Turbulence, Cost Escalation and Capital Intensity Bias in Defense Contracting

Abstract

The recent growth of defense expenditures has once more raised public concern about cost overruns on defense contractors. Economists have pointed out that cost overruns are not necessarily bad per se; instead, attention should be directed to the question as to whether the procurement policies of the Department of Defense (DoD) satisfy the criterion of economic efficiency (see Peck and Sherer (1962)). In connection with this, applications of the principal-agent model to defense contracting show that not only do cost plus fixed fee (CPFF) contracts create moral hazard problems, but that in fact so long as contractors are risk averse and perfect monitoring of their activities is not possible, inefficiencies will arise whatever the form of the contract employed in DoD procurement (see Ross (1973), Harris and Raviv (1979), and Weitzman (1980)). It has been suggested that improvements in efficiency might be achieved if contracts more closely resembling Arrow-Debreu contingent claims were employed (see Cummins (1977)), but this raises problems of manipulation of the probabilities of occurrence of the relevant states of the world. Looking at the problem of cost escalation from a completely different point of view, biases might be introduced into cost comparisons and into decision making with respect to risky projects simply because of the methodology by cost estimators (see Quirk and Terasawa (1983)).

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