Wednesday, August 03, 2011

The Economics of Military Budget Cuts

Many young economics students have taken a quick nap as their professor mumbled about the production possibilities frontier.  While my colleagues would talk about "guns versus butter", I was cool and would talk about the "guns versus roses" tradeoff (get it?).   Now the NY Times tells us  that the tradeoffs are real and that our national security is under threat.    Here is a quote from the article.

"In a letter to Defense Department personnel posted Wednesday morning on the Pentagon’s Web site, Mr. Panetta warned that if a Congressional panel could not reach agreement on cuts to the nation’s deficit, “it could trigger a round of dangerous across-the-board defense cuts that would do real damage to our security, our troops and their families, and our ability to protect the nation.”

Is this true?

The citizen inside me is worried.  The economist in me wonders whether the military has solved a cost minimization problem subject to quality constraints.  I don't believe that the military has had sufficient incentives to solve this problem and in this age of budget cuts this is a serious problem!

Permit me to provide some details.

1. What share of military employees and military subcontractors are members of unions?   Has anyone conducted an audit concerning whether workers are being efficiently employed across different tasks within the military?  Could innovations in information technology replace some workers?  Does the military have any incentives to search for such cost savings?  Or because the Federal Government has been a generous "sugar daddy", there has been no incentive to encourage efficiency and substitute capital for labor in "back office" stateside operations?

More generally, I would ask the Department of Defense to review its manpower policies.  For the "modern military", how many soldiers does it need?  How many stateside employees does it need? Why can't it "outsource" most of this activity to the private sector?  If issues of national security arise, I understand why that must be done "in house" but I doubt that is the case for issues of hospital care, xeroxing and many other typical market transactions.

2.  How does the military choose what pieces of "hardware" are needed?  Can it explain to the American people how our safety against potential enemies is enhanced from purchasing each new helicopter, aircraft carrier?

3. Once the Pentagon has prioritized a specific piece of military equipment, can it do a better job getting military hardware producers to compete to lower the resulting price per unit quality? Permit me to make a suggestion. We should allow Chinese firms to bid on these contracts!  The price per unit quality would fall.

While my jokes here are not funny, my point is a serious one.  How do we know that we are getting our tax dollars worth from the Military?  What incentives do they have? What accountability do the face to provide low cost, high quality service?  Unlike other sectors, they face no competition. We can't hire the Libyan army and fire them.  That causes some bad incentives.

This case study highlights that a silver lining of scarcity is to encourage a new look at encouraging efficiency.  Is Leon P. up to the job?

4.  How we choose which foreign nations to send our top notch military into.


My mother sent me this email as a comment on this post;

Dear Matt;
One problem you don't address in your blog today about const efficient military contracting is - if each large weapon producer bids for a project with the right to hire its own subcontractors - and each alternative weapon produced by different companies is different, doesn't this mean in effedct there is no open bidding on subcontractors; the chosen contractor has sole control over subcontractors and parts costs, to preserve the secrecy of the design so your whole assumption of competative bidding doesn't fly?

So, how do I reply to my mommy?  She points out an interesting example of the role that specificity plays in creating monopoly power.  To lower the cost of producing military hardware, we need the "bomb makers" to avoid using custom parts.  As she points out, there will not be competitive bidding for the inputs to produce a fancy bomb if there is only one company that specializes in making each part of the product. So, this raises the issue of supply chains and double marginalization.  If the military is serious about lowering its costs, it will need to think trading off how "fancy" it wants its weapons to be versus the average cost of producing them.