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EXPORT CONTROLS,TECHNOLOGYTRANSFER

REGULATION AND THE U.S.SPACE INDUSTRIAL BASE

RONALD A. CASS AND JOHN HARING*

P R E P A R E D F O R T H E

U .S . D E P A R T M E N T O F D E F E N S E S

S P A C E I N D U S T R I A L BASE STUDY ( S IBS ) , O F F I C E O F T H E U N D E R S E C R E T A R Y O F D E F E N S EF O RA C Q U I S I T I O N , T E C H N O L O G Y & L O G I S T I C S

(G E N E R A L C O N T R A C T O R : B O O Z A L L E N & HA M ILT O N)

February 29, 2000

* Ronald A. Cass is dean and Melville Madison Bigelow Professor of Law atBoston University. He formerly served as a member and vice chairman of the U.S.International Trade Commission. John Haring is a principal in Strategic Policy

Research, Inc. (SPR), an economics consultancy based in Bethesda, Maryland. Heformerly served as chief economist of the Federal Communications Commission andas chief of the Commissions Office of Plans and Policy.

7979 OLD GEORGETOWN ROAD 7TH FLOOR BETHESDA, MARYLAND 20814-2429301-718-0111 FAX 301-215-4033 EMAIL [email protected] WEBSITE: www.spri.com


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EXPORT CONTROLS, TECHNOLOGYTRANSFERREGULATION AND THE U.S.SPACE INDUSTRIALBASE

Table of Contents

1. INTRODUCTION 1

2. EXPORT AND TECHNOLOGY TRANSFER CONTROLS: WEIGHING

BENEFITS AND COSTS 4

2.1.CONTROL OBJECTIVES 4

2.2.COSTS/ADVERSE CONSEQUENCES OF CONTROLS 5

2.3.ISSUES AND INSTITUTIONS 6

2.4.CAN CONTROLS CONTROL? 7

2.5.COMMENTARY 9

3. IMPORT OF CONTROL REGIME FOR THE SPACE INDUSTRIAL

BASE 11

3.1.THEORETICAL FRAMEWORK 11

3.2.SPACE INDUSTRY PRODUCTION CHARACTERISTICS 14

3.3.IMPACT ASSESSMENT 16

4. POLICY IMPLICATIONS 18

4.1.RECALIBRATING CONTROLS 18

4.2.IMPROVING THE CONTROL REGIME 19

APPENDIX

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1.INTRODUCTION As part of a larger, in-depth assessment of the U.S. space industrial base,1 Booz- Allen & Hamilton (BAH) have asked us to analyze the likely economic effects ofexport controls and other technology transfer regulations on future U.S. supplycapabilities in this industrial sector. In this paper we explain the economic basis forour conclusion that these types of regulations are, in general, likely to exert a negativeinfluence on relevant U.S. supply capabilities (viz., reduced supplies, higher costs, lesscompetition, less innovation, etc. ). How significant a negative influence will dependon the stringency with which the control system operates.

While we have not been asked to supply and do not offer an assessment of the

efficacy of controls, our conclusion is relevant to such an assessment and hasimplications for the efficient design and implementation of a control regime. Anoptimal control regime carefully balances tradeoffs among various beneficial andadverse consequences of controls to optimize benefits from achievement of alldecision-relevant objectives. Adverse consequences in terms of the adequacy of thespace industrial base and any foregone benefits associated therewith are a cost ofcontrolsi.e., of achieving control objectives. As such they need to be suitablyfactored in deciding how tightly a control regime should be calibrated. They mayalso motivate a search for ways to reconcile conflicting objectives more effectively toimprove the terms of tradeoffs among different goals. Improvements in the controlregime that permit security objectives to be achieved at a lower cost in terms of

foregone export sales (and related, otherwise foregone benefits in terms of thequality of the industrial base), at least conceptually, supply means to eat the cakeand still have it.

The paper is organized as follows: We begin with a brief analysis of controls thatexamines their objectives, the costs and adverse consequences associated with theiroperation and various issues that have arisen with regard to their efficacy andeffectiveness. While controls carry costs and for a variety of reasons appearincreasingly less likely to achieve security policy objectives as the future unfolds, itnevertheless seems likely that government authorities will (continue to) impose them.They will likely decide that perceived benefits of controls in some instances warranttheir imposition and assumption of any related cost burdens. This strikes as arealistic assumption for the timeframe relevant to this forward-looking assessment(15 years), particularly to the extent that the locus of relevant decision-making

1Assessing The Space Industrial Base. The task is to conduct a study of the U.S. space industrial base to assesssufficiency and competition and, if warranted, identify deficiencies and potential areas for investment.

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authority within the government now probably resides closer to the Guardian endof the Merchant-Guardian spectrum as a result of the China-Loral satellitecontroversy.2

Given the probable reality of controls, what difference are they likely to make for thespace industrial base? In the next section of our paper we describe the economicframe and factual premises relevant for economic evaluation of this question.Economic evaluation rests on analysis of basic conditions of supply and demand.Given the basic conditions of supply that typify this industry sector (notably, theprevalence of significant volume effects that imply lower per unit costs withincreases in outputs), economic analysis suggests that controls that effectively limitdemands will likely reduce relevant supply capabilities along a variety of salientdimensions.

In the final section of the paper, we examine some potential policy implications of

our findings. Given the likelihood that controls will continue to be applied, indeed,perhaps somewhat more aggressively in response to the satellite controversy (and thepoliticization thereof), and that their imposition will carry costs, including someadverse consequences for the U.S space industrial base, we think it would behoovethe government to reevaluate the control regime and search for ways to reconcileconflicting policy objectives more efficiently. Technical advance in the controlregime, while perhaps difficult to achieve, does offer the promise of makingeveryone, if not happy, at least somewhat happier. We think it would make goodsense for the government at this juncture to undertake a careful reassessment toidentify ways to improve the existing control regime in light of new economic andgeopolitical realities.

Typically, the economic tradeoffs in this area have been cast in terms of security versus commercial interests,3 but security interests are themselves diverse. Thegovernment sometimes wishes to deny or delay access to sensitive technology to a

2 See Scott Pace, Merchants and Guardians: Balancing U.S. Interests in Space Commerce, inMerchants andGuardians, (John M. Logsdon and Russell J. Acker, eds.), International Space Policy Forum, Space Policy Institute,Elliott School of International Affairs, The George Washington University (May 1999). The term Guardiansrefers to members of the political class with responsibilities for governance; the term Merchants represents theentrepreneurial, energetic, risk-taking culture of international business and, to a lesser extent, internationalscience. Examples of Guardians include career civil servants, military officers, political appointees andCongressional staff. Examples of Merchants are mostly found in business, but sometimes in government, themilitary and academia. On the satellite controversy, see Clinton-Loral: Anatomy of a Mutually Rewarding

Relationship, The New York Times(May 24, 1998). Loral got export authorization for a satellite system after thepresident transferred satellite export approval to the Commerce Department, overruling a recommendation bythe Secretary of State expressing concern that American security could be compromised, and notwithstanding aninvestigation of charges that Loral had given unauthorized assistance to Chinas ballistic missile program. Loralhad earlier informed the U.S. government that a report with technical data had been given to the Chinese as partof the Chinese effort to figure out why an earlier 1996 launch had failed.3I.e., Guardian interests versus Merchant interests.

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perceived adversary, but it also wishes to acquire supplies of different goods andservices at low costs and from strong suppliers who confront at least a modicum ofcompetition.4 The point of our analysis is that the former and the latter goals may,

to some extent, conflict and thus require a balancing of (the governments ownconflicting) interests.5 That type of balancing exercise may often prove to beexceedingly difficult, entailing tough choices (and no doubt some discomfitingsecond-guessing) and perhaps even engendering decidophobia.6

Failure to optimize relevant tradeoffs implies failure to maximize payoffs. Efforts toimprove the terms of relevant tradeoffsto discover ways to offer decision-makersbetter choicesstrike us as one way to address the tradeoff issue proactively.Conflicting objectives imply the need to choose carefully, but if means can be foundto reduce conflicts/reconcile conflicting objectives, the choices that need to be madewill not be quite as tough.

We briefly address the related matter of import controls in an appendix. We areskeptical about the governments ability to exploit favorable economic conditions,where they are (perhaps erroneously) perceived to exist, through the imposition ofimport controls. Indeed, the problem of the interests implies that there willusually be too much import control without any added security rationales for furthergovernment intervention. Import controls also pose serious moral hazardproblems as competition may become less vigorous in the absence of foreigncompetition. We note that the kinds of conditions posited to make out a case forimport controls are precisely the ones that suggest that exportcontrols will have thekinds of adverse consequences we predict (viz., higher costs resulting from failure torealize economies of scale, scope and learning). On the principle of first do no

harm, we think there is a stronger case for relaxation and rationalization of theexport control regime than there is for affirmative intervention to impose moreimport restraints that could easily prove inapt and counterproductive.

4SeeJacques S. Gansler, The Defense Industry (MIT Press, 1980); Affording Defense(MIT Press, 1989); and Defense

Conversion(MIT Press, 1996).5Viz., at the margin,a little more security from prevention of harmful exports may mean a little less viable/lesscompetitive/less progressive space industrial baseother desired security objectives.6 Decidophobia is the inability to choose when confronted with a decision involving a high payoff, but also a high(opportunity) cost. If A and B are each highly desired, but choosing one means sacrificing the other, adecidophobic cannot choose. SeeWalter Kaufmann, Without Guilt and Justice: From Decidophobia to Autonomy(New

York, 1973).

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2.EXPORT AND TECHNOLOGY TRANSFERCONTROLS: WEIGHING BENEFITS AND COSTS7

2.1.CONTROL OBJECTIVESControls are, in general, adopted to serve all or a subset of four principal publicpolicy objectives: denial, delay, cost raising and signaling. The first goal, denial, aimsto prevent the target nation(s) from acquiring the restricted good. The second goal,delay, is more modest, seeking to use restrictions simply as a means to maintain sometemporal advantage in access to the restricted good.8 Delay may buy the timerequired to develop new superior capabilities, so that when the target nationeventually acquires the restricted good, it will still operate at a comparativedisadvantage.

The third goal, cost raising, is more modest yet, aimed less at denial or delay than atincreasing the costs the target nation must incur to acquire the restricted capability.Some observers think this was the principal effect of the multilateral control regime(COCOM)9 that operated for most of the post-WWII period (i.e., to increaseSoviet expenditures for technology, including expenditures on espionage and briberyto acquire technology from the West and expenditures of less efficient production ofsimilar technology at home).10

Finally, controls, even if utterly ineffective in achieving any of these goals, maynevertheless possess value simply as a means to signal displeasure with anothergovernments conduct, both to that government and others. Restricting exports is a

stronger, more tangible signal than diplomatic language, but less dangerous thanmilitary actions. Some U.S export restrictions are probably best understood on thisground.11

Within a cost/benefit framework, the benefits of controls may thus be reckoned interms of their perceived value in preventing or, more realistically, delaying orincreasing the costs of a target countrys acquisition of particular security-sensitive

7 Our treatment of controls sketches the more thoroughgoing analysis contained in our book: International Trade inTelecommunications(MIT/AEI Press, 1998), Chapters 3, 4 and 9.8 This goal is sometimes derided since it may only entail being eaten by the alligator more slowly. Sometimes thatmay, of course, be a preferred alternative, e.g., when more or less slowly are the only alternatives.9

I.e., the Coordinating Committee for Multilateral Export Controls.10See, e.g. Daniel E. McDaniel, United States Technology Export Control: An Assessment(Praeger, 1993) at 117; Igor E.Artemiev, GlobalTechnologyMarkets andSecurity Issues, in Technology Controls and Prospects for Change in the1990s(D.M. Kemme, ed., New York University Press, 1991) and Martin J. Hillenbrand, Export Control Policyin the 1990s: The Diplomatic Perspective, in Export Controls in Transition: Perspectives, Problems and Prospects(G.K.Bertsch $ S. Elliot-Gower, eds., Duke University Press, 1992) at 68.11SeeCass & Haring at 74-80.

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capabilities. In addition, controls are sometimes perceived to possess value as ameans of delivering a message calibrated to communicate a certain level ofdispleasure with the target countrys behavior both to that country and to others.

Against these putative benefits of controls are to be weighed a variety of differenttypes of costs.

2.2.COSTS/ADVERSE CONSEQUENCES OF CONTROLS The costs/adverse consequences of controls fall within four principal categories:administrative costs, economic distortions, trade diversion and related indirect costs.Administrative costs are the direct costs involved in operating the regulatory systemitself, including the costs of government and costs borne by private parties who mustprovide information to the licensing authorities. Although the costs of governmentare probably small, the costs to industry in time and money of learning about,adapting to and complying with export licensing requirements are estimated to be

quite large (i.e., in the many billions of dollars).12

The second cost category covers costs that arise as a consequence of distortions indomestic economic activity within the country imposing controls. These distortionsoccur when export opportunities are lost that would have been available without thecontrols or when the costs associated with controls depress the value of export-related activity (production of goods for export markets together with otheroperations necessary to export) sufficiently to shift economic activity to other ends.In those cases, controls alter the private values that attach to economic activity andchange the mix of activity, for example, by shifting productive resources from high-technology products that face export impediments to lower-technology goods thatcan be marketed at home or exported without difficulty. The proper cost measurefor this type of distortion is not lost export sales,per se, but the neteconomic lossesarising from controls.13 Estimates of distortion costs vary substantially, but even thelowest estimates are certainly non-negligible (estimates range from low single- todouble-digit billions of dollars).14

12 J. David Richardson reports that a single high-technology firm with annual sales of $14 billion (about one-thirdfrom exports) employs more than 100 people whose full-time job is export licensing. Overall costs ofmaintaining this department annually are in the tens of millions of dollars, verging toward $100 million for thefirm described here. SeeSizing Up U.S. Export Disincentives (Institute for International Economics, 1993) at 37.

This figure would have to be multiplied many times to account for the costs incurred by the many companiessubject to export licensing requirements. Even if the particular cost estimate Richardson gives is off by an order

of magnitude, the resulting number will be very large.13 This presumes that relevant resources would not remain completely idle with controls imposed. The differencebetween the higher value they could have produced and the lower value they actually produce is the propermeasure of distortion costs.14 The National Academy of Sciences estimated an annual cost of more than $17 billion from export controls(principally distortion costs) based on data from 1985, although this figure is not rigorously supported. SeeBalancing the National Interest(National Academy Press, 1987).

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Even if economic activity in the home market is relatively unaffected by theoperation of controls, there may yet be a third type of cost associated with tradediversion. In some cases the principal effect of export controls is to shift sales

among country markets rather than to shift activity within any country. Suppose theimposition of new export controls in the U.S. results in substitution of U.S.production for foreign imports to the U.S., while foreign sources that formerlysupplied part of the U.S. demand increase sales to other markets formerly served byU.S. firms. Insofar as these types of substitutions are induced solely by theimposition of controls, there will be some effect on activity levels and somediminution in wealth because the substitutions are judged inferior by customers.15

Finally, there are indirect costs associated with export controls, primarily the costs ofincreased risk (viz., a higher cost of capital reflecting a higher risk premium) frominvesting in commercial activity with the expectation of returns from exporting.Export licensing necessarily causes delay in the economic activity it affects and

introduces an additional uncertainty into the calculation of potential markets andrevenues. That greater degree of uncertainty and risk prompts capital investors todemand higher compensation for the use of investment funds. The higher requiredrates of return (capital costs) are indirect costs of controls that increase costs ofdoing business in much the same way as the administrative burdens would-beexporting firms must bear to comply with the requirements of a control regime.

2.3.ISSUES AND INSTITUTIONSDebate over the imposition of export controls focuses, in the first instance, on theappropriate characterization of goods for which export approval is in doubt. Theproblem of characterization involves both factual and predictive questions: Whatwill a particular product do and what harm can it cause? How much moredifficult isthe completion of a particular task (e.g., building a weapon or a weapon deliverysystem) with the product available than without? With complex equipment, andespecially with complex equipment that is dangerous only as a part of an even morecomplex network of other equipment, the factual problem can be substantial.

The predictive questions focus on the use that will actually be made of the product atissueor the probable use. An extraordinary range of products canbe used in waysthat are threatening as well as in a non-threatening manner. Consider, for instance,the consequences of selling hammers to an enemy: the enemy may simply throwthem back at us or, alternatively, may use them to construct a better society in whose

survival the enemy has a greater stake and thus one perhaps more favorable to ournational interests. Other difficult questions require judgments about whether the

15 The new configuration of trade activity could have been, but was not, freely selected in the absence of controls,implying a lower level of economic welfare (e.g., entailing higher transportation costs, a less-preferred productmix, etc.).

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imposition of controls will stifle or promote development of foreign supplycapabilities. In response to imposition of controls, a target country might deploy itsown capability. The country imposing controls might be better off supplying the

target and maintaining some degree of control through superior knowledge andcontrol of access to replacement parts, maintenance capabilities, complementarygoods and services, upgrades, etc. Controls may be subject to the law of unintendedconsequences: their application may pose risks of loss of control and loss ofeconomic and technical dominance.

The problem of predicting the applications of dual-use technology and the dynamicconsequences of imposing controls is long-standing, and it is embedded in thehistory of export controls. The basic framework for ongoing U.S. export andtechnology controls was set in the aftermath of WWII. In addition to separatenational control regimes, the U.S., France and the U.K. initiated a multilateral effortto restrict strategically important exports to the Soviet Union and its allies that

resulted in the formation of COCOM. COCOM maintained three lists of controlledgoods for weapons, nuclear material and technology, and dual-use technology. Theextent of restrictions on exports can be seen from the size of the restricted listsone estimate reckons 150,000 to 200,000 items.16

Although COCOM has disintegrated, the U.S. and most other former membersmaintain restrictions similar in kind. The current Commodity Control List placesrestrictions on more than 200 different categories of products and technologies andrestricts their export to nations grouped in seven different classes. To give somesense of perspective on the scope and magnitude of control coverage, in 1993 thelate Secretary of Commerce Ronald Brown opined that reduced impediments to

high-technology exports could expand such exports by $300 billion to $500 billionover six years.17

2.4.CAN CONTROLS CONTROL?Analysis of the effectiveness of export restrictions in controlling supply of a givenproduct to a disfavored recipient is a special case of the economic analysis developedto address the likelihood of a successful restriction of market output via collusion (asin an antitrust context where results of collusion are regarded as harmful rather thanbeneficial). The problem for collusive actions is that parties (say, members of theOPEC cartel) benefit not only from collective restriction of supply (of oil), but alsofrom cheating on the agreement to restrict supply and selectively expanding output.

16SeeMcDaniel at 14.17 As previously remarked, this type of estimate is a gross measure and likely significantly overstates themagnitude of the costs of control-induced distortions. Nevertheless, with monies of these magnitudes one caneasily see that there is a lot at stake and why there is often conflict over the imposition of controls. See SpecialReport: Clinton Unveils TPCC Export Plan, BNA International Trade Reporter(Sept. 29, 1993).

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That does not mean that cartels cannot work, but it does mean that in manycircumstances tensions within a cartel reduce its effectiveness and can, in the limit,completely undermine it.

The economic theory of collusion focuses on the benefits and costs of collusivebehavior and predicts that collusion is more likely to occur (and to succeed) whereprospective benefits of collusion are great and costs of policing and enforcing acollusive agreement (explicit or tacit) are low. Conditions affecting entry and theprospects for expansion of supply are important considerations affecting both thecosts and prospective benefits of collusion. Where conditions do not inhibit entryand prospects for expansion are favorable, there is a lesser likelihood of cartelsuccess as any attempted restriction of output is likely to prove unavailing in actuallyrestricting market output. What one set of suppliers does not produce another will.

Analogously, in evaluating the efficacy of export controls, possibilities for developing

new or substitute sources of supply, including sources within the nation that is thetarget of controls, need to be weighed carefully. Consider, for example, that after theU.S. refused an export license that would have allowed India to purchase a U.S.-made supercomputer, India quickly developed its own model and has now sold asubstantial number of supercomputers to buyers in other nations. If target countrieshave alternatives to U.S. supply, including self-supply, the use of controls to limitaccess can prove at best only an incomplete success. Indeed, short-term successcan lead to long-term failure if target nations develop their own capabilities and theseundermine U.S. technological preeminence.

From 1949 to 1994, NATO nations and their close allies operating through

COCOM had an incentive to operate in tandem, so far as the most restrictive entity(the U.S.) maintained some policing power over its partners. Now, with the demiseof COCOM and less sense of a common external security threat to a group ofclosely allied nations, there is greater reliance upon decisionmakers within each indi-vidual nation to set export policy. That means both that the prospect of creating asuccessful embargo cartel is diminished and that the officials charged with decisionalauthority are more exposed to challenge for their decisionswhether to restrict or toexport. Whatever its prior salience, COCOM made me do it is no longer anacceptable excuse. At the same time, decisionmakers in different countries may havedifferent perspectives on the wisdom of sales to prospective targets (Cf., for example,differences between the U.S. and, say, France regarding the embargo of Iraq.).

Even within the U.S. control regime, officials have different constituencies andweigh risks differently. For example, the Department of State is reportedly sensitiveto the positive effects of trade on relations with nations it believes can be induced tomake concessions on issues important to U.S. foreign policy goals. Although thesame officials are quite willing to use export controlseven in settings where thecontrols are unlikely to restrict supply to the target nationwhen they believe that it

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is important to send a message, State Department officials often are reportedlymore willing to soften controls than officials from the Department of Defense or theNational Security Agency (NSA).

The Clinton administrationlike other administrations before ithas been em-broiled in internal disputes among the NSA and the Departments of Defense,Commerce, and State over the question of appropriate policies to regulate exports ofsensitive, high-technology equipment. In those disputes Commerce Departmentofficials reportedly have supported liberalization, while representative of the defenseagencies and State Department apparently have been reluctant to deregulate suchexports and, in particular, would retain unilateral export controls.

Take, for instance, the imbroglio that ensued when AT&Ts application to exportfiber-optic transmission equipment to China, Russia, and other former Soviet blocnations was approved by the Department of Commerce. Commerce officials saw no

point in denying permission to export, as they found that the equipment wasavailable to the export markets from an Israeli supplier. Following that decision,NSA officials assertedly asked President Clinton to override the CommerceDepartments decision. When subsequent efforts to persuade Israeli officials torestrict their supplies proved unavailing, NSAs representative continued to argue infavor of unilateral restriction by the U.S.18

2.5.COMMENTARYImplementation of export and technology transfer controls involves a balancing ofrisks.19 Complaints over the operation of the U.S. regime in the post-COCOM era

18 See AT&T Scores Major Victory on Exporting Fiber Optics to China, Washington Telecom Week (Dec. 17,1993); NSA Pressing Clinton to Scrap Ruling Allowing Fiber Optic Exports, Washington Telecom Week (Jan. 7,1994); and Commerce Finding Fails to Persuade U.S. to Decontrol Fiber OpticsU.S. Wants to ControlExports Despite Key Ruling, Washington Telecom Week (Jan. 14, 1994).19 In recent testimonies before the Senate Committee on Commerce, Science, and Transportation and the SenateSelect Committee on Intelligence, Katherine V. Schinasi, Associate Director for Defense Acquisition Issues inthe General Accounting Office observes that:

The U.S. export control systemcomprised of both the Commerce and State systemsis

about managing risk. Exports to some countries involve less risk than to other countries

and exports of some items involve less risk than others. The planning of a satellite

launch with technical discussions and exchanges of information taking place over several

years involves risk no matter which agency is the licensing authority. Recently, events

have focused concern on the appropriateness of Commerce jurisdiction over communi-

cation satellites. This is a difficult judgment. By design, Commerces system gives

greater weight to economic and commercial concerns, implicitly accepting greatersecurity risks. And by design, States system gives primacy to national security and

foreign policy concerns, lesseningbut not eliminatingthe risk of damage to U.S.

national security interests.

See Issues Related to Commercial Communications Satellites (GAO/T-NSIAD-98-208) and Change inLicensing Jurisdiction for Commercial Communications Satellites (GAO/T-NSIAD-98-222).

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reflect the view that controls are, for a variety of reasons, no longer capable ofproducing the benefits they once did. The identity of perceived adversaries and thenature of perceived security threats have changed. Coordinated restriction of supply

is increasingly more difficult to achieve as nations pursue their national interests on amore unilateral, less collegial basis. Economic growth and the spread of knowledgeglobally have in some cases made it easier for target countries to overcome supplyrestrictions. At the same time, the administrative and trade distortion costs of thecontrol regime are substantial, and globalization of markets is increasing competitiverivalries and pressures. Support for controls within the U.S. is being undermined assuppliers in other countries exploit opportunities operation of the U.S. controlregime affords thema cause of significant frustration to U.S.-based businesses. Tothe extent enforcement of controls appears arbitrary and capricious, support for thecontrol regime dissipates.

We have not been asked and are not, in any event, in a position to assess the merits

of the current U.S. export/technology transfer regime. Given greater reliance onunilateral undertakings, increasingly disparate views in different countries about thedesirability of imposing controls and the increasing global diffusion of intellectualcapital (know-how), the capacity of export controls to work has, generally speaking,been significantly compromised compared to what might have been feasible, say,thirty years ago. We are thus somewhat skeptical about the likely net benefit ofexport licensing. At the same time, given the inherent uncertainties and complexitiesof the full social calculus necessary to assess the question that ultimately shouldinform a decision to retain or remove such controls (in particular settings)and thefact that information about possible risks is well beyond our kenwe are notprepared to say export controls never make sense.

For purposes of our current assignment, three points about the export controlregime are worth making:

Changes in the operating environment may well argue forreassessment and perhaps recalibration of the control regime toreflect changed conditions. As we suggested at the outset, securityinterests, narrowly construed, may themselves argue for a somewhatmore liberal policy, particularly in light of constrained militarybudgets and a shrinking supplier base. As the balance of costs andbenefits changes, the optimal level of governmental restraint on theexport/transfer of technology also changes. Failure to calibrate thecontrol regime to reflect accurately the true tradeoffs among

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conflicting objectives will result in suboptimization.20 We return tothis point later in drawing policy implications from our analysis;

As we later discuss in greater detail, there may also be opportunitiesto improve the technical efficiency with which the control regimeoperates. If such opportunities exist and can be economicallyexploited, the tension between achievement of security-relatedcontrol objectives and other objectives (economic, diplomatic,different security objectives, etc.) need not be as great;21

Notwithstanding efforts expended in either of these directions, forpurposes of industrial base assessment, we think it would beunrealistic to assume that controls are not going to continue to exerta significant constraining effect for the foreseeable future. Indeed, inthe short run restraints may become more severe as the civil servants who implement controls respond to political pressures for closer

scrutiny stemming from the satellite controversy.

3.IMPORT OF CONTROL REGIME FOR THE SPACEINDUSTRIAL BASE

3.1.THEORETICAL FRAMEWORK The economic framework relevant for analysis of effects on the industrial base isalmost as old as the study of economics itself. It was Adam Smith who, in TheWealth of Nations, famously remarked that the division of labor is limited by the

extent of the market.22

The major thrust of Smiths argument is that economicgrowth is driven by technological advance grounded in productive specialization, andthat the size of the relevant market is what principally limits such specialization. Thus Smith, the ultimate free trader, argues that removal of trade barriers andexpansion of trade would increase the wealth of nations by extending marketboundaries, thereby permitting greater division of labor, lower costs of production

20 In particular, at the margin, the security benefits controls purchase may not be worth the adverse consequencesfor the industrial base their imposition, in effect, costs.21 Thus, in contrast to point one, this approach would not necessarily entail a rational (i.e., calculated)compromise of one set of objectives, perceived to be of reduced expected value, to increase realization of adifferent set of objectives, perceived to be of greater value. It is, rather, a matter of attempting to eat the cake

and still have itto achieve security objectives at lowercost in terms of foregone export sales and related payoffsthrough technical improvements in the operation of the control regime.22 (Modern Library Edition, 1937) at 17. As it is the power of exchanging that gives occasion to the division oflabour, so the extent of this division must always be limited by the extent of that power, or, in other words, bythe extent of the market. Earlier (at 3), Smith begins by stating that The greatest improvement in theproductive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any wheredirected, or applied, seem to have been the effects of the division of labour.

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and increased outputs. The imposition of trade barriers, as in the case of exportcontrols, might thus be anticipated to work in reverse fashion: limiting the extent ofthe market, thwarting productive specialization, raising costs of production and

reducing outputs.

Economists have subsequently refined and expanded Smiths analysis, supplying a variety of specific reasons to anticipate that expansion of market size will oftenproduce economic benefits in the form of lower costs of production, greater scopefor competition (viz., more room for competitors) and greater technicalprogressivity. Of particular relevance to our discussion are the existence of so-calledvolume effectsdecreases in marginal and average costs per unit that occur as thetotal volume of output produced expands. Volume effects derive mainly fromeconomies of scale and scope in production and economies associated withlearning-by-doing.23

Suppose different production techniques enable large volumes of output to beproduced less expensively than the techniques that would be efficiently adopted toproduce small volumes.24 Adam Smith used the example of pin manufacture. Ifonly a small number of pins were to be produced, the efficient method ofproduction might entail a single workers measuring out lengths of metal, clippingthem, flattening one end and sharpening the other. If manufacture of a large volumeof pins were contemplated, (Smith argued that) it would be less costly to hire several workers with each specializing in one of the separate activities.25 But note that itwould be more expensive to utilize this approach if only a small volume of pins wereto be produced. The technique that can be used economically for large volumes maynot be economical for small volumes. The small-scale technique can be scaled-up,

but the large-scale technique cannot be scaled-down.

The simplest and a primary source of scale economies is a high initial setup cost.In the modern economy, this type of cost frequently involves technical know-how orintellectual input. To produce a particular good or service requires, in the firstinstance, an investment in the required know-how. Once the know-how has beenacquired, itscost can be spread over actual units of production and will decline on aper-unit basis as the volume of output expands. Stated differently, having incurredthe cost of acquiring the knowledge necessary to produce the first unit, the

23 Our treatment follows the discussion in Economic Nobelist Armen Alchians Costs and Outputs in The

Allocation of Economic Resources(M. Abromavitz, ed., Stanford University, 1959). Much of Alchians prize-winningwork was undertaken with the Rand Corporation and grew out of his statistical work with the U.S. Army AirForces.24 Economies of scopeoccur when larger combinationsof outputs can be produced less expensively than smalleroutput sets.25 While he offered them as an example of gains from productive specialization, in Smiths pin manufacturingexample productivity gains, strictly speaking, stem from learning effects rather than division of labor,per se.

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knowledge necessary to produce additional units is zero (i.e., free).26 For technicallycomplex goods embodying large amounts of applied technical know-how, there arelikely to be significant cost-volume effects grounded in the spreading of this type of

fixed cost. In addition, per-unit costs of production processes utilizing capitalequipment (or other resources) with large fixed costs typically decline until thecapacity of the equipment (operation) is exhausted.

The other principal source of reduced unit costs with larger volumes of output areso-called learning effects. The idea of the learning curve or experience curveis that knowledge increases as a result of production, enabling costs to be lowered asa result of improved knowledge. There is an extensive literature on thisphenomenon as it manifests itself in industry. Learning effects often occur inmanagerial functions, production scheduling, job layouts, material-flow control, on-the-job learning and physical skills. Some learning effects have the character of aneconomy of scale or scope. Suppose one were able to design a particular product

component more quickly, having previously designed a comparable component foranother product. Whether this advantage is said to derive from experience orfrom a broader scale (suppose the previous product were an earlier model) orscope (suppose the previous product involved a different product) of activity isnot important; what is important are the conditions/particular circumstances thatlead to its realization.

In addition to volume effects, there are two other economic considerations that arerelevant for assessment of control impacts. First, while it is impossible to generalize,it has been conjectured that the ongoing worldwide revolution in communicationscapabilities may be increasing the efficient size of firms at the same time it is

globalizing many markets. While small businesses are proliferating, the existence ofmany small specialist businesses may enable some firms to get bigger (i.e., operatemore efficiently at larger scales). With new means of communication, it has becomeeasier to contract out (i.e., outsource) for many services because transactions costsare reduced. By contracting out, firms can expand their core businesses withouttaking on tasks related to expansion that might otherwise serve as a drag onexpansion.27 If the optimal firm size of a defense contractor is growing, security-related limitations on firm size may limit the transactional efficiencies that can berealized.

26 For example, consider that, once the first copy of a CD has been recorded, the marginal costs of additionalcopies consist simply of the material and duplication costs. For this type of good (CDs, books, TV shows, etc.),the initial setup costs are often referred to as first-copy costs. After the first-copy costs have been incurred,the marginal cost of additional units is low.27SeeTalking About Tomorrow with Nobel Prize Winner Ronald Coase, The Wall Street Journal, (Jan. 1, 2000) atR36.

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Besides communications-derived reductions in transactions costs, it is also importantto recognize the often critical technological dimension of competition as well as theextent to which technology competition depends on the existence/maintenance of

adequate investment incentives. The competition that is important in high-techindustries is not so much (or only) a matter of shaving price-cost margins onstandardized goods (as in, say, the market for long-distance telephone calls), but(also) competition to develop and produce new, more advanced products andservices. Industrial dynamism and technical progressivity depend on investments inresearch and development. Private investments directed toward the discovery ofnew inventions and the innovation of new services are, of course, driven byidentification of appropriable payoffs. Where payoffs are constrained or theirrealization rendered more uncertain by controls, incentives to make the investmentsrequired to fund R&D will be attenuated. This kind of effect may assume greatersignificance in an environment where government funding is more limited.

3.2.SPACE INDUSTRY PRODUCTION CHARACTERISTICSSpace commerce involves products and services that are both highly know-how andcapital intensive and on the cutting edge of technological development. They thusexhibit precisely the kinds of characteristics previously described that make forsignificant economies of larger scale operations. There is also evidently significantand increasing competitive rivalry among suppliers based in different countries. Thiscompetition not only undercuts the potential utility of controls as a means of limitingaccess, but it also suggests that controlsto the extent that they limit competitiveeffectivenessmay reduce the quality of the domestic space industrial base. If therelevant economic markets are global and U.S. competitors are significantly restrictedin their ability to tap them, they may be rendered somewhat less formidable suppliersthan they would otherwise beless able to exploit potential economies and attractcapital resources to develop new capabilities.

Space commerce embodies a number of different economic activities includingcommercial space launch vehicles and launch services, satellite remote sensingservices, space insurance and a catch-all category of evolving markets formicrogravity research and manufacturing, solar power, waste removal and even spacetourism. Competitors include countries that have had an historical interest in space(U.S., France and other European nations, Russia and Ukraine, China, Japan,Canada) and now a new, rapidly expanding wave of private entrepreneurial firms.

We have not undertaken an extensive analysis of the production technologies andcost functions involved in space commerce activities, but even a cursory examinationreveals that there are important volume effects and that technology competition isthe name of the game. Consider the following illustrative examples:

Virtually all space commerce activities entail substantial investmentsin know-how inputs and are likely to experience important learning

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effects from expanded production. Consider the know-how involvedin designing and developing a new launch vehicle or the technicalplatform needed to run a launch service. Developing and figuringout ways to apply new technologies productively is the essence ofwhat many of these (new) businesses are (prospectively) about. Themore output that can ride on these investments in intellectual capital,the lower the per-unit costs as these fixed burdens are spread morewidely.

Production processes involve substantial initial set-up costs that canthen potentially be spread over increases in output. Launch pads canbe reused; many companies are now developing reusable launch vehicles that will permit greater resource sharing and per-unit costreductions. Once a remote-sensing capability is developed anddeployed, the marginal costs of additional images are small. More

units of output provide a way to recover fixed costs and spread themmore widely. Similarly, costs of communications capabilities declineas the transponders on individual satellites are employed to fullcapacity and new ways are found to increase the information that canbe communicated via a given pathway.

Intensive efforts are underway to identify and develop new, moreefficient methods for delivering current services and to create newlines of business. In addition to new launch vehicles and methods oflaunch, there is intense competition among software engineers todesign new and better programs to provide more valuable imagingservices and more efficient communications capabilities. According

to the Commerce Department, discoveries about the usefulness ofmicrogravity for scientific research and the development ofpharmaceuticals, semiconductors, and new materials are driving thedemand for the commercialization of space assets.28

Especially in an environment characterized by budgetary restraint, it presumablymakes sense for government to try to piggyback on developments in the privatesector that are complementary to or have public-sector applications. And we gatherthat this is one of the important directions being pursued in terms of the acquisitionof security-related capabilities in the world of tight budgetary constraints. Whilethere may be good reasons for controls on the export or transfer of some security-sensitive capabilities, the government should be careful not to overdo it, lest it

degrade the capabilities it wishes to exploit.

28SeeSpace Commerce, U.S. Industry and Trade Outlook 99at 29.1.

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3.3.IMPACT ASSESSMENTThe intended effect of export and technology transfer controls is to limit/constrain/condition demand for controlled goods and services supplied by producing firms

subject to the controls. If the intended effect is the actual effect (i.e., restrictions onthe extent of prospective markets for security-sensitive goods), the preceding analysissuggests that controls will, as a general proposition, likely reduce future supplycapabilities construed in a variety of important ways. The scope and magnitude ofsuch impacts will depend on the specific content and effectiveness of controls.

In general terms, we would anticipate these types of impacts:

If the effect of controls is to limit firms ability to exploit availableeconomies associated with larger production volumes or to realizelearning economies in the production of current and future products,costs will be higher and realized profits lower. Fewer firms may beviable suppliers in these lines of business.

If the effect of controls is to increase uncertainty about the terms andconditions under which (or whether) foreign buyers will be able topurchase the security-sensitive offerings of U.S. suppliers, that willlikely induce suppliers of investment funds to redirect some of theirresources to potentially more remunerative ventures in other lines ofbusiness, with adverse consequences for technical innovation anddeployment of productive capacity. Foreign countries and firms maybe led to deploy their own supply capabilities in lieu of reliance onU.S. firms.29

If the effect of controls is to limit the extent (size) of relevantmarkets, there will be less room for competitors and lesscompetition than there perhaps would otherwise be. The pool ofpotential competitors will shrink compared to the number that mightbe feasible in a bigger overall market.

There has recently been a good deal of commentary in both the trade and popularpress regarding the consolidation in the defense supply sector that has occurred with

29 In a recent debate in the House of Lords of the U.K.s Parliament regarding the desirability of developingEuropean satellite communications, reference is made by one Member to the downside of dependence,particularly on the US, and particularly, as it is run by the Department of Defense, on the continuing good will of

the US militaryThe unease arises both on security groundsin terms of how far we want to be totallydependent on the goodwill of the US militaryand on commercial grounds. There are increasingly large marketswith lucrative side-markets in areas such as sensors and transmitters which again currently fall disproportionatelyto US suppliers. Another Lord posed this question: Bearing in mind the US regime for the export of satellitesand other technological hardware, what steps will the Government and the EU take to ensure that there arereciprocal exchanges of information and that no surprise restrictions will be applied belatedly by the UnitedStates?

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the cutback in defense expenditures following the end of the Cold War. 30 A gooddeal of thinking within the defense community is being directed toward theramifications of these changes for how the government should cope. Indeed, this

paper and the larger study effort of which it is a part are, in large measure, motivatedby these and related concerns. Given limited funds, the government is naturallylooking to economize and minimize costs, to find ways to limit the erosion ofcompetition stemming from shrinkage of the market for defense capabilities, toexploit commercially available technologies where that is practical and consistent with achievement of objectivesperhaps in lieu of potentially superior, but moreexpensive custom alternatives.31

To the extent that these difficulties are all basically byproducts of shrinking marketsresulting from defense cutbacks, our conclusion that export controls that shrinkmarkets may exacerbate these problems should come as no surprise. That does notmean that the government should not impose export controls, but it means that

controls have downsides that perhaps did not loom as largely when there was abooming market and the loss of an overseas saleespecially one that no one elsewas going to make, given concerted collective action among alliesdid not amountto much.

Now the U.S. market is thinner and overseas markets beckon. Those foreign salesobviously make some contribution to supplier viability (and the viability ofcompetition); they potentially enable firms to spread overhead setup and fixed capitalcosts more widely and to gain potentially valuable experience. Investment capitalwill be forthcoming to a greater extent (i.e., on more favorable terms) to the extentthat appropriable rewards from foreign sales are not prospectively circumscribed and

put at risk. Foreign countries may be less keen to deploy their own costly supplycapabilities if they have greater assurance regarding the availability of U.S. supplieson a timely and economic basis. That may enable U.S. suppliers better to maintainpositions of technical and economic leadership.

The latter are all things that the government presumably values. Because that is soor to the extent that it is so, their sacrifice at the margin should be reckoned as costsor downsides of controls. The upside controls produce is that the target countrydoes not get the controlled goodat least from a U.S. supplier. The downsides arethe economic consequences of the lost sale. These are borne to a large extent by thebusinesses that would have made the sales, which is why they battle hard (both in themarketplace and with government authorities) to make the sales in the first place.But the government also suffers some adverse consequences from lost salesin

30See, e.g., Stan Crock, Commentary: Reveille for Government Arsenals, Business Week (Jan. 10, 2000).31SeeJ. Gansler, The Revolution in Military and Business Affairs: Today, Not Tomorrow, Defense Systems ManagementCollege, Ft. Belvoir, VA (May 12, 1998) and Gansler, supranote 4.

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particular, a marginally less viable, economical, technically vibrant, competitivesupplier base.

The negative external effects of foreign trade in security-sensitive goods are whatmotivate the imposition of export controls. Our suggestion is that there may besomepositiveexternal effects of such trade as well, particularly in an environment oflimited defense budget funding. When a foreign buyer purchases a security-sensitivegood, they get the benefit of the good. The U.S. seller gets the economic benefit ofthe sale, but the U.S. may also benefit to the extent that the sale strengthens the U.S.defense industrial base. The latter external benefit should count too informulating and implementing a control regime. It is an offset, albeit perhaps only apartial one, to the negative external effect of trade in security-sensitive goods.

4.POLICY IMPLICATIONS

4.1.RECALIBRATING CONTROLSTo the extent that the benefit of controls is perceived to be waning as former alliesbreak ranks and access to advanced technology becomes easier and morewidespread, at the same time that the cost of controls is perceived to be waxing aslimited U.S. acquisition requirements shrink the supply base, there is, in principle, acase for relaxation of controls at the margin. Without knowing the specifics ofrelevant risk/benefit tradeoffs, we are not in a position to specify preciseadjustments. It is not inconceivable, although it strikes us as unlikely, that thecurrent regime optimizes relevant tradeoffs perfectly, and that there are literally no

additional foreign sales opportunities that are worth the increased security risks theypotentially entail, even when due account is taken of positive side effects on thedomestic industrial base.

That is possible, but we suspect that a careful and thoroughgoing reassessment ofthe control regime would lead to at least a modicum of relaxation with someincreased exploitation of foreign sales opportunities at the margin. Given thesensitivities (not to mention the politics) recently surrounding the issue, this may notbe the best of times to be proselytizing for relaxation of controls, which is not to saythat a cool-headed assessment is not precisely what is called for in the instantcircumstances. The issue of security-sensitive sales can easily lend itself to

demagoguery with opponents able to point to decidedly inframarginal salessalesthat no one would ever advocate be permittedas the putative outcome of controlrelaxation. To reiterate, our point is that, given changed circumstances, it is plausiblethat a level-headed assessment of relevant risks and rewards may well lead to somerelaxation at the margin.

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4.2.IMPROVING THE CONTROL REGIMEIt may well be nave to credit seriously the possibility or significant likelihood ofcontrol relaxation in the current political environment, although a change in

executive administration may afford an opportune moment for reevaluation. Thereremains, however, an alternative reform path that could produce significant benefits. Whatever the stringency of control the government decides represents an optimalbalance of relevant risks and rewards, it is important that the control regime itselfproduce that degree of control efficiently, i.e., at minimum cost. Thus, it may beworthwhile to search for ways to improve the terms of tradeoffs between guardianand merchant objectives (and, as we have argued, tensions among differentsecurity objectives).

By developing better means of discriminating between threatening and non-threatening transactions, conditioning transactions to reduce security-related

concerns and minimizing administrative burdens and their adverse consequences forcommercial enterprises, it may be possible reconcile objectives to a greater extentand reduce conflicts. Technical advance need not be limited to productionprocesses; applied to the implementation of controls it can make for a more efficient(less burdensome) operation, one that does not entail as great a cost burden alongthe various dimensions earlier detailed. Finding ways to have the cake and eat itmay offer a more palatable and realistic way forward than simply trading off securityconcerns at the margina tack that risks easy, even if unfounded criticism.

There is, of course, nothing new under the sun, and we are aware from our researchof previous suggestions along these lines. In his discussion of Merchants andGuardians, for example, Pace remarks and offers several (at least what strike us as)

sensible suggestions for rationalizing regulation of commercialization of remote-sensing capabilities. He (at 38) recommends, inter alia, a greater routinization ofprocess, avoidance of capricious limitations, advanced warning arrangements and thedefinition of pre-set areas for exclusion. It ought not to be difficult throughconsultation with regulators and commercial interests to determine whetheropportunities for practical, productivity-enhancing advances are possible and toidentify possible improvements.

While we certainly could be mistaken, we suspect identification of concrete steps toimprove the efficiency with which the control process operates might proceed without too much difficulty, much in the same way that specifying fixes for the

budget deficit (when it was a problem) or social security funding is not that hard. The real problem is not so much identifying solutions as implementing them.Improvements in the control regime are unlikely to prove the exception in thisregard. As we earlier noted, parties to the process march to the beats of differentdrums. They have different objectives and incentives. Unless means can be foundto align incentives more consistently, process improvements are likely to come to

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naught. There needs to be an effective will to change the way control business isdone and transform the structure of incentives decisionmakers confront.

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APPENDIX

IMPORT CONTROLS

Commentators in the strategic trade theory school have argued that governmenttrade restriction can advance national economic welfare given large enougheconomies of scale. In particular, they argue that firms alone may not be ableachieve as beneficial a division of industry profits as firms acting in concert withtheir government.32 Assume, for purposes of argument, that production of aparticular good is, in fact, characterized by large scale economies. If firm Asgovernment restricts imports of the good, it lends credibility to firm As expansion

planswhatever share of As domestic market firm B previously enjoyed now canbe added to As share. That means that A can produce more, can produce at lowercost (given scale economies) and also can compete more effectively in Bs homemarket (assuming it is still permitted to compete after As government imposesimport restrictions; i.e., there is no retaliation). These advantages may enable A tocompete more effectively, perhaps even to gain a position of economic dominanceand win the lions share of the profits.

Although this argument is valid given its premises, its premises are open to question.For example, insofar as economies of scale result from learning effects, the argumentfor trade protection rests on a questionable assumption: that protection does notinduce slack. That flies in the face of common experience; in general, firms

protected from competition exhibit less zeal for increased efficiencies.33 Indeed, to asignificant extent, that is the lesson gleaned from comparison of Western Europewith Central and Eastern Europe over a period of four decades.34

We have argued that foreign trade in security-sensitive goods may generate positiveexternal effects for the industrial base, in addition to the negative external effects thatmotivate the imposition of controls. The idea is that tapping foreign demands willenable domestic suppliers ( laAdam Smith) to realize productive advantages, attractmore capital and become more viable, thereby lowering costs, increasing innovationand enhancing competition. One could argue that import controls might potentially

32

See, e.g., James A. Brander & Barbara J. Spencer, International R&D Rivalry and Industrial Strategy, Reviewof Economic Studies (1983) and Tariff Protection and Imperfect Competition, in Monopolistic Competition andInternational Trade (H. Kierzkowski ed., Clarendon Press, 1984). Seealso Paul Krugman, Import Protection asExport Promotion, Ibid.33SeeJagdish Bhagwati, Protectionism, (MIT Press, 1988).34See, e.g., David Lipton & Jeffrey Sachs, Privatization in Eastern Europe: The Case of Poland, Brookings Paperson Economic Activity(Washington D.C., 1990).

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APPENDIX

serve similar ends by increasing demands for the outputs of domestic suppliers. Theargument is that by constraining the purchase decisions of U.S. firms and, in

particular, limiting them to the offerings of domestic suppliers, U.S suppliers willbecome more formidable competitors because they will be better able to exploit theprospectively available economies. Limiting contractual freedom purportedlyinternalizes externalities associated with consumption of domestic suppliers outputs.

We have addressed the strategic rationale for import restrictions at lengthelsewhere.35 For purposes of this paper a couple of points are worth making:

If the premises necessary for import restriction to work exist (viz.,significant economies), they imply that export restrictions thatmaterially affect demands may have a significant costwhich is whatwe have argued. Thus, a case for imposition of import controls also

makes out a (partial) case for relaxation of export controls;36

It strikes us that there is a difference in kind between advocacy ofimposition of restraints on commercial freedom and advocacy ofrelaxation of restraints on commercial freedom as means tointernalize positive trade externalities to a greater extent. Considerthe moral hazard problem to which we have alluded above:Imposition of restraints may not lead to effective internalization ifsuppliers become less efficient when afforded protection fromforeign competition. In contrast, to the extent export controls arebinding constraints, their relaxation can be expected to result inrealization of internalization objectives as firms pursue theircommercial interests and expand output. There is, for this and otherreasons and apart from important considerations of economicfreedom, likely to be a significant difference in the instrumental utilityof the two approaches in internalizing positive external effects.

35SeeCass & Haring, at 24-44.36 Benefits of relaxation must, of course, still be balanced against costs.

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