Dr Maria Garcia-Alonso
University of Kent
Summer School, 2009

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.



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!

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.
SECURITY PERCEPTION:


FIRMS OWNED BY STATE
EXPORTS TO ALLIES ONLY
US
USSR
EXPORTS

Arms race between main producer countries.
EXPORTS

US
ALLIES
USSR
ALIES

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.


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 ARMS TRADE STRUCTURE
RUSSIA
US
REST
OF THE
WORLD

EXPORTS CREDIT GUARANTEES DEPARTMENT


UKTI DEFENCE & SECURITY ORGANISATION (UKTI DSO)




http://www.ecgd.gov.uk/
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-exportcontrol/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.


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.



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.
30
25
20
15
SIPRI TIV
10
5
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
0
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>.
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
TURKEY
14%
AUSTRALIA
11%
SOUTH
KOREA
7%
FRANCE
7
55
UAE
21%
PAKISTAN
12%
TURKEY
11%
UK
6
44
CANADA
18%
US
12%
TURKEY
10%
supplier
% share of
global
arms
exports
Total
number of
recipients
FIRST
SECOND
THIRD
US
31
69
SOUTH
KOREA
15%
ISRAEL
13%
UAE
11%
RUSSIA
25
46
CHINA
42%
INDIA
21%
ALGERIA
8%
GERMANY
10
47
TURKEY
15%
GREECE
13%
SOUTH
AFRICA
12%
FRANCE
8
39
UAE
32%
SINGAPOU
RE
13%
GREECE
12%
UK
4
37
US
21%
INDIA
14%
CHILE
9%
recipient
% share of
global
arms
imports
Total
number
of
suppliers
FIRST
SECOND
THIRD
CHINA
12
9
RUSSIA
92%
FRANCE
3%
UKRAINE
2%
INDIA
8
14
RUSSIA
78%
UZBEKISTAN GERMANY
5%
3%
GREECE
5
13
US
52%
RUSSIA
17%
NETHERLA
NDS
10%
TURKEY
5
10
US
54%
FRANCE
15%
UK
11%
SOUTH
KOREA
4
10
US
67%
GERMANY
11%
FRANCE
11%
recipient
% share of
global
arms
imports
Total
FIRST
number
of
suppliers
SECOND
THIRD
CHINA
11
6
RUSSIA
92%
FRANCE
3%
UKRAINE
2%
INDIA
7
11
RUSSIA
71%
UK
9%
ISRAEL
6%
UAE
6
13
US
54%
FRANCE
43%
GERMANY
1%
SOUTH
KOREA
6
8
US
73%
GERMANY
12%
FRANCE
9%
GREECE
4
13
GERMANY
31%
US
24%
FRANCE
24%


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?

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.
Country 2
Country 1
Procure more
weapons
Do not procure
more weapons
Procure more
weapons
2,2
4,1
Do not procure
more weapons
1,4
3,3
Country 2
Country 1
Procure more
weapons
Procure more
weapons
Do not procure
more weapons
Do not procure
more weapons
2,2
4,1
1,4
3,3
Pareto Optimum
(PO)
Nash
Equilibrium(NE)
Country 2’arms
Country 1’s best response function
NE
Country 1’s arms
Country 2
Country 1
Transfer
nuclear
technology
Transfer nuclear
technology
Do not transfer
1,1
2,0
0,2
3,3
Do not transfer
Country 2
Country 1
Transfer
nuclear
technology
Transfer nuclear
technology
NE
Do not transfer
1,1
2,0
0,2
3,3
NE and PO
Do not transfer
Country 2 (does not care)
Country 1
Transfer
nuclear
technology
Transfer nuclear
technology
Do not transfer
1,1
2,0
0,2
3,0
Do not transfer
Country 2 (does not care)
Country 1
Transfer
nuclear
technology
Transfer nuclear
technology
NE
Do not transfer
1,1
2,0
0,2
3,0
Do not transfer
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
Exports foreign firm
Domestic firm’s best response function
NE in second stage
Exports domestic firm

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.
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.
1
N
 n

 
S   wn  1  w  N  n    w  q j d j   1  w   1  w   u j m j   .
j  n 1
 j 1


n
G   pjd j 
j 1
N
 Pm .
j  n 1
j
j
 j  p j d j  Pj x j  C j .
C j  F  aq j  c  d j  x j  .

Military Capability:
1
N

 

Si  N   u j m j   ;i  a, b.
 j 1


Ratio form Contest Success Function:
 a Sa 

pa 
.
m
m
 a Sa    b Sb 
m

Difference form CSF:
pa 
1
1  exp  k  b Sb   a Sa  
.


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.




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!






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 rulemaking 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.



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.
fate
terrorists
fate
targets
fate
terrorists
fate
•"technology
variable.
of conflict" is usually seen as a unidimensional
•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.


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.
First argument in parenthesis always refers to the strategy of the incumbent
and the second refers to the contestant's strategy:
Pa ( A, D)= probability that incumbent has of winning if they attack and
contestant defends.
t  ea
Pa ( A, D) 
  t  eb  ea
  ea
Pa ( D, A) 
  t  eb  ea
ea
Pa ( A, A) 
eb  ea
Pa ( D, D)  status quo incumbent share  sa  1- sb
 represents the entrenching advantage.
t is the technology location of the contestant.
ea and eb represent the incumbent and contestant's effort respectively.




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
(1-
)=perceived cost of conflict type (A,A), etc...
a/b
ATTACK
DEFEND
ATTACK
Pa ( A, A)a  A, A  V Pa ( A, D)a  A, D V
Pb ( A, A)b  A, A V Pb ( A, D)b  A, D V
DEFEND
Pa ( D, A)a  D, A  V
saV
Pb ( D, A)b  D, A V
sbV




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



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.