The economics of arms trade and arms control

THE ECONOMICS OF ARMS TRADE AND ARMS CONTROL

Dr Maria Garcia-AlonsoUniversity of Kent

Summer School, 2009

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.

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!

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.

1. A BIT OF ARMS TRADE HISTORY: THE COLD WAR

SECURITY PERCEPTION: Arms race between main producer countries.

FIRMS OWNED BY STATE EXPORTS TO ALLIES ONLY

US USSR

EXPO

RTS

EXPO

RTS

US ALLIES

USSR ALIES

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.

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.

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?

POST COLD WAR (cont)

POST COLD WAR ARMS TRADE STRUCTURE

US RUSSIA

EXPO

RTS

EXPO

RTS

REST OF THE WORLD

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, Defence White Paper, 2005. Defence Industrial Policy, MOD policy papers , paper no 5. Export Credits Guarantee Department: Annual Review and Resource Accounts.

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.

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.

RECENT EVOLUTION OF ARMS TRANSFERS (SIPRI Yearbook)

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

0

5

10

15

20

25

30

SIPRI TIV

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>.

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

supplier % share of global arms exports

Total number of recipients

FIRST SECOND THIRD

US 35 77 TAIWAN 9%

EGYPT 8%

JAPAN 8%

RUSSIA 26 47 CHINA 44%

INDIA 23%

IRAN 4%

GERMANY 7 56 TURKEY14%

AUSTRALIA 11%

SOUTH KOREA 7%

FRANCE 7 55 UAE 21%

PAKISTAN12%

TURKEY11%

UK 6 44 CANADA18%

US12%

TURKEY10%

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

supplier % share of global arms exports

Total number of recipients

FIRST SECOND THIRD

US 31 69 SOUTH KOREA15%

ISRAEL13%

UAE11%

RUSSIA 25 46 CHINA 42%

INDIA 21%

ALGERIA8%

GERMANY 10 47 TURKEY15%

GREECE 13%

SOUTH AFRICA12%

FRANCE 8 39 UAE 32%

SINGAPOURE13%

GREECE12%

UK 4 37 US21%

INDIA14%

CHILE9%

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

recipient % share of global arms imports

Total number of suppliers

FIRST SECOND THIRD

CHINA 12 9 RUSSIA92%

FRANCE3%

UKRAINE2%

INDIA 8 14 RUSSIA 78%

UZBEKISTAN5%

GERMANY3%

GREECE 5 13 US52%

RUSSIA17%

NETHERLANDS10%

TURKEY 5 10 US 54%

FRANCE15%

UK11%

SOUTH KOREA

4 10 US67%

GERMANY11%

FRANCE11%

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

recipient % share of global arms imports

Total number of suppliers

FIRST SECOND THIRD

CHINA 11 6 RUSSIA92%

FRANCE3%

UKRAINE 2%

INDIA 7 11 RUSSIA 71%

UK9%

ISRAEL6%

UAE 6 13 US54%

FRANCE43%

GERMANY1%

SOUTH KOREA

6 8 US 73%

GERMANY12%

FRANCE9%

GREECE 4 13 GERMANY31%

US24%

FRANCE24%

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:1. Agents?: Governments, firms...2. Objectives? Welfare maximization

(definition?), profit maximization (market structure?)...this will determine possible strategic interactions.

3. Choice variables?: Procurement levels, exports, quality, controls...

4. Timing? This will depend on commitment power, unless it is all clear go for simultaneous decision making. Equilibrium concept?

5. Uncertainty?

Security perceptions and games

Basic 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.

Security perceptions and games

a. An arms race/ arms control game

Procure more weapons

Do not procure more weapons

Procure more weapons 2,2 4,1

Do not procure more weapons 1,4

3,3

Coun

try

1

Country 2

Security perceptions and games

a. An arms race/ arms control game

Procure more weapons

Do not procure more weapons

Procure more weapons 2,2

Nash Equilibrium(NE)

4,1

Do not procure more weapons 1,4

3,3Pareto Optimum (PO)

Coun

try

1

Country 2

A continuous choice arms race: best response function and NE

Country 1’s arms

Coun

try

2’ar

ms

NE

Country 1’s best response function

Security perceptions and games

b. Nuclear technology transfer game (both countries care equally about

security)Transfer nuclear technology

Do not transfer

Transfer nuclear technology

1,1 2,0

Do not transfer 0,2

3,3

Coun

try

1

Country 2

Security perceptions and games

b. Nuclear technology transfer game (both countries care equally about

security)Transfer nuclear technology

Do not transfer

Transfer nuclear technology

1,1NE

2,0

Do not transfer 0,2

3,3 NE and PO

Coun

try

1

Country 2

Security perceptions and games

c. Nuclear technology transfer game (only one country cares about security)

Transfer nuclear technology

Do not transfer

Transfer nuclear technology

1,1 2,0

Do not transfer 0,2

3,0

Coun

try

1

Country 2 (does not care)

Security perceptions and games

c. Nuclear technology transfer game (only one country cares about security)

Transfer nuclear technology

Do not transfer

Transfer nuclear technology

1,1NE

2,0

Do not transfer 0,2

3,0

Coun

try

1

Country 2 (does not care)

Timing of events and SPNE Only one exporter

1. Government chooses exports subsidy to maximize welfare: Welfare (exports, subsidy).

2. 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

With two exporters and Cournot competition(best response functions and NE in second stage)

Exports domestic firm

Expo

rts

fore

ign

firm

Domestic firm’s best response function

NE in second stage

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.

Timing of decisions:

1. MoD in producer countries take domestic procurement decisions: quality, quantity, price and number of domestic varieties/firms, given the export control structure and their budget.

2. All firms set international prices in a monopolistic competition fashion.

3. 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.

Producers: Security, budget constraint and profits.

1 1

.n N

j j j jj j n

G p d Pm

1

1 1

1 1 1 .n N

j j j jj j n

S wn w N n w q d w w u m

.j j j jC F aq c d x

.j j j j j jp d P x C

Non producers involved in a regional arms race Military Capability:

Ratio form Contest Success Function:

Difference form CSF:

1

1

; , .N

i j jj

S N u m i a b

.m

a aa m m

a a b b

Sp

S S

1 .

1 expab b a a

pk S S

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.

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.

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!

On the need for international coordination (cont):

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.

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.

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.

6. THE NEW POST SEPTEMBER 11TH CHALLENGES AND ASYMMETRIC CONFLICT

A game of alternative terrorist targets and preemption

targets

terrorists

Protection

investment

terrorists

fate

Target

1

fail

fate succeed

Target 2

fail

succeed

fate

Target

1

fail

fate succeed

Target 2

fail

succeed

A model of asymmetric conflict

•"technology of conflict" is usually seen as a unidimensional variable. •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.

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.

Contest success functionsFirst argument in parenthesis always refers to the strategy of the incumbent and the second refers to the contestant's strategy: ( , )= probability that incumbent has of winning if they attack andaP A D contestant defends.

( , )

( , )

( , )

( , ) 1- represents the entrenching advantage.

t is the technology locatio

aa

b a

aa

b a

aa

b a

a a b

t eP A Dt e e

eP D A

t e ee

P A Ae e

P D D status quo incumbent share s s

n of the contestant. and represent the incumbent and contestant's effort respectively. a be e

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

Third stage: Parties simultaneously choose whether to attack or defend

payoff matrix

a/b ATTACK DEFEND

ATTACK

DEFEND

( , ) ,

( , ) ,a a

b b

P A A A A V

P A A A A V

( , ) ,

( , ) ,a a

b b

P A D A D V

P A D A D V

( , ) ,

( , ) ,a a

b b

P D A D A V

P D A D A V

a

b

s Vs V

(1- )=perceived cost of conflict type (A,A), etc...

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

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.