PD Dr. Peter T. Baltes, Swiss Military Academy at the ETH Zurich Höhere Kaderausbildung der Armee, MILAK Vortragsthema Anlass Tigers on the Retreat* How the Swiss search for a successor to its outdated F-5 fighters resulted in a contract design capable of overcoming information asymmetries ? 14th Annual International Conference on Economics & Security Izmir,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, Markus Rickenbacher, Simone Rossi and Maximilian Zangger

The two fighter aircraft employed by the Swiss Air Force F 18 C/D (in service since 1996) F 5 II (in service since 1979)

What has happened so far … (Part 1) The search for the successor started in earnest in late 2007. Rafale ? Gripen Test trials in the second half of 2008 Typhoon Eurofighter

What has happened so far … (Part 2) 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? 4

The actual motive behind the request’s design 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 5

Complementing Interpretation ( The Economics of Information) A double dividend? 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. 6

The lever of the contract design Supplier‘s profit of the Swiss deal is made up of two components 1. „Instant“ profit of selling aircraft to Switzerland: 2. Present value of future profits ( selling the aircraft to other countries): 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. 7

There is only one supplier. The model: Total costs There is only one supplier. Total costs (TC) of the Swiss lot, xS: a0 = „Combat Multiplier“  Costs are positively related to the combat multiplier k = „Cost Exponent“ with  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. 8

The model: Incorporating the present value of future deals There is only one supplier. Present value of future profit is: xS = „Swiss lot“ z = „Profit Exponent“ with  Future profit increases with the number of aircraft sold to Switzerland. Why?  Concavity of the profit function. 9

Information Asymmetry Modeling the information asymmetry between supplier & procurement agency 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: 10

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. Supplier exaggerates the costs to extort some extra profit = Shirking. Supplier understates the costs = Foot in the door technique. 11

Supplier’s total profit 12

A numerical example – Part 1 13

A numerical example – Part 2 14

Results and further research 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”. 15