Jean Tirole’s award in economics reminds us that defense procurement is a deeply challenging business problem.
For me, it’s a great week when a procurement theorist wins a Nobel Prize. Fairly, Jean Tirole of the University of Toulouse won the 2014 Prize in Economic Sciences mostly for his extensive and wide-ranging work in regulatory affairs. He is, for that matter, the first to win in that field since George Stigler of the University of Chicago, way back in 1982. But his work on organizational purchasing as a principle-agent problem is most revealing for anyone interested in defense. (His 1993 book from the MIT Press with Jean-Jacques Laffront, A Theory of Incentives in Regulation and Procurement, is a good place to start.) On Monday, Tyler Cowen of George Mason University wrote about Tirole’s work on the essential incompleteness of contracts, and thus, their inherent re-negotiability:
Let’s say a regulator and a monopolist agree to a scheme of regulation and provision, creating some surplus for both parties. As time passes, will each side of that bargain stick with the original agreement? A simple example here is the defense contractor. After a procurement contract is written, sometimes the supplier has the incentive to conduct a hold-up, to report that costs are higher than expected, and to ask for more money in return for timely fulfillment of the contract. Of course this is a contract breach, but if no other supplier can step in and do the job, it may be optimal for the government to give in to these demands to some degree. The question then is: how should the contract best be designed in advance, so as to prevent this problem from popping up later on? Or should the renegotiation simply be allowed? Anyone wishing to tackle these questions likely would start with the papers of Tirole on this topic. For one thing, these papers help explain why a second-best optimal contract may offer some rents to agents and appear to give the agent “too good a deal.”
Note that Tirole didn’t just write the narrative; he did the math. Cowen describes the work better than I, but I must add a defense of defense. Contrary to theories of conspiracy, contractors don’t invariably begin with future plans for bilking governments. Designing and building complex weapons is an inherently risky and information-deprived business. The contractors’ contract breaches are not always intentional. Limiting the fiascos is then more a matter of aligning the incentives for producing that information than a simple issue of finding fraud. Napoleon once remarked that battlefield tactics featured problems worthy of a Newton or a Leibnitz. Tirole’s Nobel reminds us that procuring the systems that make those fights possible can be deeply challenging managerial problems, for both buyers and sellers.
James Hasik is a non-resident senior fellow at the Brent Scowcroft Center on International Security.