Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 1 1 Tigers on the Retreat* How the Swiss search for a successor to its

Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich

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Tigers on the Retreat*How the Swiss search for a successor to its outdated F-5 fighters

resulted in a contract designcapable of overcoming information asymmetries

14th Annual International Conference on Economics & SecurityIzmir, 18th June 2010

PD Dr. Peter T. Baltes, Swiss Military Academy at the ETH Zurich

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** For their kind help the author thanks:Jakob Baumann, Cornelia Cosma, Werner Epper, Walter Furter, Odilo Gwerder, Daniel Lätsch, Markus Rickenbacher, Simone Rossi and Maximilian Zangger


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The two fighter aircraftThe two fighter aircraftemployed by the Swiss Air Forceemployed by the Swiss Air Force

F 18 C/D(in service since 1996)

F 5 II (in service since 1979)


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What has happened so far … What has happened so far … ((Part 1Part 1))

The search for the successor started in earnest in late 2007.

Rafale

Gripen

Eurofighter

Typhoon

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Test trials in the second half of 2008


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15th January 2009: Request for proposal by armasuisse

Price Option:

What is the total price of 22 aircraft?

Quantity Option:

How many aircraft for 2.2 billion Swiss francs?

What has happened so far … What has happened so far … ((Part 2Part 2))

Main question of the paper:

Why is this design employed?


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The Political Background to Swiss Arms Deals

The notorious Mirage III “S” dealof the 1960s

Budget cap of 2.2 billion Swiss francs

= guarantees that there will be no “bad surprises” (to critics as well as promoters of the deal) in the wake of the procurement process

The actual motiveThe actual motivebehind the request’s designbehind the request’s design


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Complementing Interpretation ( The Economics of Information)

The coordination issue:

The efficiency of arms deals is threatened by information asymmetries between supplier and procurement agency.

The problem of moral hazard / credence goods:

The supplier may claim unjustified cost overruns to extort some extra profit.

Explaining the design features:

The combination of price option & quantity option may inducethe supplier to refrain from shirking.

A double dividend?A double dividend?


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Supplier‘s profit of the Swiss deal is made up of two components

1. „Instant“ profit of selling aircraft to Switzerland:

2. Present value of future profits ( selling the aircraft to other countries):

The lever of the contract designThe lever of the contract design

Components are interrelated:Swiss contest serves as a signal to other countries

The design confronts the supplier with a trade-off:

Shirking increases instant profit, but lowers future profit.

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1


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• There is only one supplier.

k0 STC a x a0 = „Combat Multiplier“

Costs are positively related to the combat multiplier

k = „Cost Exponent“ with

Concavity of the total cost function reflects experience curve effect

The model:The model:Total costsTotal costs

• Total costs (TC) of the Swiss lot, xS:

Fixed costs are Zero.

k 0,1

• Total costs (TC) of xS include “sufficient” compensation for business risk etc.


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• There is only one supplier.

z2 Sx

xS = „Swiss lot“

z = „Profit Exponent“ with

Future profit increases with the number of aircraft sold to Switzerland. Why?

Concavity of the profit function.

The model:The model:Incorporating the present valueIncorporating the present value

of future dealsof future deals

• Present value of future profit is:

z 0,1


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Information Asymmetry

Supplier: perfect knowledge.

0a a ,a

• Cost exponent k is known (due to previous deals).

Armasuisse:

Modeling the information asymmetry Modeling the information asymmetry between supplier & procurement agencybetween supplier & procurement agency

• Profit exponent z is known, too.

• Knowledge of the combat multiplier a0 is limited to:


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The supplier’s reaction to the request for proposal= choosing a level of exaggeration that in turn determines total profit.

Supplier exaggerates the costs to extort some extra profit= Shirking.

Supplier behaves honestly.

Shirking by the SupplierShirking by the Supplier

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a*av 1,V with :V

0

0

a*av 1

Supplier understates the costs= Foot in the door technique.

*v 0,1


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Supplier’s total profitSupplier’s total profit

S

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k k zvx 0 S 0 S Sv a x a x x


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A numerical example – Part 1A numerical example – Part 1


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A numerical example – Part 2A numerical example – Part 2


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Results and further researchResults and further research

• The supplier has no incentive to refrain from shirking in the case of the price option.

• In the case of the quantity option, the supplier will not shirkin certain scenarios (preference to apply f-i-t-d-t = offset operations)

• A lottery that mixes price option and quantity option provokes a consistent reaction by the supplier.

• When to buy an aircraft?Trade-off: Buying earlier implies teething problems, danger of dead-end technology, but less shirking.

• Further research:Budget is a strategic variable to shift the decision from “Shirking” to “No shirking”.

Documents

Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 1 1 Tigers on the Retreat* How the Swiss search for a successor to its