I I 1801 N. Beauregard Street, Alexandria, Virginia I Copy 3 of 25 copies. ELECTE 1 June 1995 O

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1 Copy 3 of 25 copes DA PAPER P-2995 THE ECONOMCS OF COMMERCAL-MLTARY NTEGRATON AND DUAL-USE TECHNOLOGY NVESTMENTS Rchard H. Whte, Project Manager An-Jen Ta Contrbutors: Davd Leech Tara E. Santmre Mchael S. Nash DTC ELECTE 1 June 1995 O * Prepared for Advanced Research Projects Agency Approved for publc release, dstrbuton unlmted. DTO Q.UAL~ry SPECTED NSTTUTE FOR DEFENSE ANALYSES N. Beauregard Street, Alexandra, Vrgna DA Log No. HO

2 qq5/o/f// DA Memorandum to: Dstrbuton Q 17 October 1995 From: Subject: Barbara Fealy V alone Publcatons Coordnator P-2995, The Economcs of Commercal-Mltary ntegraton and Dual-Use Technology nvestments Unclassfed HQ Due to an oversght, the copyrght statement was not placed on the nsde cover of the above stated publcaton. Please place the copyrght statement on the nsde cover under the other dsclamers. Thank you for your attenton to ths matter and sorry for any nconvenence ths may have caused you and 19,9 nsttute for Defense Analyses * ~ ~~ ~ ~~~~~h~hs 7materal ma~y /8. býe reprodue yo o dc~ h.s oenetprun (1the copyrght lcense under the clausfr te LtD.AS. GovernentPrsuan,_a

3 DEFNTONS DA publshes the followng documents to report the results of ts work. Reports 3 Reports are the most authortatve and most carefully consdered products DA publshes. They normally embody results of major projects whch (a) have a drect bearng on decsons affectng major programs, (b) address ssues of sgnfcant concern to the Executve Branch, the Congress and/or the publc, or (c) address ssues that have sgnfcant economc mplcatons. DA Reports are revewed by outsde panels of experts to ensure ther hgh qualty and relevance to the problems studed, and they are released by the Presdent of DA. Group Reports Group Reports record the fndngs and results of DA establshed workng groups and panels composed of senor ndvduals addressng major ssues whch otherwse would be the subject of an DA Report. DA Group Reports are revewed by the senor ndvduals responsble for the project and others as selected by DA to ensure ther hgh qualty and relevance to the problems studed, and are released by the Presdent of DA. Papers Papers, also authortatve and carefully consdered products of DA, address studes that are narrower n scope than those covered n Reports. DA Papers are revewed to ensure that they meet the hgh standards expected of refereed papers n professonal journals or formal Agency reports. Documents DA Documents are used for the convenence of the sponsors or the analysts (a) to record substantve work done n quck reacton studes, (b) to record the proceedngs of conferences and meetngs, (c) to make avalable prelmnary and tentatve results of analyses, (d) to record data developed n the course of an nvestgaton, or (e) to forward nformaton that s essentally unanalyzed and unevaluated. The revew of DA Documents s suted to ther content and ntended use. The work reported n ths document was conducted under contract DASWO1 94 C 0054 for the Department of Defense. The publcaton of ths DA document does not ndcate! endorsement by the Department of Defense, nor should the contents be construed as reflectng the offcal poston of that Agency. U

4 DA PAPER P-2995 THE ECONOMCS OF COMMERCAL-MLTARY NTEGRATON 3 AND DUAL-USE TECHNOLOGY NVESTMENTS Rchard H. Whte, Project Manager Acceson For An-Jen Ta NTS CRA& Contrbutors: DTC TAB Davd Leech Unannounced Tara E. Santmre Justfcaton Mchael S. Nash * By Dstrbuton ] 3 June 1995 Dst Avalablty Codes Aval andor Specal Approved for publc release, dstrbuton unlmted. DA 3 NSTTUTE FOR DEFENSE ANALYSES Contract DASW01 94 C 0054 ARPA Assgnment A-172

5 U PREFACE Snce October 1992 the nsttute for Defense Analyses (DA) has asssted the Advanced Research Projects Agency (ARPA) wth economc advce and recommendatons regardng the Technology Renvestment Project (TRP) under the task enttled "The Economc mpacts of Technology nvestments." The purpose of the TRP s to promote ntegraton of the commercal and mltary ndustral bases to mprove the affordablty of weapons and systems whle also contrbutng to the commercal compettveness of U.S. ndustry through dual-use technology nvestments. Earler versons of ths paper focused prmarly on TRP dual-use nvestments to the excluson of other Department of Defense (DoD) efforts. Durng the paper's long evoluton, t became clear that DoD was engaged n other, non-trp dual-use actvtes desgned to ncrease the degree to whch commercal ndustry may be reled upon to meet the needs of the mltary. For ths reason the fnal verson of the paper addresses the 3 broader topc of dual-use technology nvestments and commercal-mltary ntegraton as they pertan to meetng overall natonal securty needs, and the conclusons and recommendatons presented heren should be seen as genercally applcable across all such DoD efforts. 3 The authors would lke to extend ther warmest apprecaton to the revewers of ths paper for ther sgnfcant effort to mprove both ts content and organzaton. Specal thanks go to Bruce Kramer (Natonal Scence Foundaton), Carl Ray (NASA), Ruth Hanes and John Redman (Natonal nsttute of Technology and Standards), and Tom Frazer, Davd Graham, Andrew Hull, Davd Markov, Frederck Rddell, and Karen Rchter (DA).

6 CONTENTS P reface... 3Executve Summary... ES-1 ntroducton Part 1: The Economc Foundatons of Commercal-Mltary ntegraton and Dual-Use Technology nvestments ntroducton to Part Commercal-Mltary ntegraton: A New Approach to Natonal Securty A. Commercal-Mltary ntegraton and Dual-Use Technologes- mportant Dstnctons... 7 B. Can Commercal-Mltary ntegraton Meet the Warfghtng Needs of the Mltary? C. Harmonzng Commercal and Mltary Requrements D. CM and Mltary Needs: Observatons E. Summary Commercal-Mltary ntegraton and the Marketplace A. Co-Producton and CM Sngle Product Producton Co-Producton Economes of Scale and Scope B. Measurng the Degree of Commercal-Mltary ntegraton C. Observatons on the Economcs of CM D. Summary S Commercal-Mltary ntegraton and Global Competton A. Defnng Globalzaton * v

7 Part 2: B. Global Collaboraton Among Frms F oregn Sourcng Cross-B order A llances Foregn D rect nvestm ent C. Global Competton Among Frms and Choce of Locaton Porter's Thess-Regonal/Local Compettve Advantages James Bran Qunn-Core Competences and Outsourcng Dsperson versus Concentraton-Unravelng the n C ontradcton D. M arket Foreclosure E. O bservatons F. S um m ary Choosng Dual-Use nvestments to Promote Commercal-Mltary ntegraton 3 ntroducton to P art V The Techncal Bass for nvestment Choce A. Parwse Techncal Rankng B. Farness and Rankng n Selecton Processes C. Sum m ary V Prvate Rate of Return Bass for nvestment Choce A. Prvate Sector R&D Project Choce B. Rsk and Rsk Reducton C. How mportant Are "The Numbers" n Selectng Technology n nvestm ents? D. Sum m ary V Socal Rate of Return Bass for nvestment Choce A. Econometrc Evdence of the Economc mpacts of n Technologcal Changes B. Socal Net Surplus Studes Calculaton of Consumer's and Producer's Surpluses Measurement of Changes n Consumer's and Producer's Surpluses Resultng From New Technologes Labor Market mpacts v

8 1 4. E xternaltes Calculaton of N PV and RR C. Observatons on the Lmtatons to Socal Choce D. S um m ary Part 3: Conclusons and Recommendatons V Pursung a Long-Term Commercal-Mltary ntegraton Strategy Through Dual-Use nvestments: Conclusons and Recommendatons Appendxes A. Sources of Growth B. Case Study Results C. Selected References v

9 LST OF LLUSTRATONS 5 FGURES -1 D ual-u se Technology Space Shft n Emphass to Acheve Commercal-Mltary ntegraton Margnal Cost Wth and Wthout Mltary Buy V- 1 Arrow Possblty Theorem (paraphased) V- 1 Hypothetcal Econometrc Forecast of Cost and Performance for a N ew T echnology V-2 Mansfeld Socal Surplus Calculatons TABLES -1 Desert Storm Muntons Usage Selected Surge Producton Capactes ndustral Lead Tm e Estm ates H -1 Producton Costs at Defned Stages A-1 Contrbutons of the Dfferent Sources of Growth (Percent)... A-1 B-1 Socal and Prvate Rates of Return From nvestment n Seventeen nnovatons... B - B-2 Summary Results of 20 RNA Case Studes (n percent)... B-2 3 B-3 A Survey on Net Rates of Return on nnovatons... B-3 x

10 m EXECUTVE SUMMARY Whle the noton of relyng on the commercal ndustral base for the needs of the mltary s ganng new currency n the face of fallng defense budgets, mproved commercal technology, and accelerated nnovaton, ths noton was once eschewed by DoD as a crtcsm of ts practces. Durng the Cold War, defense technologes became ncreasngly specalzed to offset the numercal nferorty of U.S. and Western Allance forces compared wth those of the Warsaw Pact, Chna, and other natons. As a result, the Unted States evolved two separate and dstnct ndustral bases-one caterng to the needs of the mltary, the other fully engaged n domestc and global prvate sector 5 commercal market actvtes. Today, wth the Cold War over, poltcal, mltary, and ndustry leaders are seekng anew to operatonalze broad, and at tmes "fuzzy," 3 prncples concernng commercal-mltary ntegraton (CM). The gans that would accrue to the naton by recombnng the commercal and 3 mltary ndustral bases are beng actvely debated, most recently n nfluental reports from the DoD Defense Scence Board, the Center for Strategc and nternatonal Studes, the Carnege Commsson, and the Offce of Technology Assessment. Stll mssng from the polcy dscourse, however, s a rgorous theory of CM-a framework for explanng why t occurs where t does; why t does not occur more (or less) frequently; what forms t s lkely to take; how to encourage or cultvate t; or even how to measure the degree to whch t takes place. A subtopc of ths polcy dscourse-the use of dual-use technology nvestments to pursue ndustral base ntegraton-s the focus of ths paper. The dscusson centers ton two related areas: 1) the economc and nsttutonal ssues nvolved n achevng CM, conceptual and practcal lmtatons of CM, and how CM should be vewed from a 3 natonal securty perspectve n an ncreasngly globally ntegrated economy; and 2) the 3 ntellectual and practcal ssues nvolved n choosng among technology nvestments and assessng ther benefts. Together these lnes of nqury result n a set of recommendatons for constructng a robust approach to publc polcy-makng to take the greatest 3 advantage of defense dual-use nvestments for natonal securty purposes. a l ES-

11 PART 1: THE ECONOMC FOUNDATONS OF COMMERCAL-MLTARY NTEGRATON AND DUAL-USE TECHNOLOGY NVESTMENTS Wthn a changng envronment shaped by rapd nnovaton, classfyng the "dualusefulness" of new technologes and ther applcatons nvolves explorng dynamc nterrelatonshps, begnnng wth scentfc dscovery and extendng through the manufacture and lfe-cycle support of fnshed "products." n some cases, mltary 1 requrements cannot be met by commercal ndustry or they may be nconsstent wth commercal needs and practces. For nstance, f the warnng tme pror to a conflct s 5 short, the quantty of newly produced hgh technology weapon systems that wll be avalable wll not be sgnfcant under a regme of peacetme producton. Ths means that more tradtonal approaches to stockplng and mantanng materel reserves wll contnue to be central to natonal securty. nstances where commercal capabltes and mltary requrements may be mutually satsfed, however, offer sgnfcant opportuntes for DoD to leverage prvate sector nvestments to speed technology developments and mprove affordablty through market economes. To embark on a dual-use technology nvestment program that wll realze CM, DoD needs to change ts approach to procurement and technology nvestment, ncorporatng greater flexblty. Such changes are necessary to accommodate the consderable varance among the possbltes that CM represents. For nstance, at one extreme, complete CM could be characterzed as commercal and mltary products employng dentcal producton processes and beng sold at comparable, compettvely set market prces. Ths would be the same as purchasng all mltary requrements "off-the-shelf," an unlkely outcome even n the long run. At the other extreme, absence of CM would be much lke "busness as usual" today-mltary products requrng practces and producton technques that have lttle n common wth those of the commercal world. The branch of economc theory that deals wth enterprses seekng to produce dfferent products from a common resource base s known as "mult-product producton" or "co-producton." Ths framework s useful n explanng the lkely nteracton between government and ndustry when seekng to pursue CM goals. For nstance, wth coproducton the government needs to know a frm's profts (and costs) under a hypothetcal scenaro that may never be observed. t also needs precse nformaton about the cost structure of the frm (n partcular the nteracton between commercal and mltary goods and, therefore, how to allocate shared costs). From the government's ES-2 5

12 of vew, and n partcular Spont that of DoD, co-producton offers sgnfcant advantages snce t promses to leverage commercal capabltes for mltary purposes. However, 3, there are also ssues surroundng the noton of "far" prcng to the government, as well as complextes whch arse regardng the coordnaton of requrements between the prvate U and publc sectors n the development, plannng, and executon phases for new products. Although many have posted sgnfcant potental for spnnng off mltary technologes for commercal use, today most mltary technologes have few f any commercal analogs or applcatons. n fact, future nvestments n commercal technologes by the prvate sector are expected to be ncreasngly relevant for mltary applcatons; thus, spn-on s the more lkely route for CM. However, because commercal enterprse s rapdly becomng globally ntegrated, entwnng commercal and mltary technologes ntroduces new ssues regardng the domestc producblty of weapons systems and the nternatonal prolferaton of advanced mltary capabltes. n the context of CM and dual-use technologes, "globalzaton" s a process of ntegraton where the research, development, engneerng, producton, and marketng of mltary equpment, systems, and ther components, ncludng dual-use products, ncreasngly occurs across natonal boundares worldwde. t s made possble due to the confluence of four tenets upheld by the nternatonal communty: (1) permssve poltcal regmes, (2) cheap, unfettered transportaton, (3) hgh-capacty telecommuncatons, and (4) flexble busness practces. Under a global producton regme, weapon system desgns are not the responsblty of one or a small set of frms, but are dspersed world- 5 wde to take advantage of techncal specaltes of many partcpants. Ths also occurs for fabrcaton, assembly, and research and development actvtes. As a result, there are ncreasng numbers of cross-border collaboratve busness relatonshps n the form of foregn sourcng, cross-border busness allances, and foregn drect nvestment. But even under such a hghly agle producton regme, the ablty of one or more frms to "domnate" vtal market segments and use derved market power to dstort resource, product, or process avalablty remans. To comprehend the natonal securty mplca- 3 tons of the globalzaton of commercal busness enterprses one needs to understand the nteracton of commercal and defense producton actvtes as well as the nsttutonal nature of ndustral globalzaton. We conclude that, to provde for natonal securty n a global economy, the U.S. Smltary must buld upon world-class commercal capabltes wherever possble, ncludng actvtes whch offer unque, non-commercally avalable capabltes as 3 ES-3

13 qualty multplers. Commercal capabltes properly leveraged wll lead to more affordable mltary systems, and at the same tme wll free-up budget resources to pursue specfc mltary applcatons. m PART 2: CHOOSNG DUAL-USE NVESTMENTS TO PROMOTE COMMERCAL-MLTARY NTEGRATON Over the past two centures the economcs professon has repeatedly explored how to rank preferences among dfferent sets of socal choces. The result has been a set of formalsms and theorems that today comprse the "theory of choce," whch seeks to uncover the logcal foundatons of "ratonally" choosng among alternatves or sets of alternatves. We extend that theory here to help understand how to choose technologes and technology support actvtes for nvestment. One mportant prncple s that selectng among projects based solely on techncal measures, even when such measures are n common, generally leads to ambguous results. Selecton actvtes that rely solely on techncal mert, therefore, employ so-called experts who must make nformed judgments n order to come to closure. Techncal 3 characterstcs are not, however, the only possble evaluaton dmensons of a source selecton processes, partcularly when commercal applcatons are nvolved. 3 n the prvate sector, the monetary requrements to carry out a project, and the expected returns, are also a bass on whch to judge and rank. Such fnancal consdera- 5 tons form the bass for prvate sector assessments of a project's "prvate rate of return." Here the ssue s the perceved value of the project relatve to ts fundng requrements and rsk. Ths, n turn, reduces to an evaluaton of projected proft streams and nvestment costs adjusted for rsk. The two quanttatve measures commonly used to rank fnancal returns are net present value (NPV, also termed "dscounted cash flow") and nternal rate of return (RR). Reducng all nvestment decsons to smple NPV or RR s what allows comparson of "non-fnancal" nvestment projects of all types wth pure fnancal rsks such as stocks, bonds, and commodtes. The lterature on "fnancal" methods of technologcal choce offers two dfferent m approaches to makng "sound" decsons on R&D nvestments. A strategc management perspectve deals wth the mportance of the nnovaton process as t pertans to the over- - all management of compettve busness enterprses and ts ablty to confer a compettve "edge." The second approach nvolves detaled technques that may be used to evaluate 3 and compare dfferent technology and R&D nvestment possbltes." Such models ES-4

14 nclude smple cost-beneft ratos, applcatons of lnear programmng, portfolo analyss technques, group decson-makng paradgms, and structured herarchy processes. Underlyng the "smple" economcs of technology nvestments are a whole host of ssues that must be addressed to offer the quanttatve comparsons useful to makng busness decsons: * How easly approprable s a technology expected to be? * s there a clear path to a commercal or defense market? 0 How should ntellectual property be handled? 1 How should "qualtatve" techncal rsks be quantfed? 0 What are the opportunty costs of forgong an nvestment? Should rsks be pooled or shared? Regardless of the degree of possble quantfcaton undertaken wth such fnancal ndcators, choosng technology nvestments contnues to depend largely on the experence of nvestment managers. We observe that regardless of the attractveness of the "numbers," successful technology nvestment managers rely heavly on ther experence and accumulated knowledge of a technology, ts prospects, and the 3 marketplace to decde upon long-range actvtes leadng to new products and processes. Sthe n many cases, however, the prvate sector s not nterested n undertakng a project because ts "approprable" rate of return s unattractve or t does not have proper corporate ft. Ths does not necessarly mean that t s unattractve to socety at large- net mportance of an nvestment for socety as a whole, takng nto account all benefts and costs, may be dsproportonately larger or smaller than for prvate ndvduals. 3 n judgng the socal worth of nvestments, two approaches are n general use to retrospectvely assess the relatve sgnfcance of a project for socety. Econometrc Sstudes deal wth mprovements n productvty and output acheved due to a partcular technologcal change. Socal net surplus studes calculate overall net benefts ncludng 3 consumer savngs and job formaton or loss. Econometrcs s the quantfcaton of stochastc relatonshps based upon observatons whch are purported to be evdence supportng or refutng an economc proposton. At best we can take econometrc and other approaches to estmatng the mpacts from "progress" as quantfed bodes of evdence of the mportance of technologcal change to economc growth and productvty. f we beleve that "the past s ES-5

15 prologue," then such evdence may be used to structure publc polces to take advantage of the potental benefts from technologcal progress, but ths n no way gves us a determnstc tool for choosng nvestments or projectng ther mpacts. At the level of the frm, a host of studes have been sponsored to assess the prvate and socal rates of return for partcular nnovatons. Whle econometrc technques may be used for such assessments, n the md-1970s an approach smlar to cost-beneft analyss became fashonable. These net socal surplus technques are used to assess changes n socal welfare based on relatvely smple notons of economc surplus. We conclude that despte the sgnfcant amount of analyss of the economcs of 5 technologcal change, to date there s stll no comprehensve, workable economc theory for ex ante estmatng the precse mpacts from technologcal change on the economy 3 useful for focusng R&D nvestments, although avalable emprcal evdence, deducton, and nference appear to suggest strong lnkages. 5 PART 3: SUMMARY OF CONCLUSONS AND RECOMMENDATONS CONCLUSON: Commercal-Mltary ntegraton (CM) s a natural and logcal outgrowth of the rapdly ncreasng capabltes of prvate sector, commercal 3 technologes worldwde. n Part 1 of ths paper we argue that n recent years many mltary-unque 5 technologes have emerged, leadng some to conclude that the relevance of commercal technologes to the mltary s n the process of dsappearng. However, ths concluson s 3 nconsstent wth recent polces that seek to maxmze declnng defense budgets through affordable weapon systems that make use of commercal-sector capabltes. Accordng to these polces, n the same way that we moved from spn-off to mltarly unque systems n the Cold War, we wll move from mltarly unque to spn-on systems now by promotng an ntegraton of the mltary and commercal ndustral bases (CM). Understandng what types of dual-use technology nvestments wll lead to successful ndustral base ntegraton, and whch are mltarly attractve but not commercally 3 vable, s key to formulatng a DoD dual-use nvestment strategy. n fact, there wll always be an mportant need for some mltary-specfc technology development for state- of-the-art weapon systems and assocated producton technques. CONCLUSON: Achevng CM wll requre sgnfcant effort on the part of the 1 Department of Defense to brng ts procurement and acquston systems n ES-6 3

16 "busness practces" nto lne wth commercal norms. The role of dual-use nvestments n ths context s to demonstrate the potental benefts for both commercal and defense frms who choose to serve both sectors. n order to receve more mltarly useful technologes from commercal ndustry, the needs of the defense communty must somehow become algned wth commercal producton goals. Attendng ths process s the ssue of the approprate role of the publc sector n makng the best use of ndustry for natonal securty purposes n the absence of the mmedate purchase of weapon systems. CM technology nvestment polces must therefore be formulated to provde measured stmul that are n harmony wth exstng market ncentves and used to demonstrate the potental "synerges" that would yeld benefts n both commercal and defense actvtes. CONCLUSON: Dependence on an ntegrated ndustral base gves rse to new sorts of dangers to natonal securty. Prmary among these s the ncreased avalablty adversares wll have to technologes ncorporated nto U.S. mltary systems. n addton, a host of problems may result from the ncreasng proxmty of commercal and mltary needs that wll make defense expendtures a de facto part of the natonal welfare equaton. The Department of Defense wll need to mprove ts understandng of commercal technology and busness developments n order to counter potentally threatenng actvtes by transnatonal frms and to prevent the dverson of ts resources for purposes other than natonal securty. Whle promotng CM, DoD must remember that "unfyng" the commercal and mltary ndustral bases wll produce an envronment where commercal advances wll become ncreasngly central to natonal securty. Correspondngly, the dverson of natonal resources for defense may be seen less as a drag on overall economc growth and more as a requrement for commercal endeavor. The prevalence of ths percepton wll correlate wth the success of CM-future dffculty n separatng commercal costs and benefts from defense technology nvestments wll begn to cast such expendtures as socally benefcal. At all costs, DoD must avod beng lured by arguments for nvestments whch are perpheral to defense needs. Arms exports have tradtonally been used both as poltcal "levers" as well as a way to spread development costs for domestc arms ndustres-every ndustralzed naton and many developng natons beneft from the arms trade n ths manner. n the ES-7

17 future we should expect commercal exports wth defense applcatons to be promoted for both economc and natonal securty reasons. Arms producton has also been mportant to regonal tax bases and poltcal consttuences, prmarly by offerng a sgnfcant source of employment-as today evdenced by the reducton of U.S. mltary expendtures. t s not unreasonable to expect future natonal securty arguments to be made n support of selected commercal actvtes-as already occurred n the debate over "crtcal technologes." 5 The reactve approach by the Unted States, reflected n the growng demands for trade protecton by domestc ndustry and labor, represents "neo-mercantlst" urgngs 5 problematc for natonal securty polces that must be founded n a world n whch defense and commercal pursuts are closely algned. Ths s partcularly crtcal snce the hstorcal success of protectonst polces has been less than admrable. That s, whle natons such as Japan have found mert n "nfant ndustry" approaches to developng ndgenous commercal capabltes, even they recognze that domestc ndustres must face "world-class" competton n order to succeed n the global marketplace. Wthout such drect challenges to the organzaton and conduct of busness, frms tend to 3 underacheve both domestcally and nternatonally. Snce defense producton wll come to rely much more sgnfcantly on commercal technologes and ndustral capabltes n the future, the falure of U.S. ndustry to reman world-class wll have a smlar affect on U.S. mltary capabltes. CONCLUSON: n choosng dual-use nvestments, publc polcymakers must carefully consder the structure of the frms, ndustres, and markets whch ther 3 programs are ntended to nfluence. Such advce s not new. n the case of CM, however, specal attenton must be gven to the placement of and sgnals sent 3 through government technology nvestments. n Part 2 of ths paper we survey varous technques for choosng among 3 technology nvestments and conclude that there s no "sngle best" approach to constructng a dual-use technology nvestment portfolo for the purposes of promotng CM. Even retrospectve assessments of pror technology nvestments are not always llumnatng because of the myrad non-technologcal factors that may nfluence outcomes. We are thus led to rely on lessons from past nvestments to structure programs accordng to a pror belefs n prncples that wll regulate ther behavor and determne ther performance-we nvest accordng to parables. 3 u ES-8

18 Our dscussons n Part 2 also llumnate dffcultes whch may be encountered n managng a large portfolo of technology nvestments. Ths s because the same ssues n 5 comparng the attractveness of nvestment projects are rased when we attempt to measure ther progress and ultmate mpacts. As a result, the managers of an nvestment m 3m portfolo wth a large number of projects are forced to abstract from specfc characterstcs and to rely on generalzatons about ther ultmate goals and utlty. n ths sense we are effectvely managng technology as f t were an con, where each project s accorded a smpler representaton, tself a detal n a larger scheme. Such "nvestment by parable and management by con" suggests that success n promotng CM wth dual-use technology nvestments depends on the manner n whch the government structures the selecton of nvestments. That s, nvestments that fal to nclude the rght mx of techncal and management talent, commercal market astuteness, and understandng of mltary goals and needs begn wth a dsadvantage that s dffcult f not mpossble to overcome. 3 RECOMMENDATON: There s a dfference between dual-use technology nvestments and nvestments that wll ultmately lead to commercal-mltary ntegraton. Any successful long-term CM strategy must seek to dfferentate between what s potentally dual-use from a technologcal standpont, and what s both commercally vable and mltarly useful from both a technologcal and prvate marketplace standpont. The followng nne crtera are recommended as gudelnes for choosng dual-use technology nvestments General Defense Relevance Dual-use technology nvestments must have a clear connecton to future needs and requrements of the Department of Defense. General defense relevance pertans to the requrement that all CM projects must further the cause of natonal securty, ether drectly for mltary purposes, or ndrectly through ndustral base mprovements whch may be demonstrated as ntegral to provdng for the natonal defense Attenton to DoD Cost Drvers Dual-use technology nvestments should target nvestments that promse to leverage sgnfcant cost savngs for DoD. Ths cost-reducton, rate-of-return crteron s a corollary to so-called prvate rate of return. t focuses nvestments on the need to produce sgnfcant cost savngs for natonal defense and emphaszes not only dual-use and co-producton actvtes, but also personnel and tranng cost reductons. m ES-9

19 3. Commercal Market Drvers A commercal market drver exsts when a commercal demand for a product or process concdes closely wth a defense need. Dual-use technology nvestments should demonstrate strong lnkages to future commercal markets, both n terms of the potental sze of these markets and the natonalty of frms lkely to be major players n the markets. (There should be strong economc justfcaton.) 4. Sgnfcant Technology Leveragng To acheve desred defense-relevant goals, DoD should seek to leverage the mpact of ts dual-use technology nvestments by targetng areas n whch there s clear under-nvestment by ether the prvate sector, the publc sector, or both. Expendng DoD funds n areas where there are already large technology nvestments wll have lttle! leverage or pay-off. 5. Crtcal Path Roadblocks Dual-use nvestments should target specfc techncal challenges that are unlkely to be addressed by the prvate sector alone. Such challenges consttute a crtcal path 3 roadblock because promsng future technology developments are curtaled by the hgh cost of overcomng one or more techncal challenges. n some cases such challenges wll need to be targeted based on defense needs alone. 6. Full Spectrum ndustry Partcpaton Maxmum mpact from dual-use technology nvestments s most lkely to vary drectly wth the number of partcpants n a development project. By full spectrum we mean the need to nvolve all partes wth an nterest n a project n a partnershp or research allance. Ths s mportant for two reasons: t s necessary to make sure that the ndustry leaders are nvolved to mprove the chances for success; t mantans "safe" dstance from commercalzaton/productzaton Portfolo and Cost Share/Captal Avalablty A portfolo of dual-use nvestment projects wth varyng degrees of rskness should be developed, and goverment support dfferentated accordng to rsk. There s a need to balance prvate rate of return wth dversfcaton of rsk n a portfolo. Where rsk s low, prvate sector nvestors should carry the prmary burden for fundng a project wth commercal potental and mltary utlty. Where rsks are hgh and captal 1 avalablty s an ssue, there s a need to determne whether these crcumstances derve from approprablty concerns or lack of nformaton about opportuntes. 3 ES-10 5 U

20 S! 8. Process Technology Focus Process technologes are key to ndustral base ntegraton and should be a focus of dual-use nvestments. The essence of an ntegrated commercal-mltary ndustral base s the ablty to co-produce commercal and mltary tems. But because nternatonal competton s leadng to global out-sourcng, mantanance of a world-class 5edge both n product and n process technology. ndustral base necesstates that domestcally based, U.S. frms mantan a compettve 9. Socal Rate of Return and Pervasve mpact Dual-use technology nvestments should seek to maxmze socal benefts, partcularly as a result of external effects from projects. A measurable, benefcal, drect 3 mpact on U.S. frms and natonal securty should result from ultmate maturty of the technology development to be pursued. Benefcal mpacts on frms nclude the creaton of jobs, mprovement n productvty, and ncreased proftablty. Benefcal mpacts on natonal securty nclude reductons n weapon system costs, technologcal "leapfroggng" of foregn compettors' capabltes, and demonstraton of co-producton of mltary and commercal products. RECOMMENDATON: n order for dual-use technology nvestments to be successful, there s a need to mprove DoD's ablty to gauge the commercal attractveness 5 of such nvestments. To mprove the prospects for successfully achevng CM, DoD should assemble an n-house commercal assessment capablty for use n 5 determnng the potental commercal vablty of dual-use nvestments. As we move toward an ntegrated ndustral base, there wll be a growng need for 5 commercal expertse wthn DoD to dentfy, recommend, and select nvestments approprate to CM. Beyond the Cold War technology-based approach to nvestment for U the mltary, there s a need to address prvate and socal rate of return characterstcs as well. Unfortunately, such commercal fnancal and economc expertse s not yet avalable wthn DoD. mmedately, DoD should seek to assemble a team of experts to assess and advse on the commercal vablty and broader socal mpacts from proposed dual-use nvestments. To avod conflct of nterest ssues, such a team could be drawn from retred executves n the commercal world, Federally Funded Research and Development 3 Centers, and panels of the Natonal Research Councl. ES-l

21 Experts n fnance should be recruted before nvestments are made to help exam- ne the types of frms lkely to be attracted by dual-use opportuntes. These same experts could also assst wth the oversght of nvestments through perodc progress revews. Experts n economcs, and more specfcally ndustral organzaton, could be used to examne the lkely market consequences of dual-use nvestments pror to commttng to a project. n addton, they could look for externaltes, spllovers, and lnkages from these nvestments that would offer prospects of hgh socal rates of return. Throughout project executon they would contnue to montor markets both domestcally and nternatonally. 3 RECOMMENDATON: Consderaton of the role of the global marketplace and efforts to address t wll become central to the success of CM. t cannot be over- 3 emphaszed that world-class commercal and dual-use ndustral capabltes are the only means to an affordable mltary based on an ntegrated ndustral base. 3 Cross-border allances, ncludng consorta and partnershps, appear to be central to facltatng access to foregn technologes and capabltes that may reduce the cost of pursung mltary applcatons. Such allances take consderable tme to coalesce, however, and DoD must begn to send "sgnals" to potental prvate sector nvestors wth suffcent lead tme for ther formaton. Wth greater relance on the prvate sector, there s a need to promote commercal-mltary busness allances that seek to ncorporate foregn techncal and management nnovatons to speed the maturaton of CM nvestments and foster globally compettve U.S. commercal frms. 3 n Chapter V great emphass s placed on developng a global strategc perspectve necessary to cope wth CM. Ths perspectve s essental for keepng U.S. securty world-class snce the underlyng dual-use ndustral base must also be worldclass. n essence, DoD must avod commttng to projects that do not have the potental to help partcpants excel n the global marketplace. To realze such a strategy, dual-use nvestments must combne the best of both the commercal and defense "worlds." For nstance, European and U.S. experence suggests that strategc allances and approprately structured prme/suppler relatonshps are n mportant because of the complex nature of modern weapon systems. Allances and consorta are also rapdly becomng the norm for commercal endeavors, and have 5 ES-12 E

22 U demonstrated sgnfcant advantages n promotng enterprse aglty, reducng costs, and! delverng qualty. U 1 ES- 13

23 NTRODUCTON Technologcal progress affects our daly lves through almost everythng we read, hear, see, dscuss, or experence. From chldren's cartoons to ktchen applances, hand guns to stealth fghters, technology defnes our qualty of lfe and the hstorcal stages of our exstence. We are taught the Amercan West was "won" because a technologcal revoluton n ral transportaton supported expanded contnental mgraton and commerce; we descrbe the Cold War n terms of the nuclear and advanced conventonal weapons wth whch the Unted States and U.S.S.R. armed themselves; and we see the future of human nteracton and daly lfe n terms of transformatons resultng from faster computers, hgh capacty telecommuncatons, and vast nformaton networks. n short, we vew 3 technology as the "fx," or panacea, for every socetal problem, ncludng unemployment, ndustral uncompettveness, health care neffcences, and unaffordable defense. 3 nvestments n new technologes alone cannot cure socety's lls, however. To take full advantage of technology nvestments, other factors must also be n place: a 3 better educated work force that can assmlate new ways of producng; reformed and ncreasngly flexble management practces to adapt busness practces to rapd changes; greater harmony between ndustry needs and government polces; and a redefnton of work and success wthn the evolvng techno-economc landscape. 3 2 Even n an envronment conducve to technologcal progress, t s dffcult to decde what types of nvestments to undertake. mmense dffcultes are encountered when one attempts to choose projects not only from a techncal perspectve, but also from n the perspectves of prvate and publc sector decson makng. The relatve "goodness" of one nvestment over another s dffcult to assess a pror, and the outcome of an nvestment can only be projected wth uncertanty. Whle we accept that technologcal 1 Technologcal change s generally seen as labor-dsplacng n the short term, although ts contrbuton to economc growth n the long term has generally led to the creaton of new jobs. 2 Ths s partcularly true gven that robotcs and automaton are reducng the need for human nterventon and leadng to a host of new occupatonal categores.

24 progress offers potentally szable economc benefts, we have yet to fully understand the causal lnks nvolved n dervng such benefts. We must consder, then, how we may use our lmted understandng of the relatonshp between technologcal change and economcs to mprove the way n whch such nvestments are targeted. Commercal frms have already made such consderatons 3 part of ther decson makng, but the Federal Government s only begnnng to recognze the need to force a confluence of agency msson-orented goals wth broader socal and 3 economc goals. Ths paper revews the current "state-of-understandng" for makng prvate and 3 government technology nvestment decsons and examnes how ths understandng may be appled n selectng dual-use technologes to further the goal of commercal-mltary 3 ntegraton (CM). The dscusson s dvded nto two parts. Part provdes an economc framework for understandng the obstacles and 5 ssues nvolved n pursung an ntegrated ndustral base by addressng the followng: * What s CM, and what s the role of dual-use technology n promotng an 3 ntegrated ndustral base? Are there lkely to be repercussons n commercal markets from attempts to jontly satsfy commercal and mltary demands? Are there measures whch may be employed to gauge the extent to whch ntegraton efforts are succeedng or payng off? How does CM "play" n the global economy, and what are ts mplcatons for natonal securty? Part 2 of the paper revews the three dmensons of assemblng a publc sector technology nvestment portfolo-techncal, prvate rate of return, and socal rate of return selecton methodologes. t addresses the followng: "* s t possble to develop completely objectve technology nvestment selecton crtera? "* To what extent are fnancal calculatons useful n sftng through nvestment choces? " What s meant by socal rate of return, and why s ths an mportant part of makng nvestment choces for publc polcy makers? A summary s provded at the end of each chapter. Conclusons and recommendatons are offered n Chapter V. U U

25 3 PART 1 THE ECONOMC FOUNDATONS OF COMMERCAL-MLTARY NTEGRATON AND DUAL-USE TECHNOLOGY NVESTMENTS

26 1 NTRODUCTON TO PART 1 U Whle the noton of relyng on the commercal ndustral base for the needs of the mltary s not new, t s nevertheless resurgent. Durng the Cold War, ncreasngly specalzed defense technologes were employed to offset the numercal nferorty of U.S. and Western Allance forces compared wth those of the Warsaw Pact, Chna, and other natons. Ths led to the emergence of two separate and dstnct ndustral bases n the Unted States, one caterng to the needs of the mltary, the other fully engaged n 3 domestc and global prvate sector commercal market actvtes. Today, wth the Cold War over, defense budgets fallng, commercal technology advancng, and commercal nnovaton acceleratng, the noton of relyng on the commercal sector for the mltary's technology needs-once consdered a crtcsm of 3 DoD practces-s beng embraced anew. Ths sea change has spawned new dscussons whch seek to operatonalze broad, and at tmes "fuzzy," prncples concernng 3 commercal-mltary ntegraton (CM). n fact, these dscussons actually derve from a mature debate about the gans that would accrue to the naton by recombnng the commercal and mltary ndustral bases, most recently joned by nfluental reports from DoD's Defense Scence Board, the Center for Strategc and nternatonal Studes, the Carnege Commsson, and the Offce of Technology Assessment. 3 Stll mssng from the polcy dscourse, however, s a rgorous theory of CM-a framework for explanng why t occurs where t does; why t doesn't occur more (or less) frequently; what forms t s lkely to take; how to encourage or cultvate t; or even how to measure the degree to whch t takes place. nterest n developng such a framework, ether on a theoretcal or practcal bass, has been dampened by admnstratve and 3 Department of Defense, Defense Scence Board, Engneerng n the Manufacturng Process, March Department of Defense, Defense Scence Board, Use of Commercal Components n Mltary Equpment, Mmeo, July Department of Defense, Defense Converson Commsson, Adjustng to the Drawdown, December 31, Center For Strategc and nternatonal Studes, Crtcal ssues n Defense Converson (mmeo draft) Carnege Commsson on Scence, Technology, and Government, Technology and Economc Performance, September Offce of Technology Assessment, Redesgnng Defense: Plannng the Transton to the Future U.S. Defense ndustral Base, July OTA, After the Cold War. Lvng Wth Lower Defense Spendng, February OTA, Buldng Future Securty: Strateges for Restructurng the Defense Technology and ndustral Base, June See also: S. J. Detchman, Beyond the Thaw: A New Natonal Strategy, 1991.

27 procedural barrers erected over tme by DoD and by legslaton from Congress. ndeed, untl recently, the lkelhood of an ntegrated ndustral base has been slght. To fll the vod, ths part of the paper constructs a framework for understandng CM: where t may be approprate, what ts market mpact may be, how t mght be measured, and what t may mply for natonal securty n an ncreasngly ntegrated global economy. 3 4U 3 U 4 U

28 . COMMERCAL-MLTARY NTEGRATON: A NEW 3 APPROACH TO NATONAL SECURTY n general, we beleve most of the technologes the Defense Department depends upon-electroncs, semconductors and computer software, to menton a few-have equvalents n the commercal ndustry. Therefore we do not beleve we have to mantan a defense-unque capablty n those areas. -Dr. Wllam Perry, Secretary of Defense 1 3 Events snce the demolton of the Berln Wall n 1989 have dramatcally changed the face of nternatonal securty. Wth challenges from the USSR rapdly fadng and no 3 comparable threats apparent n the near future, the Unted States s shftng ts attenton and resources to address domestc needs. The new focus s on economc securtyprovdng for hgh qualty (well payng) employment and ncreased socal welfare for U.S. ctzens wthn the context of the compettve, global marketplace. Whle the Cold War may be over, recent developments n the Mddle and Far East, Afrca, Europe, and the Carbbean suggest that mltary securty wll reman an mportant concern for the foreseeable future. To deal wth antcpated regonal contngences, U.S. forces need not be as vast as they were durng the past 45 years; however, they wll contnue to face formdable challenges. Our choces are ether to 3 equp the mltary from a shrnkng, dedcated defense ndustral base and face certan degradaton n qualty and capabltes, or to adapt mltary requrements and procurement strateges so that they rely upon commercal ndustral capabltes. The second approach, ncreasng relance on commercal sources, nvolves 5 ntegratng the defense and commercal ndustral bases whch evolved as separate and dstnct durng the Cold War. Ths s termed "commercal-mltary ntegraton" (CM). 3 The essence of CM s that suffcent commonalty between commercal and defense needs can be "desgned nto" mltary systems and weapons so that commercal capabltes can fulfll the vast majorty of defense requrements. n research and development ths goal s pursued through so-called dual-use technologes-technologes 1 Anthony L. Velocc, Jr. "Perry Forges New Shape for ndustry," Avaton Week and Space Technology, November 15, 1993, p. 56 (hereafter cted as "New Shape for ndustry")

29 that are both commercally vable n the compettve marketplace and mltarly useful! ether drectly or wth lmted modfcaton. Wthn a changng envronment shaped by rapd nnovaton, classfyng the "dualusefulness" of new technologes and ther applcatons nvolves explorng dynamc nterrelatonshps, begnnng wth scentfc dscovery and extendng through the manufacture and lfe-cycle support of fnshed "products." n some cases, mltary requrements cannot be met by commercal ndustry or they may "contradct" commercal 3 needs and practces. For nstance, f the warnng tme pror to a conflct s short, the quantty of newly produced hgh technology weapon systems that wll be avalable wll 3 not be sgnfcant under a regme of peacetme producton. Ths means that more tradtonal approaches to stockplng and mantanng materel reserves wll contnue to be central to natonal securty. nstances where commercal capabltes and mltary requrements may be mutually satsfed, however, offer sgnfcant opportuntes for DoD to leverage prvate sector nvestments to speed technology development and mprove affordablty through market economes. To embark on a dual-use technology nvestment program that wll realze CM, DoD needs to change ts approach to procurement and technology nvestment, ncorporatng greater flexblty. Such changes are necessary to 5 accommodate the consderable varance among the possbltes that CM represents. For nstance, at one extreme, complete CM could be characterzed as commercal and 3 mltary products employng dentcal producton processes and beng sold at comparable, compettvely set market prces. Ths would be the same as purchasng all mltary 3 requrements "off-the-shelf," an unlkely outcome even n the long run. At the other extreme, absence of CM would be much lke "busness as usual" today-mltary products requrng practces and producton technques that have lttle n common wth those of the commercal world. n fact, the sometmes sgnfcant dfferences between DoD and commercal goals mean that we should not expect to acheve complete CM for all mltary products and that t wll be the ntermedate cases that wll yeld the greatest benefts to DoD from a cost and performance standpont. Large mltary platforms, such as armored vehcles, fghter arcraft, and warshps, wll contnue to be produced wthn a tradtonal Cold War 3 contractor-type or perhaps an arsenal envronment. 2 Wth CM, however, ther 2 bd.

30 components, such as radar, engnes, communcatons gear, and so forth, would be produced to address a range of dfferent requrements from the mltary-unque to commercal-off-the-shelf. n many cases, t would be possble to "share" commercal producton facltes, an arrangement called "co-producton." A. COMMERCAL-MLTARY NTEGRATON AND DUAL-USE TECHNOLOGES-MPORTANT DSTNCTONS t s mportant to clearly dstngush between dual-use and CM. When we speak of "dual-use," we are referrng to a product or process that has both mltary and commercal applcatons. n the case of dual-use technologes, ths extends to knowledge 3 that s applcable n both sectors. The concept of dual-use therefore relates 3 to the characterstcs of a product, process, or know-how wthout regard to the desrablty of ts applcaton n ether sector. Hence, an tem mght be dual-use and employed 3 mltarly but not commercally because of cost, performance, regulatons, or other -- consderatons. 3 CM, on the other hand, s a process that seeks to explot the "dual-usefulness" of products or processes to arrve at more effcent and cost effectve solutons jontly for the commercal and mltary sectors. Commercal-mltary ntegraton s acheved when the producton of commercally vable and mltarly useful products s conducted jontly usng common producton nputs, and outputs are sold at prces comparable to those set by commercal markets. Note that ths defnton nvolves two dmensons, an engneerng one ensurng the commonalty of resources and producton technques, and an 3 economc one ensurng the comparablty of costs and prces. The former represents the tradtonal Cold War mltary consderatons regardng performance; the latter, the post- SCold War affordablty concerns that underle CM as pursued through current DoD polces. Not everyone accepts the possblty of ntegratng mltary and commercal needs wthn a unfed producton and dstrbuton envronment. Some say that the dfferences between the two sectors are drven by product desgn requrements that press the lmts of engneerng feasblty. Some argue that labor costs n defense markets tend to be greater than n ther commercal counterparts because of strngent producton and admnstratve requrements, or that DoD producton runs are too small to yeld commercally vable 3 We nclude know-how as part of bg "K" knowledge. 1 7