Profit Regulation of Defense Contractors and Prizes for Innovation

by William Rogerson

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The defense sector is subject to a form of cost-based economic regulation, just as public utilities are. A set of regulations determines the price that defense contractors will receive for their products. This report describes and empirically investigates an extremely simple theory that captures an important aspect of the regulatory problem in defense contracting. The theory describes a critical difference between the regulatory problems in defense and public utilities and suggests why therefore different rules and institutions might be appropriate in each case. It also identifies several implications regarding the structuring of an optimal regulatory policy and sheds light on current policy debates over Department of Defense policy. The author empirically verifies that the incentives posited by the theory exist and are large. The theory is that profit regulation of defense contractors is structured (and necessarily must be structured) so that firms generating valuable new innovations will receive large rewards or prizes. The author attempts to establish the theoretical link between prizes and innovation and then to show that price levels induced by the current rules are large enough to make a theoretical analysis of the role of these prizes important.

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