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Defence economics is a relatively new part of the discipline of economics. One of the first specialist contributions in the field was by C. Hitch and R. McKean, The Economics of Defense in the Nuclear Age (Hitch and McKean 1960). This book applied basic economic principles of scarcity and choice to national security. It focused on the quantity of resources available for defence and the efficiency with which such resources were used by the military. For example, defence consumes scarce resources that are therefore not available for social welfare spending (for example, missiles versus education and health trade-offs). Once resources are allocated to defence, military commanders have to use them efficiently, combining their limited quantities of arms, personnel and bases to ‘produce’ security and protection. Within such a military production function, there are opportunities for substitution. For example, capital (weapons) can replace (and have replaced) military personnel; imported arms can replace nationally produced weapons; and nuclear forces have replaced large standing armies. Defence economics is about the application of economic theory to defence-related issues.

The development of defence economics and its research agenda reflected current events. For example, during the cold war there was a focus on the superpower arms races, alliances (NATO and the Warsaw Pact), nuclear weapons and ‘mutually assured destruction’. The end of the cold war resulted in research into disarmament, the challenges of conversion and the availability of a peace dividend. Since the end of the cold war, the world remains a dangerous place with regional and ethnic conflicts (for example, Bosnia, Kosovo, Iraq), threats from international terrorism (for example, terrorist attacks on USA on 11 September 2001), rogue states and weapons of mass destruction (that is, biological, chemical and nuclear weapons). NATO has accepted new members (for example, former Warsaw Pact states) and has developed new missions, and the European Union has developed a European Security and Defence Policy. Changing threats and new technology require the armed forces and defence industries to adjust to change and new challenges. Peacekeeping has become a major mission for armed forces and is an example of the trend towards globalization.

The modern era of globalization involves more international transactions in goods, services, technology and factors of production, which brings new security challenges for both nation states and the international community. Defence firms have become international companies with international supply networks. Globalization also highlights the importance of international collective action to respond to new threats such as international terrorism and to maintain world peace (for example, through international peacekeeping missions under UN, NATO or EU control). But international collective action experiences the standard problems of burden-sharing and free riding.

This article outlines the development of defence economics; it defines the field and describes the ‘stylized facts’ of world military expenditure; the defence economics problem is considered; and a case study of conflict and terrorism illustrates some of the new developments in the field.

A Brief History

Defence issues have existed throughout history as nations have been involved in armed conflict of various forms and durations (for example, the Hundred Years War). Great powers have used military force to dominate regions and parts of the world (for example, Alexander the Great; Roman legions; Genghis Khan; Ottoman Turks; Nazi Germany), with such powers rising and falling (Kennedy 1988). Conflict has also been characterized by major technical changes ranging from bows and arrows to cannons and machine guns, from sailing ships to iron and steel warships and nuclear- powered vessels, from horse cavalry to tanks, from flag communications to radios and satellite communications and from balloons to aircraft, missiles, nuclear weapons and space systems. Historically, the economic base for conflict was first an agricultural society, then an industrial society followed by a knowledge economy.

Some of the classical economists studied war and conflict (for example, Smith, Ricardo, Malthus, J. S. Mill: see Goodwin 1991, chapter 2). For these economists, war departed from much of their conventional thinking: it involved chaos and disorder rather than market equilibrium, and it required government action rather than private market behaviour. Yet it remains surprising that, with a long history of wars, including two world wars and the superpower arms race of the Cold War, relatively few economists have been attracted to the field. A review of the economics literature on conflict concludes that ‘We were surprised at the relative absence of applied economics studies of actual conflicts’ (Sandler and Hartley 2003, p. xl). There are various possible explanations for the relative absence of economists studying war and conflict. These include data and security problems, the difficulty of applying conventional market analysis to the chaos and disequilibrium of conflict, a traditional reluctance to analyse the public sector (with defence assumed to be exogenous), and the feeling that defence and security issues are not as important as other social welfare issues, with war viewed as an immoral and unethical subject. Furthermore, security issues have not been as an attractive career path for economists (compared with issues such as inflation, unemployment, growth and developing countries), and conflicts are usually of short duration so that they offer only limited research prospects before peace returns to remove war-related problems (Goodwin 1991, pp. 1–2).

Definitions

Defence economics studies all aspects of war and peace and embraces defence, disarmament and conversion. This definition includes studies of both conventional and non-conventional conflict such as civil wars, revolutions and terrorism. It involves studies of the armed forces and defence industries and the efficiency with which these sectors use scarce resources in providing defence output in the form of peace, protection and security. Reductions in defence spending (such as those following the end of the cold war) result in disarmament, which involves reallocating resources from the defence to the civilian sector. This raises questions about the impact of disarmament on the employment and unemployment of both military personnel and defence industry workers; the possibilities for converting military bases and arms industries to civil uses (the Biblical swords to ploughshares); and the role of public policies in assisting the transition and reallocation of resources.

The coverage of the subject is extensive and involves economic theory, empirical testing and policy-related issues, including applications of public choice analysis. Both defence and peace have distinctive economic characteristics in that they are public goods which are non-rival and non-excludable. There are large literatures dealing with the determinants of military expenditure, including economic theories of military alliances and arms races (that is, threats) and the impact of defence spending on economic growth and development. Armed forces are major buyers of both equipment (arms/weapons) and military personnel, and such procurement choices affect defence industries and both local and national labour markets. For example, government procurement of weapons involves choices between competition and preferential purchasing and between various types of contracts (for example, fixed-price, cost-plus), each with different implications for contractor efficiency and profitability. There is a related literature on industrial and alliance policies comparing the economics of supporting a national defence industrial base with alternative industrial policies such as international collaboration, licensed production or importing foreign equipment. Imports also involve the international arms trade, its economic impacts on both buyers and suppliers, and policy initiatives to regulate such trade. More generally, there is an extensive literature on arms control and disarmament, the adjustment costs of disarmament, the economics of conversion and the contribution of public policy to minimizing such adjustment costs. Finally, there have been some new developments involving the application of economics to the study of conflict, civil wars, revolutions and terrorism (Brauer 2003; Hegre and Sandler 2002; Sandler and Hartley 1995, 2007).

Defence economics became established in the 1960s with the publication of a number of pioneering contributions, mostly by US economists. These contributions applied economics to some novel areas and included economic models of alliances (Olson and Zeckhauser 1966), the economics of arms races (Richardson 1960; Schelling 1966), the procurement of weapons and military personnel (Peck and Scherer 1962; Oi 1967), and the impact of military spending on economic development (Benoit 1973). A further development confirming the emergence of defence economics as an accepted part of the discipline of economics was the launch in 1990 of a field journal, Defence Economics, later renamed Defence and Peace Economics (initially it was published four times per year, but in 2000 it was expanded to six issues per year).

Inevitably, defence economics generates controversy reflected in myths and emotion. Critics point to the ‘wastes’ of defence spending and its ‘crowding-out’ of ‘valuable’ civil expenditure. Classic examples include the sacrifice of schools and hospitals associated with major weapons projects such as modern combat aircraft and aircraft carriers (for example, the US F-22 aircraft and the European Typhoon). Peace economists are similarly critical of defence economics and military spending: they focus on peace topics such as disarmament and the maintenance of peace, arms control and international security, conflict analysis and management, and crises and war studies. Defence economists are not, however, ‘warmongers’: they are instead interested in understanding the economics of the military–industrial–political complex and all aspects of defence whereby a proper understanding of these issues will contribute to a more peaceful world. A starting point in showing how economists analyse defence is to review the ‘stylized facts’ of world military spending.

The Stylized Facts of World Military Spending

What is known about military spending, and where are the gaps in the data? Good quality data exist on world military spending, the world’s armed forces and the arms trade. Cross-section and time-series data are available at the country level; some examples are shown in Table 1. The data on world military expenditure show aggregate spending by the USA accounting for 45% of total world military spending and NATO accounting for some 70%. Similarly, in 2004 the USA dominated defence R&D spending, accounting for some 75% of the world total and 31% of world arms exports.

Defence Economics, Table 1 World military spending and armed forces, various years
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Table 1 shows examples of defence shares of GDP to illustrate the burdens of defence spending, especially for developing nations such as Eritrea, India and Pakistan (an arms race situation) and for the Middle East (a conflict region). Burundi and Sudan have defence burdens similar to or greater than those of the UK and Germany. Table 1 also shows other measures of the economic burdens of defence for the world’s poorer nations (that is, nations which cannot feed, house or educate their populations and which have poor health records). Developing nations accounted for 70% of the world total of 21.3 million military personnel, and such totals further show the importance of military manpower economics. Similarly, developing nations are major importers of arms, while the developed nations are the major arms exporters. Such data provide an introduction to some of the major themes of defence economics, namely, the determinants of military expenditure, arms races, alliances, the relationship between defence spending and economic development, the arms trade and the economics of military personnel.

Micro-level data are more limited but there are some useful sources especially on defence contractors and defence industries. Table 2 provides examples of such micro-level data based on the 100 largest arms-producing companies (SIPRI 2005) and employment in national defence industries (BICC 2005). Again, these data are available on a cross-section and time-series basis, and the company data include total sales, total profits and aggregate employment. From Table 2 it can be seen that the USA has six of the world’s top ten arms companies and that the American firms have a substantial scale advantage over their European rivals: the average size of a US firm from the top ten is almost twice the corresponding average of the European companies. These data are the basis for research questions about the determinants of firm size, the impact of economies of scale, scope and learning, and the determinants of performance in terms of labour productivity and profitability.

Defence Economics, Table 2 Defence companies and industries
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Table 2 also shows data on defence industry employment. The industrialized nations accounted for 63% of total employment in the world’s defence industries, with the developing countries accounting for the remaining 37%. The USA, China and Russia have the largest defence industries by employment, accounting for 75% of the world total. Overall, the world military–industrial complex employed almost 29 million personnel in the armed forces and defence industries, reinforcing its role as a major employer of labour, including some highly qualified R&D staff and other highly skilled workers. Such scarce labour has alternative uses in the civilian sector, raising questions as to whether defence spending ‘crowds out’ valuable civil investment and diverts scientific manpower from civil research projects.

Despite the available data, there remain significant gaps in our knowledge of the world’s military sector. Typically, new defence projects are surrounded by secrecy; there are problems in identifying some defence goods (for example, dual use goods, such as civil airliners which can be used as military transport aircraft); there is a lack of good-quality data on defence R&D, including employment in defence R&D; and little is known about China, especially its defence R&D programmes (Hartley 2006a). International comparisons of military expenditure data are also sensitive to the choice of exchange rate adjustments, with country rankings sensitive to the use of market exchange rates or purchasing power parity rates (SIPRI 2005). At the firm and industry levels, analysis of the military business in terms of defence output, employment and profitability is complicated because the typical output comprises a mix of military and civil components, making it difficult to compare the performance of defence contractors and civil firms. Further gaps exist in our knowledge of the world regional distribution of military bases and defence plants, so that it is difficult to assess the economic dependence of various regions on defence spending. Little is known about defence industry supply chains both within countries and within the global economy. Finally, there is a need for more reliable data on the international trade (including illegal transactions) in small arms (these are often the main weapons used in many regional conflicts, such as in Bosnia).

The Defence Economics Problem

This is the standard choice problem of economics, but applied to defence. Typically, following the end of the cold war defence budgets have been either constant or falling in real terms; and these limited budgets are faced with rising input costs of both capital and labour. Equipment costs have been rising by some 10% per annum in real terms, which means a long-run reduction in the numbers of weapons acquired for the armed forces (for example, the US Air Force’s original requirement for F-22 combat aircraft for 750 units was later reduced to some 180 aircraft). Similarly, with an all-volunteer force, the costs of military personnel have to rise faster than wage increases in the civil sector. This wage differential is required to attract and retain military personnel by compensating them for the net disadvantages of military life. Here, the military employment contract is unique in that armed forces personnel are subject to military discipline; they are required to deploy to any part of the world at short notice; they could remain overseas indefinitely; and some might never return (that is, death and injury are a feature of this contract). This combination of constant or falling defence budgets and rising input costs means that governments and defence policymakers cannot avoid the need for difficult choices in a world of uncertainty (that is, where the future is unknown and unknowable, and no one can accurately predict the future).

Faced with this defence choice problem, governments have adopted various solutions. They can adopt a policy of ‘equal misery’ whereby each of the services is subject to budget cuts (for example, reduced training, cancelling some new equipment projects and delaying others); or they can undertake a major revision of a nation’s defence commitments (for example, a defence review such as the UK’s 1998 Strategic Defence Review); or they can seek to improve efficiency in the armed forces and defence industries (for example, via a competitive equipment procurement policy and military outsourcing). Other policy options include joining a military alliance (such as NATO; EU) or avoiding the defence choice problem by increasing the defence budget (as in the USA since 11 September 2001); but then choices are needed between defence and social welfare spending.

Economics offers three broad policy principles for formulating an efficient defence policy, namely, final outputs, substitution and competition. Take first the principle of final outputs. Measuring defence output is notoriously difficult, but it can be expressed in such general terms as peace, security and threat reduction. The UK has solved the problem by committing (and funding) its armed forces to having the capacity to fight simultaneously three small to medium conflicts (for example, Bosnia, Kosovo, Sierra Leone) or one large-scale conflict as part of an international coalition (for example, the Gulf War, Iraq). This approach is a departure from the traditional focus on measuring inputs in terms of the numbers of infantry regiments, warships, tanks and combat aircraft. Such a focus fails to address the key issue of the contribution of these inputs to final defence output in the form of peace and protection. A focus on inputs also fails to address the marginal contribution of each of the armed forces: what would be the implications for defence output if, say, the air force were expanded by 5–10%, or the navy was reduced by 5–10%?

The second economic principle is that of substitution. There are alternative methods of achieving protection, each with different cost implications. Possible examples of partial substitutes include reserves replacing regular personnel, civilians replacing regulars (for example, police in Northern Ireland replacing army personnel), attack helicopters replacing tanks, ballistic and cruise missiles and unmanned combat air vehicles replacing manned strike and bomber aircraft, air power replacing land forces, and imported equipment replacing nationally produced equipment. Some of these substitutions might alter the traditional monopoly property rights of each of the armed forces. For example, surface-to-air missiles operated by the army might replace manned fighter aircraft operated by the air force, and maritime anti-submarine aircraft operated by the air force might replace frigates supplied by the navy.

The third economic principle is that of competition as a means of achieving efficiency. Standard economic theory predicts that, compared with monopoly, competition results in lower prices, higher efficiency, and competitively determined profits and innovation in both products and industrial structure. For equipment procurement, competition means allowing foreign firms to bid for national defence contracts and awarding fixed-price contracts rather than cost-plus contracts; it also means ending any ‘cosy’ relationship between the defence ministry and its national champions and any preferential purchasing and guaranteed home markets.

Competition can be extended to activities undertaken by the armed forces. Here, there is a public sector monopoly problem whereby the armed forces have traditionally undertaken a range of activities ‘in house’ without being subject to any rivalry. Military outsourcing allows private contractors to bid for and undertake such activities. Examples include accommodation, catering, maintenance, repair, training, transport and management tasks (for example, managing stores or depots and firing ranges). In some cases, outsourcing involves private finance initiatives whereby the private sector finances the activity (for example, new buildings or an aircrew simulator training facility) and then enters into a long-term contract with the defence ministry to provide services to the armed forces in return for rental payments. Another variant is a public–private partnership whereby the private sector finances an activity or asset in return for rental payments from the defence ministry, but the contractor is allowed to sell any peacetime spare capacity to other users (for example, tanker aircraft capacity which when not needed in peacetime can be rented to other users).

Application of the policy guidelines to an efficient defence policy requires that individuals and groups in the military–industrial–political complex are provided with sufficient incentives to behave efficiently. There are the inevitable principal–agent problems where agents have considerable opportunities to pursue their own interests which may conflict with those of their principals (for example, leading a quiet life rather than bearing the costs of change). Individuals and groups in the armed forces and defence ministries will be reluctant to apply the substitution principle if there are no personal or group incentives and rewards for achieving efficient substitution (that is, interest groups can be barriers to change). Compare the private sector, where there are market and institutional arrangements promoting efficiency in the form of rivalry between suppliers, the profit motive and the capital market as a ‘policing and monitoring’ mechanism through the threats of takeover and bankruptcy. Such market arrangements are absent in the armed forces (and elsewhere in the public sector).

There is also the challenge of achieving ‘top level’ efficiency in defence provision. Economic theory solves this challenge as a standard optimization problem involving the maximization of a social welfare function subject to resource or budget constraints (where welfare is dependent on civil goods and security, with security provided by defence). Operationalizing this apparently simple optimization rule is much more difficult. Individual preferences for defence are subject to its public good characteristics and free riding problems and the continued difficulty of defining defence output. In democracies, society’s preferences are usually expressed through voting at elections. However, elections are limited as a means of obtaining an accurate indication of society’s preferences for defence and its willingness to pay. Elections occur infrequently; they are usually for a range of policies of which defence is only one element in the package (which includes policies on, for example, education, health, transport, the environment, foreign policy and taxation); and the ‘voting paradox’ shows the difficulty of deriving a society’s preferences using the voting system. Nor do voters have reliable information on the output of defence spending.

Defence economics explains military spending using a demand model of the form:

$$ \mathrm{ME}=M\left(P,Y,T,A, Pol,S,Z\right) $$

where ME = real military spending; P = relative prices of military and civil goods and services; Y = real national income; T = threats in the form of the military expenditure of a rival nation (arms race models); A = membership of a military alliance and the real military expenditure of the allies (such as NATO); Pol = variable for the political composition of the government (for example, left- or right-wing, with the latter favouring ‘strong defences’); S = a variable representing the security and strategic environment (such as the end of the cold war; conflicts such as Korea, Vietnam, the Gulf War and Iraq); and Z = other relevant influences (for example, land mass to be protected). Estimation of the demand model usually proceeds without a price variable, mainly because most nations do not provide relative price data. This omission can be justified if the price of military goods and services has inflated at the same rate as civil goods and services; but such an assumption is not always realistic. A survey of empirical results is presented in Sandler and Hartley (1995, 2007).

Conflict and Terrorism

The demand model for military expenditure recognized the relevance of threats such as terrorism and conflict as determinants of defence spending. Traditionally, conflict and terrorism have been the preserve of disciplines other than economics. For example, debates and decisions about war involve political, military, moral and legal judgements. But conflict has an economic dimension, namely, its costs. Wars are not costless: they can involve massive costs (for example, the Second World War). Economics has also made further contributions in analysing the causes of conflict and in identifying potential targets during conflict (for example, the Second World War selection of aircraft factories, dams, submarine yards and oil fields as targets for Allied bombing raids on Germany).

Economic models start by analysing conflict as the use of military force to achieve a reallocation of resources within and between nations (that is, civil wars and international conflict). Nations invade to capture or steal another nation’s property rights over its resources (such as land, minerals, oil, population, water). Conflict has a distinctive feature: it destroys goods and factors of production, and it is easier to destroy than to create. In peacetime, civilian economies aim to create more goods and services through growth and expanding a nation’s production possibility frontier. Conflict uses military force and destructive power to enable a nation to acquire resources from another state, so expanding its production boundary through military force (Vahabi 2004).

Conflict and terrorism provide opportunities for applying game theory. They involve strategic behaviour, interactions and interdependence between adversaries ranging from small groups of terrorists, rebels and guerrillas to nation states. Strategic interaction means that conflict can be analysed as games of bluff, chicken and ‘tit-for-tat’ with first-mover advantage and possibilities of one-shot or repeated games. For example, first-mover advantage might indicate a pre-emptive strike (for example, Pearl Harbour in 1941; Kuwait in 1990). However, there are other, noneconomic explanations of conflict. These include religion, ethnicity and grievance (for example, Germany after the First World War); the desire for a nation state (such as Palestine); the absence of democracy; and mistakes and misjudgement.

The costs of war are a relatively neglected dimension of conflict. War involves both one-off and continuing costs. One-off costs are those of the actual conflict, while continuing costs are any post-conflict costs including those of occupation and peacekeeping. A further distinction is necessary between military and civilian costs. In principle, the military costs of conflict are the marginal resource costs arising from the conflict (that is, those costs which would not otherwise have been incurred). Examples include the costs of preparation and deployment prior to a conflict; the costs of the conflict, including the costs of basing forces overseas and the use of ammunition, missiles and equipment, including human capital and equipment losses in combat; the post-conflict occupation and peacekeeping missions and the costs of returning armed forces to their home nation.

There are further costs of conflict in the form of impacts on the civilian economies of the nations involved in the war. For example, the US and UK involvement in the Iraq war that began in 2003 had possible short- and long-term impacts for both economies. There were possible impacts on oil prices, share prices, the airline business, tourism, defence industries, private contractors, aggregate demand and future public spending plans. Further substantial costs were imposed on the Iraq economy in the form of deaths and injuries of military and civilian personnel, together with the damage and destruction of physical assets. Table 3 shows some examples of the costs of various conflicts for the UK and USA. The general point remains that wars are costly and require scarce resources which have alternative uses (that is, wars involve the sacrifice of hospitals, schools and social welfare programmes). Questions also arise as to whether the benefits of conflict exceed its costs.

Defence Economics, Table 3 Costs of conflict
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Defence economists have also contributed to the analysis of terrorism using both choice-theoretic and game-theoretic models. Terrorism shows that non-conventional conflict is also costly. The attacks of 11 September 2001 on the USA resulted in almost 3,000 deaths and economic losses of $80–90 billion (Barros et al. 2005). Other terrorist-related costs include nations spending on homeland security measures, on terrorist-related intelligence, on security measures in airports, the lost time waiting at airports to clear security, the losses of liberty and freedoms and the war on terror (for example, in Afghanistan and Iraq).

Choice-theoretic models of terrorism apply standard consumer choice theory with terrorists maximizing a utility function subject to budget constraints. The utility function can be specific, such as a choice between attack modes, say, skyjackings and bombings, or more generally involve a choice between terrorist and peaceful activities. The approach offers some valuable insights into terrorist behaviour and possible policy solutions. The model shows that terrorist behaviour and activities can be influenced by governments acting to reduce terrorist funds (that is, an income effect), by changing relative prices (that is, promoting a substitution effect), and by efforts to change terrorist preferences towards more peaceful activities (for example, Northern Ireland). The substitution effect is an especially powerful insight showing that policies which increase the relative price of one attack mode, such as skyjackings, will encourage terrorists to substitute an alternative and lower-cost method of attack (for example, assassinations, bombings, or kidnappings: Frey and Luechinger 2003; Anderton and Carter 2005).

Conclusion

Defence economics is now established as a reputable sub-discipline of economics. It shows how economic theory and methods can be applied to the defence sector embracing the armed forces, defence industries and the political–institutional arrangements for making defence choices. But this is only the beginning. Massive opportunities remain for further research in the field. Changes in threats, new technology and continued budget constraints will require further adjustments in the armed forces and defence industries, and will generate a new set of research problems. Examples include space warfare, the economics of nuclear weapons policy, assessing the efficiency of armed forces, improving the efficiency of military alliances and developing more efficient approaches to international governance and international collective action.

See Also