Curbing Innovation / 3 / 3.4

3.4 WHAT IS A FAIR PRICE TO PAY FOR A WEAPON SYSTEM?

Once he decided which technology would give him the best military effectiveness and how many weapon systems would keep the risk to his forces under control, the decision maker must decide how much he should be willing to pay for that acquisition. To determine that price, decision makers routinely rely upon a free market consisting of various defense companies competing with each other for the contract. But, as we shall argue below, this notion that national defense costs should be driven by competition is a fundamental misunderstanding of the free market theory put forth by Adam Smith more than 200 hundred years ago in his monumental book The Wealth of Nations. According to this theory, economic relations are best understood as restrictions imposed upon the underlying free-market instinct that moves each individual freely to pursue his own interest.

Left to their own devices, men are naturally driven towards a division of labor by their propensity to exchange one thing for another. To quote Adam Smith [2]:

In a tribe of hunters a particular person makes bows and arrows, for example, with more readiness and dexterity than any other. He frequently exchanges them for cattle or for venison with his companions; and he finds at last that he can in this manner get more cattle and venison than if he himself went to the field to catch them. From regard to his own interest, therefore, the making of bows and arrows grows to be his chief business and he becomes a sort of armourer.

Eventually, most people become unable to supply all their needs from the produce of their own labor and are thereby driven to exchanging the surplus of their own labor for the surplus of such other men’s labor that manufacture those things they have need for; this exchange takes place in a market.

The market price of any commodity is regulated by the relation between supply and demand and gravitates towards its natural price, that is, the whole value of the rent, labor, and profit that must be paid to bring it to the market. Indeed, when the supply falls short of the demand, not all those who are willing to pay the natural price can be satisfied and a competition will therefore soon begin between them. This competition will raise the market price above the natural price according to the greatness of the deficiency or the desire among the competitors for the commodity at hand. When the quantity brought to market exceeds the demand, it can not be all sold to those who are willing to pay the natural price and some part must be sold to those who are willing to pay less. The market will thus sink the market price below the natural price according to how the greatness of the excess increases the competition of the sellers or the urgency that might drive the seller to consummate the trade. Therefore, in a free market, where people are able to move in and out of particular trades with relative ease, the quantity of every commodity brought to market naturally tends to suits itself to the demand [3]:

It is the interest of all those who employ their land, labor, or stock, in bringing any commodity to market that the quantity never should exceed the effectual demand; and it is the interest of all other people that it never should fall short of demand.

In such a free market, every individual is continually exerting himself to find the most advantageous employment for whatever capital he commands. But, as Adam Smith shows, the pursuit of his own advantage necessarily leads the individual to prefer that employment which is most advantageous to the society. First, Smith argues, every individual endeavors to employ his capital as much as he can in support of domestic industry because, in the home-trade he has better control over his investment. Second, every individual who employs his capital in support of domestic industry, necessarily endeavors so to direct that industry as to produce the greatest possible value; for the greater the value of this produce, the greater the profit of the employer. But, the annual revenue of every society is equal to the exchangeable value of the whole annual produce of its industry. Therefore, as individuals endeavor to employ their capital in support of domestic industry and try to ensure the greatest value from that industry, every individual works to render the annual revenue of society as great as he can. This argument has led Adam Smith to write the famous paragraph about the “invisible hand” [4]

The individual neither intends to promote the public interest nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry he intends only his own security; and by directing that industry in such a manner as its produce may be of greatest value he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.

Without any intervention from outside, therefore, a free market would lead to a stock distribution among the different employments carried out in society as nearly as possible in the proportion which is most agreeable to the interest of the whole society. From this vantage point, real markets are the result of imposing a host of regulations upon the free-market instincts of society. Adam Smith found the self-serving regulations of the mercantile system of his time to be almost invariably detrimental to the wealth of the nation. The restraints imposed upon the importation from foreign countries of such goods as can be produced at home, the restraints upon the importation of all good from those countries with which the nation has a disadvantageous balance of trade, the various drawbacks from taxes, and the diverse bounties used to control the balance of trade, in a word, the entire system of political economy extant in the England of his day, strikes Smith as so many ways of serving the interests of the mercantile class [5]:

It cannot be very difficult to determine who has been the contrivers of this whole mercantile system; not the consumers, we may believe, whose interest has been entirely neglected; but the producers, whose interest has been so carefully attended to; and among this latter class our merchants and manufacturers have been far the principal architects.

There is one notable exception in Adam Smith’s excoriation of government interference with the free market: the bounties offered in help of national defense. In his chapter on bounties, Smith talks about the tonnage bounties given to the white-herring and whale fisheries. While he finds that these bounties contributed little to the wealth of the nation, Smith observes that they may contribute to its defense by augmenting the number of sailors and shipping [6]:

This may sometimes be done by means of such bounties at a much smaller expense than by keeping up a great standing Navy.

Similarly, he points out that bounties upon the exportation of British-made sail cloth and gun powder may be justified on the grounds that such bounties would help the national defense by encouraging militarily useful manufacture at home.

Underlying these observations is the proposition that military production requires a national bounty because the free market, left to its own devices, can not always be expected to develop the needed technology. This bounty should dominate the free interplay of supply and demand that usually sets the market price of other commodities and thus should make the price of defense items largely insensitive to competition. The government should therefore attend to increasing the profits of the military industry by rendering upon them the bounty Adam Smith thinks would be necessary to keep their interest focused upon national defense rather than trying to lower those profits by encouraging competition.

But if all this be granted, why is it that the government still thinks that the price of defense systems is, like any other price, driven by competition for a larger market share and that the best way to reduce military budgets is to decrease as much as possible defense industry profit by pitting one company against another in competitive battle? The answer to this question can be found in the government’s monopsonistic behavior. Because it could, the government superposed a fabricated “free-market” structure upon the unique economy of military acquisition by insisting that industry compete for contracts exactly as if the underlying structure of their relationship to the government were indeed a free-market one. Within this fictitious universe, the government felt free to insist that enough competition be kept alive to secure technological supremacy for the nation and that the various competing companies fight among themselves for the lowest price.

This imposition of a free-market structure had very pernicious effects upon the health of our military industry. First, by insisting that contracts be awarded to the lowest bidder, the government created the unfortunate incentive for deliberate underbidding. After a contract was won through deliberate underbidding, the winning company would have to inform the government that it will take longer and it will cost more to deliver on the promise than originally represented. However, by that time the government is stuck between the two undesirable alternatives of either paying the difference or losing its initial investment and cancel the contract; during the last few decades, the American government has been forced to do both.

Second, because the contracts go to the lowest bidder rather than to the most experienced one, it has often been the case that the winning company found it more difficult to invent the technology needed than it assumed at the beginning. Unfortunately, because invention comes after the bidding, the government loses its leverage immediately the contract is awarded and finds it very difficult, if at all possible, to force the winner into delivering what it would not. As a consequence, many commodities provided through the acquisition process have fallen short of the technological excellence that might have been achieved if the government were willing to pay the additional monies required to select the candidate with the best track record and then used strict contract enforcement to encourage innovation.

Finally, the low rate of return on investment brought about by the government’s refusal to grant the bounty to which, according to Adam Smith, the military industry is entitled, has brought under question the long-term financial health of that industry. Indeed, as described in the final report of a 1988 Defense Science Board Summer Study on the Defense Industrial and Technology Base [7]:

Mandated competitive acquisition policy, limitations on progress payments, limits on allowable cost, and regulated profits create a cash flow shortage and reduced profitability. Almost none of the military companies can obtain new funds in the equity markets at any price and only the largest can do so in the debt market. Company shareholders, who demand greater return on their investments, are driven off by high-risk levels assumed by defense contractors. The result is further restricted access to capital and a continuing downward spiral in the long-term viability of the defense industry.

It appears clear to us therefore that the most effective way of reversing the deteriorating condition of our military industry is to balance the government’s monopsonistic power, which after all is at the root of most of the department’s problems, with the monopolistic power of an appropriately organized defense industry. Under an acquisition program reformed in accordance with this principle of balancing monopsony with monopoly, pursuit of self-interest on both sides would naturally be tempered by the recognition that neither can exist without the other. To use Jacques Gansler’s words [8], the defense industry:

... is a largely specialized sector of American industry that is heavily dependent on the Department of Defense for business and on which the Department of Defense is heavily dependent for supplies.

In some very real sense, therefore, the government and the defense industry would negotiate with each other much like management negotiates with labor. Because both would have the power to control the other, the government would be forced to recognize the industry’s need for adequate profit margins and less regulation while the industry would have to recognize the government’s interest in acquiring the best product in time and within budget.

According to this model of negotiated funding, the decision concerning the amount of money the government should spend for new technology would happen at the end of the decision-making cycle rather constantly throughout it. Therefore, the decision concerning the technology we ought to develop, as well as the decision concerning the number of weapon systems incorporating the chosen technology we ought to acquire, should be made without any concern for the cost of things. The fact that current practice nevertheless allows cost considerations to strongly influence those decisions is a consequence of the Department’s practice of competing the price of military acquisition programs. By requiring that the acquisition program cost as little as possible, this practice tends to entangle decisions that should be independent of each other. Under the circumstances, the technology chosen for acquisition may not necessarily be the one that maximized military effectiveness and the number of systems acquired may not be the one that minimized risk.