March 1, 2006  

Monopoly money

Relying on single suppliers could cost in the long run

Besieged by spiraling weapons prices, mounting war costs and acquisition budgets that are unlikely to grow, the U.S. military is searching for savings in the unlikeliest of places: industrial monopolies.

For the third time in less than a year, the Defense Department is considering whether it can save money by granting a major weapons contract to a single builder — in effect, creating a monopoly.

This time, it’s for an Air Force program. Pentagon budget planners say they can save $1.8 billion by abandoning plans to hire a second engine supplier for the Joint Strike Fighter. Money trimmed from the JSF, they argue, is money the services sorely need for other weapons.

Last spring, the Navy made a similar argument for consolidating construction of DD(X) destroyers in one shipyard. By eliminating the cost of keeping two shipyards open, the Navy claimed it could cut about $300,000 from the cost of each $3 billion destroyer.

Even as Congress blocked the one-shipyard strategy for DD(X), the Defense Department signaled it is likely to approve plans by its two rocket-makers to merge their space-launch operations. The pair, Boeing and Lockheed Martin, said that allowing a company to produce both types of rockets the Air Force wants could save the military up to $150 million a year.

To beleaguered Pentagon program managers, any option that promises to save money seems inviting. But defense experts warn that if the military permits key sectors of the defense industry to shrink to one producer, over the long term costs will almost certainly rise or performance will decline — or both.

Yet some of those same experts concede that the Defense Department may have arrived at the point where maintaining traditional competition between companies is no longer affordable.

“In a perfect world, you would want as much competition as possible,” said Paul Taibl of Business Executives for National Security. And under ordinary economic circumstances, competition saves money, he said.

But to a certain extent, competition also costs money. Customers must buy enough of a product to keep two or more producers in business. And between rising weapons costs and flat procurement budgets, that is proving impossible.

The Pentagon’s position is that “the department seeks to gain the benefits of competition whenever it is feasible to do so,” said Glenn Flood, a spokesman for the Pentagon’s office of industrial policy.

Increasingly, however, “There’s not enough work to keep multiple companies going,” said Pete Steffes, vice president for government policy at the National Defense Industrial Association.

“From industry’s point of view, we’d like to have as many companies going as possible. But companies can’t keep production lines warm with a promise that sometime in the future the Defense Department is going to make a decision to place an order,” he said.

In shipbuilding, the answer has been provided by Congress. To prevent shipyards closing and thousands of shipyard workers losing their jobs, Congress has ordered the Navy to split production between two yards.

That was the solution in 1998 when lawmakers split Virginia-class submarine construction between Virginia’s Newport News Shipbuilding and Connecticut’s Electric Boat.

They did it again last year, overruling the Navy and awarding DD(X) construction to Maine’s Bath Iron Works and Mississippi’s Ingalls Shipbuilding.

But it’s hardly an efficient way to build ships, said defense analyst Loren Thompson of the Lexington Institute. “Congress insisted on competition. But at these levels of demand — building one submarine a year — keeping two shipyards running to build Virginia-class submarines has resulted in higher costs,” he said.

The price of the first ship rose from $3.3 billion to $3.7 billion. So far, the second ship’s cost has increased from $2.2 billion to $2.5 billion, according to the Government Accountability Office.

In terms of economics, at least, there’s even less reason to divide the DD(X) between two shipyards, Thompson said. “There’s a case where monopoly can easily be justified because demand will be roughly half-a-dozen ships.”

But for more than a century, monopolies have been anathema to the U.S. economy.

“The reason we don’t like monopolies in this country is that we hope to get a competitive marketplace. It seems like a good idea to have multiple suppliers,” said Cindy Williams, principal research scientist at MIT’s Security Studies Program.

“The problem is, once you get down to two or three suppliers, it feels pretty much like a monopoly because the decision has been made to keep two or three of them afloat even if there’s not enough work,” she said.

The benefits of competition vanish when the Defense Department divides between two shipyards the work that would keep just one of them busy.

Instead of one learning curve — the time and effort it takes workers to figure out how to efficiently construct a ship, aircraft or other weapon — there are two. Instead of one factory and one set of machines to be maintained, there are two.

“They are preserving two in case they get the opportunity to have competition sometime in the future. But they won’t,” said Williams, a former assistant director of the Congressional Budget Office.

Whether it’s ships or rockets or jet engines, it is unrealistic to expect that there will be enough work from the Defense Department in the foreseeable future to generate true competition.

But if prices are rising because the military is preserving multiple producers, they may skyrocket if the field is permitted to dwindle to just one, said John Pike, director of defense watchdog GlobalSecurity.org. If approved, the proposed merger of the space-launch operations of Lockheed Martin and Boeing will give the Air Force “the worst of both worlds,” he said.

Initially, the Air Force planned to rely on one company to build a type of rocket. But out of concern that a flaw in the rocket could halt the U.S. military’s ability to launch satellites, the Air Force decided to rely on two companies, each building a different type of launch vehicle.

A merger would saddle the Air Force with the cost of maintaining two production lines and paying two teams of engineers, and it would strip the merged company of the ability to save money through competition, Pike said. The merged company, United Launch Alliance, would lack competition-driven incentive to innovate or curb costs, he said.

For satellite launches, the U.S. government is in a bleak bargaining position in any case. Commercial demand is deeply depressed, leaving the U.S. military the main launch customer.

“If the government insists on maintaining two different launch families based on different technologies, and the government is the only customer in the marketplace, then the government’s going to have to pay the price,” whether it’s two companies or one company building two rockets, Thompson said.

Expecting two large companies to merge and work together more efficiently than they worked separately may, indeed, be unrealistic, said Jacques Gansler, former undersecretary of defense for acquisition, technology and logistics — the Pentagon’s chief weapons buyer from 1997 to 2001. But there are other ways the military can stimulate competition. It could hire a smaller company, such as Orbital Sciences or SpaceX, to begin researching the next generation of launch vehicles, Gansler said.

And the possibility that Russian or French launch companies might be hired to launch some U.S. satellites could help keep Lockheed and Boeing’s costs under control, he said.

“I understand that the market is too small,” Gansler said. But that means that the Pentagon must become more creative about finding ways to generate competition, he said.

Thompson said the Air Force’s decision to abandon competition for the Joint Strike Fighter engine is particularly uncreative.

“It’s simply a matter of intellectual laziness. They have given no thought at all to the long-term cost. It will be astronomical,” he said.

While the Air Force may save $1.8 billion in the short term, it is likely to pay much more in the long run when dealing with only one engine supplier, Thompson said.

There is precedent for that prediction. Early models of the Navy’s F-14 and the Air Force’s F-16 experienced problems with their Pratt & Whitney engines, and for a number of years, Pratt was the sole engine supplier.

“You couldn’t get Pratt to return phone calls until GE came along,” Thompson said. With competition from GE, Pratt’s engines improved and its prices went down, he said. Competition between the two engine suppliers “had a tremendous salutary effect.”

Williams, the MIT researcher, said having two engine-makers for the JSF “is probably a good idea,” but she is not convinced it is essential. It may be possible to rely on a single contractor without getting gouged, but the Defense Department will have to change the way it manages its contractors, she said.

“The government would have to make decisions about pricing and quality,” and program managers would have to be tougher about ensuring expectations are met, William said.

“The virtue of competition is that it takes the burden off the buyer to ensure performance,” Thompson said. “Once you create a monopoly, the price of performance is constant vigilance. That’s not something government is good at,” he said.