Real World Economics
by Edward D. Lotterman
Defense bargains unlikely in this bilateral monopoly
My student asked a good question: ‘Does it really make all that much difference if you have only a monopoly for this tanker contract instead of a duopoly?’ I gave him a usual economist’s answer: ‘It depends.’
Yes, now that Northrop Grumman, working with the European aerospace firm EADS, has dropped out of the running to build a new refueling tanker for the U.S. Air Force, there is less competition. And yes, ever since Adam Smith, economists have believed that decreased competition usually increases costs and often decreases quality, service and innovation.
So citizens should not be happy with the news, as less competition in defense purchasing could mean either higher costs to the U.S. Treasury or less capable defense hardware. Unfortunately, having only one bidder is becoming the rule rather than the exception in buying U.S. military hardware. For decades, only Newport News Shipbuilding has constructed aircraft carriers, and only the electric boat division of General Dynamics has produced nuclear submarines. And not a lot can be done about it.
Building large, technologically intricate ships and airplanes has become a “natural monopoly.” That is when a company large enough to achieve economies of scale in production is large enough to meet the needs of all purchasers in the market. In this case, forcing there to be two or more firms raises the cost of the product.
That historically was true for providers of natural gas, electricity and copper-wire telephone service to households. The physical distribution infrastructure was expensive. If another firm had to duplicate it to compete, then the total resources used by the industry would be much higher. The cost of these resources would have to be paid by customers. It was better to have one firm provide the service and have government regulate its rates rather than strive for multi-firm competition.
The high research and engineering costs of designing a new weapons system is the defense equivalent of pipes and wires in the utility industry. These constitute what economists call “barriers to entry,” factors that make it difficult for any challenger to get into the business.
When airplanes and ships were simpler and bought by the thousands, as bombers and fighters were in World War II (or by the hundreds, as destroyers were), things were different. Competing firms would develop rival aircraft designs. The Navy’s Bureau of Ships would design a destroyer or carrier and farm the actual construction out to various shipyards. The tools and facilities used to build military gear were not very different from those used for civilian ships and planes.
We now buy these systems by the tens. The domestic shipbuilding industry is largely gone, and most combat aircraft have little in common with civilian ones. So there is less scope for most defense companies to spread overhead costs over by switching back and forth between civilian and military output.
Tankers are an exception, as historically they were derived from passenger airliners. The stalwart KC-135s, which the new tankers are to replace, are versions of the Boeing 707. In the late 1970s, the Air Force bought tanker versions of the Douglas DC-10. Boeing now proposes a modified 767, and Northrop developed a version of the Airbus A-330.
But because the government now must choose between existing civilian airframes, it is hard to write the bidding specifications without favoring one or the other. That is Northrop’s complaint right now, that the specs favor the smaller Boeing plane. But choosing between fewer larger planes or a greater number of smaller ones is an important military decision, because it affects how the Air Force organizes its units to fight a war.
So while losing the competition from Northrop is bad, we are back to a familiar situation of bilateral monopoly, where there is not only a single seller but also a single buyer. Economic behavior and outcomes in this situation are not easily determined. But don’t expect we will get any bargains.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.