Francois Melese

Applying Insights from Transaction Cost Economics to Improve Cost Estimates for Public Sector Purchases: The Case of U.S. Military Acquisition

ABSTRACT This article uses Transaction Cost Economics (TCE) to help characterize, explain, and ultimately reduce the cost growth that plagues many of todays major investments in military capabilities. There is mounting evidence of a systematic bias in initial cost estimates of new weapon systems purchased by the U.S. military. Unrealistically low cost estimates result in cost overruns. Fixing cost overruns can substantially impact public budgets and military readiness. Cost estimates serve a dual function: first, as an integral part of the decision-making process to evaluate military purchases/investments, and second, as a baseline for future defense budgets. In the first case, underestimating costs can result in too many new weapon program starts and excessive investments in those systems. In the second case, unrealistically low cost estimates result in overly optimistic budgets. Budgets planned on the basis of optimistic cost estimates create the illusion of more resources available than actually exist. Two factors are often blamed for unrealistically low cost estimates: bad incentives (psychological and political-economic explanations), and bad forecasts (methodological explanations). While briefly exploring the former, the focus of this study is on cost estimating methodology. Conventional public cost estimating techniques focus on the production costs of public purchases (input costs, learning curves, economies of scale and scope, etc.). The goal of this article is to improve cost estimates by expanding conventional cost estimating methodology to include TCE considerations. The primary insight of TCE is that correctly forecasting economic production costs of government purchases or acquisitions is necessary, but not sufficient. TCE emphasizes another set of costs—coordination and motivation costs (search and information costs; decision, contracting, and incentive costs; measurement, monitoring, and enforcement costs, etc.). This study encourages public officials and cost analysts to capture these costs and to understand key characteristics of public-private transactions (uncertainty, complexity, frequency, asset specificity, and market contestability) to generate more complete and reliable cost estimates and improve public sector purchases.

A Multiattribute Sealed-Bid Procurement Auction with Multiple Budgets for Government Vendor Selection

This paper offers a new approach to government vendor selection decisions in major public procurements. A key challenge is for government purchasing agents to select vendors that deliver the best combination of desired nonprice attributes at realistic funding levels. The mechanism proposed in this paper is a multiattribute first-price, sealed-bid procurement auction. It extends traditional price-only auctions to those in which competition takes place exclusively over attribute bundles. The model is a multiattribute auction in which a set of possible budget levels is specified. This model reveals the benefits of defining a procurement alternative in terms of its value to the buyer over a range of possible expenditures, rather than as a single point in budget-value space. This new approach leads to some interesting results. In particular, it suggests that in a fiscally constrained environment, the traditional approach of eliminating dominated alternatives could lead to suboptimal decisions. Finally, an extension of the model explicitly examines the buyers decision problem under budget uncertainty by applying a utility function assessed over the value measure.

Defense Acquisition: New Insights from Transaction Cost Economics∗

* We are grateful to the editors of this journal, participants at the RAND sessions of theWestern Economic Association meetings, and colleagues at the Naval Postgraduate School for many helpful comments and suggestions.We would specifically like to thank our colleagues Dr Keith Snyder, John Dillard and Admiral James Greene of the Graduate School of Business and Public Policy for research sponsorship and for organizing a yearly Acquisition Research Symposium where we were invited to present this work. The usual disclaimers apply.

Exploring the structure of terrorists' WMD decisions: A game theory approach

One relatively recent, and especially ominous, development in global terrorism is the threat of weapons of mass destruction (WMD) unleashed against target populations. While terrorist groups have long known about WMD, in 1995 the Japanese group Aum Shinrikyo first used chemical weapons in an attack. Since then, there appears to have been a disturbing trend towards fewer but more deadly terrorist incidents. The growing consensus among experts in the field is that this could well represent a long-term change in the nature of terrorist methods and behavior. This paper explores the structure of the WMD decision by terrorist organizations. The working hypothesis is that understanding the attractiveness of WMD depends on two key factors: the type of terrorist organization (“political” or “fanatic”), and the relative cost and benefits of their obtaining and using WMD. The cost partly depends on the “macrotechnology of conflict”, or the characteristics of counter-measures adopted by potential terrorist targets (“defensive” or “disruptive”). An assessment of the benefits by a terrorist organization contemplating WMD is likely to include both how effective WMD is in attacking a target, and how impressive the results would be in terms of influencing an audience. A key to solving the mystery surrounding a terrorist group’s decision to adopt WMD is to understand the strategic interaction between terrorists, their targets and their audience. The terrorists’ decision to use WMD is explored using simple game theory tools. Sandler and Arce, among others, point out that highlighting the interaction between terrorists and their opponents is one of the major strengths of game theoretic methods. Defense & Security Analysis Vol. 20, No. 4, pp. 355–372, December 2004

Benefits and pay: The economics of military compensation∗

This paper develops a simple analytical framework which captures the economic impact of benefits on both employer and employee decision‐making. It is within this framework that the role of benefits in the military compensation equation is explored. It is demonstrated that employer and employee decisions concerning an appropriate wage‐benefit mix can have significant and predictable impacts on hiring, retention, labor costs and the characteristics of individuals that make up the armed forces.

Can Afghanistan avoid the Natural Resource Curse

Recent discoveries of significant mineral deposits offer Afghanistan the opportunity to attain a level of economic development sufficient to stabilize that countrys volatile security situation while providing Afghans with a reasonable standard of living. Much, however, depends on whether Afghanistan can avoid the “Natural Resource Curse,” an inter-related set of economic and social pathologies that often bedevil resource-endowed countries. In this article, the authors describe the Natural Resource Curse, evaluate the obstacles it raises for Afghan economic development, and offer a strategy to minimize the risks Afghanistan faces in its efforts to exploit its mineral wealth for the benefit of the population.

A Brinkmanship Game Theory Model of Terrorism

This study reveals conditions under which a world leader might credibly issue a brinkmanship threat of preemptive action to deter sovereign states or transnational terrorist organizations from acquiring weapons of mass destruction (WMD). The model consists of two players: the United Nations (UN) “Principal,” and a terrorist organization “Agent.” The challenge in issuing a brinkmanship threat is that it needs to be sufficiently unpleasant to deter terrorists from acquiring WMD, while not being so repugnant to those that must carry it out that they would refuse to do so. Two “credibility constraints” are derived. The first relates to the unknown terrorist type (Hard or Soft), and the second to acceptable risks (“blowback”) to the World community. Graphing the incentive-compatible Nash equilibrium solutions reveals when a brinkmanship threat is credible, and when it is not – either too weak to be effective, or unacceptably dangerous to the World community.

Tit-for-Tat, Tariffs, and Time: A Dynamic Model of Trade Policy

The objective of this study is to examine the impact of a global protectionist response to a small countrys tariff setting behavior. It is assumed that the small countrys government seeks to maximize tariff revenues for the purpose of generating funds that can be used to subsidize an interest group in return for its political support. The main result is that if a small country were to seek to raise revenues from a tariff in an environment initially characterized by free trade, while it might be optimal for the country to levy a positive tariff initially, a “tit-for-tat” type response by trading partners would drive tariff levels down over time.

Economic and Security Implications of Afghanistan's Newly Discovered Mineral Wealth

The USDepartment of Defense (DoD) recently held a special “on the record” briefing for reporters that focused on economic challenges and opportunities in Afghanistan. While the briefing touched upon many of the structural challenges facing the Afghan economy, the real emphasis was to outline findings by the US Geological Survey (USGS) on vast mineral deposits discovered in Afghanistan. The USGS’s headline numbers, widely reported in the media, are startling. The value of natural resource deposits identified in Afghanistan was estimated to be

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1.13 trillion at current prices: