2010/12/15

Supply, demand and a weird statement

.
If there is cost growth, I think we will just have to reduce the buy.”

This quote was from Pentagon comptroller Robert Hale, the context was cost growth of the F-35 combat aircraft project.

The attitude is extremely weird (and he was just the anecdote-supplier who represents decades of military spending habits in several NATO countries). It's even more weird that people seem to agree. I guess that happens only because humans can adapt and get used to almost everything.

- - - - -

It's about decision-making; there's supply and demand, and the supply was changed by a price increase. The demand side revises its decision accordingly because the demand is typically lower at higher prices. It's really first or second semester microeconomics.

The graphic below shows the situation under the assumption that national defence demand is fixed (always the same, no matter what's the price) I assumed that it's fixed because threats are exogenous - they are not being influenced by the price of an F-35. No matter what's the price of an F-35 - the same quantity is needed (that's the assumption). Demand is thus assumed to be inelastic.


This assumption doesn't seem to fit to the observed behaviour. The quantity in the graph stays the same, even after supply was changed to a higher unit price.

Well, who's wrong? Hale and all those other military spending professionals who behaved similarly over the past decades? Or maybe the assumption of inelastic demand is wrong?

Let's test the latter explanation: Let's assume that demand is elastic.
How could it be elastic? The threat that the F-35 is supposed to counter is still exogenous.Well, there could be substitutes - a higher price for a good could motivate the potential buyer to buy something else instead to meet his needs. Interestingly, military project cuts tend to be independent from other projects being enlarged or created.
The next graphic shows a variable, elastic demand. This demand is being influenced by cost. It appears as if in this scenario the F-35 has a diminishing marginal utility for the demand side.
In other words: At least some F-35s of the initial planned quantity are apparently not necessary for defence, for defence is an absolute requirement that would cause an inelastic demand.


Finally one graph for a (probably) plausible demand curve. It's a composite curve consisting of an inelastic demand for a necessary quantity of F-35's plus an additional demand curve that recognizes a reduced relative marginal utility of the F-35's.



This may of course be misleading. Maybe I applied the wrong model (a market)? A market without market failures is by design able to create the perfect resource allocation. That's why - even despite the many existing market failures - it's a popular model and was my first choice. I used the market model because of a faint hope that military procurement might actually be about serving the public, about an efficient allocation of resources.

- - - - -

There are more suitable models, and I'll employ Niskanen's Budget-Maximizing Bureaucrat model next: A bureaucracy serves itself (and thus needs to be supervised by people with useful motivations). This "serves itself" manifests itself in the maximization of the budget. ITS budget.
I was taught an Niskanen's economic view of bureaucracies which basically assumed that in the beginning, every additional buck spent on the bureaucracy yields more than one buck advantage for the society. This ratio worsens up to the point where spending more on the bureaucracy creates a net damage to society. The bureaucracy is fine with this - it looks primarily at its budget, not at the general welfare. At some point, it becomes obvious that the over-sizing of the bureaucracy compensated most of its original net advantage. The bureaucacy is unlikely to reach the point where it does more harm than good to the society because external forces (political supervision) intervene in favour of other interests than the bureaucracy's.

So basically the model of a bureaucracy is about its quest for an ever greater budget and ever more staff - up to the point where exogenous forces intervene and limit its budget.
Suddenly, the quote makes much sense. The bureaucracy has fought for its budget and got a limit imposed by an exogenous power (the legislative). Its procurement costs rise - and it simply operates within its limit, within its budget. It buys less.
It was probably not really about defence all along. Moreover, with such a model in mind the air force leadership would be not appear to be a credible source about the necessity of the buy altogether!

- - - - -

We could also assume the model of a bartering process. The requirements might have been inflated (and public cost estimates may have been intentionally low). That would enable the reduction of a quantity which was originally deemed necessary (in public, but not for real).
That, of course, would imply that the original figures were never realistic and the original quantitative requirement would have been incorrect.


Any insights?
Well, yes. First of all a trivial one; the planned quantity of a military good cannot have been an absolute necessity for defence if its reduction is ceteris paribus acceptable.

In fact, the feasibility of "Sicherheitspolitik nach Kassenlage" ("security policy according to budget situation") is a strong argument for the suspicion that there's a huge amount of waste in military budgets if the budget is not kept tight.


Sven

P.S.: This is really not about the F-35. The quote is representative for a greater symptom and was selected because it was readily available and required no translation.
.

3 comments:

  1. But countries buy the amount of defense they can afford, not the amount they need for exogenous threats - consider the case of a small country near to a superpower*: it can't possibly afford the defense it needs, so it buys as much as it can afford. Thus the determinant is the political limits put on the resources available, and the purchasers try to maximise the effectiveness of that resource spend - so if the hardware concerned is clearly more effective than alternatives, scaling back the size of purchase is perfectly rational.

    *of course this works better if you assume (as the Pentagon apparently does) that the US is overmatched by the Rest-of-the-World plus all Terrorists :)

    ReplyDelete
  2. ...and exactly this disconnect between threat and military spending means that we don't spend to counter threats. We spend as much on the military because it's a habit and because our government wants it.


    This opens the floodgates for speculations about how much we could reduce military spending without any loss of security.

    ReplyDelete
  3. "This opens the floodgates for speculations about how much we could reduce military spending without any loss of security."

    I think of all government departments, defence is the least likely to yield results from this arguement.
    Certainly on our side of the pond.

    ReplyDelete

Use a nickname and stick to it! I may block anonymous comments. Offensive comments may also be blocked, in part due to the duties of a blogger in Germany.