Inefficiency in the arms industry<\/p>\n
Andi Widjajanto, Jakarta<\/p>\n
Since Adam Smith first broached the subject, defense economics
\nhas been concerned with the appropriate level and allocation of
\ndefense expenditures to achieve an efficient production of
\ndefense capability. Although many efforts have been made to adopt
\nbest commercial-business practices in military procurement, only
\nlimited progress has been made. The acquisition of weapons
\nsystems still normally involves inflated costs, runs years behind
\nschedule, and often produces technology that is out of date when
\nthe systems are finally fielded.<\/p>\n
This essay will try to provide a brief explanation as to why
\nthe defense industry will always be incapable of reaching the
\nlevel of efficiency enjoyed by other commercial practices. We
\nwill need to apply a number of microeconomic principles in
\nanalyzing the inherent nature of inefficiency in defense
\nindustries.<\/p>\n
The first micro-economic principle that can be used to explain
\nthis is the market structure model. It is generally accepted that
\neconomic efficiency can only be achieved is there is a free
\nmarket structure accompanied by free competition between a
\nsufficient number of suppliers, the existence of various channels
\nin which to sell products, and an adequate number of consumers.<\/p>\n
This basic principle cannot be found in the defense sector. On
\nthe supply side, the number of companies that are able to
\nconstantly participate in developing defense-related products is
\ndecreasing. After the economic crisis, only the Army industrial
\nweapons producer, PT PINDAD, still made a significant
\ncontribution to defense procurement. State-owned shipbuilder PT
\nPAL and state-owned aerospace firm PT Dirgantara Indonesia are no
\nlonger major players in defense procurement. As a result,
\nIndonesia's defense industry still depends on extensive imports
\nof components and technology, with a consequent reliance on arms
\nmanufacturers in the industrialized countries.<\/p>\n
This has one significant effect. Although the Ministry of
\nDefense uses competition as one of criteria in deciding on
\ndefense contracts, most of these are not based on competition in
\nthe commercial sense. In an oligopoly, genuine competition
\nbetween two or more producers is not possible in most cases.<\/p>\n
The lack of competition in the defense industry is also
\nexemplified by the fact that the ministry intentionally takes
\npolitical steps to ensure that sufficient numbers of companies
\nremain in business. For example, during Megawati's administration
\ninstead of buying eight corvettes from the Netherlands, the
\nministry decided to award PT PAL a license deal which enabled the
\nfirm to build four corvettes under Italian supervision and two
\ncorvettes under Dutch supervision.<\/p>\n
However, since a monopoly exists whenever a single firm
\ncontrols more than 70 percent of a market, the ministry's desire
\nto maintain competition will be hard to sustain. In an era of
\nconsolidation in the defense industry, if we look closely at a
\nspecific segment of the industry we will see the existence of a
\nmonopolistic relationship.<\/p>\n
In the demand side, the government is the single largest buyer
\nof domestically produced weaponry. This creates a monopoly market
\nstructure.<\/p>\n
When the Indonesian Military (TNI) decided it didn't need any
\nmore CN-235-110s or Super Pumas, the market for PT Dirgantara
\nIndonesia collapsed. When the Navy increased its orders for KAL-
\n35 patrol boats and corvettes, the market for PT PAL expanded and
\ninvolved a significant shift in demand.<\/p>\n
Production capacity is another microeconomic principle that
\nimpinges on the efficiency of the defense industry. The biggest
\nproblem of any component of the defense industry in maintaining
\nits optimum level of production. This is because most defense
\nfirms are dependent on states' weapons spending. Since the
\neconomic crisis, defense budgets in Indonesia have been falling
\nover the last couple of years.<\/p>\n
For Indonesia, the defense budget in 2002 was 40 percent
\nsmaller in real terms that it was in 1996. While budgets are
\nfalling, the costs associated with producing advanced weapons
\nsystem are rising. This trend can also be found at the global
\nlevel.<\/p>\n
According to SIPRI World Military Expenditure and Arms
\nTransfers (1990), in 1970, U.S. firms shipped 3,500 military
\naircraft with a value of US$4 billion to their customers. In
\n1990, the number dropped to 900, but the value had increased
\nsharply to $22 billion.<\/p>\n
The immediate result of this combination of decreasing budgets
\n(lower demand) and rising costs is that the average rate of
\nreturn is lower for the defense industry that for the market as a
\nwhole. Logically, this will force many companies to decide not to
\nundertake any further defense work. To deal with this
\npredicament, governments usually protect firms in the industry by
\nproviding subsidies that most commercial firms do not enjoy.<\/p>\n
The production capacity problem is also complicated by the
\nfact that the legacy of Cold War means that there is still excess
\ncapacity as defense budgets shrink and the international arms
\nmarket contracts.<\/p>\n
This overcapacity coexists with the problem of arms
\nsmuggling and the creation of unstructured black market. For
\nIndonesia, the overcapacity in the international arms market
\nprovides an opportunity to diversify its arms suppliers.
\nHowever, this creates new problems since the diversification of
\narms suppliers heightens the difficulty of ensuring integrated
\nweapons systems.<\/p>\n
The last explanation is more related to political factors than
\neconomic principles. This industry is still subject to excessive
\nregulation. To exercise effective civilian control over
\nthe military, the ministry has constructed a labyrinth of
\nbureaucratic process to regulate and oversee defense contractors.<\/p>\n
This massive amount of government interference makes it almost
\nimpossible for any firm in the defense industry to achieve
\noutcomes that are similar to those produced by the operation of
\nthe free market.<\/p>\n
In the case of defense industry development in Indonesia, one
\ncan easily make the case that it is politics that has driven the
\neconomics when it comes to the macro decisions of whether to
\nembark on a course of defense industrialization. Defense firms in
\nIndonesia are political and mercantilist industries.<\/p>\n
The state plays an important interventionist role to secure
\nand expand on its objectives of ensuring political, military, and
\neconomic security. Accordingly, decisions on defense production
\nand procurement do not necessarily have to make economic sense
\nwhen political and strategic imperatives are higher priorities.<\/p>\n
If Indonesia is to decide that inefficient firms in the
\ndefense industry must be kept operating for allegedly strategic
\ngoals, the government must be willing to allocated sufficient
\nfunding to achieve the optimum production of defense equipment.<\/p>\n
The writer is lecturer at School of Social and Political
\nScience, University of Indonesia. He can be reached at
\nandi_widjajanto@yahoo.com.<\/p>",
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