Tigers%20on%20the%20Retreat*

1
Tigers on the Retreat
How the Swiss search for a successor to its
outdated F-5 fightersresulted in a contract
designcapable of overcoming information
asymmetries
?

• 14th Annual International Conference on Economics
  SecurityIzmir, 18th June 2010
• PD Dr. Peter T. Baltes, Swiss Military Academy at
  the ETH Zurich

For their kind help the author thanksJakob
Baumann, Cornelia Cosma, Werner Epper, Walter
Furter, Odilo Gwerder, Daniel Lätsch, Markus
Rickenbacher, Simone Rossi and Maximilian Zangger
2
The two fighter aircraftemployed by the Swiss
Air Force
F 18 C/D(in service since 1996)
F 5 II (in service since 1979)
3
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
4
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?
5
The actual motivebehind the requests design
The Political Background to Swiss Arms Deals
The notorious Mirage III S dealof 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
6
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 inducethe
supplier to refrain from shirking.
7
The lever of the contract design
Suppliers 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 interrelatedSwiss 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 modelTotal 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.

9
The modelIncorporating the present valueof
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.
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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

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Shirking by the Supplier
The suppliers 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.
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Suppliers total profit
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A numerical example Part 1
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A numerical example Part 2
15
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 shirkin 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 researchBudget is a strategic variable
  to shift the decision from Shirking to No
  shirking.