Inefficiency in the arms industry

Inefficiency in the arms industry

Andi Widjajanto, Jakarta

Since Adam Smith first broached the subject, defense economics
has been concerned with the appropriate level and allocation of
defense expenditures to achieve an efficient production of
defense capability. Although many efforts have been made to adopt
best commercial-business practices in military procurement, only
limited progress has been made. The acquisition of weapons
systems still normally involves inflated costs, runs years behind
schedule, and often produces technology that is out of date when
the systems are finally fielded.

This essay will try to provide a brief explanation as to why
the defense industry will always be incapable of reaching the
level of efficiency enjoyed by other commercial practices. We
will need to apply a number of microeconomic principles in
analyzing the inherent nature of inefficiency in defense
industries.

The first micro-economic principle that can be used to explain
this is the market structure model. It is generally accepted that
economic efficiency can only be achieved is there is a free
market structure accompanied by free competition between a
sufficient number of suppliers, the existence of various channels
in which to sell products, and an adequate number of consumers.

This basic principle cannot be found in the defense sector. On
the supply side, the number of companies that are able to
constantly participate in developing defense-related products is
decreasing. After the economic crisis, only the Army industrial
weapons producer, PT PINDAD, still made a significant
contribution to defense procurement. State-owned shipbuilder PT
PAL and state-owned aerospace firm PT Dirgantara Indonesia are no
longer major players in defense procurement. As a result,
Indonesia's defense industry still depends on extensive imports
of components and technology, with a consequent reliance on arms
manufacturers in the industrialized countries.

This has one significant effect. Although the Ministry of
Defense uses competition as one of criteria in deciding on
defense contracts, most of these are not based on competition in
the commercial sense. In an oligopoly, genuine competition
between two or more producers is not possible in most cases.

The lack of competition in the defense industry is also
exemplified by the fact that the ministry intentionally takes
political steps to ensure that sufficient numbers of companies
remain in business. For example, during Megawati's administration
instead of buying eight corvettes from the Netherlands, the
ministry decided to award PT PAL a license deal which enabled the
firm to build four corvettes under Italian supervision and two
corvettes under Dutch supervision.

However, since a monopoly exists whenever a single firm
controls more than 70 percent of a market, the ministry's desire
to maintain competition will be hard to sustain. In an era of
consolidation in the defense industry, if we look closely at a
specific segment of the industry we will see the existence of a
monopolistic relationship.

In the demand side, the government is the single largest buyer
of domestically produced weaponry. This creates a monopoly market
structure.

When the Indonesian Military (TNI) decided it didn't need any
more CN-235-110s or Super Pumas, the market for PT Dirgantara
Indonesia collapsed. When the Navy increased its orders for KAL-
35 patrol boats and corvettes, the market for PT PAL expanded and
involved a significant shift in demand.

Production capacity is another microeconomic principle that
impinges on the efficiency of the defense industry. The biggest
problem of any component of the defense industry in maintaining
its optimum level of production. This is because most defense
firms are dependent on states' weapons spending. Since the
economic crisis, defense budgets in Indonesia have been falling
over the last couple of years.

For Indonesia, the defense budget in 2002 was 40 percent
smaller in real terms that it was in 1996. While budgets are
falling, the costs associated with producing advanced weapons
system are rising. This trend can also be found at the global
level.

According to SIPRI World Military Expenditure and Arms
Transfers (1990), in 1970, U.S. firms shipped 3,500 military
aircraft with a value of US$4 billion to their customers. In
1990, the number dropped to 900, but the value had increased
sharply to $22 billion.

The immediate result of this combination of decreasing budgets
(lower demand) and rising costs is that the average rate of
return is lower for the defense industry that for the market as a
whole. Logically, this will force many companies to decide not to
undertake any further defense work. To deal with this
predicament, governments usually protect firms in the industry by
providing subsidies that most commercial firms do not enjoy.

The production capacity problem is also complicated by the
fact that the legacy of Cold War means that there is still excess
capacity as defense budgets shrink and the international arms
market contracts.

This overcapacity coexists with the problem of arms
smuggling and the creation of unstructured black market. For
Indonesia, the overcapacity in the international arms market
provides an opportunity to diversify its arms suppliers.
However, this creates new problems since the diversification of
arms suppliers heightens the difficulty of ensuring integrated
weapons systems.

The last explanation is more related to political factors than
economic principles. This industry is still subject to excessive
regulation. To exercise effective civilian control over
the military, the ministry has constructed a labyrinth of
bureaucratic process to regulate and oversee defense contractors.

This massive amount of government interference makes it almost
impossible for any firm in the defense industry to achieve
outcomes that are similar to those produced by the operation of
the free market.

In the case of defense industry development in Indonesia, one
can easily make the case that it is politics that has driven the
economics when it comes to the macro decisions of whether to
embark on a course of defense industrialization. Defense firms in
Indonesia are political and mercantilist industries.

The state plays an important interventionist role to secure
and expand on its objectives of ensuring political, military, and
economic security. Accordingly, decisions on defense production
and procurement do not necessarily have to make economic sense
when political and strategic imperatives are higher priorities.

If Indonesia is to decide that inefficient firms in the
defense industry must be kept operating for allegedly strategic
goals, the government must be willing to allocated sufficient
funding to achieve the optimum production of defense equipment.

The writer is lecturer at School of Social and Political
Science, University of Indonesia. He can be reached at
andi_widjajanto@yahoo.com.