schweizer armee höhere kaderausbildung der armee militärakademie an der eth zürich 1 1 tigers on...
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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Tigers on the Retreat*How the Swiss search for a successor to its outdated F-5 fighters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
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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)
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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
?
Test trials in the second half of 2008
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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?
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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?
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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.
2
1
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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.
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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:
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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
0
a*av 1,V with :V
0
0
a*av 1
Supplier understates the costs= Foot in the door technique.
*v 0,1
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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A numerical example – Part 1A numerical example – Part 1
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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A numerical example – Part 2A numerical example – Part 2
Schweizer ArmeeHöhere Kaderausbildung der ArmeeMilitärakademie an der ETH Zürich
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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”.