Clearly, efficiency in the conduct of weapons programs is a desirable objective… What do we mean by efficiency in this context? There is a tendency to equate efficiency in the weapons acquisition process with the absence of high profits. In part, this stems from fallaciously applying traditional concepts of competition to the weapons industry. If pure and perfect competition prevails, the profits of firms in static equilibrium will be at a minimum; this is, no higher than what is required to prevent an outflow of capital. Economists have demonstrated that under certain rigorously specified conditions, this situation represents the hallmark of efficiency.
… Nothing could be further from this model than the weapons industry, with its substantial uncertainties, uniquely differentiated products, cost reimbursement contracting, and so on. Once the purely and perfectly competitive market place is forsaken, there is no assurance that minimum profits are synonymous with economic efficiency.
Rather, a workable definition of efficiency requires considering all of the costs generated in a weapons program, profit (from the government’s point of view) being just one special form of cost. Herein lies the second reason for the emphasis on minimum profits as an indicator of weapons acquisition efficiency. It is usually much easier for government negotiators or auditors to say that profits are too high than to claim that the cost of developing some technically complex item of equipment is excessive.
That was the classic Merton Peck and Frederic Scherer in their 1962 book, The Weapons Acquisition Process: An Economic Analysis. They were writing just before the Truth in Negotiations Act was passed, which required contractors to certify their cost or pricing information ahead of contract negotiations to assure they would make no more than 10-15 percent profit. Of course, profits are a return to value creation through innovation. They also provide the wherewithal for companies to pump basic research and other R&D in a drive to maintain their technological moats.
Perfect competition assumes static technologies, meaning everyone can produce the same stuff in the same way. Competitive monopolies derive their profits from either driving down prices substantially or creating superior products.
Peter Theil says competition is for “losers,” and there’s two kinds of competitive monopolies generate high margins: those that vertically integrate and require massive capital (e.g., Standard Oil, SpaceX) and those that can scale users super fast (e.g., Facebook, Amazon). But the precondition for these things, of course, is innovation — which actually requires not competing in some ways because if you’re competing then you’re following what everyone else is doing.
Anyway, the key point here I think is that Peck and Scherer were right. Government officials focus on profits because they can’t objectively measure what weapon systems “should cost,” or whether they were even going after the right kind of weapon system. They look for their keys under the streetlight, as it were, ignoring the much more promising areas darkened by night.
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