Advertisement

Turbulence, Cost Escalation and Capital Intensity Bias in Defense Contracting

  • Katsuaki Terasawa
  • James Quirk
  • Keith Womer
Conference paper
  • 91 Downloads
Part of the Lecture Notes in Economics and Mathematical Systems book series (LNE, volume 332)

Abstract

The recent growth of defense expenditures has once more raised public concern about cost overruns on defense contractors. Economists have pointed out that cost overruns are not necessarily bad per se; instead, attention should be directed to the question as to whether the procurement policies of the Department of Defense (DoD) satisfy the criterion of economic efficiency (see Peck and Sherer (1962)). In connection with this, applications of the principal-agent model to defense contracting show that not only do cost plus fixed fee (CPFF) contracts create moral hazard problems, but that in fact so long as contractors are risk averse and perfect monitoring of their activities is not possible, inefficiencies will arise whatever the form of the contract employed in DoD procurement (see Ross (1973), Harris and Raviv (1979), and Weitzman (1980)). It has been suggested that improvements in efficiency might be achieved if contracts more closely resembling Arrow-Debreu contingent claims were employed (see Cummins (1977)), but this raises problems of manipulation of the probabilities of occurrence of the relevant states of the world. Looking at the problem of cost escalation from a completely different point of view, biases might be introduced into cost comparisons and into decision making with respect to risky projects simply because of the methodology by cost estimators (see Quirk and Terasawa (1983)).

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  1. Belden, D. “Defense Procurement Outcomes in the Incentive Contract Environment,” Stanford University, May 1969, (AD 688 561 ).Google Scholar
  2. Cummins, J. “Incentive Contracting for National Defense: A Problem of Optimal Risk Sharing,” Bell Journal of Economics and Management, Spring, 1977, pp. 168 - 185.Google Scholar
  3. General Accounting Office, Defense Industry Profit Review, March 1969, (AD 685 071 ).Google Scholar
  4. Gates, W. “UH-60A Black Hawk: Development and Procurement Cost History,” Jet Propulsion Laboratory, 1983.Google Scholar
  5. Hadar, J. and Russell, W. “Rules for Ordering Uncertain Prospects,” American Economic Review, 1969, pp. 25 - 34.Google Scholar
  6. Harris, M. and Raviv, A. “Optimal Incentive Contracts with Imperfect Information,” Journal of Economic Theory, 1979, pp. 231 - 259.Google Scholar
  7. Morse, F. “Military Procurement and Contracting: An Economics Analysis,” RM-2948PR, RAND Corporation, June 1962.Google Scholar
  8. Pegram, W. “Capital Investment by Defense and Non-Defense Industries,” Jet Propulsion Laboratory, 1983.Google Scholar
  9. Peck, M. and Scherer, F. The Weapons Acquisition Process, Harvard University Press: Boston, 1962.Google Scholar
  10. Quirk J. and Terasawa, K. “Sample Selection and Cost Underestimation in Pioneer Projects,” Land Economics,. Vol. 62, No. 2, May 1986.Google Scholar
  11. Ross, S. “The Economics Theory of Agency: The Principal’s Problem,” American Economic Review, 1973, pp. 134 - 139.Google Scholar
  12. Rothschild, M. and Stiglitz, J. “Increasing Risk: I. A Definition,” Journal of Economic Theory, 1970, pp. 225 - 243.Google Scholar
  13. Rothschild, M. and Stiglitz, J. “Increasing Risk: II. Its Economic Consequences,” Journal of Economic Theory, 1971, pp. 66 - 84.Google Scholar
  14. Weidenbaum, M. “Arms and the American Economy: A Domestic Convergence Hypothesis,” American Economic Review Papers and Proceedings, 1967.Google Scholar
  15. Weitzman, M. “Efficient Incentive Contracts,” Quarterly Journal of Economics, 1980, pp. 719 - 730.Google Scholar
  16. Womer, K. N. and Terasawa, K. L. “The Effect of Defense Program Uncertainty on Cost, Schedule, and Capital Investment,” Journal of Productivity Analysis, forthcoming.Google Scholar

Copyright information

© Springer-Verlag New York, Inc. 1989

Authors and Affiliations

  • Katsuaki Terasawa
    • 1
    • 2
  • James Quirk
    • 1
    • 2
  • Keith Womer
    • 1
    • 2
  1. 1.U.S. Naval Postgraduate SchoolCalifornia Institute of Technology (Retired)USA
  2. 2.University of MississippiUSA

Personalised recommendations