1 0, 55-73. Stole, L., 1994, Information expropriation and moral hazard in optimal second source auctions, Journal of Public Economics 56, 463-484. Stubbing, R.A., 1 986, The defense game (Harper and Row, New York). Tan, G., 1 992, Entry and R&D costs in procurement contracting, Journal of Economic Theory 58, 41-60. Taylor, C.R., 1 995, Digging for golden carrots: An analysis of research tournaments, American Economic Review 85, forthcoming. Tirole, J., 1 986a, Procurement and renegotiation, Journal of Political Economy 94, 235-259.

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Tirole, 1, 1 986b, Hierarchies and bureaucracies, Journal of Law Economics and Organization 2, 1 8 12 1 4. Williamson, O.E., 1 985, The economic institutions of capitalism (The Free Press, New York).

Chapter

13

THE ECONOMICS OF MILITARY MANPOWER * JOHN T. WARNER Clemson University

BETH J. ASCH RAND, Santa Monica,

CA

Contents Abstract Keywords

1 . Introduction l . l . Some definitions 1 .2. Summary statistics

2.

The supply of military manpower 2. 1 . Initial enlistment supply 2. 1 . 1 . Theoretical model of the enlistment process 2 . 1 .2. Empirical models 2. 1 .3 . Empirical estimates 2.2. Retention 2.2. 1 . Theoretical models of retention 2.2.2. Empirical studies

3.

Demand for military manpower 3 . 1 . Framework 3.2. Studies of personnel productivity 3.3. Force mix issues

4.

Global procurement issue: to draft or not to draft?

4. 1 .

Economic theory of the draft

4.2. Other issues

5.

The structure of pay 5 . 1 . Stylized facts about military compensation 5.2. Theory

6.

*

Force management issues 6. 1 . Women in the military

348 348 349 349 350 352 353 354 355 357 360 360 363 367 367 368 371 373 373 379 380 380 381 386 386

We would like to thank Carl Dahlman, Judy Fernandez, Curt Gilroy, Glenn Gotz, Keith Hartley, Jim

Hosek, Bernie Rostker, and especially Todd Sandler, for comments on previous drafts. Handbook of Defonse Economics, Volume

© 1995 Elsevier Science B. V All

1,

Edited by K. Hartley and T. Sandler

rights reserved

348

J. T Warner and B.J. Asch 6.2. Reserve force management issues

7. Civilian returns to military service 8. Summary References

387 390 393 394

Abstract

The USA and other countries spend a significant portion of their defense budgets on personnel. Effective management of military forces requires an understanding of the economics of military manpower. Over the past three decades economists have produced a substantial body of research about the subject. This chapter distills this literature for a general audience. Topics surveyed include the supply of personnel, personnel productivity and the demand for personnel, procurement by conscription versus voluntary means, the structure of pay, the use of women and reservists, and the civilian return to military training and experience. It also points to directions for future research.

Keywords

military, manpower, enlistment supply, retention, draft, conscription, volunteer force, military compensation, reserves, military women, military productivity, cost effectiveness and manpower

Ch. 13: 1.

The Economics of Military Manpower

349

Introduction

The USA and other countries spend a significant portion of their defense budgets on military manpower and employ large numbers of personnel. In 1 99 1 , for example, the USA spent $84 billion on 1 .9 million active duty military personnel and 1 . 1 million in ready reserve components. It is important that policymakers have an understanding of the economics of military manpower. Effective management of military personnel requires the understanding of a number of questions including the responsiveness of personnel supply to pay and other policy tools, the optimal amount of training, the optimal experience and quality mixes, and the proper mix of pay and other incentives. Because these are all questions in applied labor economics, the study of military manpower should prove interesting to a wider audience than just those responsible for policymaking. Economists have produced a substantial literature about military manpower, but as Sherwin Rosen noted in the 1 986 Handbook of Labor Economics, much of their work is unavailable in the formal literature. The purpose of this chapter is to distill this literature for a general audience. The emphasis is on the USA, but studies based on other countries are selectively cited where appropriate. This survey proceeds as follows. The remainder of this introduction makes some preliminary definitions and presents some summary statistics about the size and composition of military forces in the USA and elsewhere. Section 2 examines the supply of military manpower. Section 3 examines the demand for military manpower by reviewing studies relating the characteristics of the force to measures of productivity. Implications for the optimal experience and quality mixes of the force are considered. Section 4 then reexamines the global manpower procurement issue: should military manpower be procured by a draft or by voluntary means? Section 5 addresses questions about the structure of compensation that are now only beginning to be studied. Section 6 looks at two contemporary force management issues: women in the military, and the management of the reserve forces and their relationship to the active forces. Section 7 examines the civilian return to military training and experience. Finally, Section 8 concludes the chapter.

1. 1. Some definitions The military personnel systems of the USA and its major allies share many common attributes. All countries distinguish between officers and enlisted personnel. Officers are usually college graduates and have leadership and command responsibilities. Enlisted personnel usually have less education and assume the responsibilities of executing the orders of the officer corps. Within each of these designations there is a fixed rank or paygrade structure consisting of between 7 and 1 0 ranks. Rank structures are hierarchical, with large numbers of personnel in low ranks and declining numbers in, and lower rates of promotion to, the upper ranks. In the USA, for example, only about 10 percent of the enlisted forces occupy the top three enlisted ranks and less than 1 5 percent of the officer forces occupy ranks of Lieutenant Colonel and above. There

J. T Warner and B.J. Asch

350

is a heavy reliance on up-or-out rules to control the rank and experience distribution of the force (especially in the USA) as well as a general lack of lateral entry. Because of the lateral entry constraint, senior personnel must be "grown" from the ranks of junior personnel. In a closed military personnel system, the steady-state distribution of the force (F) and the requirement for new enlistments (E) can be derived as follows. Let c1 be the continuation rate at year of service (YOS) t. Then the survival from the initial entry point to year t is s1 IJ�= l c1 . The total steady-state force is =

F

+ + + srE = ( + tt=! s1) E.

= E s1 E

· ··

1

The steady-state enlistment (or accession) requirement is therefore

E=

1

+

F l:t= ! St T

.

+

Manyears per accession (y) are 1 2::� 1 s1• Obviously, the factors that raise continu­ ation rates raise y and reduce E. It is important to distinguish between the total force (F) and the ready force (M). Some fraction of force is located in the training establishment and therefore not available for immediate deployment. To illustrate this idea, assume that the entire first year is spent in training and that the trainers have more than one year of experience. Let k denote the required ratio of trainers to trainees. Then the ready force is

M =F-k

(f; )

St E - E

=

( 1 - k)

f; StE.

M rises with continuation rates and with the number of enlistments, but falls with the required trainer/trainee ratio. The expression for M is easily modified to account for variations in the length of training.

1.2. Summary statistics Table 1 shows the size of the active forces and the reserve force in the USA and its major allies. The USA, Germany, and the UK maintain the largest standing military forces, with the USA by far the largest. Germany and the UK have a somewhat greater reliance on reserve forces than does the US. All countries must enlist large numbers of personnel each year to maintain the force. In Fiscal Year (FY) 1 99 1 , the US active forces accessed 200 000 new enlisted personnel and 20 000 officers. Although with the end of the Cold War force levels are declining in the USA and elsewhere, the USA

Ch. / 3:

The Economics of Military Manpower

351

Table I Force levels for USA and major allies Country USA Germany UK Canada Australia a

Ground forces

884 287 216 20 29

Naval force

a

Active total

Air force

558 31 59 12 15

1 944 408 275 78 63

502 90 7 21 19

Reserve force

1 806 697 349 37 29

Numbers given in thousands. Table 2 YOS distribution of US forces, FY 1990a

YOS

Army

Navy

Air Force

Marine Corps

Enlisted 0-4 5-1 0 1 1-20 21-30

50.2 26.3 2 1 .2 2.3

49.9 27.2 20.3 2.7

35.8 3 1 .3 27.6 5.3

59.3 23.4 1 5.3 1.8

Officers 0-5 6-1 1 12-20 21-30

35.6 29.5 25.1 9.8

45.7 26.7 1 9.5 7.3

30.4 34.4 25.3 9.2

37.5 26.5 28.2 7.5

a YOS, years of service; all values given in percent.

will still have an active force of over 1 .4 million when its drawdown is completed in FY 1 997. Table 2 shows the year of service (YOS) distribution of US enlisted and officer forces at the end of FY 1 990. The table reveals that the bulk of US personnel are found in the low YOS, with the Marine Corps having the largest percentage of inexperienced personnel and the Air Force the smallest. Less than l 0 percent of US forces have more than 20 years of experience. It is evident from the table that retention and the average experience level are higher among officers than enlisted personnel. Not revealed in the data is the substantial increase in the experience of the enlisted forces since the elimination of the US draft in 1 973 . Army enlisted personnel with more than 4 YOS (hereafter denoted "careerists") made up 32.6 percent of the Army enlisted force in FY 1 974. By 1 990 the percentage had grown to 49.8 percent. The Navy careerist percentage rose from 40.4 percent in 1 974 to 50.1 percent in 1 990. In the Air Force the percentage increased from 5 1 .3 percent to 74.2. The Marine Corps careerist growth has been smaller, 32.9 percent to 40.7 percent. The change

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J. T. Warner and B.J. Asch

in the officer experience distribution since the end of the draft has been much less dramatic. A maj or theme of the research cited below has been whether these increases in experience have led to a more productive force and a more efficient force.

2. The supply of military manpower

Studies abound of both the decision to join the military (the enlistment decision) and the decision to remain after the expiration of the initial or subsequent terms of service (the reenlistment decision). The decision to enlist or reenlist is conveniently described using standard occupational choice theory [Rosen ( 1 986)]. Suppose that there are two sectors of the economy - the military sector and the civilian sector. Individuals deciding whether to join the military must compare the pay and non-pecuniary benefits available in each sector. Military service is often arduous and involves exposure to risk and loss of life. But military service offers many non-pecuniary advantages over non-military employment - pride of service to one's country, the opportunity for travel, and more stable employment. Assume that individuals are able to weigh the many non-pecuniary aspects of employment in each sector and place an overall value on the non-pecuniaries associated with employment in each sector, rM and re , respectively. Let WM denote the military wage and w e denote the civilian wage. Then the utility ofj oining the military is UM = WM + TM while the utility of remaining in the civilian sector is Ue = W e + Te . Individuals j oin the military only if uM > ue , which implies that WM - we > Te - rM. Simply stated, individuals join only if the pay differential (WM - we ) exceeds their net preference for civilian life, r = re - rM. The distribution of T over the relevant population determines the level of the supply curve for military service and its elasticity with respect to pay. Suppose that rM and re follow a bivariate normal distribution over the eligible population with mean 11 = f.le - f.lM and variance a2 = a� + a� - 2p a ae . A positive value of f.1 indicates that, M on average, the eligible population values the non-pecuniary aspects of civilian life more than the non-pecuniary aspects of military life. The shape of the supply curve is determined by the variance of the net preference factor r, ( a2 ) . Suppose that a2 = 0. Such will be the case if (a) everyone has identical preferences for the two sectors or (b) p = I and aM = ae . If a2 = 0, then everyone has the net preference T equal to f.l, in which case no-one will j oin if wM - we < f.1 or wM < w e + f.l. In this latter formulation, we + f.1 is the individual's opportunity cost of serving in the military, i.e., the wage foregone plus the difference value he or she places on the non-pecuniary aspects of life in the two sectors. The military wage must exceed the civilian wage by the net preference factor before anyone will j oin. But if wM > we + f.1 then everyone will want to join, so that the supply curve is perfectly elastic at wM = we + f.l. In the case of homogeneous preferences the parameter is the compensating wage differential required to make all individuals indifferent between military and civilian service. It follows that the more heterogeneous preferences are (the larger is a2 ) , the less elastic the supply curve will be. Figure I sketches two different supply curves on

Ch. 13:

The Economics of Military Manpower

353 Large cr2

Military Wage

0

.5N

Small cr2

Number of Enlistments

Figure 1 . Enlistment supply curves based on small and large variations in preferences for military service.

the assumption that the net preference factor r is normally distributed. N is the eligible population. When preferences are heterogeneous, only individuals for whom WM - we > r are paid in excess of that required to induce them to join (or stay) and are said to earn economic rents (payments in excess of opportunity cost). The intercept of each supply curve is w e + Tmin , where Tmin is the net preference of the person who is the least averse to military service. If tastes are normally distributed, then the cumulative density function of tastes, and hence the supply curve, will be S-shaped, as illustrated in Figure 1 . When tastes are normal, enlistments are less responsive to pay when pay is very low or very high than when pay is in the middle range of possible values. If, instead, r is uniformly distributed across the population with pdff(r) l l( rmax - Tmin) , then the supply curve will be linear over the range we + Tmin to we + Tmax and a given pay change will have the same effect on enlistments at every point on the supply curve. =

2. 1. Initial enlistment supply The occupational choice framework provides a starting point for thinking about initial enlistment supply, but it needs to be expanded to understand more fully enlistment behavior. The first factor to consider is the role of human capital development in the initial enlistment decision. Individuals may j oin because they want to acquire skills that will be useful to them later. Individuals will be more willing to j oin if the skills are transferable than otherwise. Thus, the supply of potential enlistees depends upon skill transferability such that the supply curve of potential recruits to military skills that provide transferable training will lie to the right of the supply curve to the skills that provide military-specific training. The military will have to offer a higher wage in the latter skills to attract the same number of enlistments. Another human capital factor

354

J. T. Warner and B.J. Asch

is the availability of educational benefits. In the USA since World War II, individuals who successfully serve for some period of time qualify for post-service educational benefits. A second consideration is that individuals do not make their enlistment decision in a vacuum. The decision to enlist is shaped by environmental influences such as the advice of family and friends and societal attitudes towards military service. Orvis and Gahart ( 1 989) analyzed the Youth Attitude Tracking Survey, a DoD-sponsored survey of US youth, and showed the importance of these "influencers" on youth's intentions to enlist and their subsequent enlistment rates. The third consideration is that the recruiting establishment also affects enlistment outcomes. The military services make a wide range of decisions regarding how to manage recruiting resources, including selecting recruiters, training them, and allocating them to recruiting stations throughout the country and selecting the level and allocation of advertising resources across media type. The services manage recruiters by assigning them quotas for the quantity of enlistments they make and for various enlistment categories (e.g., male versus female). They also generally use incentive plans that reward recruiters for various aspects of their productivity, such as certificates, badges, and improved promotion chances. The US services emphasize the recruitment of "high quality" youth, defined as high­ school degree graduates who score in the upper half of the Armed Forces Qualification Test (AFQT) score distribution. During the 1 980s high-quality enlistments averaged about half of total Army, Navy, and Marine Corps enlistments and 7 1 % of Air Force enlistments. There have been significant swings in recruiting of high quality personnel since the beginning of the all-volunteer force (AVF) in 1 973 . Recruiting of high-quality males fell sharply in the late 1 970s but rebounded during the 1 980s. Factors that explain these swings are now considered.

2. 1. 1. Theoretical model of the enlistment process Since high-quality youth have better civilian opportunities, they are more difficult to enlist and so are thought to be supply constrained; consequently, recruiters are given more points and higher quotas for enlisting them rather than the lesser qualified. Because of these incentive and quota systems, recruiters do not passively process enlistments but may respond to enlistments by varying their level of effort and the allocation across enlistment categories. Following Dertouzos ( 1 985), the enlistment process and the role of recruiter effort can be illustrated as in Figure 2. The recruiting production possibility curve (PPC) is given by AA' . This curve shows the feasible combinations of high- (H) and low- (L) quality enlistments that a recruiter can achieve for a given set of economic conditions, recruiting resources, and net tastes for service in the population. The mix of enlistments that the recruiter chooses depends on the shape of the PPC and the incentives he or she faces. Point Q in the diagram is the recruiter's quota for high- and low-quality recruits. If an enlistment determinant such as a recruiting resource is increased, the range of feasible enlistment outcomes increases, and if recruiters continue to supply the

Ch. 13 :

The Economics of Military Manpower

355

H

L

Figure 2. Recruiting production possibilities curves.

same level of effort, the PPC shifts out to BB' . The increase in potential high-quality enlistments (the desired category of enlistments from the service's perspective) holding the number of low-quality enlistments constant is given by the movement from point Q to point M. However, the movement to M assumes that recruiters maintain effort levels. As Dertouzos ( 1 985) shows, recruiters do not have a strong incentive to overproduce because doing so can result in a higher future quota. If so, recruiters may reduce effort so that the shift in the PPC is smaller, as shown by CC'. If recruiters also have incentives to attain low-quality enlistments, their optimal outcome may therefore be a point like D, representing fewer high-quality enlistments than M. Therefore, studies that fail to account for the role of recruiter incentives will tend to underestimate the actual supply effect, the movement from Q to M.

2.1.2. Empirical models There have been two generations of research on enlistment supply during the all­ volunteer force (AVF). The first-generation models were reduced-form models that ignored the potentially important role of recruiter behavior [see, e.g., Goldberg ( 1 982), Ash, Udis and McNown ( 1 983), Dale and Gilroy ( 1 985), and Brown ( 1985) and the summary by Nelson ( 1 986)]. The second-generation models recognized that recruiters respond to their incentive plans by varying the intensity and direction of their effort and held recruiter effort constant in their analyses. These studies include Dertouzos (1 985), Daula and Smith ( 1 985), Polich, Dertouzos and Press ( 1 986), and Berner and Daula (1993). First-generation studies typically estimated a model of the form lnH = /3 ln X,

(1)

J. T. Warner and B.J. Asch

356

where H denotes high-quality enlistments and X is a vector of determinants. Since variables were entered logarithmically, parameter estimates were interpreted as supply elasticities. Following Polich, Dertouzos and Press ( 1 986), the second-generation studies recognized that recruiters maximize their utility where their welfare is assumed to depend on the number of enlistments, quotas (Q), and recruiter effort (E). Formally, (2) where QH and QL are the quota for high- and low-quality recruits, respectively. We expect: UE < 0, UQH < 0, UQL > 0, but UH > 0 and UL > 0. Recruiters are constrained in their maximization of U by the variables included in X , the factors determining the PPC in Figure 2. Accounting for recruiter utility maximization and following past literature in specifying functional form, the (structural) enlistment supply equation is specified as ln H

=

A.ln L + f3ln X + ln E,

(3)

where A, is the tradeoff between H and L on the PPC. Although E is unobserved, it is posited that the level of effort depends on how well the recruiter is performing relative to quotas, or ln E

=

ydn

(�)

+

Yz ln

(�J

.

(4)

Substituting Equation (4) into Equation (3) gives (5) Since L and H are j ointly determined, Equation (5) can be estimated by a two-step procedure using the following equation for low-quality recruits: (6) Simultaneous estimation of Equations (5) and (6) gives coefficient estimates for Equation (4) which allows identification of the underlying structural parameters in Equation (3). Daula and Smith ( 1 985) take a somewhat different approach in incorporating recruiter incentives. They estimate a switching regression model that recognizes that high-quality enlistments are demand constrained if goals are set too low (e.g., point Q is demand constrained when BB' is the PPC) and are supply constrained when Q is infeasible. When resources are increased, recruiters will move from Q to a point like D in Figure 2 in a demand-constrained environment, but to a point like M in a supply-constrained environment. Thus, the estimated effects of an increase in resources will be smaller than when enlistments are demand constrained. Daula and

Ch . 13:

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357

Smith's disequilibrium model yields qualitatively similar results to other studies that incorporate recruiter behavior, as shown below. 2. 1 . 3.

Empirical estimates

Table 3 presents elasticities estimated by studies of US Army enlistments that have controlled for recruiter behavior. [Warner ( 1 990) provides Army estimates similar to those in Table 3 and makes estimates for the other services.] Some of the estimates in Table 3 come from data generated during controlled national experiments. For example, between 1 980 and 1 98 1 , the Educational Assistance Test Program (EATP) was conducted whereby the USA was geographically divided into a control and three test cells for the purposes of estimating the effects of varying the structure of educational benefits on high-quality enlistments [Fernandez ( 1 982)] . 1 Between 1 982 and 1 984, the Enlistment Bonus Test (EBT) was conducted for the Army whereby the level and the distribution of bonuses across terms of service were varied across the control and test cells [Polich, Dertouzos and Press ( 1 986)]. Relative military pay and the civilian unemployment rate are consistently found to influence high-quality enlistments, with relative pay elasticities ranging from about 0. 1 5 to 1 .89, with a central tendency of about 0.5 to 1 .0, and unemployment elasticities ranging from 0.49 to 1 .36. Table 3 also presents estimated elasticities for various recruiting resources. Of these resources, high-quality enlistments are the most sensitive to the number of recruiters - elasticity estimates are on the order of 0.5. On the other hand, studies find much smaller elasticity estimates for national advertising, with a central tendency of around 0.05 to 0. 1 0. Polich, Dertouzos and Press ( 1 986) find that advertising has a depreciation rate of less than 1 00 percent, i.e., the positive effects of more advertising persist for some time even if advertising expenditures fall to their previous level. They estimate that the long-run effect of a change in advertising is about 1 .4 times its initial effect. Studies also find that educational benefits have a greater effect on high-quality enlistments than do enlistment bonuses. The estimates from the EATP indicate that introducing the Army College Fund in 1 982 increased high-quality enlistments by about 9 percent whereas estimates from the EBT indicate that expanding enlistment bonuses increased them by about 5 percent (which translate into elasticity estimates of 0 . 1 7 and 0.7, respectively). Both the Army College Fund and the enlistment bonus programs are targeted toward specific occupations and both programs thus have the potential to channel recruits into hard-to-fill occupations. Although educational

1 The GI Bill was eliminated in 1 977 and replaced with a much less generous program called Veteran's Educational Assistance Plan (VEAP). Poor recruiting in the 1 978-1979 period brought about the EATP experiment. The Army College Fund and the Montgomery GI Bill, an enhancement to the VEAP, were outgrowths of this experiment. Unlike the GI Bill, under these programs new recruits must participate in a contribution plan to be eligible for future benefits.

J. T. Warner and B.J. Asch

358 Table 3 High-quality enlistment supply elasticity estimates M/C

UnEm

Recr

Ads

Edu

Bonus

L-Q E

c

-0.02to 1 1 d

0.49

0.56

0.59

0.09b

b

-0.55 g

0.94

0.60

0.06

b

1 .20

0.59

0.15

0.05

0.14

0 . 1 5-0.62

0.57-0.65

0.48- 1 . 1 5

0.43-0.72

0 . 1 6-0. 1 7

0.48

0.49

0.27

0.21

1 .89

1 .36

1.11

O.J3b

c

0.99

0.83

0.07 k

c

0.82

Table based on Berner and Daula ( 1 993) Abbreviations: M/C, Relative military to civilian pay; UnEm, Unemployment rate; Recr, Recruiters; Ads, National advertising; Edu, Educational benefits; Bonus, Enlistment bonus; L-Q E, Low-quality enlistments; H-Q G, High-quality goal. b Impressions, not expenditures. ' Study has dummy variables for the availability of various educational benefit programs, but does not estimate an elasticity of supply with respect to educational benefit levels. d Study disaggregates low-quality enlistments into two groups: AFQT category 1-3A, Non-high school graduates, and Other Enlistments (AFQT categories 3B-4). The first estimate shown is for Other Enlistments. ' Pooled sample. a

a

-0.04

r

-0.31

H-Q Goal 0.41

l '·f

0.22

2h

0.33

41

-0.29

3' 5k

0.46

c

c

Ref.

1 m,f

-0.20 to 0.38 d -0.08 to 0 . 1 7 e

0.19

1 n,f

Panel data, recruiting battalion by month,

I 0/80-6/84. The results shown do not account

for battalion effects. They do not report their results for the pooled sample. g Civilian pay only, not relative military to civilian pay. h Panel data, Military Entrance Processing Stations (MEPS) by month, 7/8 1-6/84. Data are expressed as difference from corresponding month in base period, 7/8 1-6/82. i Panel data, recruiting battalion by month, I 0/80-9/88. j Panel data, recruiting battalion by quarter, ! 98 1-1 990. k Berner and Daula ( 1 993). Panel data, recruiting battalion by month, 1 0/80-1/90. Results control for endogeneity of goals. e Study has dummy variables for the availability of various benefit programs, but does not estimate an elasticity of supply with respect to bonus benefit levels. m Supply constrained. m Demand constrained.

References

( I ) Daula and Smith ( 1 985) (2) Polich, Dertouzos and Press (1 986) (3) Goldberg ( 1 9 9 1 )

(4) Kearl, Home and Gilroy ( 1 990) (5) Berner and Daula ( 1 993)

benefits have a larger market expansion effect, evidence suggests that enlistment 2 bonuses are more effective at skill-channeling. 2 Estimates show that enlistments rose by 30-40% in the skills eligible for the enlistment bonus, holding the change in the total enlistments constant [Polich et al. ( 1 986)]. The skill-channeling effect for educational benefits was estimated to be 1 7% [Fernandez (1 982)].

Ch. 13:

The Economics of Military Manpower

359

Table 4 Estimates of the marginal cost of recruiting resources Resource Entry basic pay Enlistment bonus National advertising Recruiters Educational benefits a

a

Estimated marginal cost ( 1 990 $)

34 800 1 8 600 8 1 00 7300 6900

Estimates based on Polich et al. ( 1986), Asch and Dertouzos ( 1 994), and Asch et al. (1 992).

The coefficient estimates for the high-quality quota and the high-quality/low-quality tradeoff parameter A in the table show the importance of controlling for recruiter behavior. For example, the estimate of A from Polich, Dertouzos and Press ( 1 986) of -0.3 1 implies that high-quality recruits are about 4 times as hard to recruit as low­ quality ones. Daula and Smith's 1 985 analysis implies a trade-off of about 8-to- l . Thus, if recruiters face insufficient rewards for achieving high-quality recruits (e.g., the point trade-off in the incentive plan is at worst less than 4-to- 1 ), then recruiters will allocate their effort towards achieving low-quality ones. The size and significance of the high-quality quota coefficient estimates also suggest that quotas are one of the primary determinants of high-quality enlistments. Furthermore, the importance of accounting for recruiter behavior is also seen by comparing the supply elasticity estimates when enlistments are demand-constrained versus supply-constrained (the final two rows in Table 3). These estimates are smaller in the demand-constrained environment, as predicted by theory. The interaction between recruiter incentive systems and enlistment quotas is further studied in Asch ( 1 990), Asch and Karoly (1 993), and Berner and Daula (1993). Asch (1990) finds evidence that the structure of the Navy recruiters' incentive plan affected the timing and quality mix of enlistments, while Asch and Karoly ( 1 993) show that the structure of the incentive plan for job counselors affected the number of high­ quality enlistments and the fill rates of various occupations. Berner and Daula ( 1 993) indicate evidence that recruiting goals are endogenous (e.g., their size is based on past production and supply) so that recruiters who overproduce are penalized with higher quotas. The elasticity estimates in Table 3 provide the means to compute the marginal enlistment cost of various recruiting resources. Estimates from various studies are shown in Table 4. These estimates show the importance of considering both the resource effect (e.g., the elasticities in Table 3) and the policy cost in determining the optimal mix of recruiting resources. Although Table 3 indicates that (relative) military pay has a larger elasticity than advertising, Table 4 indicates that increasing pay is a relatively costly recruiting policy while increasing advertising is not. Raising pay is costly because to attract an additional high-quality recruit DoD must also raise the pay

J T Warner and B.J Asch

360

of everyone who would have enlisted anyway (i.e., pay rents). Enlistment bonuses are also a relatively costly recruiting resource. Table 4 suggests that recruiters, advertising, and educational benefits are the most cost-effective resources. However, effectiveness is measured in terms of high-quality enlistments. If other criteria for effectiveness were used, such as skill-channeling, a different ordering might result. Withers ( 1 978) estimated enlistment supply models for the UK, Canada, Australia, and the USA for the period 1 967-1973 . Although the shortness of the time period and multicollinearity plagued the analysis for several of the countries studied, he obtained robust estimates for enlistments into the UK Army, with a pay elasticity estimate of 1 .46 and an unemployment elasticity of 0.90. 2.2.

Retention

2.2. 1 .

Theoretical models ofretention

The analysis of retention poses a theoretical problem that is generalizable to any labor market setting. Consider an individual at time period t who is considering whether to stay or leave. Suppose that the individual can stay to t + I and then leave, t + 2 and then leave, etc. The theoretical problem is deciding the time horizon that is relevant to retention decision-making. The problem is particularly important in the US military because of the lumpiness of the military income stream - individuals are vested in a sizeable pension only upon completion of20 years of service. The simpler solution was provided by the Annualized Cost of Leaving (ACOL) model [Enns, Nelson and Warner ( 1 984), Warner and Goldberg ( 1 984)]. To illustrate the ACOL approach, suppose that for an individual at year t: ( 1 ) W}" is expected military pay in each future year j, (2) w;t is civilian earnings in future year j if the individual leaves at t, (3) Wfn is civilian earnings in future year j if the individual separates after future year n, (4) Rn is the expected present value at future year n of retired pay and other separation benefits if the individual separates after year n , (5) R1 is the present value at year t of retired pay and other separation benefits if the person leaves now, (6) rm and r0 are the preference factors previously defined, and (7) is the individual's subjective discount rate on future income. Then the present value of the future benefit from staying from period t to period n is: n 00 n m w en + rc wM r Rn + "' }, + .I (7) + "' st,n = "' L..t ( 1 + p)J-t ( 1 + p)n-t L..t ( 1 + p)J-t L..t ( 1 + p)J-t · .J=I+ I ;=t+ I ;=n+ I The value of leaving immediately is: 00

L1 -- "' L..t

J=t+l

we1 +

(1

rc

1'+ p)H . + Rt .

(8)

Ch. 13:

361

The Economics of Military Manpower

The cost of leaving is Ct, n = S1,n - L1, which can be written as: n

Ct,n

=L r +l t

WM j -

(1

we

j + + p)J-t

(

(1

Rn + p)n-t - Rt

)

00

-

L

rn+l

we

we

j, t - j,n ( 1 + p)J-t

n

-

L

J�t+l

1 +p .

(9)

The first term accounts for the military-civilian wage differential over the interval from t to n, the second term measures the change in the value of retirement benefits, the third term accounts for the change in civilian opportunities brought about by service from t to n (see Section 7), and the last is the present value of the net preference for civilian life. The individual is presumed to stay if there exists at least one future time horizon over which C1,n is positive. Of course, it could be positive over multiple periods. How to separate stayers from leavers? Saying that the individual stays if there exists at least one future horizon over which C1,n is positive is equivalent to saying that the individual stays if the following is true over at least one future time horizon:

(10) The right-hand side of Equation ( 1 0) is the annualized cost of leaving, At ,n · It is the annuity equivalent of the financial loss the individual experiences by separating now rather than at future period n. The retention criterion is to stay if there exists some future period n such that A1,n exceeds the net preference for civilian life. Thus, an individual leaves only if

Let A; denote the maximum value of the annualized cost of leaving. Then the retention rate is the fraction of personnel for whom r < A ; . The model can b e implemented econometrically as i n Warner and Goldberg (1 984). The retention probability is

P

(

T

*

< A1

)

=p

(T-f-1 a

--


- - + -A 1

a a

*

)

'

where q> denotes the standard normal distribution function and f.1 and a are the mean and standard deviation of the taste distribution, respectively. This model can be estimated by probit analysis with data on individual retention decisions. The reenlistment supply curve has the S-shaped property illustrated in Figure 1 . This simple specification o f the ACOL model does not account for dynamic selection effects. If the distribution of r is normal when individuals are making their first reenlistment decision, it will not be normal among those who in fact reenlist. Those

362

J T. Warner and B.J Asch

who reenlist form a truncated or censored sample, depending upon whether there were other disturbances to the first-term reenlistment decision. Without unobservable influences to the reenlistment decision other than the taste factor r, an implication of the model is that retention rates should be unity beyond the first decision point as long as A * is increasing, which they are not. A solution is to suppose that r is a permanent (or time-invariant) taste factor, and that other unobservable factors (random disturbances) -- such as whether or not the individual likes his commanding officer, his location of assignment, and a death in the family - affect the retention decision at each point in time. Suppose that £1 is a normally distributed random disturbance factor at time t with mean 0 and standard deviation a,. The probability that the individual stays at the end of any period t is

Since the r:: 's are independent over time, the cumulative probability of retention for t periods is

Individuals with stronger preferences for civilian life have a lower probability of survival than individuals with stronger preferences for military life. The decomposition of errors into permanent and transitory components gives rise to a panel probit model. [See Black, Moffitt and Warner ( 1 990) for more details.] When the permanent factor is not degenerate, conditional retention rates will rise with t as those with a stronger net preference for civilian life leave and those with as stronger taste for military life remain. The panel probit model thus explains the observed tendency for retention rates to rise with YOS. The model also has the feature that retention rates at different terms are not independent of one another. A higher reenlistment bonus at one reenlistment point will serve to retain more individuals on the margin of a retention decision, but these individuals will be less likely to stay at the end of the next term than others who would have stayed without the bonus. (Survival through both terms will increase unless random factors play no role in retention decisions.) Despite its frequent use in empirical studies, the ACOL model has theoretical shortcomings, as Gotz and McCall ( 1 984) and Gotz ( 1 990) have pointed out. Because it is based on a single dominant time horizon, the model is not consistent with fully rational decision-making. If individuals are aware that random factors might cause them to leave at each future point they will be uncertain about the exact separation date. In addition to random disturbances that might induce separation, another source of uncertainty is promotion and the likelihood of being involuntarily separated at some future date if not promoted. Because it is based on a single, dominant time horizon,

Ch. 13:

The Economics of Military Manpower

363

the model may fail to capture important elements of decision-making or adequately predict certain policy changes. Gotz and McCall ( 1 980, 1 984) developed a theoretically more appealing model of the following form. Let i denote an individual's rank and represent the probability of promotion. Assume that promotions occur at the start of a given period after last period's retention decision. Let V denote expected future utility and {3 = 1 1(1 + p), where p is the individual's personal discount rate. Then the model has the following structure:

m

S;,t = Jr;+l,t+l (w�l,t+l + r + {3V;+1,t+ 1 ) + ( 1 - Jr;+l,t+l ) ( W�+ l + rm + {3 Vi,t+1) , G7,1 = S;,t - L;,t. cfJ;,t = Pr(G7,1 + E;,t 0), V;,t+l = cfJ;,t+l [ni+1,t+2 Si+1,t+2 + ( 1 - Jr;+ l,t+2 ) S;,t+2] + ( 1 - cfJi,t+1 ) L;,t+1· >

( 1 1)

The first equation of ( 1 1 ) says that the value of staying in rank i at the end of period t is a weighted average of utility if promoted and utility if not promoted, with the probability of promotion being the weight. The expected gain from staying (or expected cost of leaving) is the difference between expected utility if the individual stays and the value of leaving immediately (which is now permitted to depend upon rank). The probability of staying is the probability that G71 + E1 is positive. Finally, expected utility in any rank i at the end of period t + 1 is � weighted average of the value of staying and the value of leaving, with the probability of staying supplying the weight. Individuals must begin at the maximum possible YOS (usually, 30) and solve the model recursively to obtain the values of S , V, L, and G * , and cfJ for each possible rank and YOS prior to the maximum YOS. If a rank has a mandatory separation point prior to YOS 30 then cfJ is set to zero and V is set to L at that point. The structure in Equation ( 1 1 ) has an easy interpretation: in making retention decisions, individuals evaluate the payoff to all possible promotion and separation sequences that they might follow and weight those sequence by their probabilities of occurrence, which depend on tastes, the importance of random shocks to retention decisions, and the likelihood of promotion at each rank-YOS point. G7,1 is simply the expected value of all possible future sequences minus the value of immediate separation. Equations for the probability that an individual will remain in service from period 1 to period t (and for cohort survival) can be specified analogously to those for the ACOL model.

2.2.2. Empirical studies Since the start of the AVF, economists have conducted many studies of retention of US military personnel. Some studies have used grouped data, where the unit of observation was the reenlistment rate in a given occupation/YOS cell at a point in time; others have used maximum likelihood logit or probit techniques with data on individuals. Two have estimated trivariate logit models that distinguish between reenlistments (contracts of 3 to 6 years), extensions (contracts of less than 3 years), and separations. Some

J. T.

364

Warner and B.J. Asch

Table 5 Studies of reenlistment Study

Kleinman and Shughart ( 1 974)• Warner and Goldberg ( 1 984)b

Period

1 966-1967 1 968-1969 1 971-1 972 1 974-1978

Goldberg and Warner ( 1 982) '

1 974-1 980

Hosek and Peterson ( 1 985)d

1 976-19 8 1

Service

Skill

Navy

Pooled

Term

Navy

Ship maintenance Aviation maintenance Administration Electronics Navy Aviation maintenance Administration Air Force Pooled

1 ,2 1 ,2 1 ,2

I

2 Cooke, Marcus and Quester ( 1 992) ' Quester and Adedeji ( 1 9 9 1 ) ' Smith, Sylwester and Villa ( 1 9 9 1 ) ' Buddin et al. ( 1 992) g

1979-1988

Navy

24 ratings

1 980-1990

Marine Corps Army

Pooled

1 974-1 983 entrants 1 983-1 989

Army

Infantry Maintenance Administration Pooled

Daula and Moffitt ( 1 99 1 , 1 992) k Gotz and McCall ( 1 984) 1

1 974-1 983 entrants 1 973-1977

Army

Air Force Pilots Nonrated officers

SRBM effect

2.27 2.40 4.24 2. 1 2 2.46

0.02 to 0.025

0.023 0.032

2.44 0.042 1 .89, 2.65 0.022, 0.029 2.38, 2.98 0.034, 0.064 1 .78, 2.50 0.033, 0.065 0.02 (install) 3.8 0.025 (lump-sum) 1 .7 0.024 (install) 0.022 (lump-sum) 1 .64 0.025 (main effect) 0.0 1 1 (sea-intensive) 0.066

2.1 1 ,2 1 ,2 1 ,2

I

Infantry Comm. & Intel!. Elec. & mech. maint. Air Force Pooled

Electronics Administration Elec. & mech. maint. Infantry

Pay elasticity

1 .29, 0.86 1 .76, 1 . 1 2 1 .90, 1 .76 1 .60g 1 .05 h 1 .8 0 i l . l4i 1 .40h 1 .34 h 0.87 h 1.15 g 1 .02 h 0.7 8 i 0.34i 1.17h 0.50h 1 .3 5 h

1 ,2

large

YOS 7-8 YOS 6-7

0.8 1 .4

continued on next page

Ch. 13:

365

The Economics of Military Manpower

Table 5, continued Study

Period

1 979-1990 Mackin, Hogan and Mairs ( 1 993)m

a

Service

Skill

Term

Pay elasticity

Army

Infantry officers

YOS 4-10 YOS 4-10

0.9 1 .55

Signal Corps officers

SRBM effect

Grouped data, logit model of reenlistment vs. separation, pay variable is log((M+B)/C).

b Microdata, probit of reenlistment vs. separation, pay variable is ACOL. ' Grouped data, trivariate logit model of reenlistment, extension, and separation, pay variable is ACOL. Grouped data, trivariate logit model of reenlistment, extension, and separation, pay variables are (M/C) ratio and SRBM. ' Microdata, logit model of reenlistment vs. separation, pay variables are (M/C) ratio and SRBM. f Microdata, bivariate probit model of first- and second-term reenlistment vs. separation, pay variable is ACOL. g Microdata, standard model of reenlistment vs. separation, pay variables are (M/C) ratio unadjusted for promotion timing and SRBM. h Microdata, two-equation model of months to E-5 and reenlistment vs. separation, pay variables are (M/C) adjusted for promotion timing and SRBM. ' Microdata, standard model of reenlistment vs. separation, pay variable is ACOL unadjusted for promotion timing. i Microdata, two-equation model of months to E-5 and reenlistment vs. separation, pay variable is ACOL adjusted for promotion timing. k Microdata, panel probit of first- and second-term reenlistment decisions; pay variable is the stochastic cost of leaving. 1 Microdata, panel model of stay-leave decisions in three-year window around end of initial obligation; pay variable is stochastic cost of leaving. Microdata, panel probit of stay-leave decisions in YOS 4-10, pay variable is ACOL. d

m

studies have taken a "reduced form" approach that includes ratios of military to civilian pay (W M /Wc ) and Selected Reenlistment Bonus (SRB) program variables separately 3 ; others have taken a more structural approach, including bonuses in the calculation of ACOL or some other measure of relative pay. Personal attributes, environmental variables such as the civilian unemployment rate, and controls for military occupation or other in-service effects are sometimes included. Table 5 summarizes the evidence from the more comprehensive studies of reenlistment. The table records the period of observation, service/skill group that

3 The US military services use the SRB to influence reenlistments at the first term (3-6 YOS) and second term (7-10 YOS). The Navy briefly paid third-term bonuses (1 1-14 YOS) in the early to mid- 1 980s. The services set an SRB multiplier (SRBM) for each skill and reenlistment zone that ranges from 0 to 6. Individuals may reenlist for a period of 3 to 6 years and receive a bonus equal to SRBM x monthly basic pay x years of reenlistment. Prior to April 1 979, bonuses were paid in installments on the anniversary dates of the reenlistment. From that time until mid-FY 1 982 they were paid in lump-sum at the time of reenlistment. Since then they have been paid partly in lump-sum and partly in installments.

366

J. T Warner and B.J. Asch

is the basis of analysis, term of service, the pay elasticity calculated by the study (%�r/%� WM ), and the estimated effect of a one-level increase in the SRBM. Pay is found to have a significant positive effect on retention. Early studies estimated retention elasticities in excess of 2.0 and SRBM effects of around 0.02-0.03, implying that a one-level increase generates 2-3 more reenlistments per 1 00 eligible. Lump-sum bonuses have a slightly larger impact than installment bonuses. While pay and bonuses generally have a positive impact, elasticities and bonus effects are smaller in skills with the more arduous working conditions (e.g., Army Infantry and Navy sea-going ratings). More recent studies using panel methods estimate somewhat smaller (but still statistically significant) pay elasticities [e.g., Smith, Sylwester and Villa ( 1 9 9 1 )] . Buddin et al. ( 1 992) consider the joint endogeneity o f promotion timing and retention decisions and also find smaller pay elasticities once the endogeneity of promotion is considered. Studies of officer retention estimate somewhat smaller elasticities than those estimated for enlisted personnel [Gotz and McCall ( 1 984), Mackin et al. ( 1 993)]. Gotz and McCall and the two studies by Daula and Moffitt offer the only empirical applications of the dynamic retention approach and each study reports tests that indicate that the model fits the data better than the ACOL model. However, the Daula­ Moffitt pay elasticity estimates are so at odds with collective results from other studies that they must be considered preliminary at this point. The studies are in agreement about the effects of a number of other factors. Among those at the first decision point, married personnel, black personnel, and female personnel have a higher propensity to reenlist. The higher propensity for married personnel to reenlist is somewhat surprising given the significant negative impact that military assignment and rotation patterns have on the employment and earnings of military wives [Payne, Warner and Little (1 992)], and must reflect the greater value of in-kind and non-pecuniary benefits to married personnel. Studies also agree that the propensity to reenlist is higher among those who initially enlisted for a longer term. But personnel with higher education levels and higher AFQT scores are generally found to have lower propensities to reen­ list. However, the influence of demographic characteristics diminishes as YOS increases. As expected, higher civilian unemployment is usually found to cause higher reenlistment except when it induces the military to alter retention standards [Smith, Sylwester and Villa ( 1 99 1 )]. There is a negative relationship between the present value at enlistment of educational benefits and the probability of reenlistment [Smith, Sylwester and Villa ( 1 99 1), Hogan, Smith and Sylwester ( 1 99 1), Warner and Solon ( 1 99 1)]. This result is to be expected: higher educational benefits attract personnel who desire to serve for an initial enlistment and then separate to use them. Similarly, higher entry pay and higher bonuses reduce retention at the next decision point because of their role in retaining individuals at the margin [Goldberg and Warner ( 1 982), Warner and Solon ( 1 99 1 )] .

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3. Demand for military manpower

There have been significant variations in the demographic composition and experience distribution of the US armed forces during the AVF era. The question arises, do these factors matter for warfighting capability? This section briefly describes the economic approach to this question and it reviews empirical studies of the relationship between the characteristics of the force and measures of personnel productivity and the implications of these studies for the efficiency of forces with different experience and quality mixes. 3. 1.

Framework

In their annual planning process US military planners try to determine in broad terms the forces required to fight and win various kinds of wars and regional conflicts. Desired warfighting capability is then translated into requirements for forces with a given level of readiness (R). Once the desired level of R (denoted R*) is determined, managers at the various levels in the military organization set about to determine the various combinations of ready manpower (M) and equipment (K) that will deliver the desired readiness. That is, they attempt to determine the military production function relating resources (M and K) to readiness (R): R = R(M, K). Once the combinations of M and K that can deliver R* have been determined, managers attempt to determine the most efficient or cost-effective combination and configuration of resources. Given the wide variety of equipment and its complexity, identifying the production function and determining the least-cost input combination is a daunting task for the modern military organization. The rapid pace of technological change further complicates matters. The problem of finding the most cost-effective input combination can be illustrated by supposing we are looking at an infantry company. The company delivers firepower (R) based on the quantity of rifles or other weapons at its disposal (K) and the number of ready personnel (M). Suppose that R can be delivered with different combinations of M and K and that reducing M requires an increase in K in order to maintain a fixed level of R. Then, M and K are substitutes in the delivery of R. We assume that the marginal product of K (MPK = iJR/iJK) and the marginal product of M (M PM = 8R/8M) are both positive. Define the marginal rate of substitution between K and M (MRSK,M) as MPMIMPK. We assume that the substitution of M and K becomes more difficult as the resources are traded off for one another. Thus, the marginal rate of substitution declines as M is increased and K is reduced and vice versa. The cost of a given level of readiness is minimized when the inputs are used in proportions such that MPMIMPK = PMIPK (in the case of fixed input prices) or MPMIMPK = MCMIMCK (where MC denotes marginal cost, in the case in which input prices vary with the quantities of M and K). Input proportions change when the relative marginal cost of manpower changes. Just how much depends on the elasticity of substitution (a KM ) . Intuitively, aKM shows how easily the two inputs may be substituted for one another. Formally, aKM = (%f...K/M)/(%f...MPMIMPK ) . But if input prices are constant and costs are being

368

J. T. Warner and B.J. Asch

minimized, then PMIPK =MPM!MPK, so that 0KM = (%MIM)/(%MMIPK). In this latter formulation aKM shows how sensitive the input mix is to a given percentage change in the input price ratio. The analysis can be extended to questions involving labor-labor substitution. Suppose that the readiness function is R = R(K, M1 , M2 ), where M 1 and M2 are two distinct types of manpower. Then one can define the marginal rate of substitution between M 1 and M2 as (8R/8M 1 )!(8R/8M2 ) = MP1/MP2 and the partial elasticity of substitution as 021 = (%b..M2/M 1 )/(%f1MP 1 /MP2 )K=K* · In the analysis of labor-labor substitution, categories have been defined on the basis of rank, experience, and quality.

3.2. Studies ofpersonnel productivity We first survey studies of personnel productivity that attempt to estimate marginal productivities of various categories of personnel and (in some cases) derive the partial elasticities of substitution between categories. Categories are variously defined on the basis of experience, rank, and indicators of quality. These studies implicitly hold the equipment stock fixed. Then we briefly consider studies of substitution between equipment and personnel. Holding equipment constant, do personnel have positive marginal productivity? Two studies performed with US Navy data [Horowitz and Sherman ( 1 980), Beland and Quester ( 1 991 )] say yes. Both found that an increase in the manning level relative to the Navy's stated shipboard requirements for personnel improves the relevant performance measure. Better manned ships have lower maintenance downtime (Horowitz and Sherman) and are fully mission-capable a larger fraction of the time (Beland and Quester). These two studies and others cited below also found more experienced or more highly ranking personnel to be more productive than junior personnel. Using data from the 1 975 Enlisted Utilization Survey, a large survey of junior Air Force personnel and their senior enlisted supervisors, Albrecht ( 1 979) provides the most comprehensive analysis of the substitution possibilities between different experience categories of personnel. The purpose of the junior survey was to identify their supervisors and gain some other personal information. Questionnaires were then sent to senior supervisors asking them to rate the individual 's net current contribution to unit production relative to the average specialist with 4 years of experience and also their estimates of the individual's net contribution to unit production one year from now and after 4 years of service. Supervisor responses were merged with personnel records for the junior member and with manning level and other data for the individual's unit. The supervisor's evaluation of each individual was interpreted to be a marginal productivity measure. Data were aggregated by unit and mean productivity was calculated for those with from 0 to y months of experience and y to 48 months; y varied from 8 to 1 5 months for different skills. Albrecht then estimated a two-level CES production function in which in step one ln(MPo-yiMPy_48 ) was regressed on ln(Lo-y1Ly_48 ), where the term in parentheses is the ratio of personnel in the unit with 0-y months of service to personnel with y--48 months. The coefficient on the log-input ratio provides an estimate of the

Ch. 13:

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369

elasticity of substitution between personnel in the two categories. Results of the first regression were used to then calculate a weighted mean marginal product of all first­ term personnel (MPr). In step two, ln(MPr!MPc) was regressed on 1n(Lr1Lc), i.e., the ratio of first-term to career (c) personnel in the unit, to estimate the relative marginal productivity and elasticity of substitution between first-term and career personnel. Since MPc is unobservable it is moved to the right-hand side and treated as an omitted variable, and expressions for the bias in the coefficient on 1n(Lr1Lc) are evaluated. Albrecht analyzed 1 7 Air Force Specialty Codes (AFSC). Estimates of substitution elasticities within the first term ranged from 1 . 1 (Materials Facility Specialist) to 9.39 (Ground Radio Repairman), and the estimates were generally large. Elasticities of substitution between first-term and career personnel ranged from 1 .25 (Avionics Systems Specialist) to 8.3 1 (Fuels Specialist), with estimates centering around 4.0. Substitution between different categories of first-termers and between first-termers and careerists is apparently relatively easy. At the margin, careerists were estimated to be from 1 .4 1 to 2.25 times as productive as first-term personnel. The relative marginal productivity of careerists was larger, and the elasticity of substitution between first­ termers and careerists smaller, the more highly skilled the AFSC. Using a generalized Leontief production function, Marcus ( 1 982) estimated the substitution possibilities between three rank groupings of Navy enlisted aviation maintenance personnel (E l/E3, E4/E6, E7-E9). The output measures consisted of 292 observations on aviation squadron sorties and (alternatively) mission capable rates. Marcus calculated that at the sample means an additional E7-E9 has a "mission capable" marginal product 5 times larger than the marginal product of an E4/E6 and 9 times larger than the marginal product of E l!E3 personnel. The estimates imply that E4/E6 personnel are about twice as productive as E l /E3 personnel, an estimate consistent with Albrecht's. Hammond and Horowitz (1 990, 1 992) studied the relationship between pilot training time and pilot proficiency. Recent flying time and career flying time both have significant positive effects on pilot performance. The elasticity of pilot performance with respect to career hours ranges from about 0.2 to 0.6 depending on the performance measure; the elasticity with respect to recent flying hours hovers around 0.2. Although the authors argued that the results indicate a significant return to experience, especially career flying experience, the results beg the question of whether the officer selection and retention process induces the better pilots to remain in service and continue to fly and the poorer ones to separate or be reassigned early on. Is productivity related to quality measures other than experience? Indirect evidence is provided by studies of first-term enlisted survival and by studies of promotion. High-quality personnel are more likely to complete their initial enlistments [Buddin (1 988), Warner and Solon ( 1 99 1 ), Cooke and Quester (1 992)] . Furthermore, high­ quality enlistees are promoted faster [Buddin et al. (1 992), Smith, Sylwester and Villa ( 1 99 1 )] . To the extent that the propensity to complete an initial enlistment, or to be promoted, are correlated with contributions to military readiness, high-quality personnel are more productive than low-quality personnel.

370

J. T. Warner and B.J. Asch

Several studies provide more direct evidence about the quality-productivity relation­ ship. Horowitz and Sherman ( 1 980) found evidence that ship downtime decreases as the fraction of personnel who are high-school graduates or the mean AFQT score of shipboard personnel increases. Three studies of Army enlisted personnel found AFQT to be a significant predictor ofj ob performance [Scribner et al. ( 1 986), Orvis, Childress and Polich ( 1 992), Fernandez ( 1 992)]. The effect of mental ability on performance seems to be related to the complexity of equipment and the tasks to be performed. Orvis, Childress and Polich found Patriot Missile System operators' performance in air combat simulations to rise sharply with AFQT. This result is consistent with Fernandez ( 1 992). Studying the performance of teams of radio operators in troubleshooting of radio faults, she estimated that a 1 0 point increase in the mean AFQT of the team raises the probability that the team will successfully detect at least three out of six possible faults by 25 percent. Scribner et al. ( 1 986) found weaker, albeit still positive relationships between the AFQT levels of key tank crew members and crew performance on firing ranges. An important issue is the productivity effect of rotation policy. US military personnel move frequently. Since much military output is team-oriented, personnel "turbulence" may adversely affect unit cohesion and reduce performance. Indeed, the evidence suggests that such is the case. Horowitz and Sherman ( 1 980) and Beland and Quester ( 1 99 1 ) both found that Navy productivity is adversely related to crew turnover. In the latter study, the crew turnover rate averaged 1 2 percent per quarter (so that the annual crew turnover rate is almost 50 percent). The elasticity of the mission capable rate with respect to crew turnover is about -0.3 . Furthermore, for two of three ship classes studied, Beland and Quester found that a ship's mission capable rate is related to the length of time the ship 's commanding officer has been aboard ship. Kostiuk and Follmann ( 1 989) find that the productivity of Naval Reserve recruiters doubles in their first 24 months of duty but that productivity falls as recruiters approach the date of rotation to other assignments. Scribner et al. ( 1 986) estimated that doubling the time that a tank commander and his gunner spend in the crew from the average of 7 to 1 4 months would raise the crew's score by about 4 percent. These studies point out the down side of US military rotation policy. Finally, studies of capital-labor substitution are scant. Because of the longevity of much military capital equipment and the fact that the capital-labor ratio can be varied only during the initial equipment procurement stage, in the short run the substitution possibilities are limited. Over the longer run, the substitution possibilities increase as older equipment wears out and newer equipment is purchased. Clark ( 1 978) examines capital-labor substitution in the US Navy surface fleet, estimating a substitution elas­ ticity over the period 1 956-1972 of 1 . 1 3 for all (existing plus new) capital and 1 . 74 for new capital. Over the period, newer ships were designed specifically to reduce increas­ ingly relatively more expensive manpower. Ridge and Smith ( 1 99 1 ) use UK time-series data over the period 1 953-1 987 to estimate the aggregate elasticity of substitution between equipment and manpower. Because the share of manpower in total costs was stable over their data period, the elasticity of substitution is estimated to be unity.

Ch. 13:

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371

3.3. Force mix issues There has been a substantial increase in the average experience level of the US enlisted forces since the start of the AVF. Furthermore, various quality measures fell during the late 1 970s but have increased steadily since then. Throughout the 1 970s, AVF critics wondered whether a force with sufficient experience and quality to meet readiness objectives could ever be achieved. But average experience and various quality indicators improved throughout the 1 980s such that today some might question whether the experience and quality mixes are in fact too rich. A force with richer experience may be more productive, but it is also more expensive, particularly when expected future retirement liabilities are considered. The question of optimal experience or quality mix is difficult because one must begin at the unit or occupational level and then aggregate. Only a handful of studies have tried to do so. Gotz and Roll ( 1 979) attempted to derive the optimal first-term/career mix in three Army and three Air Force specialties. Each service contained a high-skill, a medium-skill, and a low-skill specialty. They began with force mixes and compensation levels in effect in FY 1 977 and varied the first-term/career mix using supply/pay relationships in the mid-range of those considered in Section 2. Their calculations considered the full range of costs from initial accession to retirement costs and they allowed the total force size to vary to maintain a constant readiness level. Readiness was based on a Cobb-Douglas production function for each specialty, with production­ function parameters set such that beginning with the observed 1 977 force mix in each skill the model predicted relative careerist marginal productivity consistent with Albrecht ( 1 979) estimates for low, medium, and high Air Force skills. They then derived the optimal aggregate career intensity for each service by weighing the intensities in the three categories by the aggregate proportions of low-, medium-, and high-skill personnel in the given service. Their results are summarized in Table 6. Calculations for the Army indicate that optimal career intensity does indeed rise with skill. (A reversal occurs in their calculations for the Air Force, apparently a result of supply-side considerations.) For comparison, the table shows the aggregate careerist percentages for the Army and Air Force in FY 1 982 and FY 1 990 and the percentages for the one-digit DoD occupation group that contains the skill in question. At an aggregate level, FY 1 982 actual intensities are close to the Gotz-Roll calculations of the optimal force mix, but the FY 1 990 forces had significantly larger careerist percentages. The growth in career content has been particularly large in the Air Force. Whether the 1 990 forces were too senior is not known; much has changed since the Gotz-Roll study. 4 But the Office of the Secretary of Defense was clearly worried, for in FY 1 990 it directed the services to

4 One change is an exogenous rise in desired retention, which reduces (say) the marginal bonus cost of retaining careerists, thereby lowering M CclM CF and increasing the optimal careerist percentage. Shifts in the occupational distribution and skill-using changes in technology could have also increased the optimal career intensity.

J. T

372

Warner and B.J. Asch

Table 6 Optimal careerist percentages as estimated by Gotz and Roll ( 1 979) Career

Optimal percentage

FY 1982

FY 1 990

50.8 '

Army Infantryman (L)

41

37. 1 '

Auto repairman (M)

48

42.8b

53.2b

Field radio repairman (H)

61

53.6 '

47.2 '

Aggregate

44

44.7

49.8

Air Force Fuel Specialist (L)

57

50.1 d

75.5 d

Aircraft maintenance (M)

60

46. 8 b

72.1 b

Ground radio repairman (H)

49

50.3 '

62.9'

Aggregate

53

52.6

64.2'

' Percentage in DoD Occupation group 0 (Combat Arms).

b Percentage in DoD Occupation group 6 (Mechanical Equipment Repair). ' Percentage in DoD Occupation group I (Electronic Equipment Repair). d Percentage in DoD Occupation group 8 (Supply/Service Handlers).

tighten retention standards for mid-career personnel. The drawdown of the active force initiated in FY 1991 necessitated the development of compensation tools for reducing the career force proportionately to the first-term force. A final comment about career content. Most of the studies have been done in a static framework. Gotz and Stanton ( 1 986) point out that the uncertainty of warfare places a premium on personnel who can perform a variety of functions and adapt quickly to different environments. Because more experienced personnel are more likely to have been cross-trained in different skills and because of their greater variety of experiences, they are more likely to adapt to the exigencies of warfare than junior personnel. Static analyses miss this component of productivity and may therefore understate the value of more experienced personnel. Only Daula and Smith (1992) have attempted to derive the optimal quality mix of personnel. Through the Army College Fund and other mechanisms, the US Army spends a lot to attract high-quality personnel. Is it efficient to do so? Daula and Smith ( 1 992) point out that once equipment is purchased, it is used in fixed proportions with personnel. The gain from high-quality personnel, they argue, comes not from personnel savings but from the reduced expenditures for equipment. They calculated that reducing the fraction of personnel in the Army's tank force who score 50 or above from 65 percent (base case) to 60 percent would save the Army about 5 million dollars per year in personnel costs, but with a lower-quality force the Army would need 1 6 more tanks to deliver the same readiness at the same cost. Improvements in the quality content of the force are more cost-effective the larger are the productivity

Ch. 13 :

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373

differences between different categories of personnel and the more expensive is the equipment. Once the equipment savings made possible by even tiny differences in the productivity of different quality categories of personnel are considered, the military's emphasis on recruiting and retaining high-quality personnel may be quite justified.

4. Global procurement issue: to draft or not to draft?

Few public policy issues have been as divisive as how to procure military manpower. The debate was particularly vociferous in the US in late 1 960s and early 1 970s. In 1969 President Nixon established the President's Commission on an AU-Volunteer Force, commonly known as the Gates Commission, to study the issue. The commission listed nine arguments against an AVF. 5 Specifically, an AVF would ( 1 ) be too costly; (2) be too inflexible in times of crisis; (3) undermine patriotism by lessening the belief that each citizen has a moral responsibility to serve the country; (4) become an elitist institution that might threaten democratic values; (5) be racially unrepresentative, (6) be a mercenary force; (7) encourage foreign military adventurism; (8) be less effec­ tive because only low-ability personnel would be attracted to service; and (9) crowd out other defense spending, thereby eroding the quantity and quality of defense. Advocates of a volunteer force, including most economists, countered by arguing that the first criticism was wrong on theoretical grounds, and the other criticisms were weak on empirical grounds. On the cost issue, Milton Friedman, who wrote extensively for the public press on this subject and was himself a member of the Gates Commission, flatly stated in his December 1 9, 1 966 Newsweek column that "the real cost of manning the armed forces now . . . is greater than the cost of manning a volunteer force of the same size because the volunteers would be the men who find military service the most attractive alternative." The report of the Gates Commission paved the way for the abolition of the US draft in 1 973. In addition to Friedman 6 , a number of economists have contributed to the draft-AVF debate [see, e.g., Oi ( 1 967), Altman and Fechter ( 1 967), Hansen and Weisbrod (1 967), Miller ( 1 968), and Fisher (1 969)]. Lee and McKenzie ( 1 992) recently laid out the most cogent framework to date for thinking about the cost issue. This section presents the economic theory of the draft versus AVF using the Lee and McKenzie framework and then it briefly considers some of the other points in the debate.

4. 1. Economic theory of the draft The economic analysis of procurement method starts with the fact that military service imposes on a given service member the opportunity cost we + r. The opportunity cost 5

From the Report of the President�· Commission on an All-Volunteer Armed Force, pp. 5-17. selection of Friedman's pieces on the draft is provided in Friedman (1 972).

6 A

J. T Warner and B.J. Asch

374

of providing a force of a given size must be distinguished from the budgetary cost, i.e., the military wage bill that is paid by taxpayers. Analysts of the 1 960s, Friedman included, treated the budgetary cost as a pure transfer from taxpayers and argued that when the military wage is below a soldier's supply price, the soldier is bearing a conscription tax that is a pure transfer to taxpayers. Conversely, the higher pay in a volunteer system was treated as a pure transfer from taxpayers to service members. To develop the cost of either method, assume that the military force F is comprised of first-termers (Ft ) and careerists (F2 ) and that the first-term and career periods are both of length 1 . Let E be the number of enlistments in a given time period and c1 denote the continuation rate at the end of the initial enlistment period. Therefore, in a steady state, F1 = E and F2 = c1E, so that F = E + c1 E = ( l + c1 )E. Assume that the military pays a constant wage WM that is independent of period of service. The wage bill is therefore WM ( l + c1 )E. Consider the supply of personnel to the military. Recall from Section 2. 1 that on the assumption of a uniform distribution of r the supply curve for military service is the linear function E = a' + b' WM , from which we may solve for WM : W M = a + bE. Each point on the supply curve represents the marginal person's opportunity cost of service. Therefore, in a volunteer system the first-period opportunity cost of E enlistees is the area under the supply curve from 0 to E: aE + 0.5bE2 . If the condition WM > W C + T holds at the entry point, then in the absence of changes in military pay or civilian wages and preferences, it will hold at the end of the first term, so that c1 = 1 (all volunteers stay for both periods) and the total force F = 2E. Therefore the opportunity cost of the volunteer force is 2aE + bE2 = aF + 0 .25bF2 . Now consider the opportunity cost of a draft. Assume that a cohort of size N comes of age each period and is at risk of being drafted in that period. But even under a draft there will be V volunteers whose marginal opportunity costs are less than WM . The average opportunity cost of these V volunteers is a + 0.5b V, and their total opportunity cost is a V + 0.5bV2 . Now, if E is the number of required enlistments, the military will have to draft E - V individuals. If E - V individuals are drafted at random from among those with opportunity costs in excess of a + b V, then the average opportunity cost of these individuals will be the mid-point on the supply curve between V and N, or a + 0.5b(N - V). The average first-period opportunity cost of the E enlistments is therefore the weighted average E- V V [a + 0. 5b(N + V)] + E (a + 0.5bV) � and the total first-period opportunity cost of E enlistments is aE + 0. 5b(EN + E V - N V). Since V volunteers stay for the second term with opportunity cost a V + 0.5b V2 , the opportunity cost of the total force can be expressed as aE + 0. 5b(EN + E V - V) + a V + b V2 .

Ch. 13:

The Economics ofMilitary Manpower

Using the facts that c 1 is

375

= VIE and E = F/(1 + c 1 ) , the opportunity cost of the draft force

It

may be shown that this sum is larger than the opportunity cost of the volunteer force as long as one of the following is true: ( 1 ) c 1 > 0 (the draft cohort contains some volunteers) or (2) F < 2N (not everyone in the population must serve) 7. Since it is usually the case that the military does not need for everyone in the draftable cohorts to serve, and since under the draft the enlistment cohorts contain some volunteers who reenlist, the volunteer system unambiguously has the lower opportunity cost. Since the budgetary cost of a military was treated as a pure transfer from taxpayers to soldiers, the opportunity cost difference was taken to be the social cost of a draft and was almost always positive. Hence the profession's almost unanimous pronouncement that the volunteer system is preferable to a draft. Lee and McKenzie recognized that the military wage bill is not a pure transfer, but itself involves a cost. The reason is simple: when the government raises taxes (or prints money) in order to pay the military wage bill, the higher tax rates will, in general, cause distortions in economic behavior that impose deadweight losses on the economy. Browning ( 1 987), for instance, finds the deadweight loss from income tax distortions to labor supply to be about 30-40 cents per dollar of tax revenue. Thus, a volunteer force, with its higher wage bill, will impose a larger deadweight loss from taxation than a draft force. It is therefore ambiguous whether a draft force has lower cost once the deadweight loss from taxation is considered. The deadweight loss from taxation due to each procurement method is obtained as follows. First, the military wage bill is WM F. But since the marginal supply price is a + bE, the volunteer force wage bill will be (a + bE)F = (a + bF/2)F = aF + 0.5bF2 . Let [3 be the deadweight loss per dollar of tax revenue. Then the deadweight loss arising from this wage bill is (aF + 0.5bF2 ). The deadweight loss from taxation under the draft is WMF. Since wM is fixed under the draft and does not rise with E, the deadweight loss from taxation required to pay the troops does not rise as fast under the draft as under a volunteer force. Consider now training costs. Suppose that under either system training is given in the first period of service and that d is the cost of training a new recruit. Then under a volunteer force the training cost is dE = (d/2)F. Under a draft, the training cost is dE = [d/(1 + CJ)]F. Since c 1 < 1 , training costs under the draft are necessarily higher than training costs in a volunteer force of equal size. 7 With their single-period model, Lee and McKenzie derived the result that either method has the same

opportunity cost if E equals N. Our more general two-period analysis says that even F = 2N (so that everyone in two successive draftable cohorts must serve), the volunteer force will have lower opportunity cost so long as the draft force contains some volunteers (i.e., c 1 > 0).

376

J. T. Warner and B.J. Asch Total Cost

TCo

2N

0 Force Size

Figure 3. Total costs of volunteer and draft forces.

(1)

the opportunity cost of The full cost of either procurement method is the sum of the deadweight loss arising from the need to the personnel comprising the force, raise tax dollars to pay the force, and (3) training costs. Collecting the results above, the total cost of a volunteer force is:

(2)

TCA = (a(l +f3) +� ) F+0.5b(0. 5 +{3)F2.

(12)

The marginal cost of the force under the volunteer system is:

(13) MCA F. TC0= (a+f3W + -+ --F + 2) . 1 + ) F+0. 5b ( --NF+ V, TC0 F=2V c1=1 TCA=TC0. Notice that

is a linear function of M

d

C]

The total cost of a draft force is: 1 1

-

CJ

C]

C]

1

C]

(14) 2V,

If the draft force is less than 2 it will be comprised only of volunteers: there is no distinction between the draft and the volunteer force. Therefore, below and There is a discontinuity in at because at this

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point the force begins to be composed of draftees who ( 1) have higher opportunity costs than volunteers and (2) impose higher training costs because of their lower retention. As F increases beyond 2 V, c 1 = VIE = VI(F - V) decreases. Using the fact that beyond 2V, 8c 1 18F = -c 1 /E, the marginal cost of the force under the draft may be shown to be

MCD = a + 0. 5bN + f3 W M + d +

CJ

--

1

+ c1

F.

( 1 5)

F increases, MCD increases at a decreasing rate and approaches the constant a + 0.5bN + W M + d. Total force costs are plotted in Figure 3. B etween 2V and F* the volunteer force has lower total cost than a draft force. Above F* the draft force has lower total cost. Intuitively, the volunteer system is cheaper below F* (but above 2 V) because below F* the higher opportunity cost of the draft force outweighs the volunteer force's larger loss from taxation. Above F* the situation reverses and the draft becomes As

the cheaper procurement method despite its larger training costs. The crossover point F* is obtained by equating ( 1 3 ) and ( 1 5) and solving for F:

F* = F*

{3(WM - a)(l + c1) + 0.5(d + bN)(l - c,) . 0.5b[(0.25 + {3)( 1 + cJ) - cJ]

( 1 6)

decreases as both {3 and b increase. The former condition says that the draft system dominates at a lower F* the larger is the deadweight loss from taxation. An increase in b signals a less elastic enlistment supply curve, thereby lowering the enlistment level at which the draft becomes cheaper. An increase in a, which signals a reduction in the supply of enlistees, also reduces F*. But a rise in the cost of training (d) signals an increase in F*. Which system t o choose? The answer depends o n the desired force level and how it is determined. If all that matters is force size, then obviously choose the volunteer force if F < F* and draft force if F > F* . But the military is not concerned with forces of equal size so much as forces of equal readiness. There are three reasons to believe that a volunteer force will not need to be as large as a draft force to be equally ready. First, readiness is based on the number of ready personnel (denoted M above), not the total number F. Since the draft force has more personnel in training at any given time, and since some of the training must be provided by more experienced personnel, a draft force will not be as ready as a volunteer force of equal size. Second, to the extent that productivity rises with experience, a volunteer force will not need as many personnel to provide the same readiness. (Indeed, productivity studies reviewed in Section 3.2 above indicate big returns to experience in many military occupations.) Third, volunteers are likely to be more motivated than draftees, also making the volunteer force more productive than a draft force of equal size. (A theory of effort is developed in Section 5.) Importantly, as both forces increase in size, the difference in the average experience level and in personnel turnover also widens. Thus, a proportionate increase in the size of both forces will raise the effectiveness of the

J. T.

378

Warner and B.J. Asch

Value of Margina Contribution to Readiness and Marginal Cost of Force Size

CRo

0

2V

Fo

2N

Force Size

Figure 4. Optimal force size under draft and volunteer systems.

volunteer force relative to that of the draft force (i.e., 8R/8FA increases relative to 8R/8F0 as F increases). A second approach to the question of procurement method is to suppose that the military has an exogenous demand for a force with readiness level R*. If FA is the volunteer force and F0 is the draft force that will deliver the readiness level R* (where FA < F0 for the reasons just stated), then the appropriate procurement method depends on a comparison of TCA and TC0 for these two forces. As long as FA VMCRn for the three reasons cited above, and the difference between them widens as F increases for the same reasons. For either procurement method, the optimal force size is the one that equates VMCR with the marginal cost of force size. Thus, in Figure 4, FA is the optimal volunteer force and FD is the optimal draft force. Once these optimal size forces are determined, then the optimal procurement method is the one that maximizes the "surplus" from defense, i.e. the difference between the total value of the readiness provided ( VR) and the total cost (TC): S = VR - TC. (VR is the area under the relevant VMCR curve.) Thus, if SA is the surplus from force FA and Sn is the surplus from force Fn, choose the volunteer force if SA > SD · Figure 4 can be used to illustrate this approach. Suppose FA is the optimal volunteer force and F D is the optimal draft force. Then suppose that the volunteer force is expanded from FA to Fn. The change in SA (�SA) is the area A, which is the excess of increase in cost over the value of readiness. Compare this to area D (�Sn) which is the reduction in Sn brought about from reducing the draft force from FD to FA. The volunteer system is the optimal one if SA > Sn. The additional insight that follows from this approach over previous ones is that Sn will rise relative to SA the more elastic are the VMCR curves. That is, the less rapidly the value that the electorate places on additional units of defense readiness declines, the more likely the draft is to be the preferred procurement method. Outward shifts in the VMCR curves brought about by the threat of war mean larger optimal force levels and a higher likelihood that the defense surplus will be maximized through conscription. 4.2.

Other issues

It would take us too far afield to consider all of the issues raised during the US draft de­ bates. The Lee-McKenzie analysis and our generalization of it serve to make the gen­ eral point that the volunteer force is not unambiguously superior to a draft, an argument advanced informally by draft advocates such as Kester ( 1 986). The issue is ultimately empirical and hinges on questions about the elasticity of supply, the extent of the exter­ nal threat, and the productivity differences between volunteer and conscripted forces. The concern of AVF critics was that it would be "too expensive" and that its high cost would induce an underprovision of defense. Although this argument is incorrect if the choice of procurement method and force size are based on full social costs, the argument has some basis if the military behaves as a monopsonist in its choice of force size. It is clear that the military is a monopsonist in the sense that the marginal cost of expanding the force through an increase in pay is in excess of the cost as given by the supply curve (Table 4). If the VMCR curve is not vertical and if calculations of the marginal cost of force size are based on the change in the wage bill that is required to expand force size, and not the supply curve, then under an AVF the military will enlist too few personnel (and pay them too little) 8 . Despite the theoretical possibility 8

Cooper ( 1 975) was the first to analyze the monopsony problem inherent in a volunteer force.

380

J. T. Warner and B.J. Asch

that the military will hire too few personnel under an AVF, the potential loss from monopsonistic behavior does not appear large [Quester and Nakada ( 1 983)] . The fact that enlistments can be expanded relatively cheaply via tools other than pay (Table 4) diminishes the monopsony problem. Empirically, the stability of total US force size throughout the AVF period suggests that monopsony considerations have not played a large role in the determination of AVF force size. Other fears concerning a volunteer force do not seem to have materialized. It is doubtful that the volunteer force has become an elitist force that has threatened democratic values, that it has become a mercenary force, or that it has promoted adventurism abroad. A concern at the start of the AVF was that readiness would deteriorate because high-quality individuals would not volunteer. But the supply of high-quality recruits has proven sufficiently sensitive to pay, recruiting resources, and other inducements to enlist (and reenlist) that over the 20-year period of the AVF the quality of the entrants has been at least as good, if not better, than quality would have been under a draft. Furthermore, the AVF force has probably been more motivated than draft-era forces were. Whether quality could be maintained without conscription at much higher force levels is another (but now apparently less pressing) matter. The racial composition of the US force is still a contentious political issue; blacks currently make up 23 percent of the enlisted forces and 7 percent of the officer forces. Economists tend to see less problem with the racial composition of the armed forces than others [see, e.g., Tollison ( 1968)] . Finally, it is interesting to note that several US allies ended the draft earlier. The UK ended its draft in 1 957. Australia ended its draft in 1 945, reinstituted it for a time after 1 965, but is now fully volunteer again. Except for the World War II era, Canada has had a volunteer system throughout its history. Only Germany has continued to use a mixed draft-volunteer system up to the present. Conscripts currently make up 43 percent of Germany's active duty force. Perhaps their different choices of manpower procurement method have been guided by the theory developed in Section 4. 1 .

5.

The structure of pay

5. 1. Stylizedfacts about military compensation At first blush, the US military compensation system is a complex patchwork of pays and allowances. But the various items of active duty cash compensation can be conveniently grouped into three categories: (1) basic pay, which varies with rank and YOS, (2) allowances for food and housing, which vary with rank and marital status, and (3) a large number of special pays, such as enlistment and reenlistment bonuses, flight pay, sea pay, hazardous duty pay, and so forth. Basic pay accounts for about 75 percent of US outlays for active duty personnel; allowances account for 1 9 percent. Although there are a large number of special pays and allowances, together they make up only about 6 percent of cash outlays for active duty personnel.

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381

US military personnel are vested in an immediate annuity after 20 YOS; those who separate prior to YOS 20 receive nothing unless they subsequently participate in the reserves and qualify for a reserve pension beginning at age 60. The total cost of active duty manpower is the sum of active cash pay and an accrual charge for retirement. The retired pay accrual charge is over 40 percent of annual outlays for basic pay and about a quarter of total cost, indicating that the cost of funding the retirement system is substantial. It is interesting to compare US and foreign military compensation systems. Germany, like the US, has a pay and allowance system with distinctions by marital status. But the United Kingdom (UK), Canada, and Australia all have salary systems with no preference given to married personnel. Longevity increases in the US basic pay tables are based on YOS . Longevity increases in the UK, Canadian, and Australian pay tables are based on time in grade (TIG) rather than time in service. The US has no system of explicit occupational pay differentials. Pay varies by occupation only through the application of enlistment and reenlistment bonuses and other pays that depend factors related to occupation (e.g., sea pay). However, the UK has a system of "pay bands" that vary by skill based on comparisons with civilian wages. A comparison of the pay tables of these countries shows striking similarities in the rank structure of pay. The US and its allies also have generally similar retirement systems. All countries delay retirement vesting until at least the mid-career range and provide an immediate lifetime annuity to those who serve long enough to become vested. Preliminary explanations for the commonalities in the rank structure of pay and in the retirement systems are now considered.

5.2. Theory Rosen (1992) identifies two important considerations in structuring pay. In a large, hierarchical organization it is important for the organization to assign the most able personnel to the higher-ranking positions because at the higher levels even small differences in ability can have profound effects on outcomes. Thus, while more able personnel are more productive at all levels, the relative productivity of ability increases with rank. The lack of lateral entry places a constraint on the military's capacity to fill the upper ranks with the most able personnel and suggests that it must access and "sample" a larger number of personnel before identifying those capable of performing the upper-level positions than would private-sector organizations that permit lateral entry. The other important consideration is that personnel must be induced by the structure of incentives to work hard and effectively. Individual effort is costly to monitor, so rewards must be structured to induce effort supply. In the military organization, the reward for effort is promotion. In the junior ranks, promotion is based on individual skill aquisition. But beyond the junior ranks, the promotion system resembles a contest or tournament in which only a fraction of those eligible for promotion are actually selected.

J. T. Warner and B.J. Asch

382

Rosen only sketched out a model of ability sorting and effort supply in the military organization. Asch and Warner ( l 994a) formalize Rosen's arguments. Their model is briefly summarized here. Suppose that a is an individual ability parameter which is known to the individual but not to the military. Further, suppose that e;,1 denotes the amount of effort that the individual would supply in rank i at time t conditional on the structure of pay, outside opportunities, and preferences. Let Z(e;,1) denote the disutility of effort such that Z ' (e ;,1) > 0 and Z" (e ;,1) > 0. Then at each point in the career an individual with ability parameter a must decide whether to remain in service and how much effort to supply. Likewise, the military must decide whether to retain the individual and whether to promote him or her. The military decides whom to promote by administering an evaluation (E;,1) to everyone in rank i at time t, rank-ordering the evaluations, and promoting some fraction n1,1 . An individual's promotion probability (n;,1) depends on his or her ability and effort and the abilities and efforts of others (a0 and e0, respectively). The military may also use the evaluation to separate those whose evaluation E;,1 falls short of some minimum Ef:t . The model is a generalization of the Gotz-McCall dynamic programming model. It has the following structure: To begin with, the expected value of future utility at the end of period t is

v ;,t = cfJ;,tE(S;,t !G;,t + E;,t

>

0) + ( l - cfJ;,r ) L;,r,

( 1 7)

where:

cfJ;,r = pr(E'f:t < E;,r ) pr( G7,1 + E;,t > 0) = ciJf.t ciJ7,1, G7,t = ni+l,t+l [Tm + 6;+! + w� l,t+ ! + f3Vi't!,t+! - Z(eit+I )] + ( l - ni+l,t+J ) [ rm + 6; + W�+! + f3 V;,t+, - Z(e;t+J ) ] - L;,1 , L;,r = C;,t + R;,r + Fr , ni+l,t+l - n( a , e;,r, a0i,t> e0i,t> ni+l,t+l ) *

( 1 8)

·

In words, expected utility V7,1 is a weighted average of the expected return to staying and the return to leaving immediately, where the weight ciJ;,1 is the product of the (independent) probabilities that the military wants to retain the individual ( ciJf,1) and the individual wants to stay (cfJJ1 ). The expected gain to staying G71 is a weighted average of the payoff to achieving next rank in period t + l and the ret�rn to remaining in the current rank. These returns depend on the pecuniary reward associated with the ranks ( WM) and the value of rank-specific non-pecuniaries ( 6). The expected gain to staying G 71 is the expected return to staying minus the return to leaving, which equals the present value of civilian earnings ( C ;,1 ) , vested retired or separation pay (R;,1 ), and the value of non-pecuniaries in the civilian sector ( F1). Individuals desire to stay only if G;,1 + E ;,1 > 0, where E;,1 is the random shock to the retention decision. Individuals with higher permanent tastes for military service ( rm) are more likely to stay. If the individual is at a mandatory separation point in rank, then cfJ;,t = 0 and V7,1 = L;,1•

Ch. 13:

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The Economics of Military Manpower

The individual's expected future utility at the start of period

rm + W� + f3 V7,1 - Z(ei,t )·

t is: ( 1 9)

The individual supplies effort in t to maximize Equation ( 1 9). Raising effort can raise expected future utility because ( 1 ) effort raises the probability of promotion, which conveys higher monetary and non-monetary rewards, and (2) effort reduces the probability of involuntary separation arising from a failure to meet minimum performance standards. Promotion also pushes further into the future the date at which the individual might be subj ect to a high-year-of-tenure rule. The first-order condition for utility maximization is:

f3tJ>i,t [n� (w� l,t+l - w �+l + 0) as follows: ln MC

=

D1 - a ln Q,

ln MB = E>1 - {3- 1 In Q.

(24) (25)

Lichtenberg assumed that only the intercepts, and not the slopes, of the supply and demand curves are subject to revision; data limitations would not allow him to identify changes in the slopes. Equilibrium quantity at time t therefore satisfies: (26) The revision in equilibrium quantity between time 0 and time t can be calculated by subtracting Equation (23) from Equation (26): (27) The log-change in quantity is due to both supply- and demand-curve revisions, each divided by the difference between the slopes of the curves. Equation (27), along with the baseline supply curve (2 1), can under certain assumptions provide a basis for estimating the parameters a and {3. Lichtenberg had data from the Selected Acquisition Reports, for 84 major weapons systems, on the quantity- and supply-shift variables ln(Q1/Q0) and (C51-C50). Unfortunately, he lacked data on the demand shift ( E>1- E>0). But suppose, as seems reasonable, that demand shifts are uncorrelated with supply

Ch. 15: Economics of Defense R&D

453

shifts across weapons systems. Moreover, assume that a and {3 do not vary across weapons systems. Then the regression equation,

E

(28)

where the i subscript denotes weapon system i and is a disturbance term, will yield a consistent estimate of the nonlinear function of the parameters -({3-1-at 1 . Of course, neither a nor {3 can be separately identified from this equation alone, but the available data permitted him to estimate another equation which identified a. By simultaneously estimating the system of two equations, he was able to identify both parameters. His empirical results may be summarized as follows. When the data were standardized by program base year - in effect comparing a program only with those other programs entering full-scale development at about the same time - there was a significant negative correlation between quantity and cost changes. The estimated elasticity of demand was 0.55, and was significantly different from both zero and unity. This suggests that the government's demand for specific weapons is inelastic, but not perfectly inelastic. The estimates also imply that weapons acquisition is characterized by increasing returns: the mean and median values of the elasticity of total cost with respect to quantity were 0.78 and 0.72, respectively. Further analysis revealed that the negative correlation between quantity and cost revisions - hence the nonzero demand elasticity - was entirely attributable to one component of cost revisions: those associated with changes in the acquisition schedule 1 1 . The elasticity of quantity with respect to schedule-related cost increases is about twice as great as the elasticity with respect to cost increases generally. In principle, it is possible that schedule-related cost increases are due to demand-induced stretch-outs of programs rather than supply-related, or technological, shocks. But it is not clear on theoretical grounds that unobserved demand shocks could account for the correlations he observed, and the demand-shock interpretation was also not supported by one econometric attempt to correct for it. 8. Are defense R&D programs dynamically optimal?

Grossman and Shapiro ( 1986) studied the optimal pattern of outlays for a single firm pursuing an R&D program over time. Treating dynamic R&D investment as an optimal control problem facing a single firm, they characterized the profile of R&D expenditure as a single R&D project progresses. In this section, we briefly review the assumptions and implications of their model and report an analysis of data contained in the Defense 11 As Hartley and Tisdell ( 19 8 1 , p. 355) have observed, system modifications are another important source of cost escalation.

454

FR. Lichtenberg

Technical Information Center's IR&D data bank to determine whether they are broadly consistent with the theory. Grossman and Shapiro assume that a finn seeks a prize of size W and that to obtain this prize it must "travel" a distance L. The instantaneous rate of advance is determined by the rate of R&D expenditure. There are decreasing returns to effort at any point in time, given that some progress is being made, but there may be a fixed start-up cost at any moment. The firm's problem is to choose expenditures at every point in time up to some terminal date to maximize the present discounted value of net profits, subject to the constraint that total progress attained at the termination date be sufficient to complete the project. The major implication of the model is that it generally is not optimal for a finn to devote a constant level of resources to its research program, even if the relationship between effort and progress is unchanging. Rather, the finn should vary its R&D expenditure directly with the current expected value of the project. In many circumstances, this value will increase as the finn achieves progress. "Circumstances" refers to whether or not there is uncertainty about the "difficulty" of the project (i.e., the distance to be traveled) or about the relationship between effort (expenditure) and progress. They show that if neither type of uncertainty is present (the deterministic case), it is optimal to increase effort over time as the proj ect nears completion, in part because discounted R&D costs can be decreased for any given duration of the project by shifting expenditures from early to later stages. If there is only uncertainty concerning the relationship between effort and progress, a monotonously increasing effort profile remains optimal. If there is uncertainty about the difficulty of the project, the optimal pattern of investment depends on the hazard rate function. If this function is everywhere nondecreasing - i.e., if whenever success is not realized, researchers become more optimistic that a breakthrough is imminent - the optimal program again involves rising R&D outlays over time. If, alternatively, the finn learns that the project is more difficult than was originally believed, it may be optimal to reduce the scale of the R&D program, or even to abandon it entirely. Grossman and Shapiro argue that the deterministic case applies more closely to development projects than to pure research programs. Hence, their model implies that development projects should exhibit increasing effort profiles, whereas projects subject to greater uncertainty as to their difficulty (such as basic research projects) would not necessarily do so, and might be expected to exhibit flatter (or even negatively sloped) profiles. Some of the assumptions ofthe model are highly unrealistic, and one might therefore not expect actual data to be consistent with the theory. First, the model omits all R&D rivalry, i.e., strategic interaction among firms. Also, the assumption that the progress function is stationary over time may be more reasonable in some contexts than in others. It may be easier to make progress once some initial groundwork has been laid, though the groundwork itself cannot be rushed due to diminishing returns to more effort on this "subproject". This case would tend to reinforce the Grossman­ Shapiro results. But it may also be easy to make progress early on, due to a long list

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455

of "easy ideas to try". Then progress may slow once the difficult stage of the program is reached. Despite the possible lack of realism of the assumptions, it is of interest to assess the degree of consistency of the theory with the data. Lichtenberg ( 1989b) used data on over 9000 Independent R&D projects to test the hypothesis that the rate of investment in a project tends to increase as the project approaches completion. He computed, for each continuing project, the ratio (denoted R) of expected investment in the next year to average investment to date. To guard against the influence of a relatively small number of observations with very large values of R (some of which may have been outliers), he excluded from his sample observations with values of R greater than 4; his hypothesis tests are therefore likely to be conservative. The mean value of R for all projects was 1 .30 and highly significantly different from 1 ; the median was also greater than 1 ( 1 . 14), albeit smaller than the mean. This is consistent with the general implication that the rate of investment increases as the project approaches completion. But the data were not consistent with the implication that R should be lower in the case of projects involving greater uncertainty about the difficulty of completion. Mean and median values of R were essentially the same for basic research projects as they were for applied research and development; Lichtenberg (1 989b) presented evidence that the latter two categories are subject to less uncertainty than the former. He also used the IR&D data bank to develop some stylized facts about R&D in­ vestment at the project level. These are: (1) Research projects (both basic and applied) are longer and less intense than development projects; (2) the elasticity of cumulative investment with respect to project duration is greater than 1 for research projects and less than one for development projects; (3) the distributions of duration, average investment, and cumulative investment are highly skewed; (4) the shape of the duration distribution is close to lognormal, indicating that the conditional probability of project completion initially rises and then declines; (5) the degree of uncertainty about the project completion date is greater for basic research and concept formulation projects than it is for applied research and development projects. 9. Conclusions

The major conclusions of this chapter may be summarized as follows: (1) Direct R&D contracting is not the only way in which the government induces private firms to invest in defense R&D; it also does so by sponsoring design competitions and providing subsidies to "independent" R&D. (2) A considerable quantity (and share) of private R&D investment is induced by competitive defense procurement. (3) The effective rate of subsidy to independent R&D exceeds 40% - much higher than the apparent (nominal) subsidy or the subsidy to other R&D. (4) The profitability of government contractors is 68 to 82% higher than the profitability of other producers; this is consistent with the hypothesis that the former are able to shift costs from their

456

F.R. Lichtenberg

commercial operations to the government. ( 5) Both micro and aggregate estimates of the (social) "rate of return" to investment in government-funded (largely defense­ related) R&D - or its impact on productivity growth - are insignificantly different from zero, and are much smaller than estimates of the return to privately-funded R&D. (6) The best available evidence does not support the hypothesis that defense R&D tends to stimulate civilian R&D, and thereby has an indirect positive effect on productivity growth. (7) In two respects, the conduct of defense R&D and procurement appears to be "efficient" (or at least fails to be grossly inefficient). First, defense decision­ makers do seem to respond to the arrival of new information about the cost of weapons acquisition yielded by R&D: the elasticity of demand for weapons is significantly greater than zero (it is about 0.55). (8) Second, most independent R&D projects appear to be "dynamically optimal": the rate of investment increases as the project approaches completion.

References Baily, M., and A.K. Chakrabarti, 1 988, Innovation and the productivity crisis (The Brookings Institution, Washington, DC). Carmichael, J., 1 98 1 , The effects of mission-oriented public R&D spending on private industry, Journal of Finance 36, 617-627. Cohen, L., and R. Noll, 1991, The technology pork barrel (The Brookings Institution, Washington, DC). DoD (US Department of Defense), 1 985, Defense financial and investment review (Department of Defense, Washington, DC). Griliches, Z., and F.R. Lichtenberg, 1 984, R&D and productivity at the industry level: Is there still a relationship?, in: Z. Griliches, ed., R&D, patents, and productivity (University of Chicago Press, Chicago, IL) 465-496. Grossman, G.M., and C. Shapiro, 1 986, Optimal dynamic R&D programs, Rand Journal of Economics 1 7, 5 8 1 -593. Hartley, K., and C. Tisdell, 1 98 1 , Micro-economic policy (Wiley, New York). Kay, N., 1979, The innovative firm: A behavioral theory of corporate R&D (St. Martin's Press, New York). Levin, R., 1 980, Toward an empirical model of Schumpeterian competition, unpublished paper (Yale University, May). Levy, D., and N. Terleckyj, 1 983, Effects of government R&D on private R&D and productivity: A macroeconomic analysis, Bell Journal of Economics 14, 55 1-56 1 . Lichtenberg, F.R., 1 984, The relationship between federal contract R&D and company R&D, American Economic Review 74, 73-78. Lichtenberg, F.R., 1 988, The private R&D investment response to federal design and technical competitions, American Economic Review 78, 550-559. Lichtenberg, F.R., 1 989a, How elastic is the government's demand for weapons?, Journal of Public Economics 40, 57-78. Lichtenberg, F.R., 1 989b, !R&D project data and theories of R&D investment, Journal of Economic Dynamics and Control 13, 27 1 -282. Lichtenberg, F.R., 1 990, U.S. government subsidies to private military R&D: The Defense Department's independent R&D policy, Defense Economics 1 , 149-1 58.

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457

Lichtenberg, F.R., 1 992a, A perspective on accounting for defense contracts, The Accounting Review

67, 741-752. Lichtenberg, F.R., 1 992b, R&D investment and international productivity differences, in: H. Siebert, ed., Economic growth in the world economy (J.C.B. Mohr, Tiibingen, Germany) 89-1 10. Lichtenberg, F.R., and D. Siegel, 1 99 1 , The impact of R&D investment on productivity: New evidence using linked R&D-LRD data, Economic Inquiry 29, 203-228. Mankiw, N.G., D. Romer and D. Wei!, 1 992, A contribution to the empirics of economic growth, Quarterly Journal of Economics 1 07, 407-437. Mansfield, E., 1971, Technological change (WW Norton, New York). Mansfield, E., and L. Switzer, 1 984, Effects of federal support on company-financed R&D: The case of energy, Management Science 30, 562-57 1 . Nalebuff, B.J., and J. Stiglitz, 1 983, Prizes and incentives: Towards a general theory of compensation and competition, Bell Journal of Economics 14, 2 1-43. National Science Board, 1 993, Science and engineering indicators � 1 993 (US Government Printing Office, Washington, DC). Peck, M.J., and F.M. Scherer, 1 962, The weapons acquisition process: An economic analysis (Harvard Business School, Boston, MA). Rogerson, WP. , 1 992, Overhead allocation and incentives for cost minimization in defense procurement, The Accounting Review 67, 671 ---6 90. Romer, P.M., 1 986, Crazy explanations for the productivity slowdown, NBER Macroeconomics Annual

2, 1 63-202. Scherer, F.M., 1 964, The weapons acquisition process: Economic incentives (Harvard Business School, Boston, MA). Scherer, F.M., 1 984, Using linked patent and R&D data to measure interindustry technology flows, in: Z. Griliches, ed., R&D, patents, and productivity (University of Chicago Press, Chicago, IL)

41 7-46 1 .

Scott, J. , 1984, Firm versus industry variability i n R&D intensity, in: Z. Griliches, ed., R&D, patents, and productivity (University of Chicago Press, Chicago, IL) 233-245. Stiglitz, J., and A. Weiss, 1 9 8 1 , Credit rationing in markets with imperfect information, American Economic Review 7 1 , 393-409. Thomas, J., and S. Tung, 1 992, Incentives under cost-reimbursement: Pension costs for defense contractors, The Accounting Review 67, 69 1 -7 1 1 . Todaro, M., 1 969, A model of labor migration and urban unemployment in the less developed countries, American Economic Review 59, 138-48. US Congress, 1 969, Senate, Committee on the Judiciary: Competition in defense procurement, hearings before the subcommittee on antitrust and monopoly (US Government Printing Office, Washington, DC). Winston, J., 1 985, Defense-related research and development in industry, Congressional Research Service Report No. 85-205 S, 1 8 October 1 985.

Chapter 16 INDUSTRIAL POLICIES IN THE DEFENSE SECTOR KEITH HARTLEY

University of York

Contents

Abstract Keywords Introduction 2. The stylized facts and the policy problem 3. The economics of standardization 4. Taxonomy: project appraisal and procurement options 5. International collaboration

1.

5.1. 5.2.

6. 7. 8. 9.

Collaboration: a public choice analysis Empirical results

Licensed and co-production Offsets The military production function: internal efficiency Conversion 9. I . 9.2.

Direct conversion Re-allocating resources

and public policy

I 0. Conclusion: a research agenda References

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T Sandler © 1995 Elsevier Science B. V. All rights reserved

460 460 461 461 465 471 473 475 477 479 481 483 484 485 486 487 487

460

K. Hartley

Abstract

Voluntary military alliances, such as NATO, are often criticized for failing to exploit the opportunities for equipment standardization and free trade. However, nationalism means that governments adopt a variety of industrial policies for purchasing defense equipment, leading to departures from the competitive free trade model. Different procurement policies offer varying combinations of military and national economic benefits. Work sharing can be achieved through international collaboration, licensed production and offsets. Policies designed to improve efficiency in equipment procurement also affect the military production function. Job losses associated with the closure of military bases and defense plants raise issues of conversion. Keywords

Collaboration, conversion, cost-benefit analysis, licensed and co-production, market failure, military production functions, NATO free trade area, offsets, procurement options, public choice, specialization, standardization, strategic trade theory

Ch. 16: industrial Policies in the Defense Sector

461

1. Introduction

The supply side of military alliances is an under-researched field (see Chapter 5 of this Handbook). Critics of voluntary military alliances, such as NATO, stress their inefficiencies in the provision of both defense equipment and armed forces. They point to the wasteful duplication of costly research and development (R&D) programs for defense equipment and small national orders so that there is a failure to exploit the available economies of long production runs. Similarly, amongst armed forces there seems to be wasteful duplication as each member state of the alliance provides its own defense ministry, army, navy and air force, their associated training and support facilities and the necessary infrastructure of military bases and communications networks. On this basis, it seems that voluntary military alliances "fail" to exploit the available opportunities for international specialization based on comparative advantage and the associated potential for exploiting the resource savings from decreasing cost industries. These issues will become even more important in an era of falling defense budgets. Whilst many of the examples in this Chapter are based on NATO experience, the general supply-side principles apply to any military alliance. The Chapter starts by outlining the policy problem and considers the economics of standardization; it then presents a taxonomy of equipment procurement options, each of which is analyzed using a cost-benefit framework. Consideration is also given to internal efficiency issues in the armed forces and their implications for the military production function. Inevitably, policies aimed at improving efficiency involve winners and losers. Some groups will be made worse-off as reflected in the closure of defense plants and military bases. A final section focuses on conversion issues. 2. The stylized facts and the policy problem

Military alliances often focus on burden sharing as reflected in each member state's share of GNP devoted to defense. Such ratios are misleading since they measure inputs and not the output of defense, so that they provide no indication of the efficiency of military effort. At the same time, the rising costs of weapons and, at the margin, a greater preference for civil and social welfare expenditures (e.g., roads, hospitals, schools) has meant that in a period of comparative peace members of a military alliance will be under continued domestic electoral pressures to reduce defense budgets. In these circumstances, a military alliance is likely to place much greater emphasis on methods of increasing the efficiency of existing (and falling) levels of defense spending. A whole new jargon has emerged with objectives expressed in such terms as standardization, inter-operability, rationalization, managed competition, two-way streets, collaboration, co-production and offsets. For NATO, the policy problem was seen to be a failure of the allies to agree on common tactics, common training, common weapons and international specialization resulting in a waste of resources and adverse effects on military effectiveness (e.g.,

462

K. Hartley

an excessive fragmentation of NATO defense procurement markets). As a result, NATO was believed to be an inefficient organization in both its weapons markets and its armed forces. Equipment is not standardized nor inter-operable, whilst weapons production is "unco-ordinated" with "wasteful duplication" of costly programs. Standardization is advocated as the preferred solution with this policy objective embracing "commonality" in tactics, weapons, training and logistics. Attractive though it might seem, such "commonality" or standardization has major policy implications for each member of a voluntary club. To replace "wasteful duplication" in R&D and production requires nations with different preferences (and their governments seeking re-election) to agree on which weapons to buy, how and from whom. Inevitably, efforts to create a NATO free trade area in weapons will involve gainers and losers with no guarantees that the losers will be compensated. Similarly, nations in a voluntary military alliance will be reluctant to sacrifice the independence and guaranteed protection offered by their own national army, navy and air force for the dependence and interdependence associated with the international specialization of armed forces. Such international specialization based on comparative advantage might require, say, Germany to specialize in providing armored forces for the collective defense of the alliance, with France providing air defense, Turkey supplying infantry forces, the UK providing naval forces and the USA offering communications, early warning and the strategic nuclear umbrella. The gains from sacrificing nationalism and independence are believed to be substantial. One of the pioneering efforts in the field estimated annual waste in NATO at some $ 1 1 billion [I 975 prices: Callaghan ( 1 975)]. This estimate rather cavalierly assumed that waste comprised all European defense R&D expenditure together with 1 0% of US procurement, 25% of European procurement, I 0% of direct American annual NATO cost and I5% of European general purpose force expenditures. The preferred solution was a North Atlantic Common Defense Market characterized by international specialization based on comparative advantage, with Europe and the USA each developing, producing, supporting and providing the other with the equipment it is best able to make. The result was expected to be the end of "wasteful duplication" and the creation of long production runs leading to lower unit costs of standardized and inter-operable equipment, with a "two-way street" in military trade between Europe and the USA. In addition to the economic benefits, standardization was expected to increase NATO military effectiveness from 30-50% for most units to as much as 300% for certain tactical air units [Callaghan ( 1 975, p. I l l)]. The case for a NATO Common Defense Market or Free Trade Area appears impressive. The performance of defense industries in any military alliance is increasingly important in an era of expensive equipment, rising weapons costs and falling defense budgets. Indeed, cuts in military spending will force procurement agencies and the armed forces to change their traditional purchasing policies in order to seek cheaper methods of acquiring weapons (e.g., by buying off-the-shelf). Table I gives examples of the high costs of modern defense equipment. Not only is equipment expensive but cost trends are upwards reflecting improvements in quality

Ch. 16:

Industrial Policies in the Defense Sector

463

Table l Unit procurement costs " US equipment

Average rn1it cost (million $, 1 995 prices)

Army 19

Comanche helicopter Advanced field artillery system

7

Navy b 5675

Nuclear aircraft carrier New attack submarine

1 700

Aegis destroyer or successor

825

F/A-18E/F (fighter aircraft)

90

Air Force b F22 (fighter aircraft)

105

C I 7 (transport aircraft)

260 45

F l 6 replacement (strike aircraft) Rates of cost escalation: UK and US procurement

Equipment

Cost escalation' (% pa)

Fighter aircraft

II

Guided missiles

11

Frigates

1 0.5

Helicopters

9.5

Destroyers

9

Submarines

9

' Sources: CBO (I 994), Pugh (1 993). b Average unit cost for Navy and Air Force equipment is mid-point of low and high cost figures. ' Cost escalation refers to unit production costs adjusted for inflation and differences in production quantities.

and performance. New military equipment costs in real terms (unit for unit) far more than the old items which it replaces: typically such cost increases average about 10% per annum resulting in a doubling in cost every 7.25 years [Pugh (1993)]. The changing ratio of unit costs to defense budgets means that such cost increases affect the numerical strengths of armed forces, with consequent effects upon suppliers (i.e., economics as the ultimate arms controller). It also means that policies to improve the efficiency of procurement only buy a brief respite once for all time. With cost increases of 1 0% per annum, cost reductions of some 20% (e.g., as have resulted from greater competition) achieve relief from cost escalation for about 2 years [Pugh ( 1993)]. Such cost trends have led some commentators to make long-run forecasts of a one-ship navy and a one-aircraft air force [Starship Enterprise: Kirkpatrick and Pugh ( 1983)].

K. Hartley

464 Table 2a Duplication Equipment

Number of types Europe '

Tanks Armored combat vehicles

2

USA

4

I

12

3 5

3

Fighter-bomber aircraft

7

4

Ground-attack-trainer aircraft

6

l

5

Anti-tank helicopter

7

3

6

Frigates

• Europe

=

11

EC plus EFTA.

Table 2b Output of combat aircraft' Country

Orders for national forces

Total orders

France Mirage 2000

325

542

Rafale

312

312

176

746

75

98

300

300

UK Hawk Sea Harrier

Sweden Gripen

International collaboration AMX (Italy-Brazil)

1 92

192

Alpha Jet (France-Germany)

351

503

Tornado (UK-Germany-Italy)

872

992

EF 2000 (UK-Germany-ltaly-Spain)

602

602

Harrier AV8B (UK-USA)

405

439

USA Fl5

1 1 03

1 25 1

Fl6

2222

3989

Fl8

>979 442

>1410

F22 •

442

Source: Jane's (1 994).

Inefficiency in NATO weapons markets is reflected in the "wasteful duplication" of costly R&D programs and relatively short production runs. The stylized facts are given in Tables 2a,b which show two distinctive features. First, the proliferation of different

465

Ch. I 6: Industrial Policies in the Defense Sector

types of defense equipment in NATO and especially within Europe (Table 2a). For example, NATOs Rapid Reaction Corps is expected to fight together with six kinds of helicopter, ten different makes of vehicles, seven kinds of anti-tank weapons and four different communications systems [Beard ( 1 993)]. Second, the major differences in the scale of output between the USA and individual European nations (Table 2b). Whilst the examples of scale differences in Table 2b are for aircraft, the same point applies for a whole variety of equipment, including main battle tanks, armored combat vehicles, missiles, helicopters and warships. For example, between 1 979 and 199 1 , the US forces purchased almost 7800 M-1 tanks compared with the UK where the Army bought 426 Challenger I tanks. 3. The economics of standardization

The simple economic case for standardization and free trade in defense equipment markets is shown in Figure 1 . Consider two nations, with nation A operating initially on the long-run average cost curve LAC 1 purchasing Q2 at a unit cost of C 1 ; whilst nation B on a lower long-run average cost curve purchases Q 1 at a unit cost of C2. In each nation, decreasing costs show that a greater output leads to cost savings. However, if both nations combined their orders (Q 1 + Q2 = Q3) and purchased common equipment from the lowest cost supplier (nation B), then the total output of Q3 would be provided at a unit cost of C0. As a result of both standardization and free trade, nation A saves C 1 - Co and nation B saves C2 - C0. In addition to reductions in unit productions costs, there will be further savings from reduced duplication in R&D (e.g., one R&D program rather than two). If standardization is as beneficial as claimed, why has it not occurred? Are there some obvious market failures preventing worthwhile international transactions or are the existing arrangements optimal once it is recognized that all policies and exchange Average Cost

co

- · - -

0�

' '

�

- - - - - - - - - - - - -

�

'

LAC1 (A) - - - -

LACo (B)

--�----------�--�----------� 01

02

03

Figure I . Standardization and free trade.

Output

466

K. Hartley

involve costs? In fact, governments themselves are often a major barrier to free trade in defense equipment and hence the source of market failure. Governments can ensure that their national defense markets are characterized by entry barriers, preferential purchasing and restrictions on the transfer of technology so that anti­ competitive behavior results from the demand side of the market. Such policies reflect a traditional desire for independence and security of supply which necessitates protection of a nation's defense industrial base (DIB). Also, nations might dislike the expected outcome of free trade within a military alliance. In NATO, for example, it is predicted that a free trade area will result in the USA specializing in high technology defense equipment with Europe confined to "metal bashing" and having to accept a reduction in the size of its "key" technology industries such as aerospace. National governments can always justify support for their DIB by pointing to its apparent industrial and economic benefits in the form of protecting jobs, supporting high technology and spin-off and contributing to the balance of payments (see Chapter 14 of this Handbook). These apparent benefits are attractive to vote­ maximizing governments, but they should be seen as claims made by governments rather than economic statements about the social benefits of import replacement. Governments are entitled to believe that imports are "bad" and that exports are "good". However, if economists accept that the international division of labor and international trade are welfare enhancing, it follows that both exports and imports are welfare enhancing: imports create jobs by freeing resources for more productive alternative uses elsewhere in the economy. Indeed, in defense markets governments are often influenced by claims about technology and as a result ignore the opportunity cost question: would the resources currently allocated to the DIB make a greater contribution to technology, jobs, the balance of payments and ultimately GDP (economic welfare) if they were used elsewhere in the economy? There are circumstances in which state intervention in defense markets can be justified. One set of circumstances arises from market failures in the form of public goods, external economies and social benefits, including failures in R&D markets [Arrow ( 1962), Demsetz ( 1 969)]. Strategic trade policy provides a further case for state intervention. It arises where international trade is characterized by strategic rivalry between a small number of giant firms or "national champions" of different countries, or indirectly between governments acting on their behalf. In such markets, an established firm might try to create strategic entry barriers to maintain and enhance its market power. However, by using subsidies, governments have the potential to influence exit and entry decisions in oligopoly industries, thereby shifting rents between countries. The aerospace industry is often suggested as strategic in a theoretical sense in that it generates "excess rents" and subsidies can be used for "rent-snatching" (e.g., Airbus representing Europe's efforts to achieve a share of those rents [Pomfret ( 1 991), Tyson ( 1 992)]). A simple example is presented in Figure 2 which displays two game matrices in normal form showing super-normal profits and losses. Assume that Lockheed is established in the world military transport aircraft market with its Hercules aircraft.

Ch. 16: Industrial Policies in the Defense Sector

467 (b) With Subsidies to FLA

(a) No Subsidy

European FLA

European FLA

Produce Lockheed Hercules

Produce Don't Produce

-1 0,-1 0 0, 1 25

Produce

Don't Produce 1 25,0

0,0

Lockheed Hercules

Produce

-1 0,40

Don't Produce 1 25,0

Don't 0• 1 75 0•0 t----t----1 Produce L----L----J

Figure 2. Successful intervention. (a) No subsidy; (b) With subsidies to FLA.

There is no incentive for the Europeans to enter the market with their rival Future Large Aircraft (FLA) without a subsidy, because entry would involve losses (-1 0). A commitment by the European governments to pay the subsidy changes the pay­ offs and makes production a dominant strategy. With a subsidy (50), the Europeans are better off producing than not producing, whatever Lockheed does, so that they will enter the market. As a result, Lockheed will lose money and will exit if it has no access to a subsidy. At the same time, the Europeans achieve rents of 1 75 for a subsidy of 50. However, intervention through subsidies will not always pay off and there are examples of costly failures. Indeed, public choice analysis predicts government failure, whilst Austrian economics stresses the role of uncertainty and the impossibility of making accurate predictions about the unknown and unknowable future [Mueller ( 1 989)]. The potential losers from a free trade area will seek to oppose change and lobby for compensatory policies. As a result, there is often an emphasis on managed (fair) competition, balanced trade and transitional measures. These policies involve departures from the principles of a competitive free trade area as national defense ministries seek to "manage competition" so as to minimize the costs imposed on the losers. For example, efforts will be made to ensure that the opening-up of national defense markets occurs slowly over a number of years allowing time for adjustment. Similarly, an emphasis on "balanced" international trade in defense equipment can be used to protect national defense industries. However, such balance is likely to be achieved at a price of departing from principles of specialization by comparative advantage and seeking "balance" in a specific product group, namely, defense equipment as distinct from an overall balance across all international transactions. A free trade area is one possible solution for weapons procurement in a military alliance. However, this is not the only possibility: there are at least three alternative scenarios each of which needs to be specified more clearly. Indeed, rarely are efforts made to operationalize any of these scenarios. First, a competitive free trade area could be created whereby each member state would open up its national defense market, allowing firms from other member states to bid for its national defense contracts. In NATO, such a free trade area could be created for the whole military alliance; or, it could apply to a sub-set of member states, namely, European countries and the Single European Market. Furthermore, such a free trade area could apply to all defense

468

K. Hartley Table 3 Alternative alliance scenarios

Scenario

Liberalized competitive market: Extent of market Alliance-wide World-wide

National procurement by national defense ministries

2

Centralized procurement agency replacing national defense ministries

3

Twin track (a) competition (b) collaboration

equipment or there could be limited liberalization under which certain equipments would be excluded (e.g., nuclear systems). Second, the alliance could create a single centralized procurement agency which would replace national defense ministries and would purchase common, standardized equipment for all alliance forces. Third, there is the twin track scenario comprising a mixture of competition and collaboration. Competition would apply to small and medium-sized equipment (e.g., ammunition, small arms, small-medium sized missiles) where purchasing would be undertaken by national defense ministries. Large equipment projects would be undertaken on a collaborative basis with work allocated by either juste retour or by competition (e.g., combat aircraft, large missiles, nuclear systems [Moravcsik ( 1990), Sandler and Hartley ( 1 995)]). For each scenario, competition could be restricted to firms from member states of the alliance or their markets could be opened-up to firms from the rest of the world (i.e., outside the alliance), as shown in Table 3 . Of the various options, the creation of a centralized procurement agency purchasing common equipment offers the greatest potential cost savings but, politically, it is the most difficult to implement. Whichever scenario is preferred, it has to be recognized that purchasing defense equipment is a complex process involving a variety of choices under uncertainty. Decisions are required on what to buy, whether to buy on a national or a collaborative basis, at which stage in the project's life cycle the equipment is to be selected, who to buy from and how to buy. In other words, choices are required on the type of equipment to be purchased, the role of competition and the extent of the market in the selection process, the choice of contractor and the type of contract. Table 4 presents a taxonomy which identifies and classifies the variety of arrangements for both purchasing and supplying defense equipment of which alliance defense industrial policies form a sub­ set. Broadly, there are two extremes, namely, national independence whereby a nation acting alone might buy all its defense equipment from its domestic DIB; alternatively, it could import all its defense equipment by buying off-the-shelf from overseas suppliers. Between these extreme policies, there are a variety of intermediate policies such as international collaboration, the licensed or co-production of a foreign design or imports

469

Ch. 16: Industrial Policies in the Defense Sector Table 4 Procurement options Choices [

II.

Choice of buyer (A) National procurement' (B) Joint Procurement b

What to buy: peiformance features

2

When to select in project life cycle 3 5 7

4 6 8

(i) Competitive procurement: open versus selective

9

10

(ii) Non competitive: direct negotiation

11

12

13 15

14 16

17 19

18 20

21 23 25

22 24 26

27 29 31 33

28 30 32 34

35

36

37 39

38 40

(i) Design stage (ii) Development - prototype stage (iii) Production stage

III. Role of competition and extent of market

(iii) Market open to a. National firms only b . Suppliers in alliance member states c. Firms in other regions d. The world

IV Choice of contract (i) Fixed price (ii) Target cost - incentive type (iii) Cost-plus

V Supply-side: industrial organization (i) Single producer (ii) Licensed coproduction (iii) Offsets (work sharing) (iv) Collaboration-consortia

VI. Location of supplier (i) National (ii) Overseas a. Alliance b. Rest of world

' One alliance nation. b Two or more alliance nations including centralized procurement.

of foreign equipment with some form of offset or work-sharing arrangement for the domestic industry of the importing nations. Table 4 can be used to classify the three alliance defense industrial policies (as shown in Table 3). National procurement by national defense ministries in a liberalized

470

K. Hartley

competitive market would be represented by A, I 1 , II 3 or 5 or 7, III 9, 1 5 or 1 9, IV 2 1 , V 27 or 33, VI 35 or 37 or 39. This scenario involves one alliance nation buying its defense equipment on a competitive fixed price contract with competition restricted to firms in alliance member states or open to the world. Supply could be from a single producer or a consortium located within the nation or overseas. In contrast, a centralized procurement agency buying equipment for all alliance members on a competitive fixed price basis would be represented: B I 2, II 4 or 6 or 8, III 1 0, 1 6 or 20, IV 22, V 28 or 34, VI 36 or 38 or 40. Whilst the various alliance defense industrial policies appear to offer substantial cost savings, their assumptions need to be specified. Only then is it possible to assess their implications and their likelihood of success (and the reasons for departing from "first best" solutions for such regimes as managed competition). For each scenario it is assumed that: (i) The national or centralized procurement agency acts as a competitive buyer with no work sharing or juste retour constraints and the centralized procurement agency can make and enforce its equipment choices. For example, the agency would need an agreed set of rules for making procurement choices (e.g., unanimity or majority voting). (ii) Firms are awarded competitively-determined fixed price contracts for develop­ ment and production work. (iii) There are clearly specified requirements for defense equipment applicable to all bidders. (iv) Suppliers receive no preferential treatment from their national governments (e.g., subsidies; indirect support such as for civil R&D with possible military applications). In other words, there needs to be non-discriminatory purchasing and a level playing field. The problems of creating a competitive free trade area in a military alliance (e.g. NATO or the Single European Market) cannot be exaggerated. Within a liberalized market with procurement by national defense ministries, problems arise in enforcing the procedures for market openness and in preventing anti-competitive behavior by national governments. Defense equipment purchases can always be rationalized on grounds of 'national security' . And whichever the scenario, there will always be pressures from producers to restrict the market to firms from alliance member states, with the potential for cartelization and lack of contestability. Indeed, the history of trade policy shows how hard it is to defeat the power of producer lobbies. There will also be pressure from the military-industrial complex favoring 'fair and managed' competition with cost based contracts awarded on a juste retour basis. Inevitably, the long-run trend towards a smaller number of larger defense contractors will lead to departures from the competitive model and the creation of oligopolies and monopolies where there are opportunities for cartels and collusive tendering. Scenarios which create and protect alliance monopolies so as to obtain economies of scale and avoid the wasteful duplication of costly R&D will allow firms to charge monopoly prices as well as pursue a quiet life leading to dynamic costs rather

Ch. 16: industrial Policies in the Defense Sector

471

than benefits - all of which will reduce the estimated savings from achieving less duplication in R&D! Here, contestability of alliance defense markets is crucial to firm behavior and performance. Contestability can be achieved in a variety of ways through, for example, opening-up the alliance market to firms from the rest of the world; or by offering sub-contract work to the losing firm in a major competition; or by recognizing that for some equipments, it is possible that the rivals who lose a maj or contract might be able to re-enter the market at some future date. Or, with a centralized procurement agency, competing development teams might be maintained by covering the cost of developing cheap competing prototypes. However, where there is an alliance monopoly supplier, the centralized procurement agency might have to maintain competition by funding an overseas rival development program (i.e. in a non-member state), although this might not be politically acceptable. Moreover, unless the centralized procurement agency is prepared to award the contract to an overseas firm from outside the alliance, the alliance monopolist will not take the threat of rivalry seriously; and if the contract is awarded overseas, the alliance monopolist might exit from the industry! In such a situation, the alliance monopolist might have to be subject to regulatory requirements (e.g. profit controls) and will behave like any firm subject to regulation.

4.

Taxonomy: project appraisal and procurement options

Purchasing defense equipment requires nations to make difficult choices in a world of uncertainty (e.g. over time horizons of up to 40 years). Where a country is a member of an alliance, such choices might be made on an individual national basis or collectively whereby all members agree on the type of equipment to be purchased. Cost-benefit analysis provides a framework for the economic evaluation of alternative equipment. In principle, this requires an analysis of the costs of the various rival equipments, their performance in relation to the national or alliance defense requirement and any wider industrial or economic benefits. For each alternative defense equipment (e.g. rival tanks or ships or combat aircraft), a cost-benefit analysis requires the following: (i) The estimated lifo-cycle costs of the alternatives. Acquisition prices represent only part of life-cycle costs: these are the true total costs of a project which need to be expressed in terms of present values. Cost estimates for equipment under development and not yet in-service can also be umeliable and for such equipment, this umeliability is even greater for cost estimates for in-service support, operations and maintenance. Nor should cost figures be compared on a per unit basis only: for example, combat aircraft differ in their performance so that the relevant basis for any comparison is the total cost of the fleet required to meet an operational requirement. (ii) The military features and strategic implications of the alternatives. This requires an analysis of the performance, numbers required to meet the operational requirement, and delivery schedules. The alternatives might differ in their contributions to alliance

472

K. Hartley

standardization and inter-operability, to international collaboration and to maintaining the national defense industrial base. iii. National economic benefits. Equipment procurement choices involve wider economic benefits in the form of their impact on jobs, technology and the balance of payments. Employment impacts involve numbers of jobs and their skill content; technology includes any spin-offs to the rest of the economy; and the balance of payments embraces exports and import-saving. In some cases, efforts are made to include Treasury or Exchequer impacts as reflected in tax receipts and any expenditure on unemployment and social welfare payments (e.g. following the cancellation of a project). However, the inclusion of Exchequer impacts is controversial. It raises issues of transfer payments versus the resource costs of the unemployed in periods of large­ scale unemployment; the role, if any, of shadow pricing; and the extent to which local labor markets act as efficient clearing mechanisms (see Chapter 1 7 of this Handbook). Not all costs and benefits will be quantifiable: there will be some intangibles which need to be brought to the attention of decision-makers (e.g. the security offered by a national defense industrial base). Even where variables can be quantified, they might be subject to risk and uncertainty, and government as the final decision-maker might attach different valuations to those recommended by economists. For example, a Defense Ministry might focus on defense criteria only, namely, costs, performance, delivery and the risks attached to the various competing proposals, so ignoring any wider industrial and economic benefits. On the other hand, when governments have to approve an equipment purchase, their final decision might be determined by wider economic benefits, such as jobs impacts in marginal constituencies and, ultimately, the desire for re-election. Whether or not it is a member of an alliance, a nation has a variety of industrial policy options for purchasing defense equipment. Each option offers the purchasing nation a different degree of industrial involvement or work sharing in the development and/or production of the system being acquired. The options also have different implications for costs, program risks, control over equipment specifications, as well as wider industrial and economic benefits for the purchasing nation [Sandler and Hartley ( 1 995, Chapter 9)). Typically, governments prefer the indigenous development and production of defense equipment. Domestic sourcing enables governments to claim that their policies generate new technologies (which might spill-over into civil industry), provide jobs, improve the balance of payment and the security of supply. However, the costs of an independent DIB and the lack of a suitable technological capability often restrict purchasers of defense equipment to sharing the production work associated with equipment they wish to buy, rather than undertaking indigenous development or a collaborative project, where both development and production work are shared. Whichever procurement policy is adopted, care is needed to distinguish between the economic welfare implications of international trade and the beliefs, myths and special pleading which national producer groups will use to influence equipment choices and which governments will use to 'rationalize' their decisions. A taxonomy of various work-sharing arrangements is shown in Table 5. For example, importing involves

Ch. 16: Industrial Policies in the Defense Sector

473

Table 5 Work sharing Policy

Sharing arrangements Selected defense equipment b Other defense equipment b D P S D P S a

National-domestic procurement (DIB)

( 1 00%)

( 1 00%)

( 1 00%)

International collaboration

V (S%) ' v (S%)

v (S%)

V (S%)

v (S%)

X

X

Civil goods and services

Licensed production; coproduction Offsets direct indirect Importing

v (S%) X

v (S%)

v (S%)

.J, work share; x , no work share. D, development; P, production; S, support work. ' S%, sharing rate between partner nations, where S < 1 00%.

a

h

no work sharing on the contract, whereas purchasing from the national DIB offers 100% work on development, production and support for the program. Offsets can involve direct work sharing on the selected equipment or indirect involvement through other defense projects or civil goods and services (e.g. tourism). 5. International collaboration

International collaboration or joint ventures can be viewed as clubs involving two or more nations sharing the total development and production costs and work on defense equipment projects. Europe has considerable experience of such collaboration, especially in aerospace projects (aircraft, helicopters, engines and missiles). Examples include the British-French Jaguar strike aircraft; the UK-Germany-Italy Tornado combat aircraft, and the 4-nation Eurofighter 2000 air superiority fighter aircraft [Draper ( 1 990), Hartley ( 1983), Matthews ( 1992)]. The stylized facts of international collaboration in aerospace can be summarized as follows: (i) During the 1 960s, international collaboration in aerospace was largely intra­ European. (ii) During the 1 970s, there was an increase in the proportion of collaborative projects with a non-European partner. (iii) Both the number and percentage of all projects which were collaborative was higher in the 1 980s than in the 1960s. In other words, there has been a movement away from national projects towards collaboration.

474

K. Hartley Table 6 Cost savings from collaboration ' R&D costs (£m)

Production order

Unit production cost (£m)

Total production cost (£m)

Total program cost (£m)

Independence Nation A Nation B

1000 1000

200 200

20 20

4000 4000

5000 5000

1000 1000

400

18 2

7200 800

8200 1 800

International collaboration Nations A&B: equal sharing Savings from collaboration

• For collaborative production a 90% unit production cost curve is used, showing a I 0% reduction in unit costs for a doubling in cumulative output.

(iv) Between the 1 960s and 1980s, there was an upward trend in the mean number of partner nations per collaborative project. (v) The larger European economies, namely, France, Germany and the UK, have been most active in collaborative projects, usually collaborating with each other. (vi) The limited population of collaborative projects has involved different partner nations, various organizational arrangements and a heterogeneous set of projects (e.g. combat and trainer aircraft, helicopters, missile and aero-engines) . (vii) Collaboration is not restricted to aerospace: a wide variety of military equipment has been developed and produced collaboratively [e.g. electronics based projects such as airborne and naval radar: Hartley and Martin ( 1 993a)] . European collaboration is believed to offer a variety of economic, industrial, military and political benefits. In theory, there are cost savings in both R&D and production. Members of the collaborative club can share the costs and risks of costly R&D programs, and by combining their national orders they can achieve the economies of scale and learning from a longer production run. In this ideal case, the partner nations obtain cheaper equipment and avoid the 'wasteful duplication' of costly R&D work associated with competing national programs. An example is shown in Table 6 where two-nation collaboration offers cost savings of 1 8%. There are also possible industrial benefits, especially in costly high technology industries such as aerospace where collaboration creates larger European groups able to compete with the USA. Further benefits arise from greater equipment standardization between NATO members as well as demonstrating a European commitment to the cohesion and credibility of the NATO alliance [HCP 247 ( 1 99 1 ), Pugh (1 986)]. Collaboration, however, has its costs leading to departures from the 'ideal model' . Governments are involved in a set o f choices about the type of equipment to be purchased, with which partner nations, with which firms, how to organize the joint venture, and the criteria for sharing the total work on the program. These

Ch. 16: Industrial Policies in the Defense Sector

475

choices will be made in the political market place of governments, voters, political parties, bureaucracies and producer groups within the partner nations: such market arrangements provide opportunities for inefficiency in collaborative ventures.

5. 1. Collaboration: a public choice analysis The typical election arrangements mean that voters are unable to express their preferences between alternative procurement policies (e.g. nationalism, buy abroad, joint projects or licensed production); nor are they provided with information on the costs and benefits of different policies because of the alleged need to 'protect national security'. As a result, a government has discretion in interpreting the 'national interest' and it will be influenced by the views of specialists in the form of bureaucracies and interest groups of contractors and scientists. A defense ministry and the armed forces aiming to maximize their budget and the opportunities for power, prestige and personal satisfaction, will stress and exaggerate the apparently attractive cost savings from international collaboration and its major social benefits through supporting jobs, the balance of payments and promoting high technology. Bureaucrats will welcome the opportunities for regular international travel and the prestige involved in negotiating an international treaty, protecting the national interest, allocating contracts and 'policing' the program. They have an incentive to negotiate international contracts which make it costly for any partner nation to withdraw unilaterally, and to devise a set of monitoring arrangements which maximize their involvement in project decision-making (e.g. under the guise of public accountability and protecting the national taxpayer). Some of these activities represent bureaucratic behavior as 'on-the-job' leisure disguised as 'output' [Peacock ( 1 992)]. The case for collaboration will be supported by producer groups of management and unions seeking new contracts, and by the scientific lobby with its desire to expand the frontiers of knowledge - all at the taxpayers expense. As a result, the armed forces, bureaucracies, contractors and scientists within each partner nation will insist upon imposing their requirements, ideas and technical aspirations. Bargaining is inevitable. At the start of the program, each partner nation's armed forces will insist upon their operational requirements; firms will compete for project leadership; and each country's scientists will demand to be involved in the most exciting technical advances. International rivalry will dominate the early stages of negotiations, as each national interest group submits its claims, uses its bargaining skills, exaggerates its orders and threatens to withdraw (it resembles collective bargaining between employers and trade unions). Inevitably, any international agreement will be a compromise between the maximum bids of each partner and the minimum terms required to persuade it to join and remain a member of the club. Such compromises are likely to reflect bargaining behavior rather than efficiency criteria: behavior within committees will determine outcomes rather than commercial considerations of efficiency and profitability. Each partner will demand a 'fair' share of both development and production work, including an involvement in all aspects of high technology. For example, on aircraft development,

476

K. Hartley

each partner will demand a share of high technology work on the airframe, engine, avionics and equipment. In its desire to obtain a preferred part of the project, a nation might be willing to sacrifice to its partners a maj or share in a less preferred part of the program, or even offer compensation in other unrelated policy areas (e.g. support in a vital vote on EU agricultural or regional policy). As a result, work is allocated on the basis of political and equity (juste retour) rather than efficiency criteria. Collaborative projects once started are difficult to stop. International collusion replaces rivalry, and national governments will be confronted by a combined interest group of scientists, producers and bureaucrats in the partner nations. Such international groups of experts are likely to be influential in persuading vote-conscious governments of the technological, military, diplomatic and other social benefits of continuing with a collaborative venture. Their views on technology and estimates of development costs and time-scales are likely to be decisive although optimistic; and the costs of optimism are borne by each nation's numerous tax-payers. As a result, budget-sensitive bureaucracies in partner nations, supported by scientists and defense contractors, will tend to exaggerate the social benefits and cost savings of joint programs in order to persuade vote-conscious governments to undertake and continue the work. European collaborative ventures will also be attractive to governments seeking re­ election. Partner governments can be seen to be promoting European unity, avoiding dependence on US technology and weapons, and obtaining wider economic benefits (the military-industrial-political complex). A public choice analysis predicts that j oint European ventures will depart from the ideal model and will be characterized by inefficiency. The political market place and the associated bargaining process creates constraints on the choice of the most efficient organizational arrangements and contractors. On collaborative aerospace ventures, inefficiency is reflected in: (a) The administrative and organizational costs resulting from excessive gov­ ernment bureaucracy and duplicate organizations for procurement and supply. For example, the most efficient organization for managing a project might require a prime contractor-supplier relationship, but such an arrangement might be unacceptable to two equal partner nations and their prime contractors. Governments are also likely to select the major contractors on political, rather than commercial, criteria (e.g. awarding work to marginal constituencies and to their national champions). (b) Work sharing. Typically, some high technology development work has to be allocated to a partner country lacking the necessary technical knowledge and expertise. For example, a nation might join the club as a means of entering a new field of high technology. (c) The duplication of R&D and production work with each partner requiring a flight testing centre and a final assembly line. (d) Each nation requiring modifications on its military projects. Compared with the ideal model, this will raise R&D costs and possibly reduce the scale economies from a long run of one type, as well as reducing standardization.

Ch. 16: Industrial Policies in the Defense Sector

477

(e) Delays due to design by committee using unanimity rules and pursuing 'over­ elaborate' specifications reflecting the technical aspirations of the military and scientists in each partner nation. Delays also result from frequent meetings and paperwork, the need to consult all the partner nations before a decision can be taken, and the slow decision-making process by 'over-involved' governments. Further problems arise from differences in language, culture, national pride, and managerial philosophy and practices. As a result, there are transaction costs of creating new international organizations and doing business with strangers selected on political criteria. (f) The substantial costs of controlling joint programs. They require a complex set of international transactions and contracts between governments and firms, embracing high technology projects which cannot be clearly-defined ex ante. The resulting contracts are costly to monitor and cancel. For example, on the Concorde project it was stated that ". . . the inherent difficulty of the multiplicity of contracts, the number of interested parties and the participation of two sovereign states . . . meant that the project had acquired a life of its own and was out of control" [HCP 265 (198 1)]. Some of the early experience with collaboration provided lessons which were applied to subsequent joint ventures.

5.2. Empirical results The various benefits, costs and inefficiencies of collaboration can be formulated into a set of testable hypotheses about the impact of collaboration on costs and development times. Evidence from an international survey shows that compared with national ventures, there was considerable support for the hypotheses that joint European programs involved [Hartley (1995)]: (i) Higher total R&D costs, varying between an extra 5% to an additional 50% with a median cost penalty of 1 0-25%. (ii) Lower unit production costs, with cost savings varying between 10% and 25%, with a median saving of 20%. This result was completely contrary to UK experi­ ence which suggests that on collaborative production work, the expected scale and learning economies are not achieved: unit production costs are either unchanged by collaboration or might even be higher than for a national equivalent [Hartley and Martin ( 1 993b), HCP 247 ( 1 991)]. (iii) Longer development times, ranging from an extra I 0% to 1 00% and a median of an additional 20% (representing an extra 2 to 9 years in development times). The international questionnaire survey found a variety of reasons for collaboration inefficiencies. They included compromises, overlap, cross-checking and duplication, the time needed to reach agreements, work-sharing arrangements, bureaucracy, cultural differences, national rivalry, frequent specification changes, the number of partners, and the sheer complexity of some joint programs. Indeed, one respondent carefully explained that longer development periods often reflected the complexity of the program and not its joint nature. In principle, some of these hypotheses can be tested

K. Hartley

478

statistically. For example, a model of development time of the following form can be estimated:

T

=

T(C, Z, N),

(1)

where

T

total development time, C project development cost, Z a vector of characteristics of the defense equipment (e.g. aircraft speed, weight, range, etc) N = number of partner nations. =

=

=

Inevitably, empirical work on development time scales and other hypotheses about collaboration is limited by the lack of data. For defense equipment, there are problems in obtaining reliable data on development costs both in total and on an annual expenditure basis. Similarly, data on cost penalties are not publicly available: hence the need for interview-questionnaire surveys [Hartley ( 1 983, 1995)] . Empirical work is further complicated because of a limited and heterogeneous population of collaborative defense projects involving different partner nations and different organizational arrangements. Finally, there are problems with the counter-factual: what would have happened in the absence of a collaborative venture? Estimation of Equation (1) provided only limited support for the hypothesis that collaborative projects take longer to develop than national ventures. For a sample of military aircraft, collaboration appeared to add an extra seven months from the first flight of the prototype to delivery for every partner nation involved in the program, with this period increasing to fourteen months for combat aircraft. However, for the total development period from start to delivery for both military aircraft and helicopters, collaboration generally had no statistically significant effect. As an exception, one equation suggested an extra thirteen months for a two-partner program [compare the questionnaire survey results: Hartley and Martin ( 1993b)]. How might collaboration be improved to avoid its worst features and inefficiencies? There are at least three guidelines for government policy towards improving the efficiency of international collaboration: Rule I: allocate both development and production work on the basis of competition, with nations specializing according to their comparative advantage. Rule II: there needs to be a prime contractor subject to contractual incentives and penalties, which place it at risk (i.e. via competitively-determined fixed price contracts). Rule III: the principle of compensation. Adequate arrangements are needed to compensate the losers from policies designed to improve efficiency. Such compensation need not be organized within the program: it could involve offsets from other defense projects or more general assistance in the form of regional aid and manpower policies (e.g. retraining, mobility). •

•

•

Ch. 16: Industrial Policies in the Defense Sector

479

6 . Licensed and co-production

When buying foreign defense equipment, the importing nation often demands some form of compensatory or 'offsetting' economic activity for its domestic industry. One solution is for the importing nation to undertake the domestic production of the foreign-designed equipment (see Table 5). Production sharing can be achieved through licensed or co-production. Licensed production occurs where the purchaser obtains a share of the production work for its own order and, sometimes, for any exports to third parties. The license may cover the manufacture of the entire item, or specified parts, or only final assembly. Both the UK (Westland) and Italy (Agusta) have frequently purchased licenses to produce American-designed helicopters. Japan has licensed produced a range of US combat aircraft (e.g. F4, F15) and is co-developing a version of the US F 1 6 aircraft [Chinworth ( 1 992)]. A similar arrangement is co-production, where the nation buying foreign equipment is given a share in the manufacturing work for its own order, the supplying nation's order and orders from third parties. For example, the General Dynamics F 1 6 European co-production contract in 1 975 was based originally on sharing the manufacture of a 998 aircraft program. The European consortium (Belgium, Denmark, the Netherlands and Norway), which ordered 348 aircraft, was originally allocated work on ten percent of the initial US order (650 aircraft), forty percent of their own order and fifteen percent of export sales to other countries. Exports were estimated at 500 units and the achievement of this figure gave the Europeans manufacturing business to the value of 80 percent of their total order, namely, 279 aircraft [Hartley (1 983)] . Licensed and co-production offer a variety of military, budgetary, industrial and wider economic benefits. Purchasing existing equipment avoids the risks of failure; it provides operational equipment in an acceptable time scale; and it contributes to military standardization. Manufacturing under license also saves substantial R&D resources which would be required for an independent national venture. Furthermore, licensed and co-production provide support for a nation's DIB; they offer some technology transfer (e.g. in management and production); and contribute to employment and balance of payments objectives (via import savings). There is however, little quantitative evidence on the magnitude of these benefits: a deficiency which suggests the need for good economic case studies. For example, a study of Japanese experience with licensed production of US aircraft estimated that Japanese work content varied from 85% of the F 1 04 to 90% of the F4 and 70% of the F l 5 [Chinworth ( 1 992)]. The claimed benefits of licensed and co-production are not free gifts: there are usually cost penalties compared with buying directly off-the-shelf from the original manufacturer. These cost penalties have been estimated at up to 50%, with a typical cost penalty of 1 0-15% [Chinworth ( 1992), Hartley ( 1 995)] . On the American­ European co-production of the F16 it was estimated that the Europeans incurred a 34% cost penalty compared with buying the aircraft directly from General Dynamics

480

K. Hartley

Unit Cost

: ::.:� Ac1 I I

Co o 1 - - - -

�

- - - - - - - - - - - - - - - - -

�

ACo

- - -

I

L---�---�--� 0 0 0

2

3

Output

Figure 3. Economics of licensed production.

[Rich et al. (198 1)]. Such cost penalties reflect entry or start-up costs for the licensed producer (e.g. production investment in tooling), the costs of transferring technology (e.g. drawings, etc.), relatively short production runs and work starting at the top of the learning curve. An example is shown in Figure 3, where a nation undertakes the licensed production of OQ 1 , which is equal to Q2 - Q3 • Assuming that the licensed producer and the original manufacturer operate on the same unit cost curve (AC0) then licensed production of OQ 1 results in a unit cost of C 1 compared with a direct buy which increases output of the main manufacturer from Q2 to Q3 and results in unit costs of C0. More likely, the licensed producer will operate on a higher unit cost curve (ACI) so that the unit cost of OQ 1 is even higher, at C2. In an interesting exception, a Rand study of Japanese experience with the licensed production of the US F l 04 aircraft estimated that the unit costs of the Japanese aircraft were about 1 0% less than the price it would have paid for US produced aircraft: a result which reflected the transfer of learning technology from Lockheed and lower Japanese labor costs [Hall and Johnson (1967)]. There are further costs of licensed production in the form of time scales and restricted access to key equipment technologies. Japanese experience with the licensed production of the US F 1 5 aircraft provides useful case study evidence [Chinworth (1 992)]. On the F15, the time scale between signing the agreement and the first delivery of Japanese-built F 1 5 aircraft was 5.5 years. However, this time scale needs to be compared with the likely delivery schedule if the aircraft had been purchased directly from the USA. In addition, US companies used 'black boxes' to protect their key technologies and design capabilities. As a result, equipment failures involving 'black box' technologies meant that the equipment had to be returned to the USA for repair by US firms. Inevitably, repairs and servicing in the USA were time-consuming, so reducing the operational effectiveness of the Japanese-built F 1 5s and showing the limitations of licensed production in contributing to an independent DIB. Indeed, Japanese experience with F l 5 repairs and servicing, parts supplies, technology transfer

Ch. 1 6: Industrial Policies in the Defense Sector

481

and pricing further contributed towards the country's desire to create an independent aircraft industry [Chinworth (1992)].

7.

Offsets

Governments are often unwilling to pay the (sometimes considerable) premium for licensed production. Nevertheless, governments and interest groups believe that industrial benefits are desirable and this has led to the development of offsets as a further variant within the work-sharing taxonomy. Typically, an offset occurs when the foreign supplier places work to an agreed value with firms in the buying country, over and above what it would have bought in the absence of the offset. Defining offsets is difficult because different countries have different criteria for assessing whether a particular transaction is eligible towards an offset obligation. One distinction which is sometimes made is between direct and indirect offset. Direct offsets involve goods and services for the equipment which the purchaser is buying. For example, if the UK buys an American aircraft and the landing gear for those aircraft came from a UK supplier then this would be a direct offset. Indirect offsets involve goods and services unrelated to the purchase of the specific foreign defense equipment. For example, the sale of American F 1 8 aircraft to Spain allowed aid to Spanish tourism to count as part of the offset agreement. Indirect offsets can include foreign investment and counter­ trade transactions such as barter, counter-purchase and buy-back [Marin and Schnitzer ( 1994), Martin and Hartley ( 1995), Udis and Maskus ( 199 1); see also Table 5]. In addition to the distinction between direct and indirect offsets, there are cases where the offset may be unrelated to the purchase of goods. If the industrial base in the country purchasing the equipment is relatively small and underdeveloped, there may be few goods that can be purchased and thus inward investment might constitute the major component of any offset [e.g. as in the Al Yamamah sale of military aircraft by British Aerospace to Saudi Arabia: Martin ( 1 995)]. Offsets are a growing feature of the international trade in defense equipment, particularly aerospace equipment, and this is a field which is relatively unexplored by economists. Offsets impose conditions on the foreign seller of defense equipment enabling the purchasing government to recover or offset some or all of its purchase price [Udis and Maskus ( 1 99 1)]. Offset schemes are usually designed to achieve a relocation of economic activity from the country of the equipment supplier to the purchasing nation. Such relocation resembles trade diversion and has been criticized by economists as welfare reducing. For the seller, offsets reflect the desire of profit­ seeking firms for 'doing business' with governments: they can be regarded as part of the sales package and as an alternative to price discounts. For the supplying nation, there are concerns about the impact of offsets on its defense industries, especially suppliers, on employment and on technology transfer to potential rivals. For the buying nation, offsets appear to provide industrial benefits in the form of jobs, technology transfer, support for the defense industrial base and foreign currency savings [Hall and

482

K. Hartley

Markowski (1 994), OMB ( 1 987)]. But appearances can be deceptive. Many of these alleged benefits are attractive to vote-sensitive governments and such claims need to be subject to careful and critical evaluation. There might be alternative and cheaper methods of achieving these objectives. Offsets need not necessarily be inefficient and welfare-reducing. In some circum­ stances, offsets might contribute to efficiency improvements if they remove non-tariff barriers and lead prime contractors to search for, and to discover, more efficient sub­ contractors located overseas (i.e. by extending market information and knowledge, and removing entry barriers to the use of foreign sub-contractors). Alternatively, defense offsets can be viewed as a sub-set of the price-quality-quantity trade-offs which characterize negotiations surrounding complex transactions. In a world of imperfect markets, oligopoly rents, complex transactions and asymmetrical information, offsets might enhance the welfare of the purchaser (e.g. a single contract with an offset might economize on transaction costs compared with a contract for defense equipment and a variety of separate contracts for the 'benefits' supplied under the offset). On the other hand, some forms of mandatory offset obligations may inhibit the buyer's flexibility in negotiating advantageous deals and so result in inefficient procurement [Hall and Markowski ( 1 994)]. Clearly, in competitive bidding for foreign defense contracts, overseas firms have every incentive to offer an attractive offset package as part of their bid: maximizing offsets becomes part of the competitive process, with firms seeking new and ingenious methods of satisfying their contractual obligations. They might, for example, use specialist agencies, such as banks, as well as their suppliers to achieve their offset targets; and they will try to claim as much business as possible as offset. At the same time, vote-sensitive governments have every inducement to claim the maximum size of offset deal so that they can justify the import of defense equipment in terms of protecting the national defense industry, jobs and technology. There are, however, worries about the real benefits of offsets. Reservations have been expressed about the following issues [Martin and Hartley ( 1 995)] : (i) New work. There are concerns about the extent to which offset business represents genuinely new work which would not otherwise have been obtained without the offset agreement. For example, on the UK purchase of American Boeing AWACS aircraft, the UK negotiated an impressive 1 30% offset agreement (i.e. offsets to 1 30% of the value of the UK order). However, critics have suggested that, typically, genuinely new business might be 25-50% of the total offset. (ii) Civil work. On the UK purchase of AWACS, Boeing was allowed to count its purchases of Rolls-Royce civil aero-engines for its commercial aircraft as part of the offset obligation. This was criticized for allowing civil aerospace work to count against a defense offset commitment; and because the arrangement was generous to Boeing, representing more than 50% of Boeing's total offset commitment. In fact, Rolls-Royce aero-engines would have been purchased irrespective of the offset agreement: hence they were not new work resulting from the offset obligation [HCP 286 (1 989)] .

Ch. 16: Industrial Policies in the Defense Sector

483

(iii) High technology work. Whilst offsets can appear to offer substantial work shares, it is unlikely that they will provide much high technology work. This is because offsets are for the purchase of existing defense equipment where all the major development work has been completed. Moreover, the original manufacturer will wish to maintain its property rights in valuable technologies. 8. The military production function: internal efficiency

Equipment forms a major input into the military production function. The result of combining equipment with military personnel and other inputs (e.g. land) is the production of military outputs in the form of national protection, security and peace. The policies used to purchase defense equipment have major implications for its unit costs and hence affordability from a fixed defense budget. Purchasing from a high cost national DIB means less equipment for the nation's armed forces raising questions about whether policy is aiming to protect the DIB or the nation's citizens. Once equipment is acquired, military commanders have to determine its most efficient use. In theory, this is a simple optimization problem which in the private sector would be 'solved' by profit conscious firms in competitive markets seeking to minimize costs. Such firms would have an incentive to substitute cheaper for more expensive factor inputs which would be reflected in substitutions between different equipments and between equipment and personnel (e.g. quality versus quantity of defense equipment; air systems replacing land forces). However, incentives to make such substitutions are usually absent in military 'firms': the lack of competition and the nature of employment contracts for military personnel means that there are no strong pressures and incentives for individuals and groups to minimize costs [Sandler and Hartley ( 1 995, p. 1 57)]. On the contrary, each service will seek to protect its budget and maintain its traditional monopoly property rights (i.e. over air, land and sea), so reducing the opportunities for efficient substitution between the armed forces. Efficient substitution is also unlikely within each of the armed forces. Commanders of army, navy and air forces bases will be concerned with promotion opportunities which are usually related to military rather than economic performance. Indeed, military commanders seeking power and prestige will aim to maximize the size of their bases. As a result, they have every incentive to 'hoard' equipment and personnel, as well as accommodation and real estate for training purposes. Bases located in valuable city center sites or close to national capitals are especially attractive. The continued retention of such bases will be rationalized and justified on military criteria, such as the need for valuable training areas or proximity to the national defense ministry: in reality, bases in attractive locations confer non-military benefits (e.g. proximity to cultural and leisure facilities in a nation's capital; the opportunities for using training areas for leisure pursuits). It is feasible to construct institutional and budgetary arrangements which would provide military commanders and their units with efficiency incentives. Within the

484

K. Hartley

army, navy and air force, various military bases could be required to bid competitively for the provision of contractually agreed services for a fixed budget. For example, air force bases could compete for providing an agreed number of combat aircraft patrols per annum; and army units could compete to offer combat ready infantry units available for rapid deployment anywhere in the world. Military commanders and their units would have every incentive to economize on factor inputs. Once they have been allocated defense equipment (e.g. combat aircraft; tanks, etc.), they would have incentives to operate the equipment efficiently. They might substitute civilians for military personnel to maintain, service and repair the equipment: for example, repair and maintenance work could be 'contractorized' and undertaken by private firms (e.g. civilian garages repairing military vehicles). Similarly, there would be incentives to economize on spares acquisition and to substitute training simulators where these are cheaper than 'real' training which uses expensive equipment and large acres of ground. The aim of the scheme would be to provide military commanders with opportunities and incentives for entrepreneurship.

9. Conversion

Policies to improve the efficiency of procurement and the internal efficiency of the armed forces will mean a reduced demand for resources in the military-industrial sector. Some defense firms will lose from these changes with the inevitable job losses and plant closures. Military establishments will also be affected as the armed forces declare personnel redundant and close their bases. Where defense plants and military bases are major employers in a town or region, their closure has significant adverse impacts on the prosperity of local economies [see Chapter 1 7 of this Handbook and EC ( 1 992)]. Faced with plant and base closures and associated job losses, all societies and different types of economies have to consider how best to transfer resources from the military to the civilian sector. Two broad solutions are possible. First, efforts can be made to utilize existing defense establishments and their workforce to produce civil goods and services rather than defense equipment. This is the classic direct conversion of swords to ploughshares, tanks to tractors, aircraft carriers to oil tankers and bomber aircraft to civil airliners. Second, the closure of defense plants and bases might be accepted, with the focus on re-allocating the resources released to other civil firms, industries and regions in the economy. Both solutions raise questions about the appropriate role and extent of state intervention in the adjustment process. For direct conversion, state intervention might operate through a state conversion or diversification agency. For assisting resource re-allocation, state intervention might take the form of general manpower policies (e.g. retraining; mobility; information and careers advice).

Ch. 16: Industrial Policies in the Defense Sector

485

9. 1. Direct conversion Direct conversion appears attractive. If successful, it utilizes extstmg and valuable human and physical capital so appearing to avoid the costs, upheaval and 'wastes' associated with plant closure and redundancies. However, such direct conversion often fails to occur simply because of the costs required to exit defense markets and to enter new civilian markets. Some of these costs reflect the demand- and supply­ side characteristics of defense contractors. On the demand side, some defense firms are highly dependent on military sales to a single government customer, operating in a protected market with support for 'national champions' resulting in a 'cosy relationship' between contractors and the Defense Ministry [a culture of dependency: Melman ( 1 97 1)]. On the supply side, a defense firm's assets might be highly specific to defense, with little if any alternative use value. Examples include some defense technologies such as stealth and armor and the specialist defense plants needed to construct nuclear-powered submarines and inter-continental ballistic missiles [Sandler and Hartley ( 1 995, p. 293), Dumas ( 1 977, 1986)]. Further understanding of the problems of direct conversion can be obtained by using a taxonomy which focuses on the following economic characteristics for such converston: (i) The type of economy, namely, market, centrally-planned or transitional economy with a further distinction between developed and developing nations [UN ( 1 993)]. (ii) The ownership of defense plants, either publicly or privately owned [Ott and Hartley ( 1 99 1)]. (iii) The distinction between defense plants and military bases. In market economies, military bases usually have to change ownership to enter civilian markets (e.g. military air bases can be converted to civil airports, although there are examples of the joint uses of such bases). (iv) The extent to which a defense company is involved in one or all of the following activities: R&D, production, repair and maintenance. Direct conversion at each of these stages could involve different problems reflecting differences in demand requirements and asset specificity. For example, military R&D is characterized by secrecy and highly specialized military requirements with an emphasis on performance rather than costs: such features are less marketable in the civil sector [Nadal ( 1994), UN ( 1 993)]. In market economies, the direct conversion of specialist defense plants is not costless and instantaneous. There will be costs involved in re-equipping defense plants for civil production and in retraining managers, scientists and workers. It will also take time to change the culture of an organization from defense dependency to an enterprise culture: typically, an adjustment period of up to five years might be needed. Further costs will arise in searching for, and entering, new civil markets; and crucially, there is a need to discover civil markets which are expected to be profitable after bearing the costs of conversion and entry. Not surprisingly, faced with such adjustment costs,

486

K. Hartley

some specialist defense firms have decided to seek new military markets at home and overseas, to lay-off labor or close plants, or to diversify by acquiring new civil business. Adjustment will differ between the short and long run. In the short run, a defense firm's adjustment will be constrained by fixities and contractual commitments, so that variable labor without long-term contracts is most likely to bear any immediate adjustment costs. In the long run, all factors can be varied and the most efficient adjustments can be made [Hooper and Hartley ( 1 993)]. Conversion in some of the transitional economies such as Russia is occurring at the same time as the economy is changing from a centrally planned to a market economy. One of these tasks is difficult enough: to undertake both simultaneously represents a major challenge [UN ( 1 993), Wiseman (1 991)] . Conversion in Russia and the Ukraine has some further distinctive features. First, the magnitude of the adjustment problem. In 1992, employment in the military-industrial complex in the Russian Federation totalled some 5.4 million people equivalent to 7.4% of total employment, with examples of regions where over 40% of employment was defense­ related and some cities which were 'closed communities' wholly dependent on defense work [e.g. Zhukovsky, a city of 1 00 000 people, was the center of Russian aviation R&D: OECD (1995)]. The Ukraine was confronted with a similar massive conversion challenge. In the past, 700 industrial enterprises accounting for 1 8% of industrial production and 1 .2 million workers were dependent on defense orders; by 1 994, there were no orders! Second, Russian experience distinguishes between bureaucratic and technocratic conversion. The bureaucratic type involved top officials determining the output of civil goods using the old management systems and directives to produce TV sets, fridges, radios, cameras and washing machines, regardless of production costs. Technocratic conversion involved restructuring from below with the focus on purely technological criteria rather than the needs of the economy or on market research. Technocratic conversion was more successful than the bureaucratic type but it postponed 'greater conversion'. At the same time, the public was deceived as its political leaders, in attempting to preserve the existing structure, passed off small changes as major steps towards demilitarization. Conversion decisions were made by engineers rather than businessmen and economic planners and as a result many large defense production plants made poor choices and took on unrealistic or wasteful programs [Bougrov ( 1 994)].

9.2. Re-allocating resources and public policy Re-allocating resources from the military-industrial complex to the civil sector involves adjustment costs and takes time [UN ( 1 993)]. Much depends on the transferability of human and physical resources and how well and how quickly economies can adjust to change. For example, some of the skills of redundant military personnel and redundant defense workers might be highly specific with value only to the defense sector (e.g. missile operatives; nuclear weapons scientists). Other military skills might be general with value to large numbers of civil firms (e.g. air

Ch. 1 6: Industrial Policies in the Defense Sector

487

traffic controllers; computer skills; drivers; electronic and electrical repair specialists). Ultimately, though, the operation of the labor market is a major determinant of the efficiency of the adjustment process in any economy. How well and how quickly do labor markets work and clear? Similar questions need to be asked about the operation of other factor markets (capital, land, raw materials, energy). State intervention might then be rationalized on grounds of market failure, although public-choice analysis recognizes the possibility of government failure! One further issue has to be addressed, namely, is defense 'different' so that it qualifies for 'special' public policies favoring defense firms and redundant defense workers? Those who claim that defense is 'different and special' point to the importance, role and responsibility of government in determining the size and location of the military-industrial complex; the need to compensate the potential losers from change so as to minimize the barriers to change; and the fact that disarmament contributes to peace. Critics of this view claim that defense is not different and should be treated like any other declining industry in the civil sector; and that defense workers have been rewarded for the risks and uncertainties of employment in the industry. This is not to suggest that general economy-wide compensation policies should not be available for assisting industrial, employment and regional adjustment (e.g. via regional and manpower policies and income-deficiency payments). However, the question of whether defense is 'different and special' is likely to be the focus of myths, emotion and special pleading by interest groups likely to lose from policies aimed at improving efficiency in the military-industrial complex. Economists have to subject such special pleading to economic analysis, empirical evidence and critical evaluation. They need to identify the economic logic of any policy proposals for favorable assistance to defense industries, distinguishing between efficiency and equity issues. 1 0.

Conclusion: a research agenda

There is no shortage of research questions. There are extensive opportumtJes for applying public choice models (e.g. to analyze collaboration and the military production function). Much more reliable quantitative evidence is needed on the costs and benefits of different procurement policies. What are the cost and time penalties of collaboration, licensed and co-production; how valuable is equipment standardization and inter-operability; should wider industrial and economic benefits enter into equipment procurement choices; and what is the 'best' way of organizing and managing collaborative projects? What are the lessons from successful and failed conversions of defense plants and military bases in both market and transitional economies? Contrary to the prevailing fashion in economics, answers to many of these questions require the use of good quality case studies. References Arrow, K.J., 1 962, Economic welfare and the allocation of resources for invention, in: D. Lamberton, ed., \ 97 1 , The economics of information and knowledge (Penguin, London).

488

K. Hartley

Beard, R., 1 993, NATO armaments co-operation in the 1 990s, NATO Review 4 1 (2) (NATO, Brussels) 23-28. Bougrov, E., 1 994, Conversion in transitional economies: The case of the former USSR and Russia, Defence and Peace Economics 5, 1 53-166. Callaghan Jr, T.A., 1 975, US-European economic co-operation in military and civil technology (Center for Strategic and International Studies, Georgetown University, Washington, DC, September). CBO (US Congressional Budget Office), 1 994, The cost of the Administrations plans for the Army, Navy and Air Force through the year 20 1 0 (Congressional Budget Office, US Congress, Washington, DC, November). Chinworth, M., 1 992, Inside Japan's defense (Brassey's, Washington, DC). Demsetz, H., 1969, Information and efficiency: another viewpoint, Journal of Law and Economics 12, 1-22. Draper, A., 1 990, European defence equipment collaboration (RUSI/Macmillan, London). Dumas, L.J., 1 977, Economic conversion, productive efficiency and social welfare, Journal of Sociology and Social Welfare 4, 567-596. Dumas, L.J., 1 986, The overburdened economy (University of California Press, London). EC, 1 992, The economic and social impact of reductions in defense spending and military forces on the regions of the Commllllity (EC DGXVI, Brussels). Hall, G.R., and R.E. Johnson, 1 967, Aircraft production and procurement strategy (Rand, Santa Monica, CA). Hall, P., and S. Markowski, 1 994, On the normality and abnormality of offset obligations, Defence and Peace Economics 5, 1 73-1 88. Hartley, K., 1 983, NATO arms co-operation (Allen & Unwin, London). Hartley, K., 1 995, The analysis of the costs of non-Europe, in: K. Hartley and A. Cox, eds., The costs of non-Europe in defence procurement (Main Report, Part B: European Commission, Brussels). Hartley, K., and S. Martin, 1 993a, The political economy of international collaboration, in: R. Coopey, M. Uttley and G. Spinardi, eds., Defence science and technology (Harwood, Reading). Hartley, K., and S. Martin, 1993b, Evaluating collaborative programmes, Defence Economics 4, 1 95211. HCP 247, 1 99 1 , Ministry of Defence: Collaborative projects (National Audit Office, HMSO, London). HCP 265, 1 98 1 , Concorde (Second report from the Industry and Trade Committee, HMSO, London). HCP 286, 1 989, The working of the AWACS offset agreement (Defence Committee, House of Commons, HMSO, London). Hooper, N., and K. Hartley, 1 993, UK defence contractors adjusting to change, centre for defence economics research monograph series, Vol. 3 (University of York, England). Jane's, 1 994, Jane's all the world's aircraft 1 994-1 995 (Jane's Information Group, London). Kirkpatrick, D.L.l., and P. Pugh, 1 983, Towards the Starship Enterprise: Are the current trends in defence unit costs inexorable? Aerospace, May. Marin, D., and M. Schnitzer, 1 994, Tying trade flows: A theory of cotllltertrade, Discussion Paper 946 (Centre for Economic Policy Research, London). Martin, S., 1 995, The economics of offsets: Issues, policies and prospects (Harwood, Reading). Martin, S., and K. Hartley, 1 995, UK firms experience and perceptions of defence offsets: survey results, Defence and Peace Economics 6, forthcoming. Matthews, R., 1 992, European armament collaboration (Harwood, Reading). Melman, S., 1 97 1 , ed., The war economy of the United States: Readings on military industry and economy (St. Martins Press, New York). Moravcsik, A., 1 990, Defence co-operation: The European armaments industry at the crossroads, Survival XXXII, 65-85. Mueller, D.C., 1 989, Public choice II (Cambridge University Press, Cambridge). Nadal, A.E., 1 994, Military R&D: The economic implications of disarmament and conversion, Defence and Peace Economics 5, 1 3 1-1 5 1 .

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OECD, 1 995, The OECD observer 1 92, February, March (OECD, Paris) 39-43. OMB (US Office of Management and Budget), 1 987, Impact of offsets in defense-related exports (Office of Management and Budget, Washington, DC). Ott, A., and K. Hartley, eds., 1 99 1 , Privatization and economic efficiency (Elgar, Aldershot). Peacock, A.T., 1 992, Public choice analysis in historical perspective (Cambridge University Press, Cambridge). Pomfret, R., 1 99 1 , The new trade theories, rent-snatching and jet aircraft, The World Economy 14, 269-277. Pugh, P., 1986, The cost of sea power (Conway, London). Pugh, P., 1 993, The procurement nexus, Defence Economics 4, 1 79-194. Rich, M., W. Stanley, J. Birkler and M.I. Hesse, 1 9 8 1 , Multi-national co-production of military aerospace systems (Rand, Santa Monica, CA). Sandler, T., and K. Hartley, 1 995, The economics of defense (Cambridge University Press, Cambridge). Tyson, L., 1 992, Industrial policy and trade management in the commercial aircraft industry, in: Who's Bashing Whom? Trade Conflict in High Technology Industries (Institute for International Economics, Washington, DC). Udis, B., and K.E. Maskus, 1 99 1 , Offsets as industrial policy: lessons from aerospace, Defence Economics 2, 1 5 1-164. UN (United Nations), 1 993, The economic aspects of disarmament: Disarmament as an investment process (United Nations, New York). Wiseman, J., 1 9 9 1 , Privatization in the command economy, in: A. Ott and K. Hartley, eds., Privatization and economic efficiency (Elgar, Aldershot).

Chapter 1 7 THE REGIONAL IMPACT O F DEFENSE EXPENDITURE DEREK BRADDON

University of the West of England

Contents

Abstract Keywords 1 . Introduction 2. Data problems 3. Theoretical approaches for evaluating regional impacts 3 . 1 . Economic base models and regional multipliers 3 .2. Regional defense expenditure and local labor markets 3 .3. Input-output analysis

3.4. Regional econometric models

4. The regional distribution of defense expenditure 5. Selected case studies 6. Policy implications 7. Conclusions References

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T. Sandler © 1995 Elsevier Science B. V All rights reserved

492 492 493 494 495 495 498 499 502 506 513 515 518 5 19

492

D. Braddon

Abstract

This chapter examines the current state of knowledge regarding the economic impact of defense expenditure at the level of the regional economy from a global perspective. Appropriate theoretical and analytical approaches are identified and selected case studies reviewed. The regional concentration of defense expenditure is explored using a variety of indicators and perceived differences in the economic impact of defense industry decline and military base contraction and closure are evaluated. The chapter considers relevant labor market issues and examines the different impacts to be expected in developing countries. Policy implications are explored in the context of the post-Cold War environment confronting the defense sector. Keywords

regional multiplier, regional models, supplier network, military bases, labor market, adaptive capacity, regional policy

Ch. 1 7: Regional Impact of Defense Expenditure

493

1. Introduction

For many regions of the world, particularly in the advanced industrial nations, economic prosperity has depended historically upon defense-related industrial pro­ duction and/or military base-related activities, especially in periods when the adverse effects of national and international economic recession would have otherwise eroded the buoyancy of the local economy. In the 1 990's, however, the vulnerability of many defense-dependent regional economies to deep and sustained reductions in defense expenditure has become a prominent economic and political issue. Sharply declining national defense budgets, impacting upon almost all significant military goods producers and military infrastructures, have posed a serious threat to short-term regional prosperity and, in some cases, even to long-term regional and sub-regional economic viability. While similar or more extreme reductions in defense budgets have been experienced over the last 50 years (e.g. after World War II, the Korean War and Vietnam), on those occasions, the continual presence and rapid escalation of the Cold War super-power arms race made a cyclical resurgence in defense budgets inevitable [Grawe ( 1 99 1)]. Few analysts now anticipate such a cyclical recovery in defense expenditure in the future. Consequently, the effects of permanently lower levels of defense spending on the regional industrial and technological base and on the local communities, companies and workers that it supports is likely to be profound. Furthermore, the revision of military strategies following the end of the Cold War has initiated a new phase of military base closures and realignments by most of the major powers with significant regional consequences. In particular, base closures by both the USA [US General Accounting Office ( 1 99 1)] and the former Soviet Union will have the greatest impact within Europe [Sharp ( 1 990)] . The nations within the European Union most vulnerable to US military withdrawal are Germany, the UK and Italy. The case of Germany best illustrates the regional economic significance for a nation acting as host to large numbers of foreign troops stationed within its territory. During the 1980's, some 400 000 NATO troops and their families were stationed in West Germany, generating significant expenditure of DM 2 1 billion (mainly in specific regions) with direct and indirect employment effects of some 230 000 jobs. Similarly, in 1 988, some 425 000 Soviet troops were stationed in East Germany. However, the regional and national income and employment effects in this case were negligible as these troops were strictly isolated from local communities and almost all civilian posts were filled by Soviet citizens. In total, estimates suggest that the impact on demand levels from the Soviet forces amounted to no more than 4.5 billion marks in 1 989 or about 1 % of industrial output [Maneval ( 1 993)]. The scale of regional impact associated with the withdrawal of such foreign troops can be extremely significant, depending upon the specific economic condition of the host region at the time of withdrawal. Current estimates suggest that, together with planned manpower reductions in the Bundeswehr, NATO and Soviet troop withdrawals have combined to reduce the number of soldiers and their families stationed within

494

D. Braddon

Germany by some 850 000 over a period of just four years. Such rapid manpower reductions and associated multiplier consequences can generate serious regional consequences as, for example, in the Mainz region where, in the 1 980's, some 5700 people were employed in a US Army repair facility. By 1 994, over half of these j obs had been lost and recent developments suggest that the remainder may be at risk [Lock and Vob ( 1994)]. Taking an international perspective, this chapter first identifies and evaluates relevant analytical techniques employed to assess the regional impact of defense expenditure, reviewing evidence from a number of important studies, and then explores the regional distribution of that expenditure globally. Similarities and differences between the regional economic and labor market impacts associated with the defense industry and its supply chain and those associated with military bases and establishments are considered, along with particular issues confronting developing countries. The chapter concludes with an assessment of policy implications at the regional level. 2. Data problems

The precise geographical incidence of defense expenditure (defined to include spending on military personnel and bases; defense equipment supplied by the entire defense industrial base; and other relevant spending: e.g. works, maintenance, etc.) is extremely difficult to estimate and compare empirically for several reasons. First, the quantity, quality and level of disaggregation of both national and regional defense expenditure varies greatly in availability, accuracy and comparability. Secondly, government statistics relating to the distribution of defense procurement expenditure usually indicate only the region (or city) in which recipient firms have headquarters or principal locations, neglecting the regional impact of second and third stage procurement through sub-contracting and supply chains. This problem is exacerbated by the fact that major defense companies tend to operate in more than one region and in more than one industry, while frequently themselves being just one division of a national or international conglomerate engaged in many other non-defense activities. Data problems in this area of analysis are complicated further by the national secu­ rity requirements surrounding defense activities (particularly constraining information concerning industrial enterprise and military base location) and by differing views as to precisely which industries are contained within the "defense" sector. Furthermore, both final demand and intermediate products in the defense sector tend to be highly specific and do not always fit neatly into standard industrial categories. Accurate evaluation of the industrial and regional impact of defense expenditure, then, requires a particularly detailed level of data disaggregation to capture fully the real effects. A further problem relates to the selection of appropriate indicators to best reflect the economic significance of defense activity at the regional level. These could include actual or estimated numbers in defense employment within a region; the share of total regional employment emanating from the regional defense sector; the value of regional

Ch. 1 7:

Regional Impact of Defense Expenditure

495

output or income generated by regional defense activities; the share of total regional output or income emanating from regional defense business; the value of defense prime contracts awarded to a region, adjusted for supply chain leakages and so on. No single indicator, however, is likely to be suitable for the international comparison of regional defense-dependence. Even within a single nation, different indicators may be relevant since the regional economic significance of a particular kind of defense-dependence will be a function of that region's unique dimensions and characteristics as well as the economic condition and policy approach of the nation of which it is a part.

3. Theoretical approaches for evaluating regional impacts

The assessment of the regional impact of defense expenditure has conventionally been undertaken through the application of economic base models, regional multiplier esti­ mates, the regional application of input-output analysis and through the development of more complex econometric models. Defense expenditure received by one specific region is essentially income which will, in turn, encourage other economic activities and generate additional income flows in the local economy. Regional impacts will comprise the direct effects of prime contracts awarded to companies in the region (or direct expenditure on military establishments located there); the indirect effects from resulting supply and sub-contracting business generated; and the induced effects from consequent changes in regional consumption and related investment activity. In practice, the actual impact of variations in defense expenditure within a region (and between regions) will depend upon what form the expenditure change takes and the economic structure and industrial inter-relationships of the region concerned. 3. 1.

Economic base models and regional multipliers

These models seek to identify what proportion of regional output or employment is dependent upon external and internal markets. That proportion of regional economic activity driven by external markets is seen as the basic and essential requirement for regional prosperity. Non-basic economic activity with an entirely local focus is seen as being dependent upon this external stimulus. Consequently, the capacity of a specific region to maintain and expand prosperity and employment will depend upon the basic/non-basic activity ratio which can be utilized, in turn, to derive a simple regional multiplier. Separating the regional economy into its two components: (1) where Et is the total regional income or employment; En, non-basic sector income or employment within region; Eb, basic sector income or employment within region.

496

D. Braddon

With z as the ratio of non-basic to total employment, this implies that: (2) If demand now increases for basic goods such as defense production in a region, the resulting change in basic employment will lead to a change in non-basic and total employment. Substituting Equation (1) into (2) gives: and :

z

E = --Eb n 1 -z '

(3,4)

from which the multiplier can be derived as 1/(1-z). The value of economic base multipliers, however, in evaluating the regional impact of exogenous economic change is constrained by two important problems. First, localized (non-basic) economic activity may be affected by factors other than total regional income, implying that the proportionality assumption incorporated above cannot be sustained. However, assuming time-series or cross-section data exists for total regional income or employment (£1) and for income or employment generated by the basic sector (Eb), regional multiplier estimates can be obtained by regressing E1 on Eb. Second, the basic sector of a regional economy is likely to comprise a set of individual industries with significantly different import propensities and labor force socio­ economic characteristics. As a result, regional economic consequences emanating from changes in export demand will depend upon the specific industry or industries affected, a problem which can be overcome by calculating a set of basic industry-specific regional multipliers. The regional economic impact of military base contraction and closure will depend on several factors. These include the nature and size of a base scheduled for contraction or closure and the relevant closure timetable; the density of bases and the proportion closing within a specific region; base proximity to rural and urban communities and their capacity for economic regeneration; and the potential for retaining part of the operational functions of a base after closure in the form of a "contractorized enclave". It will also include employment of local civilians on the base; demand for housing for service personnel and their dependents; demand by military and civilian staff for local services and utilities; demand for local businesses to service the base and the business rates and taxes payable to local authorities [Braddon et a!. ( 1 99 1)]. In terms of local economic impact, the incomes and expenditure of military base personnel and their families should be particularly significant since salaries in the armed forces tend to be on a par with or considerably higher than for equivalent employees elsewhere in the public sector. However, military bases tend to be relatively closed economies with many goods and services provided and consumed internally, thereby diminishing the economic stimulus on the local or regional community by generating multiplier consequences significantly lower than for a comparable loss of civilian jobs. The regional multiplier effects of military base operations can also be affected by the age profile of employees. Where a base contains a large number of

497

Ch. 1 7: Regional Impact of Defense Expenditure Table I Multiplier estimates for defense-related regional activities Study

Year

Location

Activity

Weiss and Gooding

1 968

USA

naval shipyard

1 .55

air base

1 .35

Demilitarized

1 99 1

UK

Employment multiplier

manufacturing

1 .78

defense industry

0.83 1 .0-2.0

Germany

defense industry

Netherlands

defense industry

1 .33 2.1

IFO

1 991

Germany

defense industry

ADCC

1 992

UK

shipyard

1 .96

UK

defense electronics

1 .27

Aztec

1 992

UK

USAF air base

1 .15

UK

aircraft factory

1 .5

younger service personnel, the marginal propensity to consume locally (and therefore the multiplier effect) is likely to be above average. Regional multipliers in defense-dependent regions can also be derived by modifying the Kahn/Keynes employment-income multiplier process. At the regional level, withdrawals from the flow of income are likely to be significant through high import propensities, depending on the degree to which the regional defense industry supply chain extends beyond regional borders. Table 1 shows the range of regional multiplier estimates for defense expenditure generated by a number of studies. The differences in multiplier estimates observed in Table 1 can be attributed to the unique characteristics of each region, its location and the precise form defense expenditure takes. Where a region is closely inter-linked with other regions, the multiplier effect is likely to be reduced. Where defense companies or military bases have a high degree of self-sufficiency, the multiplier effect will similarly diminish. Multipliers estimated for defense activities in rural areas will differ from those in urban areas where the effects of more advanced infrastructure, high-technology industry, sophisticated services provision and a more flexible labor market will be likely to exert a significant effect. However, recent research focusing upon the supply chain of a major defense prime contractor in the highly defense-dependent South West region of the UK [Braddon et al. (1 992)] suggested that conventional approaches to the evaluation of multiplier impacts may fail to capture adequately the fundamental changes taking place within the defense industry supply chain as it adjusts to the new business conditions of the 1990's. The research confirmed that the defense industry regional supply matrix includes a much wider range of business activity than is commonly supposed, implying significantly

498

D. Braddon

greater regional economic impact from defense expenditure variations than might normally have been expected. Again, the extent of regional inter-dependencies in the defense supply industry appears much greater than previously imagined. Companies were identified in different tiers of the network supplying not only one or more defense prime contractors directly but also other companies located in different tiers of the network (including their own) and, through them, indirectly supplying other prime contractors. Examples were found of companies within the region acting as first tier suppliers for one customer; second tier suppliers for another; and, simultaneously, as suppliers to several other sub-contractors and other suppliers in the same or separate product groups. In many cases, the companies themselves were unaware of the final destination of their output, exacerbating the problem of identifying and measuring both the content and extent of the regional defense industrial base and the regional impact associated with variations in the level and content of defense procurement expenditure. At the same time, however, the intensification of competitive pressures has fractured established regional buyer-seller relationships in the defense industry with prime contractors seeking to maintain their competitive edge in world markets by retaining only the most efficient and flexible suppliers, drawn from an increasingly wide geographic area. In general, most studies of conventional regional multipliers in the defense sector have derived estimates for defense employment of between one and two, indicating that for each direct job in defense, up to one additional job will be indirectly supported by related economic activity elsewhere in the regional economy, excluding induced multiplier effects. Conflicting evidence questions the employment-creating capacity of defense expenditure compared with other forms of government expenditure [Hartley and Hooper (1 993), Smith ( 1 99 1)]. 3.2.

Regional defense expenditure and local labor markets

At a time when, almost universally, defense expenditure is declining in arms-producing nations, the capacity of a particular region to absorb adverse impacts upon employment and income will depend largely on the flexibility and responsiveness of the local and national labor markets and the potential for new injections of alternative economic activity at the regional level. Initial labor market impacts may include job-shedding as part of the planned rationalization of prime defense contractors and of small and medium sized enterprises in the defense sector; together with unplanned and sudden job-shedding by companies located in the lower tiers and levels of the defense industry supply chain, unaware of the degree to which their business is defense-dependent. Further job-shedding in non­ defense sectors of the economy will then occur as the regional multiplier consequences of reduced demand impact upon local business. Where defense industrial companies or military bases actually close, the labor market impact is unlikely to be restricted to a neat set of geographical boundaries but will extend across local government areas with variable severity, depending

Ch. 1 7: Regional Impact of Defense Expenditure

499

on the geographic distribution of defense suppliers, military bases and associated establishments and their suppliers. Some regions which have high concentrations of both defense supply companies and military bases are likely to experience regional "clustering" effects and, in the absence of compensating employment gains in other sectors following a sustained reduction in defense expenditure, their economic base could be severely eroded. The capacity of the regional labor market to respond to reductions in defense spending will be affected significantly by the mobility of displaced labor and the evolving skill profile required in any regeneration of the regional economy. There is likely to be a significant difference here between the regional impact of defense expenditure reductions which affect employment in defense industry and that in military bases and establishments. While the extent and duration of both forms of unemployment will depend upon the absorptive capacity of the local economy and the flexibility of the local labor market, redundant personnel in the armed forces are likely to be more geographically mobile, tending to move away from their place of discharge (perhaps returning to their home town, seeking new employment). With the exception of some highly-qualified defense scientists and technicians, however, unemployed defense industry workers are likely to remain in the same location, seeking alternative employment while effectively swamping the local labor market with similar skill and experience profiles. The issue of labor mobility, therefore, adds a further dimension to the variation in regional multiplier estimates in the defense sector.

3.3. Input-output analysis Another prominent type of empirical model employed to estimate the regional economic impact of a change in defense expenditure has been input-output analysis [Richardson (1 985), Miller and Blair ( 1985)]. Devised initially by Leontieff (195 1) with important developments introduced by Isard (1960) and Isard and Langford ( 197 1 ), input-output analysis is particularly appropriate to the study of the effects of demand-driven changes in the regional economy since it focuses specifically upon the inter-dependencies that bind together separate sectors of the regional economy. Such inter-relationships have been categorized as backward and forward linkages with the former relating to input provision and the latter to output utilization [Hirschman (1958)]. Backward linkages in one particular sector are induced by additional final demand for the output of that sector and, while the effects may spread widely throughout the economy, the original demand increase is said to emanate from the sector of origin. On the other hand, linkage effects could be calculated with respect to the sector of destination. Key sectors of the economy will exhibit varying degrees of linkage with, by definition, primary production having virtually no backward linkage but significant forward linkage, while manufacturing offers the possibility of significant backward linkages. In general, the nearer a sector is to production for final demand, the greater the scope for backward linkage. Within a region's industrial and consumer sector, these linkages depend upon the structure and scope of the input and component

D. Braddon

500

chain stretching from regional suppliers to their prime contractor customers and other consumers. Three variants of the input-output approach are appropriate for economic impact analysis and, suitably adapted, may be employed for regional evaluation and estimation. The open comparative static input-output model employs standard input-output tables, supplemented with average labor coefficients for relevant industries, to determine the employment effects of defense expenditure. Closed static models can be used to estimate the multiplier consequences of defense expenditure by incorporating a private consumption sector in the model. Finally, dynamic models supplement input­ output analysis with econometric equations, designed to estimate demand, both factor and final, with the additional attribute that they can be extended to incorporate the important effects of changing technology. Overall, closed static models will generate higher values than open static models, through the incorporation of full multiplier consequences. The results estimated by static and by dynamic models will differ since the former employ average coefficients while the latter employ marginal coefficients and incorporate more extensive feedback effects. The input-output approach begins with the assumption that the output of any good or service in an economy is either utilized for final consumption by households, government or exports or is employed as an input in the production of goods and services within that economy (including itself). For any regional economy, then, each output can be represented by a production function equation where output equals final consumption plus the sum of all its uses as inputs in producing the output activity of that region. To avoid excessive complexity, input-output models are usually constructed on the basis of three key assumptions. Each industry is assumed to produce a single homogenous product or two or more fixed-proportion joint products. Furthermore, each industry is assumed to employ a fixed combination of relevant factors of production or inputs in producing its output. Constant returns to scale are assumed to apply throughout the model. To produce each unit of the jth product, then, will take a 11 amount of the first required input, a21 of the second input and, in an n industry economy, ani of the nth input. The term a lJ denotes the input coefficient. For this n industry economy, input coefficients are conventionally arranged in a matrix A = au as indicated below: I II III

N

II

III

N

al l a2 1 a3 1

GJ2 a22 a32

GJ3 a23 a33

Gin Gzn a3n

Gni

Gn2

Gn3

Gnn

In this matrix, the amount required from each input industry to produce a unit of output of another industry (or of itself) is indicated by column data. In addition to an n industry formulation, an input-output model may contain an open sector (often

Ch. 1 7: Regional Impact of Defense Expenditure

501

the household sector) which generates a final demand exogenously and provides labor inputs not supplied by the n industries. This element of non-input demand means that the sum of elements in each column of the input matrix A must now be less than one in order to satisfy this additional demand. Thus:

L aiJ < 1

j = 1, 2, . . . , n.

Since the value of output generated by an industry must be matched by receipts accruing to all relevant factors of production employed in its production, the amount by which a column's aggregate value is below 1 must equal the payment to the open sector input. That is, the value of the primary input required to produce one unit of the 1th commodity will be Overall, for an industry to produce output that will both meet the input requirements of n industries as well as the final demand of the open sector, its level of output (x 1 ) must satisfy the following equation:

1-aiJ.

(5) or: (6) where final demand for output is shown by d 1 and input demand for the jth industry is represented by a11x1. In matrix form, this gives:

((1 -au) -a21

-a 12 ( 1 - an)

-an i

(1-A)

or (1-A)x = d, where x = the variable vector and d = the final (constant) demand vector. represents the technology matrix (T); therefore Tx = d. As long as The matrix T is nonsingular, the inverse r- 1 allows a unique solution to the equation as below: X = r- 1 d = ( 1 - At 1 d.

(7)

Where the exogenous sector of the open input-output model is absorbed into the system or treated as another industry, the model becomes closed. Final demand and primary inputs are excluded and replaced by the input requirements and output of the newly conceived industry. All goods are now considered to be intermediate goods with everything being produced to meet the input requirements of n + 1 industries in the new model. As a result, each column sum in input matrix A must now be exactly

502

D. Braddon

equal to

1.

Thus,

a01

=

1 - alJ - a21 - a31 - . . . an1;

where subscript

0 denotes the "newly

conceived" industry. In a closed model, there will be no unique "correct" output mix. Output levels

x1 . . . Xn can be determined in proportion to each other but their absolute

levels cannot be fixed without imposing additional restrictions on the model [Chiang

( 1 984)]. At the regional level, input-output models are conceptually similar to national models. Within a region, each industry will be related to other industries in that region and to elements of final demand. Regional models usually take one of two forms: a "square" version structurally similar to national input-output models with a highly aggregated final demand sector; and a "dog leg" variant in which the final demand sector is more disaggregated. In this latter category, extra-regional trade is often disaggregated by industry and, with this "foreign trade" sector precisely specified, the "dog leg" variant can be an extremely effective tool for the structural analysis of a regional economy [Glickman

( 1 977)].

More sophisticated inter-regional models are required to capture the regional flows of output that occur in many industries and are particularly relevant to the defense sector with its regional supply and sub-contracting networks. Adding a spatial dimension to regional input-output analysis requires the addition of subscripts to coefficients to denote the origin and the destination of such regional transfers. Thus,

n

,X; =

m

L L rsXik +r Y;, s=i k=I

i, k =

1 , 2, . . . , m,

s

= 1 , 2, . . .

, n.

(8)

The inter-regional system can then be specified as:

n

,X; =

m

L L rsaik rXk rXi s=I k=I

(9)

where

,X; is the total output of industry i in region r; rsXik denotes the movement of output of industry i in region r to industry k in region s ; , Y; is final demand for output o f industry i i n region r; rsaik is the production coefficient specifying the amount of i needed to purchase one unit of

k

for units of

i moved from region r to region s.

Dynamic input-output models, both national and regional, require the addition of some level of econometric modelling, usually employing time-series and various regression analysis techniques. This allows the construction of a regional model which is intrinsically more flexible than static input-output models, being less constrained by particular theories of regional structure or excessively inhibiting assumptions.

3.4. Regional econometric models In recent years, a number of national econometric models designed to explore the impact of defense expenditure on the economy have been constructed with regional

Ch. 1 7: Regional Impact of Defense Expenditure

503

forecasting capabilities. Specific regional economic models, some of which explicitly contain categories of defense expenditure, have been developed principally in the United States since 1965 and have evolved over time in terms of increasing levels of sophistication. Table 2 summarizes some of the most prominent of these national and regional input-output and econometric models. In the initial regional econometric modelling literature, a "satellite" type of model was employed, drawing heavily upon national econometric models. Such models focused attention at the regional level on the application of the Keynesian income­ expenditure approach where initial changes are attributable to an increase in aggregate demand, in tum facilitating supply-side response in regions where excess capacity already exists. In these models, regional economic activity is disaggregated into its component parts, each key economic activity being modelled separately (e.g. investment determinants, employment and output). Estimated relationships take the form of forecasting equations which establish a "best fit" association between variables. Disaggregation and modelling allows the impact of an exogenous shock to the region's economy to be traced and measured more precisely. Models of this kind comprise a large number of interdependent equations in which each variable determined by the model is a function of other specified endogenous variables, exogenous variables and an error term. Each equation, then, takes the form: Xit

= j(Xjt,Ykt, et),

( 1 0)

where xit is the endogenous variable i in period t; x11 is the endogenous variable j in period t ; Ykt is the exogenous variable k in period t; and e1 is the error term in period t. In such a model, the determination of xit by another variable determined elsewhere in the model, such as x11 , gives it simultaneity and allows variables to interact as they would in the real world. In recent years, regional econometric models have been extended to include the role of exports in regional growth; the effects of differences in regional and national labor costs; distributed lag formulations; extra-regional demand variations; and neo-classical supply-side modelling. Regional input-output and/or econometric models require detailed disaggregated regionally-focused data that are rarely available. As a result, many applications of the input-output and other modelling techniques at the regional level have had to employ adjusted inter-industry coefficients derived from national input-output tables. For a variety of reasons, national input-output tables contain significantly more sectors than their regional counterparts. Where econometric models at the regional level are constructed on the basis of national models, this "top down" approach implies little scope for regional effects to feed through and influence the national outcome. On the other hand, a "bottom up" approach in which regional variables are determined independently and then aggregated, while it prevents regional diversity being ignored, requires detailed, complex and frequently repeated survey work in order to capture the unique dynamism of the regional economy [Ball ( 1 993)].

504

D. Braddon

Table 2 Examples of national and regional models of defense expenditure impact with regional and/or sub­ regional forecasting capabilities National models

Canada [Center for Studies in Defense Resources Management (1983)] Comprises (i) a comparative static input-{)utput model to explore the impact of current defense expenditure; (ii) a neo-classical comparative static input-{)utput model to examine effects of marginal changes in defense expenditure and (iii) CANDIDE, a dynamic input-output model used to explore the impact of long term changes in defense expenditure. Industrial employment impact examined through both open and closed input--output models covering 1 9 1 industries. Contains regional model which revealed high defense dependence of Pacific provinces. France [Ministere de Ia Defense (1984)] Comprises AVATAR, a comparative static input-{)utput model developed to assess the average effects of defense expenditure on employment and PROPAGE, a dynamic model, designed to capture the effects of increasing defense expenditure over time. Again, the models reveal the concentration of French defense expenditure both in terms of industries and regions. West Germany [Filip-Kohn (1980)] Employs 1 972 and 1 976 input--output accounts with 34 production sectors, six final demand vectors and three primary demand vectors and utilizes average employment/output ratios to estimate defense­ related employment levels. Industrial employment associated with defense is found to be concentrated in relatively few regional industries (motor vehicles, electrical equipment, precision optics, metal manufacture, etc.). United Kingdom [Dunne and Smith (1984)] Utilized the Institute for Employment Research version of the Cambridge Growth Project Model (Warwick University), a dynamic input-{)utput model with an econometric equation system. The model is disaggregated to 40 industries, 49 categories of consumption, five categories of government current expenditure and four categories of capital expenditure. The model's estimates indicate the degree of concentration of UK defense expenditure in certain key industries and sub-regions. United States [DoD (1980)] Employs the DEIMS model (Defense Economic Impact Modelling System), a 400 industry dynamic input-{)utput model incorporated in an econometric model, developed by Data Resources Inc., the model includes a "Defense Translator" which allows for the different composition of weapons systems compared to other products. Within the DEIMS system, a regional model enables state-level projections of defense expenditure impact to be made. Regional models

Michigan [Research Seminar in Quantitative Economics (1965)] A basic econometric model with OLS regression equations employed to predict regional variables such as employment, personal income, change in government, State purchases, retail sales, labor force and net migration). Depended heavily upon national variables. California [Burton and Dyckman (1965)] A model comprising 1 7 9 OLS regression equations which predicted personal income, wage and non­ wage income, employment in over 50 industries, taxes, etc. 2 1 national variables taken as exogenous, including several categories of Department of Defense expenditure. North East Corridor [Crow (1973)] A large regional econometric model comprising 50 stochastic equations and covering 1 0 states (from New Hampshire in the North to Virginia in the South and included the District of Columbia), divided into 3 sub-regions. Predicted general economic activity in the region and focused in particular upon gross output originating in the region, employment, wages for nine sectors, consumption, investment, state and

continued on next page

Ch. 1 7: Regional Impact of Defense Expenditure

505

Table 2, continued local expenditure, non-wage income and net migration. This model utilized both pooled cross-section and time series data.

Pennsylvania [Klein and Gliclanan (1975)] A large econometric model with 92 equations (60 stochastic), employing time series data and logarithmic functions. Predicted output, employment, agricultural production, wage and non-wage incomes, consumption, government revenue, labor force and demographic change and retail sales. Output and employment sectors were disaggregated into nine economic sectors with both national and local variables determining the estimates derived.

References Dunne ( 1 9 9 1 )

Glickman ( 1 977)

Where regional tables are derived from national input-output tables, a national transactions matrix of dimension N is taken and condensed to create a regional coefficient matrix of dimension R < N and is then adjusted with the use of location quotients. These are derived, in turn, from national and regional employment figures. For a given industrial sector, the location quotient is the ratio between the regional and national share of output or employment. As an example, if the manufacturing sector of a region employed 25% of total regional employment compared with a national figure of 50%, the location quotient would be one-half, implying that manufacturing is significantly under-represented in that regional economy. Applying location quotients to national data allows for the derivation of a new matrix of input coefficients which should better reflect regional employment and output patterns. However, the use of general location quotients of this kind (usually for large industrial sub-groups such as manufacturing) presumes that the difference between national and regional coefficients remains the same whichever manufacturing sector is being considered. This will be a significant problem for regions which, historically, may have concentrated on supplying the requirements of one or two specialized manufacturing sectors (e.g. defense and aerospace). Recently, this conventional approach has been criticized and an innovative, alternative approach proposed which has potential for improving the reliability of intra-regional coefficients and, thus, for regional multiplier estimates generated in future studies [Flegg et al. ( 1994)]. Output and employment in the defense sector do not fall neatly into standard industrial classifications and the definition of what constitutes a "defense supply industry" at the regional level will therefore determine what is included in the relevant regional model. Considerable effort has gone into improving the availability and accuracy of regional statistics [in particular, through survey-based approaches: e.g. McGregor and McNicoll ( 1 992)] but, nonetheless, this lacuna in the data available inhibits derivation of more reliable estimates. A range of other problems can also be anticipated in the design, conduct and interpretation of regional models and their estimates. First, data are often available only on an annual basis, thereby yielding relatively few observations

506

D. Braddon

to include in the model. Since there are few time series of any length in regional data, models are often rather limited in terms of the variables they can include, implying relatively simple models based upon sets of bivariate equations and effectively reducing the degrees of freedom. Furthermore, econometric estimates of employment-elasticity with respect to changes in defense expenditure can be affected by internal corporate decisions regarding the retention of key personnel. Attempts by defense companies to protect their interests when defense expenditure declines may lead some companies to effectively stockpile skilled labor (for example, design teams) in the hope of improving business conditions in the future. Existing labor will then be under-utilized for a period, reducing the marginal requirements when demand conditions improve and introducing estimation errors into the results of dynamic models. Again, the process by which changes in defense expenditure are translated into employment impacts can be an important source of error. It is usual to multiply the output generated by defense expenditure by appropriate output/employment ratios for the industry concerned. However, the ratio for military production in such an industry may be very different to that for civil production, especially in an industry where military production has historically taken place in the less competitive, cost-plus environment. Large divergences may occur, therefore culminating in estimation errors. Furthermore, all such models simplify reality and tend to ignore critical distinctive economic, political, and social aspects of a particular region which may have significant implications for the accuracy of the estimates generated. Nevertheless, input-output and econometric models still offer the most appropriate and effective approaches to the evaluation of regional impacts and continue to be refined over time, enhancing their predictive performance [Groenwold, Hagger and Madden ( 1 987), Jensen, West and Hewings ( 1 988), Cole ( 1989) and Hsiao and Mountain ( 1994)]. 4. The regional distribution of defense expenditure

For reasons of history, military strategic requirements and economic policy, defense expenditure within nations tends to be unevenly distributed spatially and exerts a powerful influence in the geographic reconstruction of nations over time [Markusen and Yudken ( 1 992), Lovering ( 1 99 1)]. Table 3 provides a provisional guide to the principal centers of defense production across a wide range of nations, both developed and underdeveloped. However, limited information on the precise location of defense production activities means that Table 3 is at best impressionistic and by no means comprehensive. It does, nevertheless, highlight many significant areas of defense­ related economic activity on a world-wide basis and confirms the view that defense spending has an intensely regional focus. In the United States, for example, more than half of all prime defense contracts allocated in the late 1980's were concentrated in six states while in the former Soviet Union, more than half of all defense enterprises were located in five of the twenty maj or economic regions. Similarly, in the United Kingdom, almost two-thirds of defense industry employment is located in three out of eleven regions, while in Italy about 80%

Ch. 1 7: Regional Impact of Defense Expenditure

507

Table 3 Indicative national regions of defense production • Country

Regions

Argentina

Buenos Aires, Borghi, Cordoba

Australia

Sydney, Victoria, Canberra, New South Wales

Austria

Liebnitz, Gunskirchen, Graz, Steyr, Rustdorf

Belgium

Hainaut

Brazil

Sao Paulo, Rio de Janeiro, Rosario

Bulgaria

Shumen

Canada

Ontario, Quebec, Nova Scotia

Chile

Santiago, El Bosque, Valparaiso, Punta Arenas

China

Beijing, Shanghai, Shenyang, Wuki, Sichuan, Yunnan, Guizhou, Gansu, Qinghai, Ningxia, parts of Hunan, Hubei, Henan and Shaanxi

Colombia

Bogota

Czechoslovakia (former)

Prague, Otrokovice, Kunovice, Pardubice, Brno, Letnany, Narodni Podnik

Egypt

Cairo, Helwan, Heliopolis

Finland

Riihimaki, Helsinki, Halli, Lapua, Tampere

France

Bretagne, Aquitaine, Provence-Alpes-Cote d' Azur, Centre, Lirnousin, Midi-Pyrenees, Ile-de-France, Basse-Normandie, Haute Normandie

East Germany (former)

Magdeburg, Schonebeck-a/d-Elbe, Sachsen

West Germany (former)

Bremen, Oberbayern

Greece

Sterea Ellada

Hungary

Budapest, Veszprem, Csepel, Szigethzlem

India

Bangalore, Kanpur, Jabalpur, Kirkee, Khamaria, Jubbulpore, Varangoan, Hyderabad, Calcutta, Bombay, Ranchi, Nagpur, Kavadigida, Ghaziabad, Pune, Kukatpally

Indonesia

Jakarta, Bandung, Pindad, Surabaya, Serpong

Iran

Teheran

Iraq

Baghdad

Israel

Tel Aviv, Haifa, Tikva, Ashdod, Yahud, Ashkelon, Kinyat Shimona, Karmiel, Jerusalem, Beersheva, Galilee, Dirnona

Italy

Liguria, Friuli-Venezia-Giulia

Japan

Tokyo, Asahi, Nagoya, Amagasaki, Totsuka, Kobe, Yokohama, Nagasaki, Shimonaseki, Tamaro, Fijinaguta

South Korea

Seoul, Gyenriggido, Kyoriggi-Do

Mexico

Mexico City

New Zealand

Auckland, Hamilton

Nigeria

Boshni State

Norway

Raufoss, Oslo, Kongsberg, Nesbru

Pakistan

Karnra, Chaklala, Risalpur, Dhamial, Wah, Islamabad, Taxile, Karachi

Peru

Lima, Callao, Chimbote, Iquitos

continued on next page

D Braddon

508

Table 3 , continued Country

Regions

Phillipines

Manila

Poland

Warsaw, Swidnik, Wroclaw, Labedy Mielic, Zelcz, Bielskio-Biala, Lodz, Kalisz, Rzeszow, Starzchowice

Portugal

Lisboa e Vale do Tejo

Romania

Bucharest, Bacau, Craiova, Brasov

Russia

Central, Urals, Volga

Saudi Arabia

Riyadh

Singapore

Paya Lebar, Julan Boon Lay, Jurong Town

South Africa

Pretoria, Johannesburg, Transvaal, Cape Town

Spain

Murcia

Sudan

Khartoum

Sweden

Eskilistuna, Linki:iping, Stockholm, Bofors, Jarfalla, Ormskoldskvik, Malmo, Norsborg, Lindingo, Gi:iteborg, Spanga

Switzerland

Zurich, Berne, Lausanne, Lucerne, Emmen, Altemheim, Altdorf, Thun, Arbon, Kreuzlingen

Syria

Damascus

Taiwan

Taichung, Taipei, Kang-Shan, Tso-Ying, Ma-Kung, Kao-Hsing

Thailand

Bangkok

Turkey

Ankara, Kurumu

United Kingdom

Cumbria, Essex, Lancashire, Cornwall, Devon, Avon, Gloucestershire, Wiltshire, Hampshire

United States

California, Virginia, Texas, Florida, Georgia, Maryland, New York, Pennsylvania, Washington, North Carolina, Ohio, New Jersey

Yugoslavia (former)

Belgrade, Mostad, Pancevo, Konjic, Titovo, Uzice

• Information derived from Jane's Weapons Systems ( 1 980- 1 990); various trade publications.

is located in just five regions out of twenty [Paukert and Richards ( 1 99 1)]. Tables 4-8 provide more specific information indicating the regional economic impact of defense expenditure for different countries. For the USA, the availability of quality data on the regional distribution of defense expenditure by state enables regional defense-dependency to be explored using a variety of measures. State rankings in Table 4a,b reveal the extent to which defense expenditure impacts upon different States. If regional defense-dependence is measured by the share of total Department of Defense (DoD) purchases received, California, Virginia and Texas are the most dependent states. Using an employment share indicator, however, the District of Columbia, Alaska and Hawaii appear most defense dependent with California falling to 7th place in the rankings. Using other indicators such as the number of active duty military personnel located in a specific region or state, California regains its predominant position in terms of defense-dependence.

Ch. 1 7: Regional Impact of Defense Expenditure

509

Table 4 USA: most defense-dependent states by various indicators' 4a. State share of 1 992 purchases by US Department of Defense % State

4b. Defense-related employment as percentage of 1 992 State employment State % Distr. of Columbia

1 8.2

Virginia

8.4

Alaska

1 2.7

Texas

7.4

Hawaii

12.3

Florida

5.3

Virginia

1 0.4

Georgia

3.8

Maryland

6.0

Maryland/New York

3.4

Connecticut/Utah/Colorado

5.9

1 8.0

California

Pennsylvania

2.7

California/New Mexico

5.8

Washington/North Carolina

2.6

Washington

5.7

Ohio

2.5

Georgia/Oklahoma

5.1

New Jersey

2.3

Massachusetts

5.0

a

Kosiak and Bitzinger ( 1 993)

Table 5 Regional employment in the Russian military-industrial complex Region

Northwest (II) Urals (VIII)

Military industrial employment ( x 1 000)

% of total employment'

455.3

30.7

1 1 1 6.4

30.7

Udmart ASSR

1 67.7

55.3

Volga-Vyatka (IV)

45 1 . 1

28.5

750.9

27.9

Volga (VI) Saratov Oblast Central (III) Western Siberia (IX)

2 1 2. 1

50.9

1 2 1 1 .4

22.7

472.5

22.7

Novosibirsk Oblast

172.4

43.5

Central Chernozem (V)

247.2

22.6

Far East (XI)

1 78.3

17.8

Kaliningrad Oblast ( 120)

1 8.9

1 5.0

Eastern Siberia (X)

1 67.5

1 3.9

North Caucasus (VII)

255 . 1

1 3 .7

North (I) Russian Federation

92.2

9.4

541 6.8

23.5

' World Bank ( 1 992).

Table 5 illustrates the degree of regional concentration of defense employment in the Russian military-industrial complex. Very heavy employment dependence is observed

510

D. Braddon

in the Urals, Volga, and Central regions. Cooper ( 1 991) identified 7 60 significant defense facilities within the former USSR, including production enterprises, science­ production associations, research institutes, design organizations and military-related "closed" towns. Of this total, some 75% are located within Russian territory, a further 14.5% in the Ukraine, and the remainder distributed across the other republics . Newer "electronics-related" production facilities tend to be less regionally concentrated than the more traditional defense industries. The immense significance of military production for some regions is evident in, for example, Udmurtiya, where it apparently contributes 85% of total industrial output, some 60% of total employment and dominates economic activity in all the most important towns, namely Izhevsk, Votkinsk, Sarapul and Glazov. In the most comprehensive study of its kind the regional significance of defense expenditure across the European Community (EC) was estimated employing a "threshold" indicator of twice the European average for the share of the regional labor force directly employed in defense [Commission of the European Communities ( 1 992)]. Applying this indicator to specific regions of the EC, 1 9 regions were found to be especially dependent on defense industrial activity and a further 3 1 regions were identified as particularly dependent upon military base activity. Table 6 summarizes the findings for European Union regional concentration by defense employment share. Table 6 reveals that the European Community contained several regions in which defense industries were extremely significant contributors to employment, for example, Cumbria in the UK and Bretagne and Acquitaine in France. Again, Table 6 identifies some regions of the European Union as especially dependent on the military base sector for employment, including exceptional dependence in parts of Greece (Voreio Aigaio, Notio Aigaio, Kriti); Spain (Ceuta y Melilla); and Portugal (Acores). Finally, a few regions (such as Avon, Gloucestershire and Wiltshire in the UK and Friuli in Italy) exhibit significant dependence for employment on both elements of defense sector activity, making them potentially very vulnerable to deep and sustained cuts in defense expenditure. Information relating to the regional distribution of defense activities across Eastern Europe is only now becoming available in the more liberal post-Cold War environment. Table 7 provides limited information on regional centers of defense activity for some of the countries of Eastern Europe. Tables 4 to 7 provide an approximate guide to the regional distribution of defense expenditure for most of the major arms-producing nations which, together, constitute over 90% of global aggregate production. However, about 40 other industrial and developing nations now have defense industries of their own, each with specific regional location and consequent economic impact. Data availability for these nations, primarily developing countries, regarding regional distribution of defense expenditure is extremely limited and precludes precise regional data tabulation. Nevertheless, Third World countries represent an important emerging force in global arms production. At the start of this decade, 36 non-communist Third World countries were engaged in arms production, about twice the number producing arms in the 1 970's and

Ch. 1 7: Regional Impact of Defense Expenditure

511

Table 6 Regional defense-dependence within the European Communities ' : by employment sector Country

Region Defense industries only

Employment shares (%) Military only Total defense related

Greece

Voreio Aigaio

0.00

29.88

29.88

Spain

Ceuta y Melilla

0.00

22.86

22.86

Portugal

Acores

0.00

1 1 .82

1 1 .82

Greece

Notio Aigaio

0.00

1 1 .27

1 1 .27

Greece

Kriti

0.00

10.61

1 0.61

Italy

Friuli-Venezia-Giulia

1 .65

8.98

1 0.57

Greece

Dytiki Makedonia

0.07

1 0.39

1 0.46

Greece

Anatoliki Makedonia, Thraki

0.05

1 0.06

1 0. 1 1

UK

Hampshire, Isle of Wight

1.18

7.83

8.95

Germany

Trier

0.07

8.72

8.78

UK

Cumbria

6.40

0.95

7.35

UK

Cornwall, Devon

1 .55

5.32

6.81

UK

North Yorkshire

0.00

6.25

6.25

Spain

Madrid

0.58

5.63

6.20

Germany

Kob1enz

0.08

6.0 1

6.09

France

Bretagne

2.5 1

3.59

6.05

Dermany

Luneburg

0.08

5.87

5.95

Germany

Bremen

2.74

3.14

5.84

France

Provence-Alpes--cote d' Azur

2.08

3.80

5.83

UK

Avon, Gloucestershire, Wiltshire

1 .26

4.25

5.48 5.17

Germany

Rheinhessen-Pfalz

0.09

5.08

Germany

Schleswig-Holstein

0.50

4.54

5.02

France

Aquitaine

2.36

2.56

4.89

' Commission of the European Communities ( 1992).

approximately two and a half times the number in the 1960's [Singh ( 1989)]. In the late 1980's, 30 developing countries were engaged in small arms and ammunition production, 22 in small naval craft construction, eight in fighter aircraft (usually under license), 1 1 in other aircraft work, 1 2 in guided missiles, 1 0 in military avionics and electronics, 14 in large naval ships, and 5 in submarine and tank production [Wulf (1987)]. Elsewhere in this book, Ram (Chapter 1 0) and Deger and Sen (Chapter 1 1) explore in detail the theme of military expenditure and the developing countries. The regional implications of such expenditure in the Third World context, however, needs to be briefly considered here. Brauer (1991) identifies the most significant arms producers in the Third World (in terms of the advanced nature and scale of their production) as being, in rank order,

D. Braddon

512 Table 7 Defense-related employment in Poland and the Czech Republics• Region

Poland Mid East: Niewiadow, Pionki, Radom, Swidnik Skarzysko-Kamienna,

Employment in defense-related activities (%)

40. 1

Starachowice, Krasnik, Warsaw

South East: Tarnow, Rzeszow, Mielec, Jaslo, Nowa, Deba, Stalowa Wola Mid South: Krupski-Mlyn, Gliwice, Bienin Stary

40.4 4.0

Czech Republics Central Slovakia

32.6

Moravia

23.0

Prague

1 7.4

• Data compiled from background papers presented at the NATO defense conversion seminar on Central and Eastern Europe, 1 992, Brussels.

Israel, India, Brazil, Yugoslavia, South Africa, Argentina, Taiwan and South Korea. Most of these countries have a significant industrial base, infrastructure and labor force skill profile appropriate for the development of a defense manufacturing capability. Critical technical linkages between the arms production sector and specific industries such as iron and steel, metal products, machinery, electrical products, shipbuilding and repair, and motor vehicles exist in these more industrially-advanced developing countries. In theory, the spin-off effects on other industries - and thus on the rest of the economy - should be considerable. Such a regional transmission effect has, however, been called into question [Deger and Sen ( 1 986)]. For the other significant arms producers in the Third World where production is more limited in quantity and level of sophistication (for example, the Philippines, Turkey, Indonesia, Egypt, North Korea, Pakistan, Singapore and others) the regional economic implications of defense expenditure are likely to be significantly different. In some of these countries, regional concentrations of arms production may dwarf other forms of local economic activity, considerably intensifYing the exposure of the regional economy to variations in defense budgets with serious implications for regional economic viability. With relatively weak industrial infrastructures in many of these nations, the development of indigenous arms producing industries is likely to develop as a high-technology capital intensive industrial enclave in a region and nation which is capital-poor and labor intensive. In such an economic system, the potential for scale economies will be limited with very few beneficial spillover effects for local or national civil industry. Arms production in the Third World depends to a significant degree on licenses and technology imports from major arms-producing nations (especially the USA,

Ch. 1 7: Regional Impact of Defense Expenditure

513

UK, France and Germany), reducing the capacity for such developing countries to secure industrial and technological self-sufficiency and reduce import-dependence. If powerful backward linkages could be observed in the defense sector, the impact upon developing countries of a sizeable indigenous arms industry could be beneficial. However, production runs in defense manufacturing tend to be relatively short-term, rendering the development of symbiotic input industries uneconomic. Again, the input requirements of the arms industries are for high-technology, high quality products at variance with those required for consumer products in the developing countries. These perceived national drawbacks of expanding defense production in the Third World are likely to be even more significant in regions where such economic activity is concentrated. 5. Selected case studies

In recent years, the case study literature exploring the regional impact of defense expenditure has expanded considerably. Table 8 summarizes and reviews some of the most important of these case studies. The Washington State study, summarized in Table 8, provides a good illustration of a regional impact analysis. The defense sector has been a crucial element of the Washington State regional economy for decades with large military installations as well as significant contributions from the aerospace, shipbuilding and nuclear weapon production industries. As well as the key findings, noted in Table 8, this study also provides important information on the dynamism of regional economies in response to changes in defense expenditure flows. Findings revealed that, in 1982, the Washington economy received $ 1 143 m. from military and civilian personnel payrolls and a further $3361 m. in purchases from the private sector (where the principal recipients were aerospace, shipbuilding and construction industries.) As a result, some 6.3% of all jobs in the Washington economy in 1 982 (excluding military personnel) depended upon military expenditure, many in the service and distribution sectors. By 1 987, regional income from Department of Defense contracts and installation expenditure had increased by some $800 m. in real terms. The ranking of principal industrial sectors benefitting from this increased expenditure had changed over the five year period with shipbuilding falling from second to fourth place behind aerospace, other services, and electrical machinery. This additional real expenditure generated an extra 39 600 jobs in the private sector of the region, together with 6500 active duty and DoD civilian jobs. Excluding active duty jobs, military expenditure by 1987 accounted for 7.3% of total regional employment, indicating the important role of the defense sector as a source of employment growth. In general, case studies provide valuable information on the defense-dependency of specific regions and can highlight the degree to which income and employment, as well as other important regional economic indicators such as local tax receipts and various components of consumers' expenditure are influenced by defense-related

D. Braddon

514 Table 8 Selected regional case studies of defense expenditure impacts

Warf and Cox (I989): Prime Defense Contracts in the New York Region The analysis focused on defense firms receiving DoD contracts over $25 000 in 1 985 and estimated impact on the New York Metropolitan Region and 3 sub-regions [New York City (NYC); New York suburbs (NYS) and Northern New Jersey (NNJ)]. Study used an 89 sector input-Dutput model. Estimated 76 000 jobs in region attributable to defense receipts in 1 985 with 40 000 jobs lost due to associated additional tax burden. Fifteen of the 89 industrial sectors experienced declining output, while 48 of 53 manufacturing industries experienced increasing output. At the sub-regional level, NYS received one-half of all contracts value and paid least additional taxes, yet employment and income gains low due to aerospace/electronics activity with high capital intensity and significant regional "leakages". NYC receive9 only one-half defense receipts ofNYS, yet gained 1 0 000 jobs due to labor intensity of business activities.

Hughes et a/. (I99I): Defense and Washington State Utilized data from the 1 982 Washington input-Dutput model with 5 1 industrial sectors and six final demand vectors. The employment impact of a 1 0% cut in the defense expenditure component of final demand was estimated implying a total loss of 1 6 500 jobs in the region compared with, for example, 23 600 lost jobs for a similar reduction in state exports. Again, an increase in defense expenditure of $ 1 00 m. would have created an estimated 1 536 jobs in the private sector compared with 2600 jobs for a similar increase in state exports. In this case, however, an additional 2179 jobs in military bases and establishments would have been created.

Bischak and Oden (I99I): Regional Impact of the INF Treaty Considered the regional implications of a Treaty designed to eliminate two classes of nuclear weapons, employing a comparative static input-Dutput model (utilizing the Department of Commerce's RIMS II regional multipliers). The cancellation of the Ground Launched Cruise Missile was estimated to reduce output in the five most dependent states by $ 1 1 4.6 m. with a loss of 1 370 jobs. Most severely affected was California losing over $ 1 27 m. in income and experiencing employment Joss of 1435 jobs, annually. In Florida, the annual estimates were over $43 m. and 6 1 5 lost jobs, respectively. In Michigan, $ 1 1 m. of output would be lost annually and also 143 jobs. The elimination of the Pershing II missile, similarly, would cost Florida $50.9 m. and 7 1 6 jobs annually, while Ohio would suffer an output loss of $37 m. and 428 lost jobs annually.

Huck (199I): Regional Economic Dependence on Defense Expenditure in Munich This study offers tentative estimates of the regional impact of defense expenditure, constrained by severe data limitations in former West Germany. Taking a "bottom up" approach to the impact estimation process, the study concluded that 8% of manufacturing employment and 1 1% of metalworking industry employment was defense-dependent in 1 986. At a more disaggregated level, estimates suggest that while 58% of employment in aerospace industries was defense-dependent, other key sectors were much less reliant (for example, precision instruments 8%; electronics 6%; and vehicle manufacture 4%). Overall, the study concluded that while the manufacturing base of the Munich area was defense-dependent, this was largely attributable to the aerospace industry.

Battistelli (1991): Occupational Defense-Dependence in the Rome Region Surveys for this study of defense-dependent occupational groups in 1 987 identified 52 small, medium and large defense companies (principally engaged in electronics production) in the region, employing about 1 2 000 workers with a further 2000 jobs in sub-contractors also defense-dependent. This amounted to about 8% of all industrial employment in the Rome region. Among the principal findings relating to occupational issues were a below average share of women workers; a high proportion of university graduates; a high proportion of technical/professional staff; an above average concentration of R&D activities and employment; and an above average share of salaried employees compared with other regional industries.

continued on next page

Ch. 1 7: Regional Impact of Defense Expenditure

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Table 8 , continued

Office ofEconomic Adjustment (1986): Regional Impact of Stapleton Homeport Examined the regional economic significance of a new military facility (Stapleton Homeport Naval Base, New York City). The study estimated that regional economic activity would increase by some $597 m. during the construction phase with an increase in employment of 8690 person-years. When fully operational, additional annual economic activity was estimated at $228 m. with additional employment of 4530 military and 309 1 civilian jobs in the region. Over 1 800 indirect and induced jobs were expected to be created in the private sector as a result and business income was expected to increase by $82 m. in the construction phase and $25 m. when operationaL New York City was estimated to gain $2.1 m. in City taxes with additional municipal outlays of $327 000.

Bishop (1992): Devonport Dockyard and Naval Base, UK This study examined the regional economic impact of a major Dockyard and associated naval base in a peripheral sub-region of the UK (the counties of Devon and Cornwall). The Devonport complex was estimated to generate £52 1 m. of annual income for the sub-region or 5% of annual total income. Directly and indirectly, 29 900 jobs were supported by the Dockyard complex, of which some 6900 jobs depended upon local expenditure by base and Dockyard facility employees. In the event of closure of the Dockyard and simultaneous base run-down, it was estimated that the sub-region would lose 3.7% of its income and some 22 600 jobs with a potential increase in the regional unemployment rate to 20%.

activities. However, where such studies are conducted on the basis of industrial surveys, problems are encountered in identifying precisely what is defense-related activity at the regional level; in separating defense from non-defense production at the corporate level; and, consequently, in ensuring that the results reflect genuine defense­ dependency. Where case studies employ input-output or other forms of econometric models, the limitations of such models (discussed previously) have to be borne in mind. It is the "uniqueness" of regions that constrains the applicability of regional case studies in drawing lessons from the experience of defense contraction. Findings relevant to one particular case study will not necessarily be appropriate for a different region, even where the type of industrial change is similar. Regions will differ in economic structure and infrastructure, in social composition and economic prosperity, in industrial and skill specialization and, of greatest importance, in adaptive capacity [Cheshire ( 1990)] and ability to respond to appropriate policy stimuli. Consequently, each case will be different. Case studies certainly provide a useful learning exercise about the range of impacts to be expected at the regional level as defense budgets contract but cannot be expected to generate outcomes that are universally relevant.

6.

Policy implications

Two basic questions lie at the heart of the policy debate regarding declining defense expenditure. First, is the scale of the problem sufficient to warrant specific policy design and implementation or can the interplay of market forces deal effectively with the process of economic regeneration? Second, what policy measures are available and

516

D. Braddon

what is their actual or potential efficacy in resolving the adverse economic impacts of the defense contraction problem? Most analysts anticipate that the scale of the problem at the macroeconomic level will be relatively modest (with the exception of the former Soviet Union where reductions in military expenditure, combined with dramatic macro- and micro-economic reforms are likely to generate massive economic disequilibrium and instability). In the case of the European Community, the effects of even a 50% reduction in defense expenditure, spread over several years, have been projected to affect the macroeconomy by less than I % annually [Hartley and Hooper ( 1 99 1 )] . For the United States it has been estimated that, incorporating the 1 993 Clinton defense expenditure plans, defense cuts from 1 986 to 1 998 would affect US GDP by no more than 3.3% over a period of 12 years. The regional concentration of defense expenditure, however, highlighted in this chapter, suggests that local economic impact - in certain instances - considerably exceed national impacts. Yet, US estimates suggest that even in the most defense-dependent states, the employment impact should not exceed 1% of the employed labor force on current defense expenditure plans [Defense Budget Project ( 1 993)]. However, the implication is not that these regional impacts are inconsequential but that they are "manageable" with appropriate policy action by government. Experience of rapid decline in other important industrial sectors in recent years confirms the need for appropriate policy action to facilitate economic adjustment to declining defense expenditure, particularly at the regional level. Several traditional heavy industries (for example, steel, coal and shipbuilding), especially those located within the European Union, have experienced dramatic contraction over a ·relatively short period of time, generating significant adverse regional economic consequences. Across the European Union, the industrial, social and economic impact has been felt most significantly in the regions of North and East France, the Ruhr and Saar regions of Germany, South and East Belgium and in the UK in the regions of West and Central Scotland, the South West, North and North West of England and in Northern Ireland [Hitiris ( 1988)]. Despite relatively expansionary economic conditions and the emergence of new growth sectors at the national level, market adjustment failed to correct the adverse economic conditions experienced in these regions, since new industrial activity tended to occur in growth centers well away from the deprived areas. Unaided by national or local government policy, markets proved ineffective at coping adequately with the speed and scale of industrial change and the constraints of wage inflexibility in an increasingly competitive market environment. As a result, policy intervention was necessary to facilitate the process of economic regeneration at the regional level. Measures employed to ease regional problems have included the selective allocation of regional development grants (such as the European Regional Development Grant), allocated on the basis of perceived national economic strength or weakness as well as the scale of the expected industrial change; financial and technical support from government for training, retraining and employment initiatives; measures designed to

Ch. 1 7: Regional Impact of Defense Expenditure

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encourage land re-use and development; and more specific policies at the regional level focusing upon technology, the environment, industrial expansion and social issues. Some of these policy approaches may be relevant to meet the requirements of regions adversely affected by defense contraction but will require flexibility in application. For example, large numbers of military personnel with specific attributes (mainly male, young and well-disciplined with focused skills) are likely to become redundant in relatively remote regions. At the same time, Defense Ministries in most countries are likely to release large amounts of land for alternative use as their military exercise and associated training requirements diminish over time. Conventional regional policies will need refinement if such problems are to be effectively resolved. The key to dynamic economic regeneration appears to lie in enhancing the adaptive capacity of disadvantaged regions and a combination of supply-side reforms, together with suitably targeted regional measures, seem to offer the best strategic response. However, the design and implementation of such a response at the national level has been both piecemeal and minimal. Across Europe, to varying degrees, national governments have shown little concern with the need to facilitate regional economic regeneration to counteract the impact of declining defense budgets. Within Europe, it has been left to the European Commission to develop and implement a limited policy response under the KONVER I and II strategy. The Commission offers limited funding for regions where defense cuts have created severe problems on a competitive, selective basis. KONVER supported projects in the UK include the identification and upgrading of defense sector skills; employer subsidies to recruit redundant defense workers; the creation of technology revival centers; and new employment opportunity programs for redundant defense workers. Most of these KONVER initiatives commenced operation in 1993 and it is too early to judge their effectiveness. Almost all represent initiatives to help the regional economy achieve a relatively smooth adjustment to the new business environment. In the United States, concern at the potential economic damage that defense cuts might inflict at the regional level has produced a modest degree of national policy response in the 1990's, building upon earlier initiatives. In the 199 1 Defense Authorization and Appropriations Bill additional government support was committed for regional communities adversely affected by defense cuts. The Bill offered $200 m. of aid for defense conversion initiatives, specifically targeted at the community level. Under the provisions of the Act, the Department of Defense provides some $ 1 50 m. directly to the Department of Labor to help fund the Job Training Partnership programmes, while a further $50 m. is allocated to the Department of Commerce for allocation through the Economic Development Administration in the form of planning grants to facilitate economic recovery strategies. In addition, further financial support at the regional level is provided through the Office for Economic Adjustment in the form of nominal grants to states or communities adversely affected by defense contract cancellation or military base run-down or closure. In conclusion, it remains the case that most forms of regional policy assistance, both for defense-dependent and other regions, is reactive, offering limited support after the

518

D. Braddon

adverse effects of industrial change have been experienced. Analysts in the United states have concluded that more pro-active policies need to be developed to ensure that regions retain at least part of their economic core. The most effective means of addressing this policy requirement may be to design industrial and competition policy in such a way that no region again becomes over-dependent on a single industry, such as defense, in the future. 7. Conclusions

If effective policies are to be designed to facilitate regional economic regeneration following defense expenditure contraction, wider understanding of the scale of regional defense-dependence, the specific nature of the regional problems associated with defense expenditure contraction, and the most effective methods of enhancing regional adaptive capacity will be essential pre-requisites. While this chapter has explored the current state of knowledge regarding these issues, it is clear that such knowledge is fairly limited and that a research agenda remains to be addressed. There are three areas where more extensive research is required. First, there remains an urgent need to improve the measurement and availability of detailed, disaggregated regional data both for the defense sector and for a regional economy as a whole. Second, from the viewpoint of relevant economic theory, there is considerable scope for refining and developing regional models of defense expenditure impact. With improved data accuracy and availability at the regional level, this could include the incorporation of greater disaggregation of regional industries (and particularly those industries where defense and non-defense activities are conducted simultaneously); as well as the possible construction of a "defense composite" indicator, drawing together all industrial and military base related economic activity in a region as a specified variable for inclusion in such models. Given the increasing globalization of industry, the evolution of post-Fordist production paradigms and their application to the defense sector, and the remarkable changes currently taking place within defense industry supply networks, the export sector and inter-regional trade elements of regional economic models need considerable refinement. Finally, there is considerable scope for researching different aspects of the policy debate. On the one hand, recognizing advances made in recent years in this area, further research is still needed into the transmission process by which cuts in defense expenditure impact upon the regional economy, especially in local labor markets. The tracking of redundant defense industry workers and their military personnel counterparts as they seek alternative employment would provide relevant data to better inform policy makers. As noted in this chapter, a considerable range of research surveys, econometric studies and broader investigations over the last decade have added an immense amount to our understanding of the regional impact of defense expenditure. However, such progress in our knowledge has raised important questions as well as partial answers and the analyst is left with many fruitful areas to explore

Ch. 1 7: Regional Impact of Defense Expenditure

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at a time when international developments make such study at the regional level increasingly relevant. References ADCC, 1 992, The impact of reduced military spending on local economic activity: A case for European Community assistance (Association of County Councils, Association of District Councils and Association of Metropolitan Councils, London). Aztec Training and Enterprise Council, 1 992, Changing the future (Aztec, London). Ball, D.N.F., 1 993, Regional econometric modelling in the UK - a review, Regional Studies 27, 777-782. Battistelli, F., 1 99 1 , Regional and occupational dependence on defense contracting in the Rome area, in: L. Paukert and P.J. Richards, eds., Defense expenditure, industrial conversion and local employment (International Labor Office, Geneva) 7 1-98. Bischak, G., and M. Oden, 1 99 1 , The INF Treaty and the United States experience: The industrial, economic and employment impact, in: L. Paukert and P.J. Richards, eds., Defense expenditure, industrial conversion and local employment (International Labor Office, Geneva) 1 23-1 52. Bishop, P., 1 992, The impact of Devonport Dockyard/naval base on the economy of Devon and Cornwall (South West Economic Research Center, Polytechnic South West, Plymouth). Braddon, D., P. Dowdall and A. Kendry, 1 99 1 , The economic consequences of the closure of a military base (Research Unit in Defense Economics, Bristol Polytechnic). Braddon, D., P. Dowdall, A. Kendry and S. Reay, 1 992, Defense procurement and the defense industry supply chain (Research Unit in Defense Economics, Bristol Polytechnic). Brauer, J., 1 99 1 , Arms production in developing nations: The relation to industrial structure, industrial diversification and human capital formation, Defense Economics 2, 1 65-1 75. Burton, R., and J. Dyckman, 1 965, A quarterly economic forecasting model for the state of California (Center for Planning and Development, Research Institute of Urban and Regional Development, University of California, Berkeley, CA). Center for Studies in Defense Resources Management, 1 983, The economic impact of Canadian defense expenditure (The Royal Military College of Canada, Kingston). Cheshire, P.C., 1 990, Explaining the recent performance of the European Community and major urban regions, Urban Studies 27, 307-329. Chiang, A.C., 1 984, Fundamental methods of mathematical economics, 3rd edition (McGraw Hill, New York). Cole, S., 1 989, Expenditure lags in impact analysis, Regional Studies 23, I 05- 1 1 6. Commission of the European Communities, 1 992, The economic and social impact of reductions in defense spending and military forces on the regions of the Community (Commission of the European Communities, Brussels). Cooper, J., 1 9 9 1 , The Soviet defense industry and conversion: The regional dimension, in: L. Paukert and P.J. Richards, eds., Defense expenditure, industrial conversion and local employment (International Labor Office, Geneva) 1 57-176. Crow, R.T., 1 973, A nationally liuked regional econometric model, Journal of Regional Science 1 3 , 187-204. Defense Budget Project, 1 993, Defense-related economic adjustment and federal policy (Washing­ ton, DC). Deger, S., and S. Sen, 1 986, Defense industrialisation, technology transfer and choice of techniques in LDC's, in: S. Borner, ed., Structural change, economic interdependence and world development (Macmillan, London). Demilitarised, 1 99 1 , Diversification ofthe European military industry (Lancashire Enterprises, Preston). DoD (US Department of Defense), annual, Defense Economic Impact Modelling System annual forecasts (Department of Defense, Washington, DC).

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Dunne, J.P., 1 99 1 , Quantifying the relation of defense expenditure to employment, in: L. Paukert and P.J. Richards, eds., Defense expenditure, industrial conversion and local employment (International Labor Office, Geneva) 1 1-26. Dunne, J.P., and R. Smith, 1 984, The economic consequences of reduced UK military expenditure, Can1bridge Journal of Economics 8, 297-3 1 0. Filip-Kohn, R., 1 980, Macro-economic effects of disarmament policies on sectoral production and employment in the Federal Republic of Germany with special emphasis on development policy issues (German Institute for Economic Research, Berlin). Flegg, A.T., C.D. Webber and M.V. Elliott, 1 994, Methodological problems in building a regional input­ output model using national data: location quotients and aggregation revisited (University of the West of England Working Papers in Economics 8, Bristol). Glickman, N.J., 1 977, Econometric analysis of regional systems (Academic Press, New York). Grawe, O.R., 1 9 9 1 , Defense rationalisation in the US (Division of Economic Policy Analysis, Federal Trade Commission, Washington, DC). Groenwold, N., A.J. Hagger and J.R. Madden, 1 987, The measurement of industrial employment concentration in an input-output model, Regional Studies 2 1 , 255-263. Hartley, K., and N. Hooper, 1 99 1 , Economic adjustment, in: S. Kirby and N. Hooper, eds., The cost of peace: Assessing Europe's security options (Harwood Academic Publishers, Reading). Hartley, K., and N. Hooper, 1 993, The economic consequences of the UK government's decision on the Hercules replacement (Center for Defense Economics, University of York). Hirschman, A.O., 1 958, The strategy of economic development (Yale University Press, New Haven, CT). Hitiris, T., 1 988, European Community economics (Harvester Wheatsheaf, London). Hsiao, C., and D.C. Mountain, 1 994, A framework for regional modelling and impact analysis, Journal of Regional Science 34, 361-375. Huck, B.J., 1 9 9 1 , The regional and occupational dependence on defense contracting in the Greater Munich area, in: L. Paukert and P.J. Richards, eds., Defense expenditure, industrial conversion and local employment (International Labor Office, Geneva) 5 1 -70. Hughes, D., D. Holland and P. Wandschneider, 1 99 1 , The impact of changes in military expenditures on the Washington State economy, Review of Regional Studies 2 1 , 3 1 1-327. IFO, 1 99 1 , Production of defense materials in GDR (Institut flir Wirtsschaftsforschung, Munich). Isard, W., 1 960, Methods of regional analysis (MIT Press, Cambridge, MA). Isard, W., and T.W. Langford, 1 97 1 , Regional input-Dutput study: Recollections, reflections and diverse notes on the Philadelphia experience (MIT Press, Cambridge, MA). Jensen, R.C., G.R. West and G.J.D. Hewings, 1 988, The study of regional economic structure using input-Dutput tables, Regional Studies 22, 209-220. Klein, L.R., and N.J. Glickman, 1 975, An Econometric Model of Pennsylvania. mimeograph (Economics Research Unit, University of Pennsylvania, Philadelphia, PA). Kosiak, S., and R.A. Bitzinger, 1 993, Potential impact of defense spending reductions on the defense related labor force by state (Defense Budget Project, Washington, DC) May. Leontieff, W., 1 95 1 , The structure of the American economy, 1 9 1 9-1 939 (Oxford University Press, New York). Lock, P., and W. Vob, 1 994, The German arms industry in a European context: A study in successful downsizing, Defense and Peace Economics 5, 341-348. Lovering, J., 1 9 9 1 , The changing geography of military industry in Britain, Regional Studies 25, 279293. Maneval, H., 1 993, Defense spending in West Germany, Defense and Peace Economics 5, 221-246. Markusen, A., and J. Yudken, 1 992, Dismantling the cold war economy (Basic Books, New York). McGregor, P.G., and I. H. McNicoll, 1 992, The impact of forestry on output in the UK and its member countries, Regional Studies 26, 69-79. Miller, R., and R. Blair, 1 985, Input-Dutput analysis; foundations and extensions (Prentice Hall, Englewood Cliffs, NJ).

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Ministere de Ia Defense, 1 984, Analyse economique des depenses militaires (Paris). Office of Economic Adjustment, 1 986, Stapleton Homeport fiscal impact analysis (President 's Economic Adjustment Committee, Department of Defense, Washington, DC). Paukert, L., and P.J. Richards, eds., 1 99 1 , Defense expenditure, industrial conversion, and local employment (International Labor Office, Geneva). Research Seminar in Quantitative Economics, 1 965, Econometric Model of Michigan (University of Michigan Press, Ann Arbor, MI). Richardson, H.W, 1 985, Input-<Jutput and economic base multipliers: looking backward and forward, Journal of Regional Science 25, 607-662. Sharp, J., ed., 1 990, Europe after the American withdrawal (SIPRI/Oxford University Press, Oxford). Singh, B., 1 989, Asean's arms industries: potential and limits, Comparative Strategy 8, 249-264. Smith, R., 1 99 1 , Measuring the peace dividend in the UK, Working Paper 90 1 9 (Department of Applied Economics, Cambridge). US General Accounting Office (GAO), 1 9 9 1 , Planning for the drawdown of forces and equipment in Europe (GAO, Washington, DC). Warf, B., and J.C. Cox, 1 989, Military prime contracts and taxes in the New York metropolitan region ­ a short run analysis, Regional Studies 23, 241-252. Weiss, S., and E. Gooding, 1 968, Estimation of differential employment multipliers in a small regional economy, Land Economics 44, 235-244. World Bank, 1 992, Russian economic reform: Crossing the threshold of structural change (A World Bank Country Study, The World Bank, Washington, DC). Wulf, H., 1 987, Arms production in Third World countries, effect on industrialisation, in: C. Schmidt, ed., The economics of military expenditure (Macmillan, London).

Chapter 18 ECONOMICS OF A R MS TRA DE * CHARLES H. ANDERTON

College of the Holy Cross

Contents

Abstract Keywords 1 . Introduction 2. The structure of the international arms market 2 . 1 . Arms imports 2.2. Arms exports 2.3. Structural change: end of the Cold War

3. Causes of arms trade 3 . 1 . Economic causes 3 . 1 . 1 . Supply and demand model 3 . 1 .2. Neoclassical trade model 3 . 1 .3. Trade models with economies of scale and learning economies 3 . 1 .4. Imperfect competition and trade 3 .2. Domestic political economy 3 .2. 1 . Defense industrial base 3.2.2. Employment 3.3. Economic and political synthesis

4. Arms trade and conflict 4 . 1 . Theoretical models of arms trade and conflict 4.2. Empirical studies 4.3. Case studies

5. Arms trade and foreign policy influence 5. 1 . Sislin's theory of arms influence success

5.2. Determinants of arms influence success 5 .3. Recipient influence

6. Concluding comments References

524 524 525 527 527 529 531 534 535 535 536 539 541 543 543 544 546 547 548 550 553 554 555 556 558 558 559

* I am grateful to Todd Sandler for comments and encouragement on earlier drafts of this chapter, Roxane Anderton and Joseph Smaldone for extensive bibliographic help, and Daniel Gallik for valuable assistance with the arms trade data.

Handbook of Defense Economics, Volume 1, Edited by K. Hartley and T Sandler © 1995 Elsevier Science B. V. All rights reserved

524

C.H. Anderton

Abstract

The end of the Cold War has increased the relative importance of economic causes and consequences of arms transfers. Unfortunately, there is surprisingly little theoretical and empirical development of the economics of arms trade, making it a sub-field of defense economics ripe for foundational contributions. We offer some preliminary steps in this direction by applying simple international trade models to the arms trade. Fields other than economics have made major contributions to our understanding of arms transfers. We review the sub-literature on arms transfers and foreign policy leverage as well as the sub-literature on the relationship between arms trade and war. The central problem of the arms trade literature, for both economists and geopolitical scientists, is how to go beyond the proliferation of (albeit useful) policy position articles, to a more solid base of theoretical and empirical models. A new theoretical synthesis of economics and geopolitics would represent a major breakthrough, but the development of the economics of arms trade must move beyond its incipient stages for this synthesis to occur. Ultimately, it would be desirable to see theoretical and empirical work on the arms trade, narrow the range of outcomes which are regarded as plausible. Keywords

alliances, arms export restraint, arms trade, arms transfers, COCOM, conflict, Cold War, co-production, defense industrial base, defense industry, economic causes, economies of scale, employment, foreign policy influence, geopolitics, imperfect competition, information systems, intra-industry trade, learning economies, preemption, trade theory

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Economics of Arms Trade

525

1. Introduction

Weapons have been traded across national and territorial borders throughout human history. In the last one hundred years, the arms trade passed through six major phases, the historical attributes of which are summarized by Gerner ( 1 983, p. 7) in Table 1 below. To the six phases identified by Gerner, we must now add a seventh: the post­ Cold War arms trade. The end of the Cold War ushered in a dramatic structural change to the international arms market. For the first time in half a century, arms transfers are no longer viewed through the prism of superpower politics; economics now plays a central role in understanding the motivations and consequences of arms transfers. Of course, politics still matters in understanding the weapons trade; not only the politics of defense firms lobbying government officials to promote weapons exports (which can be viewed as "economic" under the rubric of public choice), but the geopolitics of transfers, i.e., nations using weapons sales as instruments of foreign policy in the international system. The usual starting point in the literature is that the arms trade is a geopolitical phenomenon, subject to domestic political variables, occurring interdependently with other segments of the international system [Pierre (1 982), Catrina ( 1988), Harkavy ( 1 975)]. One of the weaknesses of the geopolitical arms trade paradigm was that until the 1970s, it was essentially non-explanatory. The literature was dominated by three types of studies: descriptive compilations of data, case studies, and j ournalistic accounts, often condemnatory [Gerner ( 1 983, p. 1 8)]. While many of the studies provided useful information about arms transfers in specific cases, in general, there was little systematic development of a theoretical structure and therefore little cumulative effort. There were some important exceptions to the atheoretical, non-cumulative approach. Some works in the 1 970s were conducive to a cumulative effort: e.g., Leiss (1 970), Leiss et al. ( 1970), SIPRI ( 1 971), Stanley and Pearton ( 1972), and Harkavy ( 1 975). Although Harkavy ( 1 994, p. 12) sees his theoretical approach falling into disuse, his international systems approach is considered by some to be a methodological landmark in arms trade research [see, e.g., Laurance ( 1 992, p. 12); Gerner ( 1 983, pp. 1 9-20)]. According to Laurance ( 1 992, p. 1 2), Harkavy linked the arms trade to the larger international system and focused on system change, thus providing a methodological approach that can be used to explain further shifts in the system. A few other theoretical and empirical works focused on specific issues like the relationship between arms transfers and war [e.g., Milstein ( 1 972)] and were conducive to a cumulative effort. A second weakness of the geopolitical paradigm is its failure to promote a systematic empirical and theoretical treatment of the economics of arms trade. Economists have not adequately filled the gap. There are a few studies on the arms trade by economists, e.g., the economic impacts of arms trade [Grobar et al. ( 1 990), Bajusz and Louscher ( 1 988)], fungibility of military and civilian aid [Frey ( 1975), Ferejohn ( 1 976), McGuire (1987)], motives for arms transfers [Smith et al. ( 1 985), Levine et al. ( 1994)], and a review of the arms trade literature [Sandler and Hartley ( 1 995, ch. 1 0)]. These works are exceptions to the general rule that economists have not seriously examined the arms

u. N 0\

Table 1 Historical attributes of the arms trade" Purposes

Environment

private profit

public opinion neutral, uninformed

same

same

strong opinions against; conventions to study and limit

US a major governmental supplier

same

same + foreign policy

public generally supportive

predominantly governmental, some private

US, France, Britain, USSR

same + selected third same world allies

moderate-high

same

same + Italy, Germany, others

same + third world, esp. Middle East

foreign policy + economics

Cold War period

very high

same

40+ nations, dominated by US, UK, France, USSR

everywhere, particularly third world

economics + foreign policy

renewed public concern, N-S issues important

Recipients

Historical period

Volume

Private vs. governmental

Suppliers

Pre-WWI

low

private

French, German, US, Western Europe and their colonies UK manufacturers

Inter-war

lower than during private with WWI government controls

same

WWII

moderate

private and governmental

1 945-1950s

moderate

1960-1973 1 973-1980s

Cold War period

' Source: Gerner ( 1 983).

n ::J::

:... ;,

� ;,

Ch. 18: Economics of Arms Trade

527

trade. This is unfortunate because economists have much to offer in understanding the causes and consequences of arms transfers. A large body of international trade theory remains untapped. Even during the Cold War, non-economists cited the importance, albeit secondary, of economic motivations for arms transfers [e.g., Stanley and Pearton ( 1972, ch. 6); Pierre ( 1982, p. 24); Ferrari et a!. (1987, pp. 63-66)] . With the end of the Cold War there has been an increase in the relative importance of economic causes and consequences of arms transfers. This chapter is about the economics of arms trade. Our aim is to review the half dozen or so major topics in arms trade research, but with a hefty bias toward economic aspects of the trade. Despite our emphasis on the economics of arms trade, our intention is not to discount geopolitics; it is crucial for understanding arms transfers. The relative research gaps in the arms trade literature, however, lie more in economics than geopolitics. In Section 2 we describe the major trends in the international arms market over the past twenty years. The primary economic impacts of the end of the Cold War on the arms market are woven throughout our data analysis in Section 2. In Section 3 we explore the causes of arms trade, primarily in the context of international trade theory. In Sections 4 and 5 we move to empirical and theoretical studies of selected geopolitical topics. The relationship between arms trade and conflict is explored in Section 4. In Section 5 we cover the relationship between arms trade and foreign policy leverage. Concluding comments are offered in Section 6. 2. The structure of the international arms market

The decline of the Cold War led to a precipitous drop in the world arms trade. Figure 1 shows the trend in arms deliveries in constant 1 993 dollars over the 1983-1 993 period. The real volume of weapons trade reached a peak in 1984, fell for two years, rose in 1987, then declined by over two-thirds up to 1993 . World arms sales agreements also declined substantially from a peak of $69.8 billion in 1985 to $3 8.0 billion in 1993 in nominal terms [US ACDA (1 993/94)]. From 1 992 to 1 993, however, arms sales agreements rose in nominal terms from $28.7 billion to $3 8.0 billion [US ACDA (1 993/94)]. Since arms sales agreements reflect probable future arms sales deliveries, the recent increases may signify that the volume of world arms trade has bottomed out and may start increasing. The major source of the increase in arms export agreements from 1992 to 1993 was the United States, whose nominal export agreements more than doubled from $ 1 3.5 billion in 1 992 to $28.3 billion in 1 993. 2. 1.

Arms imports

The decline in the volume of world arms trade over the last ten years is reflected in regional breakdowns. Arms imports fell in both the developed and developing countries. Real developing country arms imports fell from a peak of $60.8 billion

528

C.H. Anderton 80 70 60 50

billions of 1 99 3 4 0 do llars

30 20

10

0 �---+----�--� C') co m

LO co m



C\1 m m

---•i---

Middle East

----D-

Africa

---+---

East Asia

---------

South Asia

C') m

"'

Year 1 2

/\

10 8

Billions of 1 993 dollars

�

6 4

2 0

C') co m

v co m

LO co m

CXl 0>

Year

0 0> 0>

0>

"'

C\1

"'

0>

C') 0> 0>

---•---

Western Europe

--D---

Eastern Europe

---+---

North America

---------

Central America Carribien

&

---k--- South America L---------- �

Figure 2. Arms imports by selected region, 1 983-1 993 [US ACDA ( 1993/94)].

1 984 to $1 7.2 billion in 1 993 while real developed country imports fell from a peak of $16.4 billion in 1 986 to $4.8 billion in 1993 [US ACDA ( 1993/94)]. Figure 2 shows real arms imports by selected region over the 1983-1 993 period. From 1 990 to 1 993, dramatic reductions occurred in the weapons imports of all regions. m

529

Ch. 18: Economics of Arms Trade Table 2 Arms import share by selected region a, 1 973, 1 983, 1 993 (in percent) Region

1 973

1 983

1 993

Middle East

28.4

40.4

42.6

Europe, All

26.0

20.0

20.8

Western Europe

9.7

1 5.9

Eastern Europe

1 0.2

4.9

9.6

1 2.4 2.1

East Asia

31.1

South Asia

3.4

4.7

Africa

3.6

1 4.2

1 .3

North-America

3 .0

7.4

South-America

3 .7

1 .0

Central America & Caribbean

3 .4

0.7

a Source: US ACDA ( 1 984, 1 993/94).

In addition to dramatic declines in the arms imports of regions, there have been significant changes in the distribution of arms imports. Table 2 shows regional arms import shares, comparing 1 973, 1 983, and 1 993. The Middle East has dramatically increased its import share from 28.4% in 1 973 to 42.6% in 1 993 . Europe is the second largest region in import share even though it has declined from 26.0% in 1 973 to 20.8% in 1 993 . East Asia had a decline in import share from 3 1 . 1 % in 1 973 to 9.6% in 1 983 (due, primarily, to the end of Vietnam hostilities). Since 1 983, East Asia's import share has risen to 12.4%. Africa has significantly decreased its share of weapons imports since 1 983, from 1 4.2% to 1 .3% in 1 993. In 1 97 1 , South Vietnam, West Germany, Egypt, Iran and North Vietnam had the highest arms import shares, primarily reflecting the geopolitical rivalry between the USA and USSR. By 1 98 1 , the top four importers were from the Middle East: Iraq, Libya, Saudi Arabia and Syria. By 1 99 1 , Saudi Arabia held the dominant share of the world's arms imports, followed by Afghanistan, the USA and Iran. It is likely that Iraq would have been the second largest arms importer in 1 99 1 , but for the Gulf War embargo.

2.2. Arms exports The dramatic reductions in arms imports, of course, are reflected in the arms export data. Real developed country arms exports fell from a peak of $66.7 billion in 1 987 to $20.2 billion in 1 993 while real developing country arms exports fell from a peak of $ 1 0.5 billion in 1 984 to $ 1 .8 billion in 1 993 [US ACDA (1993/94)]. Developed countries continued to be the major exporters of weapons, providing more than 90% of world arms exports in 1983 and 1 993.

530

C.H. Anderton 35 30

--1•1----

25

Billions of 1 993 2 0 d o l lars 15

---o--- Western Europe

10

---+--- North America

5

0

Eastern Europe

� East Asia C') co "'

"'" co "'

lO co "'

"' co Ol

r-... co m

co co m

0> co cn

0 "' m

0> m

C\1 0> m

C') 0> m

-----..-- Middle East

Year

Figure 3. Arms exports by selected region, 1 983-1993 [US ACDA ( 1993/94)].

Table 3 Arms export share by selected region", 1 973, 1 983, 1 993 (in percent) Region

1 973

1 983

1 993

Middle East

0.2

0.7

1 .0

Europe, All

59.6

70.5

45.1

Western Europe

23.5

32.2

Eastern Europe

46.9

1 2.8

East Asia

1 .9

5.2

5.0

South Asia

0.0

0.6

0.0

Africa

0.0

0.2

0.6

North America

22.6

47.9

South America

0.4

0.3

' Source: US ACDA ( 1 984, 1 993/94).

Figure 3 shows real arms exports by selected region over the 1983-1 993 period. Beginning in the late 1980s, significant reductions took place in the arms exports of all regions. Arms export market share by major region is shown in Table 3 . Europe and North America dominated the arms export market in 1983 and 1 993, accounting for greater than 90% of export market share. The market share of Eastern Europe declined dramatically between 1983 and 1993, due primarily to the breakup of the Soviet bloc. The market shares of the four major arms exporters from 1 983-1 993 are shown in Figure 4. The decline in market share in the USSR/CIS is dramatic. Many believe that the CIS's loss of market share is due to the relatively poor performance of Soviet weapons in the Gulf War and buyer perceptions that the CIS cannot provide adequate after-sales services for weapons given its recent political turmoil. In 1993, two developing countries were among the top ten weapons exporters: China and Israel [US ACDA ( 1993/94)]. With roughly $950 million in arms exports in 1 993 (4.3% of market share), China has emerged as one of the top five or six weapons

Ch. 18: Economics ofArms Trade

53 1

50 40

--•-- U n ited States

Q)

30

--D-- Soviet Union/C I S

Q) a..

20

--- U nited Kingdom

c

�

1 0 0

� France (') co "'

v co

"'

10 co

"'

0, e � 0) and adversaries (g < 0, e :( 0). Sales to allies increase a supplier's security while sales to adversaries reduce security. In two other cases, the short-run and long-run effects of arms transfers differ. In the "legitimate security limits" case (g > 0, e < 0), arms transfers increase security up to a point, but beyond that point reduce security. In the "potentially cooptive" case (g < 0, e > 0), transfers reduce security in the short run, but in the longer run the supplier can coopt the recipient thus increasing security. In a dynamic version of the model, the authors derive the following propositions (among others):

Ch. 1 8: Economics ofArms Trade

547

( 1 ) If the recipient is an ally or is sufficiently capable of being coopted, the total volume of arms sales exceeds the pure profit maximizing level. (2) If the recipient is an adversary or represents a "legitimate security limit", the total volume of arms sales is below the pure profit maximizing level. (3) Greater competition in the arms market (i.e., greater number of suppliers) increases the total volume of arms sales. (4) If the recipient is an ally or is sufficiently capable of being coopted and the suppliers can credibly pre-commit to future deliveries of weapons and spare parts, then the effect of forward-looking behavior by the recipient is to import a greater volume of weapons. If the suppliers lack a reputation for pre-commitment, then the effect of forward-looking behavior by the recipient is to import less weapons. The Levine, Sen and Smith model not only treats the commercial and security motives for arms exports, it also highlights the likely lobbying strategies of arms manufacturers. Weapons manufacturers have a profit incentive to counteract arms export restraints. If the recipient is questionable from a security point of view (as in the "legitimate security limit" case), arms manufacturers would tend to discount security considerations and highlight the economic benefits of arms exports. On the other hand, when security is promoted by weapons sales (as in the allies case), arms manufacturers would highlight the importance of security considerations in arms sales. An extension of the Levine et al. model could be the development of an analytical framework for how the supplier's objective function is a product of the domestic political process. 4. Arms trade and conflict

SIPRI ( 1 9 7 1 , p. 73) states that "perhaps the most important question about arms supplies [is] . . . what effect they have on the development of wars - on the likelihood of wars breaking out, on the course of wars and on their general severity". The "destabilizing school" generally believes that arms transfers promote conflict by exacerbating regional or international tensions, strengthening the clout of the military, and providing the tools to carry out a greater level of conflict. The "stabilizing school" generally believes that arms transfers can restrain conflict by restoring a balance of power in unstable regions. Connections between arms trade and conflict, however, are not easy to make. Arms transfers can increase or decrease the likelihood of inter-state war or internal conflict depending upon a variety of intervening variables: conflict setting (i.e., intensity of rivalry, issues at stake, history, geography), types and quantities of weapons transfers, existing weapons stocks, goals and perceptions of political leaders, commitments of allies, and prospects of foreign intervention. In many cases there will be too many intervening variables to establish causality between arms trade and conflict. But, if the word "causal" is used in the weaker sense of Dessler ( 1 99 1 , p. 347) t o mean "an insufficient but necessary part o f an unnecessary but sufficient condition", then what we would really mean when we use the word causal is whether arms transfers promote or restrain conflict [Kinsella ( 1994, p. 20)].

548

C.H. Anderton

The relationship between arms transfers and the outbreak and longevity of wars is similar to the question of the relationship between arms rivalry and war. Since arms transfers are part of the material of arms racing (along with the rivals' indigenous weapons production), understanding the impact of arms rivalry on the probability and severity of war would help us understand connections between arms transfers and war. The literature, however, is ambiguous on the relationship between arms races and war (see chapter 6 of the Handbook). The necessary research directions on the relationship between arms trade and conflict are theoretical and empirical. Can arms trade scholars sort out the set of variables and conditions under which arms transfers promote and restrain conflict? Relatively little systematic theoretical and empirical work has been directed to this question, although useful case study research and anecdotal evidence abounds.

4. 1. Theoretical models of arms trade and conflict Figure 1 1 shows attack and defend regions in a rivalry between J and L. The weapons stocks of the two nations, WJ and WL, are measured on the axes. If the weapons vector is in region 1 , mutual security exists, i.e., neither party can successfully initiate attack against the other. If the weapons vector is in region 2J or 2L, then respectively, J and L could attack the other and win the war. The slopes and positions of the attack/defend lines can be derived from the Lanchester war model [Anderton ( 1 990)]. A variety of variables affecting the course of war - quality of weapons, terrain, defense production capacity, perceptions of decision makers, resource constraints - can be embodied in the attack!defend lines depending on the variant of the Lanchester model chosen [Anderton ( 1 992, 1 993)]. Even the simple model of Figure 1 1 illustrates the ambiguity in the relationship between arms trade and conflict. Suppose the weapons vector is at point A. Based on the technical specifications of the Lanchester model, L could attack and defeat J. Some policy makers might conclude that the regional imbalance in weapons between J and L might lead to aggression by L. A third nation, say K, could move the weapons vector from A to B by exporting weapons to J under the pretext that a regional weapons balance would reduce the possibility of war. This stabilizing view of weapons exports underlies the arguments of some US officials for allowing US weapons exports to Bosnia in its conflict with the Serbs. It could be argued, however, that the weapons export illustrated in Figure 1 1 increases the likelihood or intensity of war. Party L might perceive the arms exports to J as eliminating L's advantage or eventually moving to a point where J could attack L. L might initiate war (i.e., preempt) or prosecute an existing war more fervently before it loses its dominance or becomes vulnerable. In this case, the weapons exports to J serve as a catalyst for war. The preemption motive for war based on arms transfers is cited as a possibility in Pakistan's 1 965 attack on India [Gerner ( 1983, pp. 20-21 )] and Israel's 1 956 attack on Egypt [Becker ( 1977, p. 4)]. Critics of US arms export restraints on Bosnia claim that months of speculation about whether the restraints

Ch. 18: Economics ofArms Trade

549

J can attack

L can attack

WL

Figure 1 1 . War creation and war diminishing aspects of arms trade.

would be lifted gives the Serbs an incentive to be extra aggressive to gain territory before their weapons advantages are diminished. The Wittman ( 1 979) model can be used to evaluate theoretically the promotion or restraining influence of arms transfers on war initiation and termination. The variables in a model of possible war between J and L are (for i =J,L): P;w, country i's subjective probability of winning the war; u:, country i's utility function; s, settlement outcome (e.g., amount of territory gained or lost); s;, unconditional surrender by i; u;(w), i's expected utility of initiating or continuing a war; Ui(s), i's expected utility of settlement or not initiating a war. Figure 1 2 shows two cases: ( 1 ) the feasibility of peace between J and L and (2) necessary conditions for war initiation or continuation. If J receives expected utility Uj(w) =A? from initiating or continuing a war, J will only accept a settlement that gives it at least as much utility as A?. Settlements to the left of A; give J more utility than Uj(w). L will only agree to a settlement if it is to the right of B;. The area of overlap between points to the left of A; and points to the right of B; indicate the feasibility of a negotiated settlement. On the other hand, if Uj(w) = A j is J's expected utility from initiating or continuing a war, the gap between A;' and B; implies that a peaceful settlement is not feasible. In this case, necessary conditions are met for war initiation or war continuation. In Figure 12, suppose Uj(w) =A? and peaceful settlement holds. If L receives new weapons imports and J does not, it could create the necessary conditions for war initiation. Since L has additional weapons and J does not, L 's expected utility from war would rise while J's would fall. If L's expected utility rises sufficiently more than J's expected utility falls, the settlement region could vanish, possibly giving way to war initiation. Alternatively, the settlement region might not vanish but it would move in L's favor as L's new source of weapons gives it greater relative negotiating power. In Figure 12, suppose Uj(w) = Aj and J and L are at war. Suppose L receives new weapons imports. If L's expected utility rises by a sufficiently smaller amount than J's expected utility falls, a settlement region could emerge. US exports of Stinger missiles

C.H. Anderton

550 u ti I ity

4_(

A"t

.....__

B't

s)

s

---1··

A;

+-­

settlement region

settlements favorable to L settlements favorable to J

Figure 12. Peace and war in the Wittman model.

in the 1 980s to the Mujahadeen may have dramatically reduced the Soviet Union's expected utility from continuing the war, thus contributing to their withdrawal. The Wittman model seems inherently ambiguous on the relationship between arms trade and conflict initiation or termination. Only if the weapons trade has a sufficiently asymmetric impact on expected utilities of war for the two parties will a peaceful settlement shift to war or a war settlement shift to peace. Where the Wittman model is unambiguous is on the effects of weapons trades on the relative negotiating powers of the conflicting parties.

4.2. Empirical studies Table 6 summarizes selected empirical studies of the relationships between arms trade and conflict. Relative to the arms race modeling literature where over one hundred empirical studies can be found, the arms trade/conflict empirical literature is quite sparse. The majority of the studies cited in Table 6 indicate that arms trading promotes conflict, but there are enough exceptions to suggest that the relationships between arms trade and conflict are not amenable to general statements. The results vary quite widely depending on the nations, data sets, empirical models, and time frames of the studies. Some of the ambiguity of the arms trade/conflict relationship, which is borne out in the theoretical models, is prevalent in the empirical literature as well. The necessary empirical research directions on the arms trade/conflict relationship are two-fold. First, some of the new empirical work should draw upon existing studies and data sets in order to develop a cumulative effort. Second and perhaps more importantly, empirical research should, if possible, identify the conditions under which arms transfers seem to promote conflict in some situations but not in others.

Table 6 Summary of selected empirical studies of arms trade and conflict Conclusions

Conflict data source(s)

Arms suppliers

Arms recipients

Arms trade/conflict Empirical model setting

Smaldone

Aggregate

Sub-Saharan

Impacts of arms

Bivariate

and

of all

African nations

transfers on

regression and duration, casualties and refugees of 1993) and SIPRI

Anderton

suppliers

Sub-Saharan regional

logistic

wars and major

regression

Authors

( 1 995)

Arms transfers correlate with wars and internal conflicts

Sivard ( 1 987,

Arms trade data Time

source(s)

period

US ACDA

1972-1991

Yearbook ( 1 992)

;:;

�· � �

�

1}

duration! casualties, refugees US, USSR

�

c ;: c

"'

terms of occurrence,

Kinsella

......

!':"

;...

internal conflicts in

( 1 994)

p

COPDAB, WEIS

SIPRI

1949-1985

(arms transfers/GNP) significantly

Numerous; see

US ACDA

1 963-1980

related with coups and nearly

Maniruzzaman

US ACDA

1968-1980

SIPRI data scaled

1950--!965

Israel, Egypt,

Impact of US and

Vector auto-

USSR transfers, more than US

Syria

USSR transfers on

regression

transfers, acerbated Middle East

Arab/Israeli conflict

rivalry; USSR transfers, more than US transfers, encouraged

compensatory transfers by the other Maniruzza-

Aggregate

80 developing

Impact of transfers on Logistic

man

of all

countries

coups and length of

multiple

( 1 992)

suppliers

military rule in

regression

developing countries

significant with length of military

( 1 992, fn. I I ,

rule

p. 736)

Kiefer

Aggregate

87 developing

Relationship between

Markov

( 1 988)

of all

countries

arms imports as

regression

Military aid hinders the restoration Small and Singer (1 982) of peace. There is a positive, but

fraction of GNP and

model

insignificant, relationship between

suppliers

inter-state war

arms imports and war outbreak NATO aircraft and WTO tank

Starr and Most

Baugh and

NATO,

Selected

Impact of transfers on Step-wise

Squires

WTO

developing

war outbreaks and

logistic

transfers occur contemporaneously ( 1 980); Majeski

by sophistication

country war

impact of war

regressions

with wars; NATO aircraft transfers and Jones ( 1 98 1 )

and firepower

dyads

outbreaks on transfers

( 1 983a,b) Schrodt

Aggregate

Selected nations Correlation of

( 1 983)

of all

in Arabian Sea

suppliers

area and Middle cooperation/conflict East

transfers with

occur prior to wars Rank

Transfers correlate strongly with

correlation

conflict/cooperation; transfers seem

test

to cause behavior rather than vice versa

COPDAB

SIPRI

1948-1978

continued on next page

lJ> lJ>

V\ V\ N

Table 6, continued Arms recipients

Conclusions

Authors

Arms suppliers

Sherwin

Aggregate

87 developing

Correlation of

( 1 983)

of all

countries

transfers with conflict. correlation

not linked causally; variations in

Extent to which

the two occur simultaneously. For a

suppliers

Arms trade/conflict Empirical setting model Rank test

Conflict data source(s)

In most cases, conflict and transfers WEIS

Arms trade data Time source(s) period US ACDA

1 967-1976

Bendix Corp. and

1955-1966

small subset of countries, arms

transfers cause conflict

imports precede conflict Bobrow

5 "great

15 Asian nations Impact of military

et al. ( 1 975) powers"

Linear

assistance on recipient, multiple political strife and

regression

foreign policy

Milstein ( 1972)

US, USSR

Selected Middle Impact of US/USSR East nations

aid on Aarab/Israeli

Domestic

correlated with domestic conflict in

conflict:

recipient nations in most cases; a

Handbook of

World

US House Foreign Affairs Committee

few cases have robust correlations, Political and

Bivariate and

economic and military multivariate violence

Military assistance not significantly

regression

but in both directions. Military

Social Indicators

assistance correlated to increased

II, Banks ( 1 97 1 )

international cooperation in

International

recipient nations in 6 of 7 cases of

conflict:

robust results

Corp.

Violent behavior between Israeli

Milstein's index

US House

and Arabs is dominated by

based on Middle

Approp.

Bendix

unresolved conflict issues;

East Journal

US/USSR aid and trade have little

Chronology

impact on Arab/Israeli violence

The Nrn> York

Eco. Hearings,

Times Index

Muller ( 1 967)

and

1948-1967

Committee, US Congress Joint

n t:r: ;,.. ;,:

�

s;,:

Ch. 18:

Economics of Anns Trade

553

4.3. Case studies The arms trade literature is replete with useful qualitative studies on the relationship between arms trade and conflict. An early example is Kemp's ( 1970) study of the correlations between arms trade and Third World conflict between 1 945 and 1 970, with an emphasis on the 1 960s. During this period, many Third World conflicts took place and "nearly all the weapons used in these conflicts . . . originated from the factories of the industrial powers." [Kemp ( 1970, p. 5)]. Nevertheless, Kemp maintains that "it cannot be argued from this evidence alone that arms cause or contribute to conflict." [Kemp (1 970, p. 9)]. The relationships between arms supplies, conflict and Third World stability are exceedingly complex. Kemp's paper is designed to cull out general principles about arms transfers, military requirements, and conflict in the Third World and then apply these principles on a regional case-by-case basis. A summary of Kemp's principles is that in evaluating the impacts of arms transfers on Third World conflict, it is important to estimate the effectiveness of the weapons transferred. Effectiveness is a multi-dimensional variable depending on military environments, technical specifications of weapons and political factors. "Only if it is possible to apply qualitative criteria based on some measure of a weapon's "effectiveness" can one argue that the transfer of some types of weapons would introduce more destabilizing factors in the Third World security environments than the transfer of others." [Kemp ( 1970, p. 22)]. Kemp recognizes that it is difficult if not impossible to label weapons as "offensive" or "defensive" based on technical specifications alone, but this does not mean that no judgment can be made. "When making a qualitative distinction between various classes of weapons, it is essential to be more precise about the various types of military, geographical, and technical environments that exist, or are believed to exist, in various areas of the Third World." [Kemp ( 1 970, p. 26)]. Kemp undertakes a region-by-region analysis of the impacts of arms trade and arms trade control on Third World environments in terms of peace and security in those areas. Kemp (1 970, p. 70) reaches the following conclusions: ". . . it has been suggested that the arms trade to the Third World is neither "good" nor "bad", that certain types of arms transfers can both serve and harm the interests of suppliers and recipients and, more particularly, that there is no a priori truth that predetermines that arms transfers inevitably contribute to the outbreak of conflict." Figure 1 1 above illustrates how the arms trade might restrain or promote conflict. The direction of causality is from arms trade to conflict. Neuman ( 1986) considers how conflict, by fueling the demand for weapons, can cause more arms trade. She investigates the impacts of war on arms transfers for eight less developed country wars - five conventional inter-state wars and three insurgencies. Neuman finds that for most warring states, the dollar value of arms imports escalated during conflict, but the contributions of the USSR and, particularly, the USA declined, with other suppliers moving in to meet the demand. Neuman ( 1 986, p. 92) concludes that both superpowers showed concern about escalating Third World conflicts with arms exports,

554

C.H. Anderton

and exercised restraint, particularly during the early stages of war or until a political or strategic advantage emerged. Harkavy ( 1987) also considers the interrelationships between arms trade and on­ going conflict. He lays out the myriad dimensions of the subject and creates a preliminary classification of cases of arms resupply during conflict. Harkavy believes that there has been so little systematic treatment of the subject that it is premature to venture generalizations or describe causal interrelationships. Pearson et al. (1 992) analyzed the effects of arms transfers on ten inter-state wars, reaching the following general conclusions: (1) Arms transfers are a factor in decisions to go to war because of considerations of military superiority, perceptions of changes in the balance of power, and interest in establishing links with supporting states. (2) Supplying states have little leverage in conditioning or even determining the outcome of hostilities. (3) Arms transfers generally prolonged and escalated wars, resulting in more suffering and destruction. (4) Arms embargoes, whether partial or total, in and of themselves had little chance of compelling warring parties to stop wars or come to the negotiating table. They did serve to contain the actual fighting. (5) The two superpowers were more prone to use arms transfers as a means to influence warring parties than were other suppliers. During wars the superpowers' share in deliveries generally declined. Consistent with the theme of ambiguity in some of the theoretical and empirical literature described above, Pearson et al. ( 1 992, p. 399) conclude: Arms transfers have both precipitant and deterrent effects on armed conflicts; they are also a factor in the conduct and the cessation of wars. Often heard categorical statements - either that arms transfers are inherently conflict enhancing or that, properly managed, they are a trustworthy instrument for stability - ignore the complex record. Despite the obvious relevance of these factors, the literature contains little systematic evidence of the actual effects of arms transfers on conflicts.

5. Arms trade and foreign policy influence

Arms suppliers often use their weapons exports to create foreign policy influence over arms recipients. For example, Snider ( 1 978) found empirical evidence that, under certain conditions, some weapons exporters gained influence over several Middle Eastern countries through arms transfers. Roeder ( 1985) found that Soviet economic and military aid to Third World countries from 1 960--1 980 increased the recipient's trade dependence on the Soviet Union, which in turn induced political compliance. Case studies of the US-Israeli relationship, e.g., Nachmias ( 1 988), Pollock ( 1 982), and Wheelock (1978) found that the USA sometimes used its weapons exports

555

Ch. 18: Economics of Arms Trade Table 7 Frequency of US arms influence attempts by administration Administration

a,

1 950-1992

Average attempts per year

Truman ( 1 950-1 952)

3.0

Eisenhower ( 1 953-1 960)

2.0

Kennedy ( 1 961-1963)

3.0

Johnson ( 1 964-1 968)

6.4

Nixon ( 1 969-1 974)

3.8

Ford ( 1 975-1976) Carter ( 1 977-1 980)

8.5 1 0.5

Reagan ( 1 98 1-1 988)

3.5

Bush ( 1 989-1992)

3.8

Total ( 1 950-1 992)

4.5

a

Source: Sis1in ( 1 993, p. 1 59).

to influence Israel. Table 7 shows the frequency of 1 9 1 arms influence attempts by US Presidential Administration. Although arms influence attempts are widespread, they are successful only part of the time. For example, Snider ( 1 978, p. 262) says that his relationships do not always hold and Gelb ( 1 976/77) shows examples of both US successes and failures in arms influence. Although these studies and others identify both successes and failures in arms influence attempts, they fail to solve the key puzzle: why are such practices successful only part of the time? Answering this question requires that the context of arms trade influence attempts be thoroughly examined. "The key question then becomes: What environmental, contextual, or intervening variables involved in the influence attempt are important in determining success?" [Sislin ( 1 993, p. 4)] .

5. 1. Sislin s theory of arms influence success Sislin (1993) makes a major contribution toward identifying the determinants of arms influence successes by offering a theory of arms as influence. He considers two decision-makers: recipient and supplier that are assumed to behave as unitary actors [for caveats see Sislin ( 1 993, pp. 47-48)]. Stage 1 has the recipient engaged in some behavior which the supplier does not approve of. In Stage 2, the supplier decides to manipulate arms exports to alter the behavior of the recipient. Finally, in Stage 3, the recipient decides how to respond to the supplier's influence attempt. Although Sislin did not present his three-stage theory mathematically, it can be done as follows: Stage 1

(15)

V 5 (c) V5 (nc), where V5(c) is the value to the supplier of compliance by the recipient; V5(nc) is the >

value to the supplier of non-compliance by the recipient.

C.H. Anderton

556

Condition 15 is necessary for an arms influence attempt, but it is not sufficient. "It is possible, and frequently the case, that the costs of the influence technique, . . . , would be so high as to lower the benefit the supplier receives from compliance to the point where more value could be obtained by simply doing nothing." [Sislin ( 1 993, p. 47)] . Stage 2 (Supplier Decision Calculus)

E [ V5 ] = P0 V 5 (c) + ( 1 - Pc) V5 (nc) - C5 (i) > V5 (nc)

(16)

where E[V5] is the expected value to the supplier of an arms influence attempt; P0, probability of recipient compliance as perceived by the supplier; C5(i), cost of influence attempt as perceived by the supplier. Ignoring risk preference, condition 16 is sufficient for an arms influence attempt. A variety of arms influence techniques might satisfy condition 1 6 [see Sislin ( 1 993, pp. 5 1-54)]. Assuming that only Pc and cs are functions of the arms influence attempt, the supplier chooses an arms influence instrument to maximize E[V5]. Stage 3 (Recipient's Decision Calculus)

vr(c) > vr(nc) - PiCr(i),

( 1 7)

where vr(c) is the value to the recipient of compliance; vr(nc), value to the recipient of non-compliance; C(i), costs to the recipient of arms influence instrument; Pi, probability that costs of arms instrument will actually be incurred. Ignoring risk preference, condition ( 1 7) is sufficient for the recipient to comply with the arms influence attempt.

5.2. Determinants of arms influence success What are the key determinants under which Equations ( 1 6) and ( 1 7) would hold, giving rise to arms influence success? Sislin ( 1 993) addresses this question for the United States based on his data set of 80 successful influences out of 1 9 1 attempts over the 1 950-1992 period. Table 8 lists the variables that Sislin identifies as possible determinants of arms influence success. Using a winnowing procedure on multivariate logit analysis, Sislin identifies the core determinants of arms influence success. He finds six variables that seem to play a significant role in the probability of successful influence: sanction type, policy, regime, hegemony, supplier arms, and alternate supplier. Sislin's ( 1 993, p. 1 87) general conclusion is: "Influence attempts are more likely to succeed when (1) sanctions are positive (reward or promise) rather than negative; (2) the focus of the attempt is to alter the recipient's foreign rather than domestic policy; (3) the recipient is a civilian regime, not a military one; (4) the United States was more powerful in the world system; (5) the recipient receives more of its arms from the United States; and (6) the recipient has less alternative suppliers available to it." Sislin's research implies that arms influence success is not determined by one or two key variables, but by a set of variables which defines the context for a high probability

557

Ch. 18: Economics of Arms Trade Table 8 Possible determinants of arms influence success

•

I. Characteristics of influence attempt

I

2 3

Sanction type - supplier's sanction is positive or negative

Goal - supplier's goal is deterrence or compellence Policy - supplier is attempting to alter recipient's foreigr. policy or domestic policy

II. Characteristics of recipient

A. Political 4

5

Regime - recipient state ruled by military elites or civilian elites Recipient cohesion - recipient elites are cohesive or fragmented

B. Military 6 Conflict - recipient engaged in international conflict or not 7

Security - recipient feels secure or insecure

8

Civil strife - recipient leaders face domestic conflict or domestic tranquility

C. Economic 9 Resource - recipient's resource base I0 Indigenous arms - recipient's level of indigenous arms production III. Characteristics of interaction between recipient and supplier

11 12

Trade - degree o f economic interaction between supplier and recipient

13

Precedent - outcome o f previous influence attempt (if any)

Supplier arms - degree of dependence of recipient on supplier's arms

IV. Characteristics of supplier 14

15

Supplier cohesion - supplier elites are cohesive o r fragmented

Presidential style - active-positive US presidents versus other types

V. System characteristics

16

Hegemony - trend o f US hegemony

17

Cooperation - degree o f friendliness o r hostility between the U S and USSR

18

Alternate supplier - number of alternative arms suppliers available to the recipient

• Source: Sislin ( 1 993, pp. 1 08-1 09).

of arms influence success. Altering any one of the variables in the set has only a small impact on the probability of arms influence success. Sislin's results challenge some of the conventional wisdom in the arms influence literature. For example, the recipient's level of indigenous arms production is sometimes cited as a variable which diminishes a recipient's vulnerability to arms influence. Sislin finds that indigenous arms production is not a significant determinant of arms influence success or failure. Another example is the belief by some analysts that a nation involved in conflict is more likely to be influenced through weapons restraints. Sislin, however, finds that this variable is generally insignificant.

C.H. Anderton

558

5.3. Recipient influence Sislin ( 1993, pp. 1 96-200) identifies directions for future research: (1) test other suppliers, (2) consider other forms of influence attempts, (3) test the robustness of his work, and (4) comparative analyses of arms influence with other forms of influence. One direction of research that Sislin did not mention is recipient influence. The literature on arms influence generally presumes that the supplier has the leverage to initiate an arms influence attempt. Although the presence of alternative suppliers might diminish the recipient's vulnerability to the arms influence attempt, the action is still from the supplier to the recipient. It is possible, however, that the consumer of weapons could exercise foreign policy influence over the supplier. The economic perspective reminds us that a market is made up of two sides. Under conditions of pure competition or bilateral monopoly (or bilateral oligopoly, etc.), each side of the market might lack a clear path for creating arms influence. Other market structures (e.g., monopsony, oligopsony) might allow the buyer to levy influence on the seller. The arms trade literature to date, theoretically and empirically, has not investigated arms trade influence from the buyer to the seller. This part of the spectrum could be relevant in the immediate post-Cold War era which is often characterized as a "buyer's market". Nykvist ( 1 995) has undertaken theoretical and case study research on arms trade foreign policy leverage from the buyer's side.

6.

Concluding comments

The international arms market experienced a dramatic structural change with the end of the Cold War. Economics has risen in importance, relative to geopolitics, in understanding the motivations and consequences of the arms trade. Nevertheless, there is surprisingly little theoretical and empirical development of the economics of arms trade. Almost the whole body of international trade theory remains untapped. It seems reasonable to conclude that the economics of arms trade is essentially an unexplored sub-field of defense economics, ripe for foundational theoretical and empirical contributions. Fields other than economics have contributed much to our understanding of arms transfers. A myriad of useful case studies exist, offering important insights and data on the geopolitics of the arms trade. Empirical sub-literatures on foreign policy leverage and the relationship between arms trade and conflict are now in place beckoning researchers to further develop these sub-fields. The international systems model of Harkavy ( 1 975), Laurance ( 1992) and others is a useful theoretical and applied approach for understanding the geopolitics of arms transfers. Catrina ( 1994) identifies many arms trade research directions, including some on the economics of arms trade. At this point, the central problem of the arms trade literature, for both economists and geopolitical scientists, is how to go beyond the proliferation of policy position articles and descriptive studies (which are useful and important in their own right), to

Ch. 18: Economics ofArms Trade

559

a more solid base of theoretical and empirical models. A new theoretical synthesis of economics and geopolitics would represent a major breakthrough. The development of the economics of arms trade must move beyond its incipient stages for this synthesis to occur, but it seems that Levine, Sen and Smith ( 1994) have already taken steps in this direction. Ultimately, it would be desirable to see theoretical and empirical work on the arms trade narrow the range of outcomes which are regarded as plausible.

References Alexander, A.J., W.P. Butz and M. Mihalka, 1 9 8 1 , Modelling the production and international trade of arms: An economic framework for analyzing policy alternatives (The Rand Corporation, Santa Monica, CA). Anderton, C.H., 1 990, The inherent propensity toward peace or war embodied in weaponry, Defence Economics 1 , 1 97-2 1 8. Anderton, C.H., 1 992, Toward a mathematical theory of the offensive/defensive balance, International Studies Quarterly 36, 75-100. Anderton, C.H., 1 993, Arms race modeling and economic growth, in: J.E. Payne and A.P. Sahu, eds., Defense spending and economic growth (Westview Press, Boulder, CO) 55-82. Bajusz, W.D., and D.J. Louscher, 1 988, Arms sales and the U.S. economy: The impact of restricting military exports (Westview Press, Boulder, CO). Banks, A., 1 97 1 , Cross-polity time-series data (MIT Press, Cambridge, MA). Baugh, W., and M. Squires, 1 983a, Arms transfers and the onset of war part 1: Scalogram analysis of transfer patterns, International Interactions 1 0, 39-63. Baugh, W., and M. Squires, 1 983b, Arms transfers and the onset of war part II: Wars in Third World states, International Interactions 10, 129-141 . Becker, A.S., 1 977, Arms transfers, great power intervention, and settlement of the Arab-Israeli conflict (The Rand Corporation, Santa Monica, CA). Bobrow, D.B., P.T. Hopmann, R.W. Benjamin and D.A. Sylvan, 1 975, The impact of foreign assistance on national development and international conflict, Journal of Peace Science 1 , 39-60. Carus, W.S., 1 994, Military technology and the arms trade: Changes and their impact, The Annals of the American Academy of Political and Social Science 535, 1 63-174. Catrina, C., 1 988, Arms transfers and dependence (Taylor & Francis, New York). Catrina, C., 1 994, Main directions of research in the arms trade, Annals of the American Academy of Political and Social Science 535, 1 90-205 . CBO (US Congressional Budget Office), 1 976, The effect of foreign military sales on the U.S. economy (Congressional Budget Office, Washington, DC). Dessler, D., 1 99 1 , Beyond correlations: Toward a causal theory of war, International Studies Quarterly 35, 337-355. Engelbrecht, H.C., and F. C. Hanighen, 1 934, Merchants of death: A study of the international armament industry (Dodd, Mead, New York). Ferejohn, J., 1 976, On the effects of aid to nations in an arms race, in: D.A. Zinnes and J.V. Gillespie, eds., Mathematical models in international relations research (Praeger, New York) 21 8-25 1 . Ferrari, P.L., J.W. Knopf and R.L. Madrid, 1 987, U.S. arms exports: Policies and contractors (Investor Responsibility Research Center, Washington, DC). Frey, B.S., 1 975, Weapon exports and aid to developing countries, Journal of Peace Science 1 , 1 1 7-126. Gelb, L., 1 976/77, Arms sales, Foreign policy 25, 3-23. Gerner, D., 1 983, Arms transfers to the Third World: Research on patterns, causes and effects, International Interactions 1 0 , 5-73.

560

C.H. Anderton

Grobar, L.M., E.M. Stern and A.V. Deardorff, 1 990, The economic effects of international trade in armaments in the major western industrialized and developing countries, Defence Economics 1 , 97-120. Harkavy, R.E., 1 975, The arms trade and international systems (Ballinger, Cambridge, MA). Harkavy, R.E., 1 987, Arms resupply during conflict: A framework for analysis, in: C. Schmidt, ed., The economics of military expenditures (MacMillan, London) 1 4 1-17 5. Harkavy, R.E., 1 994, The changing international system and the arms trade, The Annals of the American Academy of Political and Social Science 535, 1 1-28. Hartley, K., 1 987, Efficiency, industry and alternative weapons procurement policies, in: C. Schmidt, ed., The economics of military expenditures (MacMillan, London) 283-300. Johnson, J., 1 994, Financing the arms trade, The Annals of the American Academy of Political and Social Science 535, 1 10-1 2 1 . Jones, P.R., 1 988, Defense alliances and international trade, Journal of Conflict Resolution 32, 1 23-40. Kemp, G., 1 970, Arms traffic and Third World conflicts, International Conciliation 577, 1-77. Kiefer, D., 1 988, Interstate wars in the Third World: A Markov approach, Conflict Management and Peace Science 10, 2 1 -36. Kinsella, D., 1 994, The impact of superpower arms transfers on conflict in the Middle East, Defence and Peace Economics 5, 1 9-36. Kolodziej, E.A., 1 987, Re-evaluating economic and technological variables to explain global arms production and sales, in: C. Schmidt, ed., The economics of military expenditures (MacMillan, London) 304-335. Krugman, P., 1 989, Industrial organization and trade, in: R. Schmalensee and R. Willig, eds., Handbook of industrial organization, Vol. 2 (North-Holland, Amsterdam) 1 179-1223. Krugman, P., and M. Obstfeld, 1 994, International economics: Theory and policy, 3rd edition (Harper­ Collins, New York). Laurance, E.J., 1 992, The international arms trade (Lexington Books, Lexington, MA). Leiss, A.C., 1 970, Changing patterns of arms transfers: Implications for arms transfer policies (Center for International Studies, MIT, Cambridge, MA). Leiss, A.C., G. Kemp, J.H. Hoagland, J.S. Refson and H.E. Fischer, 1 970, Arms transfers to less developed countries (Center for International Studies, MIT, Cambridge, MA). Levine, P., S. Sen and R. Smith, 1 994, A model of the international arms market, Defence and Peace Economics 5, 1-1 8. Majeski, S., and D. Jones, 1981, Arms race modeling: Causality analysis and model specification, Journal of Conflict Resolution 25, 259-288. Maniruzzaman, T., 1 992, Arms transfers, military coups, and military rule in developing states, Journal of Conflict Resolution 36, 733-755. McGuire, M.C., 1987, US foreign assistance, Israeli resource allocation and the arms race in the Middle East: An analysis of three interdependent resource allocation processes, in: C. Schmidt, ed., The economics of military expenditures (MacMillan, London) 1 97-238. Milstein, J.S., 1 972, American and Soviet influence, balance of power, and Arab-Israeli violence, in: B.M. Russett, ed., Peace, war, and numbers (Sage, Beverly Hiils, CA) 1 39-166. Moodie, M., 1 994, Constraining conventional arms transfers, The Annals of the American Academy of Political and Social Science 535, 1 3 1-145. Muller, J., 1 967, The foreign aid programs of the Soviet bloc and Communist China (Walker, New York). Nachmias, N., 1 988, Transfer of arms, leverage, and peace in the Middle East (Greenwood Press, New York). Neuman, S.G ., 1 986, The arms trade in recent wars: The role of the superpowers, Journal of International Affairs 40, 77-1 00. Neuman, S.G., and R.E. Harkavy, 1 979, Arms transfers in the modem world (Praeger, New York).

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561

Nykvist, K., 1 995, A nontraditional approach to arms trade foreign policy leverage, Department of Economics Honors Thesis ( Holy Cross College, Worcester, MA). Pearson, F.S., M. Brzoska and C. Crantz, 1 992, The effects of arms transfers on wars and peace negotiations, in: SIPRI yearbook 1 992: World armaments and disarmament (Oxford University Press, New York) 399-4 1 5 . Pierre, A.J., 1 982, The global politics o f arms sales (Princeton University Press, Princeton, NJ). Pollock, D., 1 982, The politics of pressure (Greenwood Press, Westport, CT). Roeder, P., 1 985, The ties that bind: Aid, trade, and political compliance in Soviet-Third World relations, International Studies Quarterly 29, 1 9 1-2 1 6. Sandler, T., and K. Hartley, 1 995, The economics of defense (Cambridge University Press, Cambridge). Scherer, F.M., and D. Ross, 1 990, Industrial market structure and economic performance, third edition (Houghton Mifflin, Boston, MA). Schrodt, P., 1 983, Arms transfers and international behavior in the Arabian Sea area, International Interactions 1 0, 101-127. Sherwin, R., 1 983, Controlling instability and conflict through arms transfers : Testing a policy assumption, International Interactions 1 0, 65-99. SIPRI (Stockholm International Peace Research Institute), 1 97 1 , The arms trade with the Third World (Almqvist & Wiksell, Stockholm). SIPRI Yearbook, annual, SIPRI yearbook: World armaments and disarmament (Oxford University Press, New York). Sislin, J., 1 993, Arms as influence: The elusive link between military assistance and political compliance, Ph.D. Thesis (Department of Political Science, Indiana University). Sivard, R.L., 1 987, World military and social expenditures, 1 9 87-1 988 (World Priorities, Washington, DC). Sivard, R.L., 1 993, World military and social expenditures, 1 993 (World Priorities, Washington, DC). Skons, E., and H. Wulf, 1 994, The internationalization of the arms industry, The Annals of the American Academy of Political and Social Science 535, 43-57. Smaldone, J., and R. Anderton, 1 995, Arms transfers and regional conflicts in Africa, mimeograph. Small, M., and J.D. Singer, 1 982, Resort to arms: International and civil wars, 1 8 1 6-1 980 (Sage, Beverly Hills, CA). Smith, R., A. Hurnm and J. Fontanel, 1 985, The economics of exporting arms, Journal of Peace Research

22, 239-247.

Snider, L., 1 978, Arms transfer and recipient cooperation with supplier policy references: The case of the Middle East, International Interactions 5, 241-266. Snider, L., 1 987, Do arms exports contribute to savings in defense spending?: A cross-sectional pooled times series analysis, in: D. Louscher and M. Salomone, eds., Marketing security assistance (Lexington Books, Lexington, MA). Stanley, J., and M. Pearton, 1 972, The international trade in arms (Praeger, New York). Starr, H., and B.A. Most, 1 980, Diffusion, reinforcement, geopolitics and the spread of war, American Political Science Review 74, 609-636. US ACDA (US Arms Control and Disarmament Agency), annual, World military expenditures and arms transfers (US Government Printing Office, Washington, DC). Wheelock, T., 1 978, Arms for Israel: The limit of leverage, International Security 3, 123-137. Wittman, D., 1 979, How a war ends: A rational model approach, Journal of Conflict Resolution 23,

743-763.

Chapter 19 THE ECONOMICS OF DISARMAMENT JACQUES FONTANEL

Universite Pierre Mendes France de Grenoble

Contents

Abstract Keywords 1 . Introduction 2. Economic definitions of disarmament 2 . 1 . Disarmament via physical reductions and a ban or limitation on forces 2.2. Military expenditure reduction 2.3. Thoroughgoing disarmament

3. Theoretical economic analysis of disarmament 3 . 1 . The peace dividend approach 3.2. Disarmament as an investment 3.3. Development as the main factor of disarmament 3.4. Disarmament/armament

as

elements of a national strategy

4. Empirical analysis of disarmament 4.1. 4.2. 4.3. 4.4.

The United States France United Kingdom Simulations for developing countries

5 . Disarmament for development 5. L The nature of the transfers

5.2. The economic effect of a disarmament for development process

6. The role of public policy 7. Conclusion References

Handbook of Defense Economics. Volume 1, Edited by K Hartley and T. Sandler © 1995 Elsevier Science B. V. All rights reserved

564 564 565 565 566 566 567 569 570 571 572 572 575 576 578 578 579 580 580 581 583 585 585

564

J Fontanel

Abstract

The economics of disarmament is a new discipline. It involves analyses on the economic causes of the arms race, the definitions of disarmament and the economic determinants and military expenditure. Simultaneously, disarmament is considered as an obstacle to economic development, a peace dividend or an investment. The construction of economic models of disarmament produces some controversial results. Questions arise concerning the economic effects of a reduction in military expenditure on growth, employment, inflation, budget deficits, the costs of conversion or the dual use of military products, capital capacity and R&D. Long term disarmament needs a development process and an adequate public policy. Keywords

disarmament, military expenditure (ME), conversion, arms industry, peace dividend, disarmament for development, national security, investment, growth, econometric models

Ch. 1 9: Economics of Disarmament

565

1. Introduction

Economists have not derived any real inspiration from disarmament for four main reasons. First, they have attempted to establish scientific regularities, they are involved with optimization problems in a peaceful paradigm and usually they are not interested in the multidisciplinary analysis of the real constraints of power, risks and conflicts. Second, if the reduction of military expenditure (ME) is seen as an instrumental variable that may modify the conditions of economic growth, economic factors condition the disarmament process. Third, public interest in security questions is variable reflecting the course of conflicts. Fourth, the defense budget is often analyzed as an unproductive expenditure and it seems to be economically uninteresting; moreover, the theory of public expenditures has been neglected for much of the history of economic thought [Goodwin ( 1991)]. However, states have to protect their wealth. The basis of conflict and war exists in the contexts of the struggle for power and of religious and ideological convictions. It can reflect a struggle for resources or economic competition. In peacetime, governments have to take into account the balance that must be maintained between impoverishing military expenditure and a necessary level of national security. There is a choice to be made between today's and tomorrow's security and the state must settle on the "razor edge" of spending, choosing just the amount needed to give itself military protection in the short term without threatening the increase in wealth needed to maintain the defense effort. There are three main reasons for disarmament. First, the reduction of "excess" armaments is based on the definition of excessive stocks of weapons [Fontanel (1991)]. Second, disarmament can be imposed by disastrous national economic conditions (the "guns or butter" dilemma). Third, the goal of disarmament is to reduce the risk of armed conflict, that is to increase security. In this context, the economic aspects are of secondary importance. Disarmament may develop the idea of establishing a lasting peace able to overcome the ideological, political and religious differences that may lead to wars. This chapter deals with (i) the economic definitions of disarmament; (ii) the theo­ retical economic analysis of disarmament; (iii) the empirical analysis of disarmament; (iv) disarmament for development and (v) the role of public policy. 2. Economic definitions of disarmament

A disarmament process leads to a modification of a nation's military strategies. There are many forms of disarmament, such as reduction of military expenditure, reduction or destruction of stocks of specific weapons, a ban or limitation on the production of some types of military equipment, reduction in the numbers of military personnel in their geographical location, limitations on arms transfers, control of defense R&D, and the monitoring and verification process [Sandler and Hartley ( 1 995)]. There are

566

J. Fontanel

three main forms of disarmament, namely destruction and reduction of military forces, reduction of military expenditure, and "thoroughgoing" disarmament.

2. 1. Disarmament via physical reductions and a ban or limitation on forces The superpowers might find an acceptable level of weaponry which they believe ensures their security. Disarmament is then a way of reducing the stockpile of destructive power. Defense spending in an arms race can be analysed by the Prisoner's Dilemma problem of game theory (but it is often difficult to know who are the players, what is the mutual information and what are the nation's preferences?). Classical arms control is useful to decide a lower level of defense spending for each nation, with the same national security, with a strong verification regime [Schelling ( 1966)]. The destruction of military stocks is a costly business and its initial effect is an increase of the economic burden of defense [Fontanel and Ward ( 1 993)]. Bischak and Oden ( 1 989), attempting to compare the reduction of military purchases, operational and maintenance costs and personnel costs with the financial commitments occasioned by the destruction of arms and the verification of the INF Treaty, estimated that the overall reduction of ME for the USA were equal to $ 1 .5 billion for 1 988-2000. Unclassified assessments by the Russian military estimate that implementing START would cost Russia 90 to 95 billion rubles, equivalent to $6 million (1 992 prices). Ukraine has requested $2.8 billion to ship nuclear arms to Russia for dismantling [Renner ( 1 994)]. Annual funding for the US Army's Chemical Material Destruction Agency has risen from $200 million in the late 1980s to $500 million in 1 994. The US Army demilitarized 300 000 tons of ammunition during 1 990-1 995, at a cost of $300 million, when Congressional appropriations to procure new ammunition add up to $6.6 billion. In Europe, conversion funding by government is marginal ($320 million for Italy, $ 1 60 million for France, but German expenditures are greater: $7.6 billion of grants and credits available to facilitate the pullout of ex-Soviet troops). Without reductions of military outlays, quantitative limits to armaments must focus on currently developed weapon systems, and may release resources to develop new and destabilizing weapon systems that are not covered by any treaty and which involve a redesign of strategic doctrine, at greater costs. It is certainly useful to control R&D and to establish reductions of most weapons systems. However, it should be recognized that below certain thresholds physical weapons stockpiles have little utility, either in battle or in preventing it. Under the Ricardian theory of international trade, the government normally seeks to keep those arms of which it has the greatest comparative advantage or opts for the agreement that is most costly in economic terms to its potential adversary.

2.2. Military expenditure reduction For a long time, Soviet leaders felt that attaining a "superpower" status required a large military and were convinced that the free world would not be able to preserve

Ch. 19: Economics of Disarmament

567

its standard of living and its military advantage. At the same time, the US government felt that pressure on the Soviet Union's military would bring about a final blow to the Soviet economy. These considerations brought about a "rational" arms race only when security has been defined as a zero-sum game. The dynamics of military expenditure progressively undermined the economic basis of the great powers. Military spending provides evidence of the price that is collectively attached to security, but the economic factors are not likely to be the best source of reliable indicators of security. This arises because some types of delivery vehicles (e.g. nuclear missiles) are clearly more effective than conventional weapons, and at a relatively low cost in terms of the strategic, military and political advantages. Moreover, relations of strength are often expressed in terms of thresholds and an equal reduction of ME for each state does not necessarily result in the former balance of forces being maintained. Disarmament by reduction of defense budgets implies that the structure of expenditure has to be taken into consideration. Cuts in defense spending reduce the demand for manpower and capital in the military sector (armed forces and defense industries). Costs of conversion can be very important and last a long time for groups, regions and industries [UNIDIR ( 1 993)]. A disarmament predicated on the notion of cost-savings will also have as a primary goal the increased efficiency of reduced expenditures. Military-industrial institutions will try to find ways, by giving greater attention to waste, fraud, and mis­ management, to produce the same level of weapon stocks with a reduced budget and to exploit economies of scale in order to reduce unit costs or to attempt to produce "better" weaponry. In responding to cost-saving measures, governments will tend to specialize their defenses in areas in which they may have the greatest economic advantage. Reduction of military expenditure must be analyzed in opportunity cost terms. A disarmament predicated on responding to an economic crisis, may well lead towards a less stable and more dangerous global environment. Simply constraining the flow of resources for military purposes will be insufficient to ensure a disarmament that increases global security. 2.3.

Thoroughgoing disarmament

Thoroughgoing disarmament appears when military expenditure becomes more of an endogenous variable than a true instrumental variable of the government. It may have several causes - economic, political, strategic and even ideological. Economic competition involves cost reductions, better information on the basic rules of defense, the search for international co-operation, some opening up of the market to foreign companies, privatization of state undertakings, limited industrial policy by the state, and the search for economies of scale. The pursuit of a new international co-operation over armaments is almost invariably dictated by the reduction of unit costs of weapons which have become very expensive. When it works properly, which is rarely the case, this international co-operation leads a more equitable calculation of the expenditure to be collectively undertaken [Fontanel and Smith ( 1 990)]. Under these conditions the

568

J. Fontanel Table I Some econometric results

Partial economic endogenous variables

References

Civil budget of state

Fontanel (1 980), Gyimah-Brempong ( 1 992)

Bureaucratic procedures in the allocation of military resources

Fontanel and Smith ( 1 990), Looney ( 1 988, 1 989), Byers and Peel ( 1 989)

Availability of public funds

Hewitt ( 1 9 9 1 )

Per capita income

Lotz ( 1 970), Fontanel and Smith ( 1990)

Material well-being of citizens and social spending

Hewitt ( 1 9 9 1 )

Economic cyclical movement

Griffin, Wallace and Devine ( 1 982), Smith and Smith ( 1983)

Inertial economic effect

Correa and Ji-Won Kim ( 1 992)

Petro-dollars

Deger and Smith ( 1 983), Looney ( 1 989)

Military industrial complex

Galbraith ( 1 972), Melman ( 1 974)

National arms production

Looney ( 1989)

Other partial endogenous variables Militarization of the society

Maizels and Nissanke ( 1 987), Thee ( 1 982), Whynes ( 1 979)

Power struggle or imagined threats of the ruling class

Looney ( 1989), Griffin, Wallace, Devine ( 1982)

National security, wars and arms race

Adams and Gold ( 1 987), Byers and Peel ( 1 989), Hewitt ( 1991 ), Brito and Intriligator ( 1 987)

Urbanization

Lotz ( 1 970)

Arms race strategies

Correa and Ji-Won Kim ( 1 992), Fontanel and Smith ( 1 990), Rajmaira and Ward ( 1 99 1 )

Ideological priorities of government

Thee ( 1 982), Hewitt ( 1 9 9 1 )

Political situation (monarchy, dictatorship, . . . )

Hewitt ( 1 99 1 ), Nincic and Cusack ( 1 979), Grindle ( 1986), Kende ( 1 980)

Geographical variables

Hewitt ( 1 99 1 )

defense sector loses its priorities and is then regarded as a burden. It has been stated that national security can no longer be analysed in purely military terms: economic security must also be taken into account. There is considerable econometric research into the analysis of the economic foundations of ME (Table 1). The results obtained have not always been either coherent or generalizable. However that may be, current economic analysis is still failing to produce decisive results in this field. Military expenditure, an economic variable which is partly endogenous and partly exogenous, is limited by the available resources, although national security implies costs that are often determined by other than economic considerations (e.g. threat or probability of conflicts). Econometric methods established several economic, political and geographical determinants of

569

Ch. 19: Economics of Disarmament

military expenditure, which reduce the exogenous character of a disarmament process. Disarmament is not only a public decision and, without reference to an internal and external situation, it depends on economic and social variables which modify its content and its importance [Fontanel ( 1995)] . 3. Theoretical economic analysis of disarmament

The history of economic thought on defense and development is very controversial. In a world of sovereign states the security of nations is both a priority and a constraint that economists have not always viewed in the same way. Disarmament has been analyzed as (i) an obstacle to economic and power development; (ii) a positive economic effect; (iii) a process which has some contradictions with economic systems such as socialism and capitalism and (iv) a complex process producing various economic results, depending on geographical, political and economic situations (Table 2). The history of economic thought is instructive in this context [Fontanel ( 1994, 1 995)]. There are four main economic analyses of disarmament: the peace dividend ap­ proach, disarmament as an investment, development as the main factor of disarmament, and armament/disarmament as elements of a national strategy. Table 2 History of economic thought and disarmament Main analyses

Authors

Disarmament as an obstacle to development Good relationship between armament and development.

Plato

Armament is a stimulus for production, innovation and employment in capitalist countries.

Rae ( 1834), Mandel ( 1 975), Attali ( 1 978)

Economic development makes international antagonism inevitable. Laissez-faire leads to the domination of the strongest and military forces ensure the sovereignty of states threatened by less developed countries. Underdevelopment is a product of development of the great powers and disarmament is an element of game theory in international relations.

Seligman ( 1 91 5), Emmanuel ( 1 969), Freyssinet (1 966), List ( 1 840), Veblen ( 1 9 17), Brewer and Shubik (1 979), J.S. Mill ( 1 824)

The power of the Prince is the main economic objective.

Mercantilism

War is a solution to excessive population growth.

Malthus ( 1 826), Bouthoul

( 1 96 1 ) The threat of war is essential in keeping anti-social trends under control.

J.S. Mill ( 1 824), Galbraith

( 1 972)

Disarmament as a positive economic effect Military expenditures are not productive. War and its preparation are explicit variables of the monopoly spirit. Laissez-faire produces development and development produces disarmament.

A. Smith ( 1 776), J.B. Say ( 1 803), Ricardo ( 1 8 1 7)

Military expenditures reduce the competitiveness of a nation. Disarmament produces "peace dividends".

Melman ( 1 974), Nef ( 1 949)

Continued on next page

570

J Fontanel Table 2, continued

Main analyses

Authors

Disarmament as an investment process.

UNIDIR ( 1 993)

Military force is a means to deter agression, but it increases the likelihood of wars. A negotiated disarmament is needed to avoid wars.

Richardson ( 1 960) Brito and lntriligator ( 1 987) ,

Disarmament and economic systems Wars are conditioned by antagonist social relations. Disarmament is desirable only with socialism.

Marx ( 1 8 67), Engels ( 1 878)

Military investment is a catalyst of primitive accumulation and an instrument of colonial domination.

Luxemburg ( 1 9 1 3)

The capitalist exploitation of the world and imperialism need an armament process.

Lenin ( 1 9 1 7), Hilferding (1 9 1 0)

Military expenditure exerts a positive influence on profits, capitalist technology and demand for labor. It serves to absorb the economic surplus of monopoly capitalism.

Baran and Sweezy ( 1 966), Kidron ( 1 970)

Disarmament is impossible with colonialism.

G. Frank ( 1 972)

Disarmament is impossible with imperialism.

Boukharine ( 1 9 1 5)

The complex relations between disarmament and development Military preparedness is necessary as a national insurance policy. Costs of defense are tolerable so long as combat does not disrupt the civilian sector.

Pigou ( 1 92 1 ), Giffen ( 1 872)

Military expenditure is a public good, which is not the best solution for a deficit spending policy.

Keynes ( 1 940), Samuelson ( 1964)

War is tending to disappear with the industrial class and the elimination of pauperism. Disarmament is an effect of development.

Proudhon ( 1 8 6 1 ), Fourier ( 1 848), Saint-Simon ( 1 8 1 9)

3. 1. The peace dividend approach Disarmament is likely to contribute to peace and the reduction of military expenditure makes a contribution to the peace dividend. Resources released from defense become available for alternative use, such as social, health, education, environment or other economic uses [UN ( 1 983), Klein ( 1 990), Eisner (1993)]. The "peace dividend" must be a simple reallocation of public expenditure from defense to other budget headings, or a rather good substitutability between defense and other economic activities [UNIDIR (1 984)]. With disarmament, there is the release and reallocation of resources from military to civilian uses, which is likely to have favorable effects on growth and international trade [UN ( 1 989)]. There are two main myths surrounding the peace dividend [UNIDIR ( 1 993)] : it is reputed to be large and immediate and to be able to solve the main social and economic

Ch. 19:

Economics of Disarmament

571

problems of a nation. According to Kennedy ( 1 988), military superpowers devote a large share of the nation's economic power to unproductive military expenditure and they take the risk of eroding their national economic competitiveness. The economic effects of disarmament are transmitted through four main channels, namely the possible increase of investment [Smith ( 1980)]; substitution effects for the work force [Richards ( 1 99 1)]; reduction in the application of a military technology that has less respect for the economic rules of profitability [UN ( 1989)]; and limitation of public effective demand [Melman ( 1974)]. The positive effects of disarmament have often been high-lighted but it does not necessarily produce the cumulative effects that are a feature of economic development. Besides, it is paradoxical to note that economists have sometimes explained the growth of Germany and Japan between 1 930 and 1 940 by investment in armaments while explaining the economic miracle of the same two countries since 1 945 by the weakness of their military expenditure. It has to be conceded that there are far more essential arguments to account for these two periods. According to Deger (1986), a percentage point reduction in military expenditure increases economic growth by a third of a percentage point and completely eliminates the external capital requirements of the least advanced countries. The competitiveness of the economy is increased and the deficit on the trade balance is reduced. There is evidence that some exporting activities are impoverishing, notably when payment conditions become difficult or even impossible, and when the largely subsidized arms industry is persuaded to sell at a loss to the community [Smith, Humm and Fontanel ( 1 985), Chesnais ( 1990)]. But expectations of a peace dividend must be challenged, because econometric analyses seem relatively incapable of providing indisputable information on the existence of the negative or positive relationship under consideration. Moreover, the peace dividend alone is not able to solve all the world's problems, and major reallocations of resources involve costs and take time.

3.2. Disarmament as an investment Peace dividends are likely to be small in the short-term; they are mainly affected by the adjustment costs associated with the reallocation of resources from military to civilian uses in order to obtain long-term benefits. They have to solve the problem of unemployment and all investments are not successful. In some cases, society's rate of return from disarmament will be low or even negative [Intriligator ( 1 994)]. In the opinion of Alexander ( 1 990), the shift into non-defense products will generally be unsuccessful because of mismatches between defense and civilian experiences, skills and technologies, but primarily because the culture and management of the defense industry militate against civilian success. In the end, the task is not converting the defense industry from military to commercial markets but changing the industry. Diversification reduces the company's dependence on defense by acquisition or organic growth of non-defense operations. There are various kinds of diversifications, mainly in production (dual technologies or military specialization

572

J. Fontanel

for market needs), in markets (exports and new buyers), in regions (relocation of installations and markets), in portfolios (financial operations involving the purchase and sale of companies) and in the negotiation of stable and lasting agreements with other companies. Innovative uses of military resources do not assure success in the new market. Complete adjustment may require the mobility of both labor and capital. Public policies are needed such as low-interest loans to industry or aid to R&D, exports, unemployment, retraining and regional development policies. Institutional culture is highly resistant to change. Good management of disarmament has positive long-term effects on civilian R&D, on the real productivity of national economies, and on confidence in international trading relations that cannot be quantified by econometric studies. According to the experts of UNIDIR (United Nations Institute for Disarmament Research) [UNIDIR ( 1 993)], disarmament has maj or economic consequences involv­ ing costs as well as benefits, and its economic dividends are likely to be small in the short-term. But, in the long-term, disarmament can produce significant benefits through the production of civil goods and services as resources are reallocated to the civilian sector (the peace dividend). Disarmament is like an investment process involving short­ term costs and long-run benefits. Disarmament can be an worthwhile investment for economic development, ceteris paribus, if the countries feel that their national security is not threatened by the process [Hartley ( 1993)] .

3.3. Development as the main factor of disarmament Advocates of the New Economic Order see disarmament more as a consequence of development. For Russett (1982), the long term burden of US military spending helps to explain the decline of US productivity relative to Japan. The Cold War left a legacy of significant debt, both internal and external, as well as an under­ capitalized and declining infrastructure, each due in part to the costs of maintaining the liberal structure of the international system [Goldstein ( 1988)]. The provision of public goods requires devoting considerable resources to military and foreign affairs resulting in inadequate investment [Kennedy ( 1 988)]. The World Bank has adopted the position that high levels of ME are detrimental to industrialization, at least at the level of opportunity costs and now low levels of military outlays are required by the recipients of development aid. It established that for Japan, the economic miracle has been created, in large part, by avoiding high levels of ME/GDP and concentrating on national economic policies, but Japan obtained free US protection. Ward and Davis (1 990) found evidence of a significant negative trade-off between ME and economic growth. The long-term impact of such significant trade-offs between defense effort and investment is thought to be reduced economic growth and national well-being.

3.4. Disarmament/armament as elements of a national strategy Colonial wars are historically seen as basic, although not exclusive causes of under­ development [Fontanel (1 990)]. They promoted export products to the detriment of the

Ch. 19: Economics of Disarmament

573

crops that provided food for the population, and they had the effect of stimulating the mining industry and destroying local craft industries, the economy being developed in a disjointed way, entirely geared to the economy of the colonial power. These relationships remain unchanged. Major international economic negotiations provide reminders of the existence of relations of conflict and the importance of the status of a nuclear power. The threat of armed force is always a decisive factor in the spread of the dominant modes of production and in the maintenance of existing powers. Moreover, the major economic powers use military and non-military aid to maintain their political, economic, ideological and even moral influence. Western technology is strongly influenced by the militarization of the advanced economies, which is still dominant in contemporary economic development despite the examples of Germany and Japan, where the contrary holds. Under these conditions, disarmament definitely does modifY relationships of strength, and this is also reflected in the economic sphere. Economic war fulfills all the classical functions of war. The economy has become an instrument of power often applied to relations of conflict between states [Fontanel (1 994)]. War must be understood as the projection of national power through means that are political and economic as well as military [Wolfson and Farrell ( 1987)]. Insecurity is dependent on the arms race, on inequality, international domination, and even social exploitation. Indirect strategies of dissuasion, economic forms of retaliation, embargoes and boycotts are all powerful weapons with economic and political effects dependent on defense measures, international expressions of solidarity and the potential for substitution [Baldwin ( 1 985)]. All the dimensions of social life have to be taken into consideration in international strategy. Direct (military) strategy being difficult by the strength of nuclear forces, states are led to follow a strategy of "indirect manoeuvreing". The idea is to sell only those products that would not improve the economic growth of the country receiving them more than that of the country selling them. In other words, unequal exchange is something to be demanded and sought. There are many differences of opinion as to the usefulness of these measures. Some authors are of the opinion that the grain embargo did not adversely affect the Soviet economy, but American governments have calculated differently. The defense of the industrial base undertaken by the Pentagon has proved to be extremely costly and has gradually eroded the competitiveness of the American economy. This policy was initially based on three essential principles: that the USA is an economic leader and can therefore control advanced technology; that the exports concerned are not overly important for the American economy and the cost of such controls would be relatively slight; lastly, that dual-purpose technologies are relatively few in number and can readily be isolated. There are many indirect strategies which can be pursued by nations: (a) Impoverishment resulting from the strain of preparing for war is often presented as one of the basic reasons for the collapse of the Soviet economy. An arms race reduces the development potential of states, but the poorest are the most rapidly impoverished, with the result that the might of the richest countries is increased [Brito and Intriligator (1 987)].

J. Fontanel

574

(b) The strategy for effecting the break tries to create economic problems in the rival country so as to increase its political and social difficulties. An embargo is an instrument of deterrence capable of changing the behavior of a potential enemy, but it is a weapon that is dangerous to the user, because prolonged interruption of trade flows may lead to a permanent loss of outlets and illegal trading (black markets). The economic weapon enables a country to dominate another country through the exercise of the power conferred by the exercise of a monopoly over the supply of goods and services vital to the country's survival. The USA often uses food as a weapon against developing countries [Strange (1985)]. (c) The aim of a containment strategy is to develop ties of economic interdependence capable of ensuring peace; commercial ties had a moderating role on ideologies. The impact of this strategy cannot really be measured [Tinbergen (1993)]. For Kennedy ( 1988), the history of the rise and later fall of the leading countries in the Great Power system shows a very significant correlation over the longer term between production and revenue-raising capacities on the one hand and military strength on the other. Ward, Davis and Lofdahl ( 1994) found that after 1945, Japan's defense policy was shaped with a variety of non-military goals in mind. They demonstrate that Japanese defense spending was driven by macroeconomic goals as well as the desire for political and economic co-operation with the USA, and they identified two main effects: (i) Size effects convey the contribution of the overall spending levels to national product. In this way, government purchases may contribute to national productivity by increasing the volume of activity. (ii) Externalities through spill-over contributions. Government spending (an inter­ mediate, not final demand) on education may contribute to the efficiency and productivity of non-governmental sectors, by an indirect effect upon the technical skills of the labor force. The defense-growth trade-offs in the USA and Japan change in character and dimension, sometimes rather quickly. Ward, Davis and Lofdahl (1994) built an economic model of the defense-growth trade-off. The estimating equation is: DY

I

L1

L1

DL

- = a- + b- + + qM

L1

(

-qM +

--1 --1 DM s

+ qN

DN s

dM d( 1 + M)

) DM ( -- +

Y-1

-qN +

dN ) DN -1 d Y_I +

N

(1)

+ e,

where Y is national income, I is national investment, L is labor, M is military spending, N is non-military state spending, q is the externality and d is the factor productivity differential. Size effects convey the contribution of the spending levels to national product and the externalities are the spin-off contributions. The USA emerges as a society in which there has been a recent growing linkage between non-military spending and economic productivity. When the central government purchases defense goods, the

Ch. 19: Economics of Disarmament

575

volume effect appears to be negative, while the spin-offs are positive but declining. Government spending for non-defense programs does not contribute to economic growth. Disarmament is unlikely to bring about an aggregate downturn in the economy though local dislocations are already evident in some communities. This result suggests that disarmament will generate greater positive short-run size-effects on the aggregate economy for the USA, and not for Japan, but there is no evidence that higher ME is likely to be deleterious to the Japanese economy. For Japan, government spending does not contribute positively to the volume aspects of economic output in the way it does in USA and this is true for defense as well as non-defense government spending, but spin-off effects of ME are strong and growing for the Japanese economy. This finding contradicts Kennedy's hypotheses. The size impacts were negative over the entire period and the externalities have been positive and growing for about a century. 4. Empirical analysis of disarmament

All the methods in general use in economic analysis may be applied to the economics of disarmament. No economic situation is ever repeated in exactly the same form and the experimental approach is practically impossible in economics. Under these conditions the methods of analysis most employed are deductive analysis based on postulates (e.g. see Table 2), empirical simulation models, evaluations of reduced forms, input-output models, computational general equilibrium models and historical studies (which can provide useful knowledge about past disarmament such as World Wars I and II, the Korean and the Vietnam Wars) and monographic studies (such as regional or sectoral case studies which are very useful for the understanding of firm behavior). The information from statistical methods [Atesoglu and Mueller(l 990)] must be interpreted and there is often a confusion of simple correlations with causation. Econometric analysis in which chronological series of data are used lay the emphasis on short-term effects, since all the information considered relates to the recent past. Input-output analyses are mainly interested in the technological structures and inter­ industry relationships in the economy [Leontieff and Duchin ( 1 983)]. They are very useful for the measure of the direct or indirect changes in output, employment or capital utilization induced by a change in the structure of the demand of final goods. These analyses require detailed data on the actual technological structures of military and civilian productions. The validity of a model cannot be restricted to the truth of the hypotheses, but must also be dependent on the capacity of the system as set out to predict the behavior of the real system, even if, in some instances, the cause and effect relationships or simultaneous relationships misrepresent or simplify the reality. Models have to be evaluated in terms of how well they communicate and the quality of the information created in relation to the objectives laid down at the time of construction. The economist has therefore to consider which variables should be accepted, the level of their aggregation, the relationships being tested and the basic aims of the study.

J. Fontanel

576

Nevertheless, this methodology is not without its shortcomings, prominent among which are the dubious significance of the results obtained, equation misspecifications [Kirby and Hooper ( 1 99 1 )], the excessive generalization of the results [Hebert ( 1 993)], the obvious risk that the relationships will be unstable and the low degree of relevance as a tool in economic decision-making [Dunne and Smith ( 1990a,b)]. Whereas a number of economic models have been constructed to analyze the impact of increased ME there are few formal analyses of the economic effects of disarmament. But, in econometric modelling it is assumed that the response to an increase or decrease is symmetric; this may not be appropriate when considering a large reduction of ME. It is interesting to analyze some studies of the American, French and British economies. ,

4. 1. The United States Paul Kennedy (1 988) formulated the hypothesis that the decline of the American economy could be due to the high level of ME Under those conditions, peace dividends from disarmament could appear as much in favor of social programmes as of national productivity. The reduction of defense expenditure did further the competitiveness of enterprises, since the technological spin-off from the military sector was considered to be inefficient and costly [Melman ( 1 974)]. With the available scientific tools, econometric analysis does not provide irrefutable proof of a negative relationship between capital formation and ME, and the productiv­ ity problems of American industry cannot be ascribed to the defense effort alone [Gold and Adams (1990)]. Kinsella ( 1 990) indicated by the use of an autoregression vector that no substantial causal relationship existed between ME and prices, unemployment and the interest rate. A direct positive relationship (without a time lag and causal relationship) did exist between ME and national output, but only for monthly or quarterly information, notably when the economy was in crisis and thus was under the effect of the Keynesian multiplier. Huang and Mintz ( 1990) confirmed this analysis. Atesoglu and Mueller (1 990) showed that there was a positive relationship between ME and economic growth but that the multiplier was very small. They used for each regression equation the Cochran-Orcutt iterative procedure assuming first order autocorrelation of the disturbance terms since the ordinary least squares estimates indicated the possibility of autocorrelation. With the growth in real input GQR, the investment ratio (of real gross fixed investment to the real GNP) IQ, the growth in employment LRG, the growth in real defense spending DGR, then: .

QGR = -0.078 + 0.551IQ + 0.965LGR + 0.062.DGR with ( 1 .59) ( 1 .75) (3.35) (2.47)

u

= 0.399 (2.47)

(2)

period: 1949-1989, R2 = 0.720, SE = O.O l 5, D\V = 2.058. A change in defense spending has positive and significant effects on the growth rate of the economy and both defense effects (the change in the rate of defense spending and the relative size of the defense sector) are individually significant. A study by

Ch. 19: Economics of Disarmament

577

Ward and Davis ( 1 990) revealed the existence of contradictory effects, the result of which was dependent both on the magnitude of defense expenditure in the US economy and on the importance of the military effort in the US budget. The relative weight of ME in the national economy is a burden for the economy, whereas public non-ME tends to have a positive effect. It must be pointed out that the state often has to be responsible for activities (justice, freedom, democracy) that are not very productive but are necessary for society as a whole, and that cannot be handed over to the private sector for economic considerations of profitability or the principle of public service. Ward and Davis concluded that the global effect of American ME during the period 1 952-1988 had been very slightly positive, but that its contribution to national productivity had declined, in contrast to that of governmental civilian expenditure. Furthermore, Aschauer ( 1 989) was of the opinion that whereas expenditure on the state infrastructure had very positive effects on growth, the same could not be said of military capital expenditure. Klein ( 1 990, 1 993) thought that the effect of disarmament on the American economy was bound to be positive. Because there is a crowding-out effect between ME and investment, the production of civilian capital goods will be very useful when it takes the place of military production, because the former creates new income flows, whereas the latter is used to destroy without any economic return. Thus, a motorway will still have utility far beyond the expenditure period and will further the expression of other utilities. With disarmament, the government ought simultaneously to pursue a policy of compensatory public expenditure or a reduction of the budget deficit. In the medium term, lower interest rates will lead to more investment (for the LINK model a 3 percent reduction in ME, accompanied by a more flexible monetary policy would produce a reduction of 2 percent in interest rates), and that situation will favor both international trade and a reduction of the public deficit. For Olszewski, Payne and Ross ( 1 993 ), there is a cointegrating relationship between real MEs, real output and the real dollar-mark exchange rate. ME cannot significantly affect the real dollar exchange rate value in the long run. For Eisner ( 1 993), ME exerts undoubted inflationary pressures, because the economy provides salaries without a flow of goods being produced in exchange. The result of disarmament should therefore be an increased propensity for investment. By using two time periods and two macroeconomic and industrial models, Thomas, Stekler and Glass ( 1 99 1 ) concluded that reducing the level of US defense expenditure will reduce real output, price level, and employment, with an attenuation of the effects after five years. With a constant reduction, changing the composition of the cuts had a small but perceptible effect. For Hormats (1 992), the so-called "peace dividend", which is not real money, will be insufficient by itself to cure the structural ills afflicting the US economy (budget and commercial deficits, insufficient investment, inadequate national savings and deficient training methods). It is preferable to create incentives for savings, investment and education, and to invest a few thousand million dollars more to help former socialist nations to consolidate democratic and market reforms.

J Fontanel

578

4.2. France A very simple model focusing on chronological series ( 1950-1 980) showed that progressive disarmament had a weak positive effect on the GDP of France [Fontanel ( 1 980)]. This impact was due mainly to a reduction of the inflationary tensions to which the armament effort gives rise and to the appreciable increase in national investment. Above all, this analysis took into consideration the dual nature of ME: as public expenditure it exerts important effects on global demand, capable of exerting Keynesian multiplier effects; as ME in the strict sense it must be analyzed in comparison with other forms of public and private expenditure. Under these conditions ME has quite high opportunity costs, notably because it reduces investment. Disarmament improves economic growth very quickly, because it reduces inflation and competitiveness. With a model of the input-output type, Aben ( 1 98 1 ) analyzed the effects of a 40 percent reduction of ME on the main sectors of the economy and on employment. It concluded that a reduction without a substitution of civilian expenditure for ME led to an appreciable decline in national production (34 percent for the armaments sector, shipbuilding and aeronautics) and a loss of 400 000 jobs; when military expenditure is substituted for public civilian expenditure, none of the possibilities for the conversion of defense activity made it possible to avoid a worsening of the employment situation in the short term (a loss of some 140 000 to 2 13 000 jobs). However, very few economic activities subjected to such a reduction of their outputs would emerge with such a satisfactory result. More recently, Aben and Daures ( 1 993) used an input-output model to describe the economic consequences of a transfer of the budget from the defense sector to education. Based on a Parliamentary hypothesis of growth, their simulations confirmed, on strict economic grounds, that it is better to have chalk rather than guns, except if chalk really means education equipment.

4.3. United Kingdom Dunne and Smith ( 1 984) are of the opmwn that disarmament is more of an opportunity than an economic problem. Using the Cambridge Growth Project model, they made several simulations of the economic impact of disarmament in Great Britain. With compensation, disarmament produced a slight improvement in the balance of payments, a limitation of inflationary pressures, the creation of new jobs connected with the labor-intensive nature of the defense expenditure relative to the civilian governmental expenditure, and additional growth. Without compensation, there are reductions in GDP, a fall of the price index, and a worsening of the jobs situation. This situation was brought about more by the deflationary policy than by the actual reduction of ME The structural changes were, however, mainly of a microeconomic and sectoral order and highly heterogeneous. These results are in line with the historical experience of the United Kingdom [Smith and Smith ( 1 983)] and with studies that stress the effects of substitution of military R&D to the detriment of civilian products .

Ch. 19: Economics of Disarmament

579

Table 3 Cuts in UK defense spending: simulation results with and without compensation 1 993

Variables Consumers' expenditure Government consumption Investment Exports (G&S) Imports GOP at factor cost

1 996

with

without

0.22 -0.21

•

2000

with

without

-0.3 1

1 .73

- 1 .97

5.39

-4.41

- 1 .87

-1.31

-6.99

-2.79

-12.13 -3.64

-0.3

with

without

1 .58

- 1 .77

4.27

-0.02

-0.01

-0.25

0.06

-0.79

0.69

0.09

-0.50

0.99

-2.34

3.21

-4.39

0.25

0.1 0

-0.45

0.63

-2.03

1 .84

-3.64

Balance of payments

-0.04

0.16

-0.40

0.93

- 1 .36

2.17

Unemployment

-0.05

0.06

-0.22

0.25

-0.52

0.46

Percentage difference from base. Source: Barker, Dunne and Smith ( 1 9 9 1 ).

•

[Hartley ( 1 993)], poor use of military technology [Maddock ( 1 983)], and the crowding­ out effects of investment [Smith ( 1980)]. Barker, Dunne and Smith ( 1 99 1 ) used a multi-sectoral macro-economic model to evaluate the impact of cutting UK defense spending. The scenario under consideration was one of a reduction in ME, with real cuts of 8.5% a year (starting in 1 993), with UK ME reduced to around 2% of GDP by the year 2000. It assumes that the cuts fall broadly proportionately on the major components and that the current balance between personnel, equipment and other spending is maintained. Without compensation, disarmament produces adverse economic results at the beginning; but a reduction in ME to one-half of its 1 992 level by the year 2000, with the released "peace dividend" allocated to other government current and capital expenditures, would lead to a reduction in unemployment of 0.52 million and an increase in GDP factor costs above base by 1 .84% (Table 3). The transmission mechanism is thus likely to depend on the macro-economic policy adopted. Questions arise as to how UK companies are responding to present reductions in ME and how they are likely to respond to future changes. There is a new, more commercial procurement regime, with increased competition, the use of fixed price contracts and a greater willingness to import. The consequence has been massive restructuring in the UK defense industries and a prompt diversification. Such problems of transition may not be as difficult as in the past, as the restructuring of the UK armaments industry is already taking place because of the present reduction in defense spending.

4.4. Simulations for developing countries For Linden (1 992), a two-sector growth model is derived to indicate the effects of the military burden and government expenditure on the growth of GNP in selected Middle Eastern countries ( 1 974-1 985). A four equations simultaneous model (growth rate,

580

J. Fontanel

defense burden, skilled labor rate and investment rate) of Gyimah-Brempong (1 989) is used to investigate the relations between defense outlays and economic growth and their channels in less-developed countries (LDCs). Defense burdens affect economic growth directly through providing an increased supply of skilled labor and decreased investment. For African countries, there is a trade-off between a high defense burden and economic growth. With a simple neoclassical formulation of economic growth to account for the role of military exports in economic productivity, Ward (1990) showed that for India, only the military aspects of government spending appear to generate short-term economic productivity gains. Since these are a small part of the government budget, the overall impact of government spending is likely to be slightly negative. There are negative externalities for military spending when examined separately from its marginal productivity for civilian production and separated from size effects of the overall governmental budget. The relative marginal productivity of military and non­ military spending in both Brazil and India is also negative. There is strong cross­ sectional evidence that increased defense expenditures actually serve to retard the rate of resource creation, compounding the negative effect of defense expenditures on growth and development [Deger and Smith ( 1 983)] . The potential benefits of security expenditure that lie in the possibility of modernization are indisputable, but the negative impact on savings and investment that seem to result from higher levels of defense spending are such that an alternative means of acquiring the modernizing results could be more beneficial to the economy. The conclusion is that military spending has negative consequences for economic growth when compared to alternative potential allocations. The application of simulations based on the reduction of ME involves the hypothesis that the effects on the national economy of an increase or a decrease in the economic effort of defense will be inverse but similar. Now, it is probable that threshold effects will emerge to render such a generalization questionable. 5. Disarmament for development

Disarmament and development are two essential objectives of our time and the problem is to know whether it is desirable that they should be linked. French governments have frequently called for the establishment of an international fund of disarmament for development that would enable the amounts saved on arms to be used to develop productive activities that would speed up economic development and aid arrangements to the developing countries [Fontanel (1 986), UNIDIR ( 1987)].

5. 1. The nature of the transfers International aid effects are interesting to analyze. The question is differently analyzed when the military effort is accompanied by assistance from a developed country. Aid

Ch. 19: Economics of Disarmament

581

linked to disarmament should normally have the same effects as existing traditional forms of aid, except perhaps at the level of the size of transfer, which may exceed the threshold above which the solidarity accorded has significant economic effects. It should, however, be noted that the confiscation of the savings by a social grouping that decides to devote it to unproductive uses such as exports of capital or imports of luxury goods, is not favorable to economic development. A transfer makes economic sense only if it finds expression in a highly productive activity and not by aggravating inflationary trends owing to the appearance of demonstration effects. A resource transfer may also be the occasion of new markets for the developed countries and new dependence for the poor countries [Lebovic ( 1 988)]. The developing countries must therefore avoid the transfers being impoverishing, when it reintroduces unequal trade flows or transfers in kind which competes directly with the national activities of the recipient and which bears the stamp of a culture and the dominant values of the society in which it was created. Aid from developed countries may lead to distorted development. Some forms of transfers prove ultimately to be costly, notably in operating costs, and political constraints are rarely absent from such an undertaking by rich countries. Aid to developing countries may be devoted to prestige expenditure and to the increasing of social inequalities. The main aim of disarmament for development must be to narrow the disparities in growth. 5.2.

The economic effoct of a disarmament for development process

Reduction of ME has been simulated in several models of the world economy built for international organizations [UN, UNITAD (UN Institute for Trade and Development), OECD and IMF) or for OECD countries with the three-equation model of Cappelen, Gleditsch and Bjerkholt ( 1 984). For the UN model of Leontieff and Duchin (1 983), the transfer of resources to poor countries furthers their economic development. Ongoing disarmament would have a positive effect for all the regions of the world and the transfers of resources would appreciably increase consumption and the per capita GDP of the arid countries of Africa, and the low-income countries of Asia and tropical Africa. However spectacular these results may seem to be for the sparsely populated underdeveloped countries, they are not very significant statistically. Thus, an annual reduction of ME by 1 .2 percent between 1 980 and the year 2000 would further the economic growth of almost all coun­ tries: 1 percent for Japan, 1 .5 percent for North America, 3 percent for Europe, 1 0 per­ cent for the planned-economy countries of Asia, 20 percent for the low-income Asian countries and tropical Africa, over a period of 20 years. It may be noted that aid for de­ velopment appreciably improves the situation of the poorest countries. The econometric results obtained do not seem to be very significant. They give only a very global idea of the economic impact of disarmament. The model of Leontieff and Duchin ( 1 983) is not very adequate as an indicator of the ways in which the groups of countries under consideration were growing in 1990. For example, the excellent results foreseen for the planned-economy countries are very wide of the mark, because the formalized system

582

J. Fontanel

had to use optimistic figures (based on bureaucratic planned prices) supplied by the socialist governments, and it was scarcely possible to analyze the latent political and economic crisis of the Eastern countries on the basis of the raw official data. The UNITAD world model simultaneously examines an initial disarmament sce­ nario which is not accompanied by an international redistribution of the amounts saved, while a second scenario studies a policy based on the satisfaction of basic needs. Whereas the reduction of ME depresses demand and causes an increase in unemployment in the short term, its spin-off is expressed in the longer term in the growth of the developing countries by an increase in demand for the most developed regions of LDCs, mainly when the policy is based on basic needs. These effects will be strengthened by measures for the easing of trade and currency restrictions, but the gains may rapidly become losses if there is an increase either in interest rates or in the amount of the annual repayments of the debt burden of LDCs. Disarmament may relax some economic constraints but it cannot resolve all the problems of the developing countries. Even on the most satisfactory hypothesis, the real per capita consumption in Africa south of the Sahara will continue to worsen because the population is growing at too fast a rate, and because of the endemic weakness of agricultural production. The LINK model [Klein ( 1 990)] shows that a 1 0 percent reduction of ME accompanied by an improvement in international assistance (0.7 percent of the GNP of the developed countries) is capable, in the best case, of a transfer relating exclusively to capital goods, of leading to a 1 .7 percent growth of the GNP in the developing countries and an 0.2 percent growth in the developed countries. For this transfer to be positive for all parties (donors and recipients), 60 percent of the aid must be spent on capital goods [Klein ( 1 990)]. The MULTIMOD model of the IMF ( 1 993) considered the long term benefits of a 20% homogenous reduction of ME, international arms transfers and military aid. It calculates these benefits, for the long run, to be more than 10 000 billions of constant ( 1 992) US dollars. For the first year, there is a decline of 6 billion US dollars of the GDP of developed countries, but during the second year, with the reductions of interest rates and public · outlays and the increases of private consumption and investment, the effects will become positive. For the eleventh year, there will be 60 billion US dollars of benefits for developed countries and 1 1 .5 billion US dollars for LDCs. The indebted countries will obtain the best results with the interest rate reduction and the increased exports. This model is interesting and positive, but it does not introduce economic policies, the effects of disarmament on regions, sectors and enterprises or the conversion problems. The model of Cappelen, Gleditsch and Bjerkholt ( 1 984) developed a theoretical model, consisting of three equations, which was tested empirically for seventeen OECD countries in the period 1 960-198 1 . This study suggests a negative relationship between economic growth and defense spending and does several simulations of the world model. Without transfers, the developed countries are the main beneficiaries of ongoing disarmament. With significant international aid the gap between rich and poor countries tends to narrow. Maneval, Rautsola, Wiegert ( 1 99 1 ) tested a slightly modified

Ch. 19:

Economics of Disarmament

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model with a different kind of estimation for the four main neutral European nations, which appeared to be rather homogenous in regard of this study (populations, standard of living, annual per capita incomes, politically stable). They used the OLS-estimation for structural equations (unmodified single equations and additionally the best-fitting lag-versions). If GDP is the growth rate of gross domestic product; MANU, the growth rate of manufacturing output; MIL%, defense spending relative to GDP; INV%, investments relative to GDP; u, the stochastic terms in the individual equations; X%, exports relative to GDP; and DGC%, defense spending relative to government consumption, then: GDP1 = ao + a1 MANU1 + a2INV%1 + a3MIL%1 + uu,

(3)

+ b3MIL%1 + u21,

(4)

INV%1 = co + CJ GDP1 + c2 DGC%1 + c3MIL %1 + u31•

(5)

MANU, = bo + b 1 INV%1 + b2X%1

The main finding was that defense spending had a positive effect on manufacturing output, but a negative effect on investment; also that the net effect on economic growth was, when significant, negative for the whole sample, but it varied from country to country. Disarmament cannot be confined to quantitative choices on the limitation of ME. It calls for a range of decisions on political priorities, the international economic order, the nature of development, the rate and direction of technological progress that could be developed in a less militarized society, the management of the natural environment, and the reallocation and redistribution of economic resources. Disarmament that failed to take into account the insecurity constituted by economic arms would not be very durable. Furthermore, foreign aid is often part of a package with military aid. Disarmament must take account of economic weapons.

6.

The role of public policy

Conversion is defined broadly as a new allocation of resources from the military sector to civilian uses. It is the process of deploying the resources released by military activi­ ties in favor of civilian sectors, in a continuous macro-economic process depending on the proper functioning of labor and capital markets. Technological conversion could take place as an acceleration of the spin-off mechanisms, but a British report concluded that less than 20 percent of the UK military R&D had civil spin-offs [Hartley ( 1 993)]. Defense firms have difficulty in transition because their "core competencies" are derived from defense production and are unsuited to civilian activities [Cronberg and Hansen ( 1 992)]. The military-industrial complex requires a dichotomy between civil and military production (length of the product cycles, importance of weapons performance, radical innovations and planned obsolescence). The economic policy of the government needs to help the enterprises to solve these problems.

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Defense managers have a lack of skills in the civil sector (e.g. the importance of effective advertising campaigns, the public acceptance of the new product line and the prices for the penetration of a new market), because in the military market they have mainly to know the administrative rules, to develop good working relationships with key procurement government personnel, and to lobby politicians [Dumas ( 1 982)] . Military enterprises respond to disarmament in six main ways: (i) by developing weapons exports, (ii) by the restructuring of companies, implying a reduction in production volume by laying-off workers and selling or closing plants, (iii) by developing dual technologies, (iv) by specialization, narrowing the range of products manufactured and identifying niches with high profit potential, (v) by diversification, with the production of civil and military products, (vi) by complete conversion, based on a transfer of activity away from the military to the civilian sector. There are a variety of policy options, which are summarized in Table 4. Table 4 Policy options Type of policy

Examples

Manpower policy

Training Retraining of managers and workers Job information Labor mobility Early retirement Retooling old plants and equipments Investing in new plants and equipments Producing new consumer goods Use of scientists and engineers New civil research and development programmes, e.g. energy; environment; space exploration Location of industry policy Building airports, roads and expanding telecommunications

Capital policy

Science and technology policy

National regional policy Social infrastructure policy Industry policy

State conversion agency Aggregate demand policy International trade policy Income deficiency payments International action

•

Source: UNIDIR ( 1 993).

Subsidies to civil research and development Subsidies to labor and/or capital Government contracts for civil goods Aiming to assist the conversion of defense plants to civil markets Using government expenditure to avoid recessions Support for exports and import saving Aimed at compensating the losers from disarmament: e.g., unemployment pay and redundancy pay (social safety net) Role for international agencies in disseminating information and experience on adjustment

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There are some economic principles for disarmament which are important to follow [UNIDIR ( 1 993), Fontanel ( 1 993)). These principles are: (i) reductions of ME should be gradual and predictable, allowing for smooth economic and social adj ustments; (ii) a distinction must be made between stock conversion and expenditure flow diversion; (iii) public policies must assist change and resource allocation in order to minimize the costs of disarmament; (iv) joint conversion project should be an important aspect of international economic co-operation; the management of conversion is difficult and sometimes it is better simply to abandon specialist defense plants; (v) disarmament requires control of military technology, especially in military research and development, and control of arms transfers; (vi) industrialized countries might use some of the benefits of disarmament to assist developing countries.

7. Conclusion

The economics of disarmament is a new discipline. Much work, involving multi­ disciplinary analysis, is needed to explain the causes of war, the arms race and disarmament models (arms limitations, disarmament, conversion); the definition and the intertemporal and international comparisons of military expenditure; the analysis of the determinants of military expenditure; the economic effects of the arms trade and of international aid; the economical and political role of military alliances (international public goods); the micro-economics of demand and supply (defense markets, public procurement, defense industries and regions, research and development, military manpower, the employment in defense industries); and the cost of civil defense. Questions arise concerning the costs and policies of conversion, the dual use of military products, the substitutability of military and civilian research and development, the effects of disarmament on capital capacity, the systemic and military transitions for the former Soviet Union, the relevance of the various models for the economic analysis of disarmament, the costs of wars, the economic effects of arms exports on growth, employment or technology. This agenda is not exhaustive of the variety of research questions on the economic aspects of disarmament. However, economists have to remember that the main dividend of disarmament is peace itself and that disarmament without development is not synonymous to durable peace [Fontanel and Ward ( 1 993)].

References Aben, J., 1 9 8 1 , Desarmement, activite et emploi, Defence Nationale (Mai). Aben, J., and N. Daures, 1 993, Chalks vs guns: some economic consequences of an announced French scenario, Defence Economics 4, 353-364.

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Adams, G., and D. Gold, 1987, The economics of military spending. Is the military dollar really different? in: C. Schmidt and F. Blackaby, eds., Peace, defence and economic analysis (Macmillan Press, London) 266-300. Alexander, W.R.J., 1990, The impact of defence spending on economic growth: A multi-sectoral approach to defence spending and economic growth with evidence from developed countries, Defence Economics 2, 39-55. Aschauer, D., 1 989, Is public expenditure productive?, Journal of Monetary Economics 23, I 77-200. Atesoglu, H.S., and M.J. Mueller, 1990, Defence spending and economic growth, Defence Economics 2, 1 9-27. Attali, J., 1 978, La nouvelle economie fran