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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How the Swiss search for a successor to its outdated F-5 fighters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 design
capable of overcoming information asymmetries
?
14th Annual International Conference on Economics & Security
Izmir, 18th June 2010
PD Dr. Peter T. Baltes, Swiss Military Academy at the ETH Zurich
* For their kind help the author thanks:
Jakob Baumann, Cornelia Cosma, Werner Epper, Walter Furter, Odilo Gwerder, Daniel Lätsch, 11
Markus Rickenbacher, Simone Rossi and Maximilian Zangger
The two fighter aircraft
employed by the Swiss Air Force
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F 18 C/D
(in service since 1996)
F 5 II (in service since 1979)
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What has happened so far … (Part 1)
The search for the successor
started in earnest in late 2007.
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Rafale
?
Gripen
Typhoon
Eurofighter
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What has happened so far … (Part 2)
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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?
Main question of the paper:
Why is this design employed?
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The actual motive
behind the request’s design
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The Political Background to Swiss Arms Deals
The notorious Mirage III “S” deal
of 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
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A double dividend?
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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 induce
the supplier to refrain from shirking.
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The lever of the contract design
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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:
1
2. Present value of future profits ( selling the aircraft to other
countries):  2
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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The model:
Total costs
•
There is only one supplier.
•
Total costs (TC) of the Swiss lot, xS:
TC  a 0   x S 
k
a0 = „Combat Multiplier“
 Costs are positively related to the combat multiplier
k = „Cost Exponent“ with
k   0,1
 Concavity of the total cost function reflects experience curve
effect
Fixed costs are Zero.
•
Total costs (TC) of xS include “sufficient” compensation for business
risk etc.
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The model:
Incorporating the present value
of future deals
•
There is only one supplier.
•
Present value of future profit is:
2   x S 
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z
xS = „Swiss lot“
z = „Profit Exponent“ with
z   0,1
 Future profit increases with the number of aircraft sold to
Switzerland. Why?
 Concavity of the profit function.
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Modeling the information asymmetry
between supplier & procurement agency
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Information Asymmetry
Supplier: perfect knowledge.
Armasuisse:
•
Cost exponent k is known (due to previous deals).
•
Profit exponent z is known, too.
•
Knowledge of the combat multiplier a0 is limited to:
a 0 a  ,a  
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Shirking by the Supplier
The supplier’s reaction to the request for proposal
= choosing a level of exaggeration that in turn determines total profit.
Supplier behaves honestly.
v* 
a0
a0
1
Supplier exaggerates the costs to extort some extra profit
= Shirking.
v*  1, V  with
a
a0
: V
Supplier understates the costs
= Foot in the door technique.
v*   0,1
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Supplier’s total profit
  v  a 0   xS   a 0   xS    xS 
v
xS
k
 1
k
z
2
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A numerical example – Part 1
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A numerical example – Part 2
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Results and further research
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•
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 shirk
in 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”.
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