When More is Less: Defense Profit Policy in a Competitive Environment

Prices on some Department of Defense (DoD) procurement contracts are determined by competitive bids, while on others prices are negotiated on the basis of so-called "DoD profit policy," whereby price is equated to expected cost plus a percentage markup. This article focuses on the interaction between these two contractual arrangements. Specifically, it is assumed that an initial contract is let competitively, with common knowledge that the winner will later become a monopolist regulated according to profit policy. Under these conditions, it is shown that expected contractor profit and government expenditure can often be reduced by raising the profit policy markup. The intuition is not only that firms "buy in" to the initial contracts, but also that the differential subsidization induced by profit policy (higher-cost producers receive larger absolute markups) encourages more aggressive competition. Mathematically, this seemingly restrictive regulatory setup is shown to generalize the McAfee and McMillan (1986) procurement bidding model.