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Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich Tigers on the Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich Tigers on the Retreat* How the Swiss search for a successor to its outdated F-5 fighters resulted in a contract design capable of overcoming information asymmetries ? 14 th Annual International Conference on Economics & Security Izmir, 18 th 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, 1 1 Markus Rickenbacher, Simone Rossi and Maximilian Zangger

The two fighter aircraft employed by the Swiss Air Force Schweizer Armee Höhere Kaderausbildung The two fighter aircraft employed by the Swiss Air Force Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich F 18 C/D (in service since 1996) F 5 II (in service since 1979) 2

Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich What has happened Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich What has happened so far … (Part 1) Te The search for the successor started in earnest in late 2007. st ? Rafale tri als in th Gripen e se c on d ha l fo f 2 Typhoon 00 8 Eurofighter 3

What has happened so far … (Part 2) Schweizer Armee Höhere Kaderausbildung der Armee What has happened so far … (Part 2) Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 15 th 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 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie The actual motive behind the request’s design Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich The Political Background to Swiss Arms Deals The notorious Mirage III “S” deal of the 1960 s 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

A double dividend? Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich A double dividend? Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 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 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an The lever of the contract design Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 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

The model: Total costs • There is only one supplier. • Schweizer Armee Höhere The model: Total costs • There is only one supplier. • Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich Total costs (TC) of the Swiss lot, x. S: a 0 = „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 x. S include “sufficient” compensation for business risk etc. 8

The model: Incorporating the present value of future deals • There is only one The model: Incorporating the present value of future deals • There is only one supplier. • Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich Present value of future profit is: x. S = „Swiss lot“ z = „Profit Exponent“ with Future profit increases with the number of aircraft sold to Switzerland. Why? Concavity of the profit function. 9

Modeling the information asymmetry between supplier & procurement agency Schweizer Armee Höhere Kaderausbildung der Modeling the information asymmetry between supplier & procurement agency Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 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 a 0 is limited to: 10

Shirking by the Supplier Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Shirking by the Supplier Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 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 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich Supplier’s total profit Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 12

A numerical example – Part 1 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an A numerical example – Part 1 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 13

A numerical example – Part 2 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an A numerical example – Part 2 Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich 14

Results and further research Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Results and further research Schweizer Armee Höhere Kaderausbildung der Armee Militärakademie an der ETH Zürich • 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