Cooperative Procurement in Building National Defence: Why Are There So Few?

Abstract

The economic benefits of cooperative procurement derive from, at minimum, increased bargaining power relative to contractors and from economies of scale in production. There is, however, a puzzle: why is this kind of procurement so rare? This paper introduces a bargaining model with forward-looking expectations about the scale of procurement. It is shown that the price sensitivity of the scale of acquisition is favourable for the buying partnership, as it tends to push down the bargaining price. We propose several explanations for why it is hard to align buyers’ incentives: First, preferences for the properties of the products are country-specific, with divergent implications for national security. Second, countries that place a low value on the product have more bargaining power than those that value it highly, and may require a side payment in order to enter a partnership, while the partner may not have sufficient incentives to make such a payment. Third, the gains from cooperative procurement for the producer may not be sufficient to compensate for conflicting preferences among contractors. Fourth, while the future unpredictability of technologies or the future risks of deteriorating national security might support longer-term cooperative procurement, short-term opportunism tends to prevent long-term commitments.

Keywords:

• Cooperative procurement
• defence materiel
• bargaining
• national security

JEL classification:

• H12
• H41
• H56

Acknowledgement

The authors want to express their gratitude to a reviewer for careful reading of and evaluating the paper.

Notes

1. All European Union member countries except Denmark are EDA members.

2. According to statistics from the EDA, the UK (EUR 10.3 billion) and France (EUR 9.7 billion) were the dominant countries in European defence investments (including R&D expenditures) in 2014. Germany was the third (EUR 4.7 billion). The EDA’s collaborative equipment procurement benchmark of 35% was met only by Spain (46%), Italy (40%) and Belgium (35%), calculated over a ten-year period. Of course, the European average is maintained by the UK, France and Germany, which carry out most of the defence investments.

3. For an early analysis, see Kapstein (1991–1992).

4. Off-the-shelf or military-off-the-shelf do not mean that the equipment is already manufactured and readily available from stock. In practice, such capital equipment is usually made to order. However, it is common practice to refer such purchases as ‘off-the-shelf’.

5. By focusing on cooperative purchasing and in order to keep the theoretical model analytically tractable, the model thus abstracts from the domestic production of defence materiel, making it relevant for small countries, too.

6. Defence equipment has long life cycle and renewal times and does not easily fall into the same time-window. Consider as an example the timing of decisions on fighter aircraft in the Nordic countries: Sweden has a fleet of JAS Gripen, Norway selected the F-35 in 2008 and Denmark in 2016, while Finland plans to select an F-18 replacement in 2021.

7. The Swedish–Norwegian Archer Artillery System, a project aimed at developing a next-generation, self-propelled gun system, is not included in Table 1 because our focus is in cooperative purchases.

8. The free riding incentive in cooperative organizations has been analysed by Holmström (1982), d’Aspremont and Jacquemin (1988), and Kamien, Muller, and Zang (1992).

9. Cooperative procurement represents an action which has some similarities to cartel formation. Another analogy from non-defence industries would be consumer and producer cooperatives. It should be noted that cooperative procurement does not violate EU legislation. The clear difference compared with, say the formation of a cartel (monopsony), is, however, that no gains in terms of price undercutting arise from a deviation from the partnership.

10. Luoma (2006a) has reported that in the case of NH90 helicopters, Finland was searching for a transportation helicopter, Denmark for a rescue helicopter, Norway for an anti-submarine warfare helicopter, and Sweden wanted a helicopter with all these properties, on the condition that it would have Saab systems. Luoma (2006b) reports an amusing anecdote where it was suggested by one of the countries that the helicopter should have an option for toilets, while another country demanded that the option should include male and female toilets. The final offer by the producer included the option for a toilet, but it was so expensive that the toilet option was disregarded on short notice. There was more to the story. Of the 18 NH90 TTH helicopters ordered by Sweden, 13 were high-cabin versions facilitating surgery performed by taller, male doctors (Lehtonen and Anteroinen 2013).

11. The economic theory of coalition formation has highlighted the free riding incentive. We notice that the use of term ‘bribe’ is symbolic and not used in a legal sense.

12. The Folk Theorem refers to multiple equilibria in repeated games. ‘Folk’ comes from the notion that the result has been generally known for a long time and cannot be associated with any particular theorist.

13. Backward induction will be applied to solve the two-stage decision–negotiation problem. Because the decision process involves expectation mechanisms, the model is quite complicated. For this reason and to obtain analytical solutions at various stages, the basic structure of the model is as simple as possible. The backward induction procedure guarantees that the solution is time-consistent and that the expectations of the partners in the model world are rational.

14. Alternatively, the heterogeneity of the varieties may result from the different timing preferences of the delivery.

15. When Country A prefers the more sophisticated product and Country B does not, Country A may have to compensate Country B for its participation through some compensation mechanism. Of course, Country B may join even in the absence of compensation if the gains from the cooperation exceed the opportunity cost of not participating.

16. A great producer can benefit from the economies of scale in production. The greatest producer of the defence materiel in the world is the United States. As of 18 June 2017, SIPRI listed on its Arms Industry Database, the share of U.S. firms is 57% among top 100 producers of defence materiel, while that of Great Britain is 10 %, France has 4 %, and for example the share of the Swedish firms is 0.7 %.

17. Apart from the role of the declining average cost, another mechanism for the economies of scale is provided by the so called ‘learning by doing’ hypothesis (Arrow 1962).

18. The effectiveness (the α parameter) can be thought of in terms of the performance of the equipment relative to that of the adversary. The authors are indebted to the reviewer for this interpretation. Differences in the valuation variable may also arise, for example, from the different timing of when a country needs to have access to the new materiel. To take an example, a highly advanced modern submarine may be a technological miracle. Despite its technological superiority, Switzerland may not want to spend money on it. The square root specification has the appealing property that the mechanism of diminishing returns in the creation of natural security is nicely introduced by such a formulation. It is analogous to having ½ as the exponent. From another angle, Hove and Lillekvelland (2016) analyse the cost increase between generations of weapon systems.

19. This approach is typical in the public finance literature.

20. Trade in defence material is, of course, often used as an instrument of political power. Our paper is welfarist as it does not discuss the public choice issues.

21. This case arises if no close substitutes exist for the materiel under consideration.

22. The solution to such a negotiation is called a Nash bargaining solution (Nash 1950, 1953). A Nash bargaining solution is a Pareto-efficient solution to a Nash bargaining game. In this game, the solution consists of each player getting their status quo payoff (i.e. the noncooperative payoff) and an addition to a share of the benefits occurring from cooperation. Many applications of the Nash bargaining process allow for differences in the negotiating power. This idea is also built into the model of the current paper.

23. The threat point is the outcome of the negotiation process in the absence of successful contracting.

24. A characterization of the solution when no closed-form solution is available is typical in other fields of economics – in optimal tax theory in particular.

25. The parameters φ, ψ and τ can be obtained from a, b and c, and they can be evaluated as

$\phi =\frac{{\theta }_H\left(1+\lambda \right)\left(F+nk\right)+\left(1-{\theta }_H\right)\left[S+k\left(1+\lambda \right)n\right]}{\left(1+\lambda \right)n}>0$

$$\psi =\frac{{\theta }_H\left[-\mathrm{\Delta }S+\left(1+\lambda \right)n\right]\left(F+nk\right)+\left(1-{\theta }_H\right)nS}{\left(1+\lambda \right)n}>0$$

$\tau =\frac{\left(1-{\theta }_H\right)kS}{\left(1+\lambda \right)n}>0.$

26. ‘Tit-for-tat strategy’ means choosing cooperative action in the first round, and in subsequent rounds of a game, choosing the action that the other player chose in the previous round. This strategy results in a situation where cooperation is sustained once it begins, but uncooperative behaviour is punished by a lack of cooperation in the next round of the game. Using computer simulations, Axelrod (1980a, 1980b) observed that the tit-for-tat strategy was the most successful in its ability to maintain long-term cooperation in repeated games.

27. Asymmetrical deterioration of national defence may make national time preferences diverge from each other.

28. The current analysis assumes that the buying countries are independent. A point can be made that within an alliance, there is a further gain from cooperative procurements not discussed here: it tends to enhance the compatibility of the defence material acquired. The case of the Baltic states – all NATO members – however, points surprisingly to the opposite case: those states decide on their materiel acquisitions purely on a national basis, without paying attention to the compatibility gains arising from cooperative procurements.