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Essays DEC 1 4 199M iEn cothenomics of Procurement Edited byAnthony G.B ower andJames N Dertouzos Prepared for the Office of the Secretary of Defense 19941207 008 RAND National Defense Research Approved for public release; distribution unlimited LisIltute PREFACE This volume of essays is part of a larger project on the economics of defense acquisition. This work was sponsored by the Director, Program Analysis and Evaluation, and was carried out in the Acquisition and Support Policy Program of RAND's Na- tional Defense Research Institute, a federally funded research and development center supported by the Secretary of Defense, the Joint Staff, and the defense agencies. The separate essays in this volume summarize earlier RAND reports and reprint articles that have appeared in the professional literature. The following publications, among others, were fully or partially supported by this project: James J. Anton and Dennis A. Yao, "Measuring the Effectiveness of Competition in Defense Procurement: A Survey of the Empirical Literature," Journal of Policy Analysis and Management, 1990. Anthony G. Bower, "Procurement Policy and Contracting Efficiency," International Economic Review, 1993. Anthony G. Bower and Kent Osband, "When More Is Less: Defense Profit Policy in a Competitive Environment," The RAND Journalo f Economics, 1991. Frank Camm, How DoD Policy Affects Private Expenditure on Independent Research and Development: A Comparison ofEmpiricalS tudies, RAND, N-2834-OSD, 1989. Yeon-Koo Che, "Design Competition Through Multi-Dimensional Auctions," The RAND Journalo f Economics, 1993. Stefan Reichelstein, "Constructing Incentive Schemes for Government Contracts: An Application of Agency Theory," The Accounting Review, October 1992. William P. Rogerson, An Economic Framework for Analyzing DoD Profit Policy, RAND, R-3860-PA&E, 1992. William P. Rogerson, "Incentives, the Budgetary Process, and Inefficiently Low Production Rates in Defense Procurement," Defence Economics, 1993. iii... ... . . iv Essays in the Economics of Procurement William P. Rogerson, Profit Regulation of Defense Contractors and Prizes for Innovation, RAND, R-3635-PA&E, 1992. A shorter version also appeared in the Journalo f PoliticalE conomy, Vol. 97, 1989. William P. Rogerson, "Quality vs. Quantity in Military Procurement," American Eco- nomic Review, Vol. 80, 1990. Rachel Schmidt, Defense Profit Policy and Capital Investment, RAND Graduate School Dissertation, 1993. Lars Stole, "Information Expropriation and Moral Hazard in Optimal Second Source Auctions," Journalo f Public Economics, forthcoming. CONTENTS Preface ..................................................... iii Figures ..................................................... ix Tables ...................................................... xi Acknowledgm ents ............................................. xiii Chapter One INTRODUCTION, byJames N. Dertouzos ............................ 1 1. The Regulatory Framework .................................. 2 Promoting Competition ................................... 2 Profit Policy ............................................ 3 Contract Design ......................................... 3 2. Overview of Defense Procurement ........................... 4 Multiple Regulatory Objectives .............................. 4 The Multiple Players in Defense Procurement ................... 4 Government Contracts Are Interrelated ........................ 4 Incomplete Information and Uncertainty ...................... 5 3. Overview of Recent Contributions to the Economics of Procurem ent ........................................... 6 4. Policy Im plications ....................................... 16 Chapter Two PROFIT IN NEGOTIATED DEFENSE CONTRACTS: A SURVEY OF SOME RECENT LITERATURE, byJohn H. Nachbar .......................... 19 1. Introduction ............................................ 19 2. Profit and Profit Policy .................................... 20 3. An Overview of Profit Policy Structure ......................... 22 Contract Form s ......................................... 22 Dr The W eighted Guidelines .................................. 23 4. A Theory of Contract Profit ................................. 25 No Cost Uncertainty ....................................... 26 L(cid:1) Cost Uncertainty .. ...................................... 29 ý d True Profit and Other Compensation ......................... 32 M easurem ent ........................................... 33 5. Theoretical Versus Actual Contract Profit ...................... 34 W orking Capital ......................................... 34 jiii vi Essays in the Economics of Procurement Facilities Capital ......................................... 35 Cost-Sharing Risk ........................................ 37 True Profit and Other Compensation ......................... 38 6. Conclusion ............................................. 39 Appendix A: Contract Types .................................. 39 Appendix B: Uncertainty ..................................... 40 Appendix C: Facilities Profit in Continuous Time .................. 44 Chapter Three PROFIT REGULATION OF DEFENSE CONTRACTORS AND PRIZES FOR INNOVATION, by William P. Rogerson .............................. 47 1. Introduction ............................................ 47 2. Background ............................................ 47 3. Theory ................................................ 48 4. Implications for Regulatory Policy ............................ 52 5. Estim ation Theory ....................................... 55 6. Estimation of Changes in Market Value ........................ 59 7. Estim ation of Prizes ...................................... 63 Chapter Four WHEN MORE IS LESS: DEFENSE PROFIT POLICY IN A COMPETITIVE ENVIRONMENT, by Anthony G. Bower and Kent Osband ................ 67 1. Introduction ............................................ 67 2. The Model Without Moral Hazard ............................ 69 3. The Model With Moral Hazard .............................. 74 4. Conclusions ............................................ 81 Chapter Five BUY-IN AND GOLD PLATING UNDER DEFENSE PROFIT POLICY, by Yeon-Koo Che .............................................. 83 1. Introduction ............................................ 83 2. The M odel ............................................. 85 3. A Simple Illustration of the Averch-Johnson Effect ................ 88 4. The General Model of Profit Policy Regulation ................... 90 5. Num erical Exercise ....................................... 96 6. Conclusion ............................................. 97 Chapter Six INFORMATION EXPROPRIATION AND MORAL HAZARD IN OPTIMAL SECOND-SOURCE AUCTIONS, byLarsA. Stole ....................... 99 1. Introduction ............................................ 99 2. The M odel ............................................. 101 3. The Optim al Contract ..................................... 104 The First Best ........................................... 104 Asymmetric Information and Limited Liability .................. 105 The Value of Technology Transfers ........................... 107 An Exam ple ............................................ 108 4. M oral Hazard ........................................... 109 The Problem of Moral Hazard ............................... 110 Contents vii The Model with Moral Hazard .............................. 110 The Optimal Contract Under Moral Hazard ..................... 111 5. Conclusions ............................................ 112 Appendix ................................................ 113 Chapter Seven CONSTRUCTING INCENTIVE SCHEMES FOR GOVERNMENT CONTRACTS: AN APPLICATION OF AGENCY THEORY, by Stefan Reichelstein .................................................. 119 1. Introduction ............................................ 119 2. Theory Background ....................................... 121 3. Constructing Budget-Based Schemes ......................... 125 4. Application of the Budget-Based Schemes in Germany ............ 131 Profit Policy ............................................ 131 Implementation for Pilot Projects ............................ 133 5. Concluding Remarks ...................................... 135 Appendix ................................................ 136 Chapter Eight PROCUREMENT POLICY AND CONTRACTING EFFICIENCY, byAnthony G. Bow er .................................................... 141 1. Introduction ............................................ 141 2. The M odel ............................................. 143 2.A. Full Commitment .................................... 143 2.B. Commitment Plus Renegotiation ......................... 154 3. Com parisons ........................................... 156 3.A. Performance Comparisons ............................. 156 3.B. Value of Procurement Instruments ....................... 158 4. Conclusions and Extensions ................................ 162 Appendix ................................................ 163 Chapter Nine INCENTIVES, THE BUDGETARY PROCESS, AND INEFFICIENTLY LOW PRODUCTION RATES IN DEFENSE PROCUREMENT, by William P. Rogerson .................................................... 171 1. Introduction ............................................ 171 2. The M odel ............................................. 173 Assumptions and Notation ................................. 173 Equilibrium ............................................ 176 3. Form al Analysis ......................................... 178 4. The Effect of Scale on Marginal Cost .......................... 181 5. Fixed Budgets ........................................... 183 6. Incentives to Choose Inflexible Technologies .................... 184 7. Flexible Manufacturing Technology .......................... 187 Appendix ................................................ 188 Bibliography ................................................. 189 FIGURES 2.1. Corrections for Risk and Contract Parameters .................... 33 2.2. Corrections for Risk and Contract Length ....................... 36 2.3. Corrections for Risk in Employing Facilities Capital ................ 37 3.1. Excess Daily Returns for Winners ............................. 60 3.2. Excess Daily Returns for Losers ............................... 60 3.3. Excess Daily Returns for Total Firms ........................... 61 4.1. Government Expenditure and Firm Profit (without moral hazard) ..... 73 4.2. Government Expenditure and Firm Profit (with moral hazard and . < .............................................. 78 4.3. Government Expenditure and Firm Profit (with moral hazard and m > n2 l ) .............................................. 78 5.1. Markups and Government Costs When Quality Is Given ............ 88 5.2. Markups and Government Costs When Quality Is Variable .......... 90 6.1. Optim alAuctions ......................................... 109 7.1. Illustration of the Density Given by Eq. (13) ...................... 129 8.1. Tim eline ............................................... 143 8.2. C osts .................................................. 147 8.3. The Constrained Solution ................................... 152 8.4. Value of a Menu and Commitment (uniform f(.)) .................. 159 8.5. Solution to the Full-Commitment, Uniform-Quadratic Case ......... 160 8.6. Percentage of Potential Savings, 1-4 Firms ...................... 162 9.1. The Equilibrium Weapons Program ........................... 180 9.2. Equilibrium with Fixed Input Proportions ....................... 182 9.3. Incentives to Adopt Tailor-Made Inflexibilities ................... 185 ix TABLES 1.1. Relationship Between Procurement Costs and Markup ............. 9 2.1. The W eighted Guidelines ................................... 24 3.1. Description of Events ...................................... 59 3.2. Excess Returns and t-Statistics for Various Event Windows .......... 62 3.3. Estimated Change in Market Value of Winners and Losers ........... 63 3.4. Average Value of Prizes Across All Twelve Contests ................ 63 5.1. Quality Distortions and Markups ............................. 97 7.1. Matrix of Incentive Profits for One GDOD Project ................. 134 8.1. Uniform Distribution, K= .01, , 0.5, x = ........................ 157 xi ACKNOWLEDGMENTS This volume of essays benefitted from contributions made by many individuals, including RAND and university colleagues, seminar par- ticipants, and current and previous staff from the sponsoring office of the Director, Program Analysis and Evaluation. Of this large group of contributors, we owe our greatest debt to David McNicol and Craig College of PA&E. Their support, encouragement, and critical reviews of draft articles were invaluable. Other notable contributions over the course of the project were made by John Birkler, Michael Kennedy, Michael Rich, and Dennis Smallwood. Finally, special thanks to Patricia Bedrosian for outstanding editorial work in putting this volume together. xiii Chapter One INTRODUCTION byJames N. Dertouzos At the peak of defense spending during the mid 1980s, over 60 percent of the De- partment of Defense's (DoD's) annual outlays of nearly $300 billion was spent on research, development, testing, and production contracts with private sector firms.1 By necessity, the award, administration, and completion of these contracts is sub- jected to an extensive, complex, and idiosyncratic series of rules and regulations. This process, which governs the interaction between DoD and contractors, appears to be fertile ground for economic analysis. However, insufficient scholarly attention has been directed toward the analysis of these heavily regulated markets. Although significant portions of the applied economics literature address issues related to public utilities, health care, and telecom- munications, many fewer contributions to defense procurement have emerged. This dearth of relevant research may not be surprising given that procurement regulation is extremely complex, diffuse, and decentralized. In addition, products and services purchased are highly differentiated and multidimensional, making generalizations quite problematic. As a result, analysts are faced with significant obstacles to acquir- ing reliable data and integrating information on the regulatory process, institutions, and structure of the defense industry. This is unfortunate, because recent advances in the literature, including general the- ories of incentive contracting and more specific applications of microeconomic concepts to procurement issues, have potentially important implications for the regulation of the defense industry. However, previous research on the economics of procurement has not, in general, been used in the design of specific government policies. This stems from a variety of reasons. To begin with, much of this work is published in scholarly journals and remains virtually inaccessible to most practitioners. These articles are prepared for academic audiences that are more interested in the technical contributions of the research than in policy relevance. Even if a dedicated practitioner wished to survey this literature to gain theoretical insights into actual problems, the models rarely incorporate real-world attributes that characterize defense procurement. This is not surprising, since scholars do not 1Even with subsequent budget declines amounting to over 20 percent in nominal terms, the magnitude of taxpayer resources allocated via the procurement process remains very large.