Pentagon pricing policy should aim for long-term value, not an economically intractable concept.
Shay Assad, the Pentagon’s director of pricing policy, has had over his tenure a tense relationship with industry. At a private meeting at the Aerospace Industries Association last week, and in an interview with Reuters this week, Assad insisted that his accountants haven’t been always and everywhere “asking for certified cost data. We just want to pay a fair price.” But what does he mean by fair? Might not long-term best value be a more suitable objective? Getting this right is not just a matter of treating taxpayers fairly, but of acquiring the best equipment and services possible for the military.
To start, fairness in procurement is applied not just to price, but to process, in the pursuit of the government’s business by prospective contractors. Indeed, the Defense Business Board’s study Innovation: Attracting and Retaining the Best of the Private Sector (July 2014) found the Pentagon’s procurement approach “anchored in a concept of fairness, and the importance of creating a competitive playing field that disadvantages no prospective bidder” (p. 16). That absolutely discourages innovators from bringing ideas to the US armed forces in advance of their promulgating requirements—why would I want to alert my future competitors to what I’m prototyping today? This insistence on a fair process, which is culturally hard-wired into the bureaucrats, could subsequently produce fair prices—if we could agree on a definition for those.
So, in the government’s concept, just what does fair mean? Appropriate? Legitimate? On an even playing field? Not actually over the foul line? Venture capitalist Peter Thiel often asks job candidates to tell him something they know to be true, but which most people don’t grasp. Here’s mine: fairness is not an economically tractable concept. As Stanley Jevons, Léon Walras, and Carl Menger all explained over a century ago, value is subjective. How then can one articulate an objective theory of how value should be shared? Back in 1998, in a course at the University of Chicago, I heard Toby Stuart (now of the Haas School at the University of California at Berkeley) propound that issue of subjectivity. After years of reflection, he had come to the conclusion that the best definition of fair was “I like it”. People will agree that something is fair is it’s good for them.
I am always amused by this insistence in procurement offices on fair pricing and fair processes. Troops in the field frequently profess no interest in a fair fight. Rather, they want weapons that will let them dominate their enemies in an unfair fight. That seems contradictory: why buy fairly when you have no intent of fighting fairly? Perhaps that’s because even Assad would agree that contractors are not actually the enemy, but creative tension still seems closer to the intent. His approach, as espoused by the Carter-Kendall idea of ‘Better Buying Power‘, leverages the government’s monopsony power—or at least its market power with commercial items—to extract more producer surplus. Fair prices, in this concept, are really just lower prices.
But “The Monopsonist’s Dilemma,” as my colleague Steve Grundman wrote (October 2010) at the first promulgation of BBP, is knowing how to extract that value while keeping an eye on the long term. As Thiel related yesterday in a discussion of “The Future of Innovation” at George Mason University, making shiny new things is not about finding equilibrium and pricing at long-term average unit cost. Those are textbook conditions, as Israel Kirzner wrote in Competition and Entrepreneurship, “in which all competitive behavior has by definition been ruled out.” (1973, p. 108). Competition, that is, can produce more than lower prices. When competitors strive for higher margins, the results can be higher quality and new products. The problem is that the cultural focus on fairness often prevents the government from buying the right kit from the right supplier at the right price, just because everybody has to be given a fair chance to try for that fair price. But in building the best military you can for decades to come, it will sometimes make sense later to have paid more now.
James Hasík is a senior fellow at the Brent Scowcroft Center on International Security.