The economics of arms trade and arms control

1. The economics of arms trade and arms control Dr Maria Garcia-Alonso University of Kent Summer School, 2009

2. Some economists in the area • On arms trade: • Paul Dunne (UWE) • Keith Hartley (University of York) • Paul Levine (University of Surrey). • Ron Smith (Birckbeck College) • On terrorism: • Todd Sandler (University of Texas) and co-authors.

3. My objectives for the day • Get you interested in the economics of arms trade and conflict. • Give you the sources of information in case you want to know more. • Provide an example of how economic theory can be used to model and understand complex problems in simple way even when the topics at hand a bound to involve judgements of value we might not even be aware of!

4. Outline • 1. The arms trade facts: a bit of history. • The Cold War • The Post Cold War Era • 2. Regulation of arms trade in the UK. • 3. Arms trade data. • 4. A model of the arms trade. • 5. What can we learn from the arms trade literature? • 6. The New Post September 11th challenges and asymmetric conflict.

5. 1. A BIT OF ARMS TRADE HISTORY: THECOLD WAR • SECURITY PERCEPTION: • Arms race between main producer countries. • FIRMS OWNED BY STATE • EXPORTS TO ALLIES ONLY USSR US EXPORTS EXPORTS US ALLIES USSR ALIES

6. THE POST COLD WAR ERA • CHANGES IN SECURITY PERCEPTION: • Security (Domestic Procurement, Global Exports). • CHANGES IN INDUSTRY STRUCTURE: • Consolidation through 90s merger wave: • 5 largest firms now account for 44% of market. • More openness: joint venture, semi-open tenders. • More independence: no longer government controlled.

7. POST COLD WAR (cont) • BUT: • Maintaining domestic defence industry still seen as strategic: national champions. • Heavily regulated and supported. • Not so open (exemption to the General Procurement Agreement). • Not as concentrated as other industries of similar characteristics. • GOVERNMENTS FACE CONFLICTING INTERESTS: • security versus profits trade off when maximizing national welfare.

8. POST COLD WAR (cont) • EVOLUTION OF ASYMETRIC INFORMATION : • Nationally between governments and their national champions: • Efficiency levels? • Exported quality? • Target clients? • What use? • Internationally between governments and firms: • Quality? • Security concerns? • Target clients? • What use?

9. POST COLD WAR ARMS TRADE STRUCTURE RUSSIA US EXPORTS EXPORTS REST OF THE WORLD

10. 2. REGULATION OF AT IN UK • EXPORTS CREDIT GUARANTEES DEPARTMENT • http://www.ecgd.gov.uk/ • UKTI DEFENCE & SECURITY ORGANISATION (UKTI DSO) • formerly Defence Export Services Organisation. • belongs to UK Trade & Investment (UKTI): • http://www.dso.uktradeinvest.gov.uk/: works closely with industry and the MoD to promote UK equipments, products and services in the best possible way. • EXPORT CONTROL ORGANIZATION • belongs to BIS=BERR + DIUS • http://www.berr.gov.uk/whatwedo/europeandtrade/strategic-export-control/index.html Relevant policy papers: • Defence Industrial Strategy, DefenceWhite Paper, 2005. • Defence Industrial Policy, MOD policy papers , paper no 5. • Export Credits Guarantee Department: Annual Review and Resource Accounts.

11. EXPORT CONTROL REGIMES • Aimed at coordinating policies of supplier and recipient states • Acknowledge a need for coordination and harmonization of national controls. • Missile Technology Control Regime (MTCR). • Nuclear Suppliers Group (NSG) • Australia Group (chemical and biological weapons) • Wassenaar Arrangement on Export Controls for Conventional Arms and Dual-Use Goods and Technologies (includes most cold war adversaries). • EU’s Common Rules Governing Control of Exports of Military Technology and Equipment.

12. 3. ARMS TRADE DATA • Transparency in arms transfers: as of January 2008, 31 states had published at least 1 report on arms exports as opposed to 6 in1998. • Best data source is the Stockholm International Peace Research Institute (SIPRI) Arms Transfers Database (http://www.sipri.org/). • The volume of international arms transfers peaked in 1982. Following the end of the cold war there was a steady decline in global arms transfers; they reached their lowest point in 2002, when transfers amounted to only 38 percent of their cold war high. Since 2002 there has been a more steady increase in transfers.

13. RECENT EVOLUTION OF ARMS TRANSFERS (SIPRI Yearbook) Figure 1. The trend in transfers of major conventional weapons, 1999–2008 The bar graph shows annual totals and the line graph shows the five-year moving average, they give an idea of volume of transfer of major weapon systems. Source: SIPRI Arms Transfers Database, <http://armstrade.sipri.org>.

14. Top 5 suppliers of major conventional weapons and their largest recipients, 1999-2003

15. Top 5 suppliers of major conventional weapons and their largest recipients, 2004–2008

16. Top 5 recipients of major conventional weapons and their largest suppliers, 1999–2003

17. Top 5 recipients of major conventional weapons and their largest suppliers, 2003–2008

18. 4. A MODEL OF THE ARMS TRADE • Our objective now is to construct an economic model of the arms trade. • First thing to do is to choose sensible modelling assumptions to provide a good fit for the stylized facts we have already seen: • Agents?: Governments, firms... • Objectives? Welfare maximization (definition?), profit maximization (market structure?)...this will determine possible strategic interactions. • Choice variables?: Procurement levels, exports, quality, controls... • Timing? This will depend on commitment power, unless it is all clear go for simultaneous decision making. Equilibrium concept? • Uncertainty?

19. Security perceptions and gamesBasic equilibrium concepts • Nash Equilibrium: a set of strategies such that each strategy is the best response (payoff maximizing) to the other player’s strategy (suitable for simultaneous choice decisions/games). We solve finding the intersection points of best response functions. • Subgame Perfect Equilibrium - a set of strategies that satisfies both the Nash and credibility conditions (suitable for sequential decisions). We solve using backwards induction.

20. Security perceptions and gamesa. An arms race/ arms control game Country 2 Country 1

21. Security perceptions and gamesa. An arms race/ arms control game Country 2 Country 1

22. A continuous choice arms race: best response function and NE Country 2’arms Country 1’s best response function NE Country 1’s arms

23. Security perceptions and gamesb. Nuclear technology transfer game (both countries care equally about security) Country 2 Country 1

24. Security perceptions and gamesb. Nuclear technology transfer game (both countries care equally about security) Country 2 Country 1

25. Security perceptions and gamesc. Nuclear technology transfer game (only one country cares about security) Country 2 (does not care) Country 1

26. Security perceptions and gamesc. Nuclear technology transfer game (only one country cares about security) Country 2 (does not care) Country 1

27. Timing of events and SPNE Only one exporter • Government chooses exports subsidy to maximize welfare: Welfare (exports, subsidy). • Exporter chooses exports to maximize profits: Profit (exports, subsidy) SPE by backwards induction: (2) ∂ Profit/ ∂ domestic exports=0 (1) (∂W/ ∂ s)+ (∂W/ ∂exports) (∂exports/ ∂s)= 0

28. With two exporters and Cournot competition(best response functions and NE in second stage) Domestic firm’s best response function Exports foreign firm NE in second stage Exports domestic firm

29. An example of a formal model of AT • Public procurement with two way international trade. • Governments impact on market structure. • Firms are prices setters in the exports market. • Non producer countries involved in regional conflict. Model’s Objectives: • Impact of post-cold war changes on market structure.

30. Timing of decisions: • MoDin producer countries take domestic procurement decisions: quality, quantity, price and number of domestic varieties/firms, given the export control structure and their budget. • All firms set international prices in a monopolistic competition fashion. • Importer countries make imported procurement decisions. Non producers also make nonmilitary consumption decisions. The model is solved for the Subgame Perfect Equilibrium and calibrated using sensible data.

31. Producers: Security, budget constraint and profits.

32. Non producers involved in a regional arms race • Military Capability: • Ratio form Contest SuccessFunction: • Difference form CSF:

35. 5. WHAT CAN WE LEARN FROM THE LITERATURE?On the need for international coordination: • During the cold war arms race between main producers: an arms race is a Prisoner’s Dilemma Game, i.e., in the Nash Equilibrium countries end up stocking too many weapons, an agreement to reduce stockpiles would be a Pareto Improvement, however, both countries have incentives to unilaterally deviate from such agreement. • Modelling tools: • Game theory, both static and dynamic models. • Collective action problems: for allies weapons are seen as a public good.

36. On the need for international coordination (cont): • After cold war, even though there is not direct arms race between main exporters, there is still a “double” Prisoner’s Dilemma game. • Still, a trading country only considers the impact of exports on their own welfare (which now includes both security and export profits) and fails to consider the impact on the other countries’ welfare: negative externality. • Modelling tools: • New Trade theory: partial equilibrium models of oligopolistic international trade. • Procurement theory: to model the relationship between governments and national champions. • Subsidies: not just direct export subsidies, R&D subsidies and domestic procurement can act as indirect export subsidies.

37. On the need for international coordination (cont): • Arms exporters (and importers) would benefit from adhering to the Word Trade Organization agreement on export subsidies which prohibits the use of such policies. • Although WTOs motivation is rooted on the positive impact subsidy savings for governments, in the arms trade case, a free trade agreement would also be beneficial for security: • Higher export prices would lead to lower exports, and hence higher security and welfare for both exporters and importers (as regional arms races fuel imports). • A cartel of weapon suppliers or increase in concentration would have the same effect but, there is a danger in encouraging some countries to try to start home production. • Once quality is made endogenous in these models, there is a danger with cartels and mergers that more quality would be produced then, direct qualitative export controls become crucial, WTO is not enough!

38. On implementing export controls: • As Maggi (1999) notes multilateral institutions have an important role to play in: helping coordination; verifying violations of the agreement and inform third parties to facilitate enforcement; and promoting multilateral rule-making procedure in place of a web of bilateral negotiations. • Easier with less players • Certainty • Transparency helps • Credible punishments are crucial • Export subsidies increase the likelihood of defection from Export Control Agreements as a given deviation results in higher increases in profits.

39. On asymmetric information: • Between governments: it makes it more difficult to implement multilateral export control agreements. • Between domestic government and it national champion over efficiency: will cause a decrease in exports as it will be more difficult to provide incentives for firms to behave efficiently, hence higher prices leading to lower level of exports. • By importers of the quality of imported weapons or future replacement needs, it will reduce imports demand.

40. 6. THE NEW POST SEPTEMBER 11TH CHALLENGES AND ASYMMETRIC CONFLICT • Uncertain enemy • Export controls on dual use technologies become ever more relevant. • Other “players” perceptions of security often unknown. • Asymmetric Payoffs for similar outcomes. • Asymmetric warfare. • Literature results: • traditional warfare escalation may be counter productive. • An increase in defence mechanisms against specific technology may just trigger a technological change by the opponent • An increase in defence by a specific potential target may just encourage substitution for another softer target.

41. A game of alternative terrorist targets and preemption fail fate succeed Target 1 terrorists fail Protection investment Target 2 fate succeed targets fail fate succeed Target 1 terrorists fail Target 2 fate succeed

42. A model of asymmetric conflict • "technology of conflict" is usually seen as a unidimensionalvariable. • A higher amount of effort, translated into more or more advanced weapons, is the only is the only technological decision conflicting parties take. • Reality though does not always seem so simple. • Technological decisions seem to be multidimensional. • This results in a potential asymmetry of technologies actually being acquired. • Most likely to arise when conflicting powers are themselves asymmetrical in nature.

43. Sources of asymmetry • Inertia vs “dynamism”: Having invested so much in a certain conflict technology and the industry to produce it and export, incumbent countries might find it difficult to change it. • Resource availability vs resource constraint: Contestant powers' constrained resources and small share of existing wealth may actually encourage them to find new ways of fighting • One defined adversary vs the “average” adversary. • Perceived relative cost of war.

44. Contest success functions

45. Conflict game structure • Stage 1: Incumbent chooses effort. Contestant's effort is considered exogenous. • Stage 2: The contestant chooses the type of technology to be acquired; the technology used by incumbent is exogenous through out the model. • Stage 3: Incumbent and contestant simultaneously decide whether to adopt an attack or defense strategy. • We find the Subgame Perfect Equilibrium of the above described game using backwards induction

46. Third stage: Parties simultaneously choose whether to attack or defendpayoff matrix (1- )=perceived cost of conflict type (A,A), etc...

47. Assumptions • Assumption 1 the incumbent enjoys the status quo and so prefers peace to attacking unthreatening challengers, this excludes unprovoked attack as a possible equilibrium(A, D). • Assumption 2 defence reduces the destruction of an attack, so for the incumbent more of the prize is left under (D, A) than (A, A) • Assumption 3 similarly for the challengers • Assumption 4 the challengers may have an incentive to attack because the proportion of the prize left after they attack is greater than their status quo share

48. Results • There are two candidates for unique Pure Strategy Nash Equilibrium in the conflict game (D,D) and (D,A). • A decision by the incumbent to induce (D,D), that is, to prevent conflict, will become less feasible and less likely to be adopted by the incumbent, even if feasible, if differentiation by the contestant is a possibility. • Asymmetric conflict may make traditional warfare prep useless in preventing conflict.