The inherent inefficiency of the defense 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systems still normally involves inflated costs, runs years behind schedule, and often produces technology that is out of date when the systems are finally fielded.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.