Industry structure, procurement and innovation in the UK defence sector

There is agreement within industrial organisation economics that an inverted U-shape relationship exists between the level of competition in an industry and the level of innovation in that industry. Thus, when consolidation changes the level of competition in an industry we might expect this to have implications for the level of innovation in that industry. The key question for our paper is whether the sort of relationship found to hold, on average, across all of manufacturing industry applies in the specific case of the defence industry. We note that the defence industry has unusual structural characteristics and in particular a single (monopsony) buyer on the demand side that can determine the number of competitors in the industry by imposing regulatory barriers to entry, use its contract terms to control the profits that companies make, and support industry innovation through funding R&D by industry and in its own research facilities. We present data on changes to the structure of the UK defence industry and patterns of innovation, 1989-2007. We note in particular that industry consolidation has been accompanied by a steep decline in industry's own funded defence R&D (an input measure of innovation). We argue that this may be explained in part by changes in industry structure but that industry competition is not the whole story. We argue that another part of the explanation relates to public policy: changes in the level of demand, procurement reform and the changing character of demand have all played a part in reducing both the opportunities and incentives for defence industry innovation. We also offer a third explanation, namely that changes in the nature of defence innovation may themselves in part have driven consolidation. We conclude by considering the concerns of UK policy makers about the decline in industry's own funded defence R&D and the policy options that may be open to them.