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Abstract
A dynamic multi-stage decision-theoretic approach is introduced to establish the optimal offset and its incidence, the contract price arising from bargaining, and the scale of the acquisition. A new rationale is suggested for offsets in terms of their role as an insurance devise. Results are derived for the pricing of delivery contracts subject to offset claims and their national security implications. It is shown that the national security is strictly convex in the offset transaction. As to the incidence of the offset, the offset claim is shown to be capitalised in the delivery price. The bargaining price is shown to depend on the value of the product to be delivered for the national security, the relative negotiation power of the contracting partners and the social cost of public funds. The analysis highlights the expectation effects of offsets on the bargaining price and the scale of delivery. The results aid in explaining why offsets are widely used in procurement contracts for defence materiel. As they contribute to the national security, they should be allowed to survive and not be denied under competition laws.
Acknowledgement
The authors are indebted to Tapio Palokangas and two anonymous referees for helpful comments and suggestions.
Notes
1. EC (Citation2013).
2. Taylor (Citation2012) refers to an audit performed by PriceWaterhouseCoopers showing that the net benefits of offset agreements signed by the government of the Netherlands were positive.
3. These figures were released by the U.S. Department of Commerce (see Taylor Citation2012).
4. Large exporting countries (such as the United States and France) do not need offsets, since they strive for self-sufficiency and complete independence. For medium-sized countries with sizeable exports (e.g. Italy and the Netherlands), offsets can be desirable for strengthening the country’s industrial base. In countries that are members of an alliance (such as Denmark or Norway), offsets may lead to the possibility of delivering components, thereby strengthening the interdependence within the alliance.
5. Defence White Paper, Australian Government, Department of Defence (Citation2016). The authors are grateful to a referee for this reference.
6. It was reported in a Der Spiegel article of 20 December 2017 that, for example, only eight of the 109 Eurofighters in the German army’s equipment base are available for flying, seven of the 67 transport helicopters and five of the 33 NH90 helicopters are in operational condition, and 21 of the 56 transport aeroplanes are in sufficiently good condition for operation. Of course, such cases are not limited to the German army.
7. There is some empirical and analytical work (Caves and Marin Citation1992; Hennart and Anderson Citation1993; Kanniainen and Mustonen Citation1989; Yavas, Freedand, and Vardiabasis Citation2000) on countertrade which is close to indirect offsets.
8. In analytic terms, backward induction must be applied to solve a three-stage decision negotiation problem. Because the decision process therefore involves expectation mechanisms, the model is quite involved. For this reason and to obtain analytic solutions in various stages, the basic structure is kept as simple as possible. The backward induction procedure guarantees that the solution is time-consistent and that the expectations in the model world are rational.
9. It is appropriate to read n as a ‘mass’ instead of a discrete variable. The easiest way to consider the model is to think of p as the gross unit value of, say a fighter as paid by the acquiring country to the delivering country. Then, q can be thought of as the cost paid by the delivering country to the acquiring one for the services produced domestically by the acquiring country. It is the net cost per fighter, p − q multiplied by n, that has to be financed by domestic taxes. Many countries try to impose an offset of up to 100% of the delivery contract. However, this is achieved via a ‘multiplier’ process. Such a procedure is not applied in the case of direct offsets – which can amount to, say, 25%, for example. General knowledge suggests that the associated price premium could amount to, for instance, 5%.
10. While formally introducing the operation and servicing uncertainty for the arms materiel acquired is possible, this would complicate the notation unnecessarily without adding insight, so we introduce a more straightforward view that the offset enhances insurance against such risks.
11. The fact that n is thought of in terms of a quantity and q in terms of a value should not be a great worry, since q at the same time measures the quantity of domestically provided services.
12. The authors are indebted to one of the referees for this suggestion.
13. The model’s linearity with respect to variables p and q and the quadratic term are introduced to make the model solvable. The expectation effects to be introduced, , assist in characterising the internal solutions at each stage of the decision process.
14. Notice that the effectiveness of the offset parameter β does not enter (3) directly but interacts with the scale of delivery through the price and offset variables p and q.
15. The solution is referred to as a Nash bargaining solution (Nash Citation1950, Citation1953). This is a Pareto efficient solution to a Nash bargaining game. In this game, the solution consists of each player obtaining her status quo payoff (i.e. the non-co-operative payoff) and an additional share of the benefits that arises from co-operation. Many applications of the Nash bargaining process allow for differences in negotiation power. This idea is built from in the model described in the present paper.
16. The relative bargaining power may depend on how many competing producers are active in the market. For instance, with respect to rivals for production of the fighter replacing the F/A-18 Hornet in Finland, publicly available material from the media has considered the U.S.A., Sweden, France, and Eurofighter GmbH as potential candidates.
17. As the bargaining process is quite involved, it is appropriate to simplify by working with 0 threat points.
18. The greater root represents the minimum.
19. Such an approach is typical in other fields of economics – in optimal tax theory in particular.
20. It has, however, been suggested by Taylor (Citation2012) that a high optimal offset claim may follow from the Prisoners’ Dilemma being acted out by the bidders.