The Effect of Military Downsizing On The Defense Industry - What Is The Microeconomic Impact And What Can The Firm Do?

Research Paper for ECON 6000, Microeconomics

Submitted to Dr Peter Sassone

By Verner M. Kiernan

December 2, 1994

The defense industry has been through many cycles of highs and lows, usually corresponding to times of conflict since the start of World War II. However recently, the industry has gone through a swing from one of its highest levels to one of its lowest, due primarily to political and economic reasons. During the Reagan era, the military experienced a missive buildup, resulting in prosperity for the defense industry. While other types of industries were cutting back, defense spending increased by 55% in the early 80s.(Ellis, p.64) The figure peaked in 1985 with a defense budget of $375 billion (1993 dollars).(Dyer, p.20) However, further economic hard times, attempts to reduce the federal budget, and the end of the cold war have signaled the end of such good times for the industry. Now, as well as for the past few years, the emphasis is on defense spending cuts. By 1989, military spending had already fallen to $329 billion, and by 1997 it is expected to be at $200 billion and predicted to go down to $170 billion by the year 2001 (all 1991 dollars). These figures represent the lowest level in 40 years.(Atkinson, p.108) Murray Weidenbaum summed up the situation by writing "the military market is not about to disappear, but a period of severe belt tightening has arrived."(Weidenbaum, p.29) In the face of such austere numbers, defense firms are left in a perilous position. These firms cannot survive without change of some sort, either in their organizational structure, operations, or in where and how they market and sell their goods. In fact, the industry has already begun to change and all defense firms are looking at ways to make the best out of this seemingly bad situation. This paper will explore the environment that the defense firms operate in and the impact of the severe spending cuts in terms of options available to them, problems associated with change, and what some firms are doing.

In order to understand the dilemma facing firms in the defense industry, it is first important to understand their role in a economic sense. From a microeconomic perspective, they make up a unique situation that is not easily explained by any one model. The defense industry is comprised of manufacturers of military-related items such as high-performance aircraft, ships and submarines, missiles, communications equipment, tanks, artillery, munitions, and weapons components. While there are numerous small companies that support the industry, it is in effect dominated by a handful of large firms. The seven major players and the percentage of their sales that depended on the military (as of 1989) are Boeing-20%, General Dynamics-87%, Grumman-70%, Lockheed-91%, McDonnel Douglass-60%, Martin-Marietta-75%, and Rockwell-25%.((Weidenbaum, p.29) A firm that is responsible for delivering the overall product is known as a 'prime contractor' even though it may subcontract much of the work. As an example, Boeing has been known to outsource 65% of the cost of its planes.(Dyer, p.24) Each of these firms act as prime contractors for some projects as well as subcontractors for others, and in fact many times they depend on each other.

In effect, these firms constitute an oligopoly. This market fits the definition of a small number of firms who have a great deal of interdependence. As it is, there are several models to describe oligopolistic markets, however, this situation deviates from them in two major aspects. There is no competition for buyers and the demand is not set by price, but is dictated by the government. The result is that "the Pentagon is a monopsonist - a single buyer in a guaranteed market - largely unconcerned about price or profit."(Glasmeier, p.103) These firms compete to land contracts for military equipment, but once it has been awarded, there is no longer any competition from the losers. "The demand for military goods and services, therefore, is highly price-inelastic, resulting in enormous cost-overruns extending to the point of price gouging. Rather than emphasize cost savings, military-related firms, which constitute a powerful oligopoly, rely on political lobbying to maximize their profits."(Glasmeier, p.103) That means that the demand curve for a product is essential a vertical line, intercepting the x-axis at the quantity that Congress authorizes. To further complicate the model, as in a monopoly, there would seem to be no supply curve since one firm becomes the sole supplier of the contract it wins. However, the firm does not have the ability to set production at the point which maximizes its profit (where marginal revenue equals marginal cost) and charge the appropriate price since the quantity, as noted earlier, has been dictated by Congressional appropriation. Many would argue that they more than make up for this lack of control by charging what seem to be exorbitant prices for military equipment. One analyst summed it up in stating "the absence of competition tends to drive up prices in any market, including that for tanks or jet fighters."(Stokes, p.9)

These defense firms are burdened by the fact that they have no control over the actions of Congress (other than intensive lobbying and politics, which plays a substantial role). Therefore they cannot control their own destiny, at least in the short run. For example, when Congress decided to cut the B-1 bomber program, it deprived Rockwell of expected future earnings and a use for its facilities. In this case, Rockwell was able to adapt by using the B-1 hangars to repair and service commercial aircraft, and currently has contracts with Federal Express and Japan Air Lines.(Ellis, p.70) When McDonnell Douglas constructed its facility to build the F-18 fighter jet for the Navy, it was designed for a capacity of 318 planes. However, in 1993, plans only called for 36 planes.(Stokes, p.9) Obviously, these companies realize that they are in jeopardy, and that the cutbacks will continue. The response is predictable - "the typical reaction path for a company threatened with military cutbacks if first to lobby against the cuts, then to lay off labor, and then to try to diversify into other military-related work. Only after these steps have been tried is the firm likely to sell its military subsidiaries or diversify into civilian work."(Brauer, p.159)

One strategy not included in the previous quote that should be addressed is expansion into foreign markets. This option relaxes the constraint of the U.S. government being a monopsonist, and is very attractive to defense firms because they can use the fixed assets that they already have. There is still politics involved, since Congress must approve any foreign arms sales of high-tech weaponry, but they are very anxious to promote U.S. superiority and to assist the industry. Lobbyists in this area have been very successful at linking foreign sales to protecting jobs at home and improving the domestic economy.(Stone, p.16) It is ironic that even though the United States speaks of disarmament and reducing weapons proliferation, one means of keeping its own important defense industry intact is to promote it.

The fact is that foreign arms sales is one area in which the U.S. weapons makers have an advantage. Many other American industries seem to be loosing in the competition for market share here in the United States, much less on an international scale. However, when it comes to defense-related products, the U.S. firms dominate the market. The breakup of the Soviet Union has also served to enhance their position, since they were the major international competitor. The statistics support the claim to dominance. In 1989, U.S. firms held 25% of the developing world's market for weapons. By 1991, that figure had risen to 57%. By the end of the decade, it is expected that U.S. firms combined will have monopolistic power over this market.(Stokes, p.9) By exploiting this international market, U.S. firms are attempting to shift the demand curve to the right. Because there are other foreign suppliers, price does start to play a role, but still not as in a perfectly competitive market.

As a result of supplementing domestic sales with foreign deals, the defense firms reap several benefits. Most obviously, they increase overall sales and can earn a greater profit since they can better cover their fixed costs. In doing so, they can achieve better economies of scale. As a case in point, McDonnell Douglas claims that the Navy saved $2 million each on the purchase of 871 F/A-18 fighters because it also sold 325 overseas.(Morrison, p.18) Even though foreign sales have been a boon to the industry, it is still not enough to sustain the industry. Richard F. Grimmett, an arms transfer specialist with the Congressional Research Service, made the comparison that "foreign sales used to be the icing on the cake. Now the cake is foreign sales. And there is not going to be enough cake to go around."(Morrison, p.15) Thus the industry is still must adapt in other ways to the effect of the peace dividend.

It becomes readily apparent that in the current environment, there can be no equilibrium point with the current number of defense-related firms. This fact is plainly obvious in the aerospace side of the market. The seven companies mentioned earlier as well as Northrop all can build military aircraft. However, there is not room for all of them. There simply aren't enough military aircraft being designed and built to justify a place in the market for each of them. Some analysts predict that by the year 2000, only three or four producers of military aircraft will still remain, and of the top 100 defense companies, only 75% to 80% will be around.(Perry, p.94) This reduction will come as a result of the fact that firms will leave the industry in the long-run because it simply is not profitable to stay in. Consequently, a new equilibrium number of firms will be established.

The obvious question is "what happens to the firms that leave the industry?" In reality, it is not very plausible that firms which depend heavily on defense dollars will abandon military contracts completely and be successful. There actually are actual and perceived barriers to firms that try to leave the industry to compete in the civilian market. These "barriers include excessively large but government required specialized capital equipment unsuitable for alternative employment; specialized labor forces working with disregard for cost minimization; lobbying rather than marketing staffs [and] lack of knowledge on how to scout commercial markets and locate potential customers." Furthermore, many lending institutions will not agree to lend money to companies without a successful track record in the civilian market.(Brauer, p.149) In general, a firm would not be just producing one product instead of another. Rather, a complete transition would mean moving from one type of market structure to another, which it is not well- equipped to handle. Stated plainly, "the fact that it is accustomed to a single client ordering a highly specialized product has made the defense industry reluctant, and ill-paced, to compete in civilian markets."(Richards, p.279)

There is no model available to predict what companies can make a successful transition to civilian production. In fact, the history of defense firms branching out into totally unrelated fields is not good. Grumman attempted it with buses, Teledyne Ryan Aeronautical tried its luck at making coffins, and General Dynamics ventured into the mining business by producing coal slurry. Each of these met with very poor results. On the other hand, the key to success is to take advantage of current competencies and gradually move into the civilian market by offering products which capitalize on them. A good example of this idea is Hughes Electronics developing a miniature receiving dish for home use with a satellite television network.(Perry, p.98) Historically, the best example of such diversification is in the civilian aircraft market. Boeing and McDonnell Douglas both have developed strong positions in this market. (Originally there were others, like Lockheed, that have since abandoned their attempts.) In fact in 1971, Boeing decided that it needed to significantly reduce its dependence on the Pentagon. As a result, it downsized by laying off over half of its workforce and significantly reducing the number of military contracts in favor of civilian production.(Weidenbaum, p.33) The gamble paid off for them, as they now have the largest international market share of the civilian aircraft business.

A more likely response to the posed question is acquisitions and mergers. Weidenbaum contends that "the sooner the major contractors reduce their excess capacity through restructuring, mergers, sales of assets, or simply closing down unneeded facilities, the greater will be their ability to withstand the competitive rigors of the new military environment."(Weidenbaum, p.32) This reasoning actually has the effect of downsizing to some firms, and possibly of expanding to others, both of which are hopefully profitable for each party. To illustrate this point, General Dynamics produced the F-16 at its plant in Fort Worth, Texas. They also have other substantial contracts for items such as submarines for the Navy and the Army's M1 main battle tank. CEO William Anders attempted to strengthen the company and improve the position of the stockholders by selling its fighter division to Lockheed and repurchasing $1 billion worth of General Dynamics stock. In doing so, he narrowed the focus of the company, cut its operating costs, and saw its stock rise from $25 to nearly $110. On the other hand, a firm can hope to increase its share of the dwindling market by getting bigger. This tactic would have the effect of lowering overhead costs per unit of output and enabling the company to be more viable in the future. Recent (1992) examples of this strategy are Martin-Marietta's purchase of General Electric's aerospace division and General Motors' Hughes Electronics buying General Dynamics' missile unit, consisting of four missile plants, the operations of which it will consolidate with its own single missile facility.(Perry, p.95) Even so, it can be seen that plant closings will still be necessary as a means of cutting costs, as evidenced by the closing of these four separate former General Dynamics plants and the much publicized closing of Lockheed's original facility in Burbank, California, in favor of relocating these operations to its Marietta, Georgia location.

Regardless of other measures taken to counter the effects of the cutbacks, defense firms will have to make improvements in the long run. For starters, the prime contractors will begin to do a larger part of the work themselves. In addition, even though there will be less competition for contracts (since there will be fewer firms) and there still will be a sole U.S. buyer, the companies must begin to consider manufacturing time and cost in the same sense that their civilian counterparts do. Currently, the average time for a major weapons system to move from a conceptual phase to initial deployment is in the range of 16 years. With the current pace of technology, these systems will be obsolete prior to being fielded, or the design is upgraded at considerable cost. The industry will benefit enormously with a move towards concurrent engineering, where the design can be modified rather easily. Firms should also take advantage of products that are available on the civilian market. Many times a defense contractor will reinvent some component that can readily be obtained already and at a significant savings. This is especially true of electronic systems.(Gansler, pp.24-26)

As demand for their products continue to decrease, defense firms must understand that the norm will be limited production of customized items rather than long production runs as in the past. In order to meet this need they will have to undergo "conversion from rigid, hard-tool production lines to soft-tool, flexible machines and agile teams that can build more than one thing without facility changes."(Perry, p.99) These concepts, formally known as flexible manufacturing or dual-use manufacturing, are all an attempt to reduce the fixed costs of manufacturing while allowing more diversity in their products. Some defense contractors already employ these techniques in the production of military items. LTV has a flexible manufacturing line which produces parts for Boeing's 747, 757, and 767 civilian aircraft as well as the Air Force's B-2, and C-17.(Dyer, p.24) Likewise, Essex Industries has a facility in Saint Louis that produces stick grips for the F-15 fighter as well as medical valves and fuel system components for high-performance vehicles.(Perry, p.99) On an even larger scale, Boeing itself can be viewed as a dual-use success in the adaption of its aircraft production lines.

The future may also bring more joint ventures between contractors. This has been a trend due to the substantial costs of developing a design and putting it into production. It costs up to $2 billion to develop an advanced aircraft engine, and the next generation aircraft will cost about $20 billion in development costs. Boeing has already realized the utility of cooperation by entering partnerships with Deutsche Aerospace and other European Airbus affiliates.(Dyer, p.24) Specifically for defense, General Dynamics, Lockheed, and Boeing are teaming as joint developers of the new F-22 fighter for the Air Force.

As another point of view, some analysts think that the best way to achieve a new equilibrium is to leave the market alone to run its course without excessive interference from the government. This may include loosening some of the anti-trust restrictions which govern restructuring and consolidations. In doing so, it may turn out that due to the high development costs, a natural monopoly could emerge for some of the more expensive items such as aircraft and combat vehicles. As one author put it, "the best way to protect the public interest may not be by forcing competition but by finding other ways of ensuring efficiency by a single producer."(Stokes, p.11) The government could also assist the firms by removing the seemingly needless administrative requirements that in reality are nothing more than bureaucratic hassles. Compliance with all of the policies of the Department of Defense only serves to creates a burden on the firm, resulting in even more time wasted and overhead costs which further divide them from civilian counterparts.

The severity of the cuts in defense spending unquestionably has had a profound impact on the defense industry. At the present time, there does not seem to be an upside to this problem. Even in the 1995 budget, defense was one of the big losers. As the appropriation committees were determining what cuts had to be made in the budget, Senator Sam Nunn, the Armed Services Chairman, predicted that 60% of them would come from the defense portion. This fact could further be a harbinger of bad news for the industry since the current year usually serves as a benchmark for future budgets.(Hager, p.724)

For the time being, as the military drawdown is in full swing, individual firms find themselves in a wide variety of positions. There are some that diversified enough to not experience any major setbacks. But unfortunately, those that specialize solely in strategic weapons may discover that they are in a poor position to withstand the market forces or to make the changes necessary to continue profitable operations. Nonetheless, there are options available. As has been shown , "corporations can pursue a wide array and mix of strategies, among them diversification, acquisition and merger, teaming and strategic partnering, expansion to related and foreign markets, consolidation and retrenchment, downsizing, focus on core strengths and outsourcing, and divestment."(Dyer, pp.22-23 As has been cited, changes such as these have already taken place and will certainly continue through the end of the decade. Although the firms and the market itself may not appear the same as they did in the pre-drawdown years, they will as a conglomerate withstand these changes just as it has for the past forty years.


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