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When More is Less: Defense Profit Policy in a Competitive Environment

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  • Anthony G. Bower
  • Kent Osband

Abstract

Prices on some Department of Defense (DoD) procurement contracts are determined by competitive bids, while on others prices are negotiated on the basis of so-called "DoD profit policy," whereby price is equated to expected cost plus a percentage markup. This article focuses on the interaction between these two contractual arrangements. Specifically, it is assumed that an initial contract is let competitively, with common knowledge that the winner will later become a monopolist regulated according to profit policy. Under these conditions, it is shown that expected contractor profit and government expenditure can often be reduced by raising the profit policy markup. The intuition is not only that firms "buy in" to the initial contracts, but also that the differential subsidization induced by profit policy (higher-cost producers receive larger absolute markups) encourages more aggressive competition. Mathematically, this seemingly restrictive regulatory setup is shown to generalize the McAfee and McMillan (1986) procurement bidding model.

Suggested Citation

  • Anthony G. Bower & Kent Osband, 1991. "When More is Less: Defense Profit Policy in a Competitive Environment," RAND Journal of Economics, The RAND Corporation, vol. 22(1), pages 107-119, Spring.
    • Handle: RePEc:rje:randje:v:22:y:1991:i:spring:p:107-119
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    Cited by:

    1. William P. Rogerson, 1993. "Economic Incentives and the Defense Procurement Process," Discussion Papers 1078, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    2. Lansdowne, Z. F., 1996. "Extensions of bidding theory: Concealed bidding, optimal number of bidders, and follow-on contracts," Omega, Elsevier, vol. 24(1), pages 107-114, February.
    3. William P. Rogerson, 1994. "Economic Incentives and the Defense Procurement Process," Journal of Economic Perspectives, American Economic Association, vol. 8(4), pages 65-90, Fall.
    4. Antonio Fonfria & Paulina Correa-Burrows, 2010. "Effects Of Military Spending On The Profitability Of Spanish Defence Contractors," Defence and Peace Economics, Taylor & Francis Journals, vol. 21(2), pages 177-192.
    5. Pavlova, Natalia (Павлова, Наталья) & Morozov, Anton (Морозов, Антон), 2018. "Markets in the Field of the State Defense Order: Opportunities and Limitations for the Development of Competition [Рынки В Сфере Государственного Оборонного Заказа: Возможности И Ограничения Для Ра," Working Papers 061811, Russian Presidential Academy of National Economy and Public Administration.

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