The economics of the UK aerospace industry: A transaction cost analysis of defence and civilian firms Ian Jackson PhD Department of Economics and Related Studies University of York 2004 Abstract The primaryaim of this thesisis to assessvertical integration in the UK aerospace industrywith a transactioncost approach. There is an extensivetheoretical and conceptualliterature on transactioncosts, but a relativelack of empiricalwork. This thesisapplies transaction cost economics to the UK aerospaceindustry focusing on the paradigmproblem of the make-or-buydecision and related contract design. It assesses whetherthe transactioncost approachis supported(or rejected)by evidencefrom an originalsurvey of theUK aerospaceindustry. The centralhypothesis is that UK aerospacefirms are likely to makecomponents in- housedue to higherlevels of assetspecificity, uncertainty, complexity, frequency and smallnumbers, which is reflectedin contractdesign. The thesismakes these concepts operational.The empiricalmethodology of the thesisis basedon questionnairesurvey dataand econometric tests using Ordinary Least Squares (OLS) andlogit regressions to analysethe make-or-buy decision and the choiceof contracttype. The resultsfrom this thesisfind limited evidencein supportof the transactioncost approachapplied to the UK aerospaceindustry, in spiteof a bespokedataset. The empiricaltests of verticalintegration for both make-or-buyand contracttype as the dependentvariable yield insufficientevidence to concludethat the transactioncost approachis an appropriateframework for analysingthe UK aerospaceindustry as appliedin this thesis. ii The economics the UK aerospace industry: A transaction cost analysis of defence and civilian firms Page Abstract Contents Acknowledgments vi Preface viii List of tablesand figures x Part 1: Theory and Overview Introduction 2 The researchproblem and researchquestions 3 Plan of the thesis 4 The UK aerospace industry 6 Definitionsof the UK aerospaceindustry 6 Structure-Conduct-Performance 16 Verticalintegration and transaction cost economics 32 Conclusions 33 Literature survey of transaction costs 35 Definitionsof transactioncosts 35 " review of the theoreticaltransaction cost literature 44 " review of the empiricaltransaction cost literature 58 Summary 74 Conclusions 76 Applying the transaction cost model 77 Backgroundto the model 77 Themethodology of transactioncost models 80 Thetransaction cost model 82 Transactioncost hypotheses 92 Applicationsof thetransaction cost model 99 Conclusions 108 iii Part 11: Empirical Results 151. Methodology and questionnaire Research methodology The survey population 116 The pilot survey 118 The questionnaire 120 Survey sample 123 Dependent variables 124 Independent variables 126 Conclusions 131 Empirical results 1: industry level 132 Diagnosticchecks on the dataset 132 Pricing profile 138 Companyprofile: turnover and employment 140 Transactioncost: assetspecificity, uncertainty, ftequency 144 Smallnumbers 150 Economiesof scale 152 Make-or-buy 154 Crosstabulations 155 Conclusions 160 171. Empirical results II: firm level 162 UK aerospacesupply chain 162 Activity of firms in the aerospaceindustry: evidenceof make 168 Contractsin aerospace 173 Other supply-sideissues 179 Conclusions 182 Econometric analysis of UKAI 1: make-or-buy 183 Organisationalform 184 Themodel 187 Centralhypothesis 188 Dependentvariable: bought-out 195 Dependentvariable: make 204 Summaryof the OLSand logit regressionresults 211 Conclusions 212 Econometric analysis of UKAI IT: contracts 214 The hostagemodel 214 Centralhypotheses 217 Explanatoryvariables 219 Summaryof results 221 Comparisonof resultsin ChaptersEight andNine 224 Critique of results 226 Conclusions 227 iv Part III: Conclusions [101. Conclusions and proposals for further research 229 Thesisconclusions 229 Interpretingthe conclusions 230 Proposalsfor furtherresearch 231 Appendix 1: The rangeof empiricalstudies in TCE 235 Appendix H: UK aerospacesupply chain questionnaire 242 Appendix IH: Pilot study of LJK aerospacefinns 250 Appendix IV: UK aerospacesurvey results 260 Appendix V: Abbreviationsand variablelisting 263 Appendix VI: Glossary 268 References 271 Index 291 V Acknowledgements Therearc manypeople I would like to thankfor the considerablehelp and support givento me throughoutthe yearsof studyingfor this degree. First and foremost,I would like to thank ProfessorKeith Hartley without whose considerableand consummateguidance this thesiswould not havebeen completed. Keith allowedme the time to exploreand examine issues whilst keepingme on task. Therefore,I would like to expressmy sinceregratitude for his professionalsupport and also to John Suckingwho asthe othermember of my thesisadvisory group (TAG) at theUniversity of York gaveme copiousadvice. A specialword of thanksis alsodue to Margaret McCaffreyfor all the supportshe provided to me. My family hasborne the brunt of the time I havespent on this thesis. To my wife Francesca,my two children,Thomas and George and my parents,Jean and Allan, I can only offer my heartfeltlove andappreciation in returnfor the absences.They have all beena constantsource of encouragementand motivation. Incidentally,this thesishas been finishedover 30 yearsafter I startedmy formal primary education. I have attendedfour schoolsand four universitiesand I havethoroughly enjoyed every single minuteof thejourney. My unreservedthanks go to PaulDownward, a colleagueand a fiiend,who hasalways listenedsympathetically and given good adviceand encouragement.Paul has been a mentorand a sourceof inspiration.Also specialthanks are also due to manypeople I havemet and workedwith duringthis researchincluding Todd Sandler,Ron Smith, PaulDunne, Jurgen Bruer, David Saal, Tim Webb,Samuel Britten and Bruce Kent. At StaffordshireUniversity this list includesJohn Bridge, Alastair Dawson, David Golby, JeanMangan, Geoff Pugh, John Ramsay, Peter Reynolds and Lisa Woodhouse. I fully appreciateall theacademic help, which these people have given to me. Many aerospacecompanies have given considerablehelp, includingBAE Systems (formerlyBritish Aerospacep1c), Rolls-Royce plc andMBDA (formerlyBAe-Matra). The firms in the pilot studywere also very co-operativenamely, Aero & Industrial Technology,Aerospace Metals limited, BellhouseHartwell and Companyand DidsburyEngineering. Also I am deeplygrateful to the 82 firms who completedthe questionnairethat formsthe basisof the research.I would alsolike to acknowledge vi the guidancegiven by ProfessorKeith Hayward, formerly Head of Researchat SBAC and StaffordshireUniversity. Finally, I would like to thank the playersand officials of Swinton RLFC (my beloved hometown rugby leagueteam) who collectively have given me causeto worry about somethingelse over the past few years. vii Preface The UK aerospaceindustry has a long and varied history dating back to the antecedentsof poweredflight. Over a hundredyear periodthere havebeen many technicalsuccesses, as well as muchcontroversy about excessive costs and delaysin delivery(e. g. TSR-2;Typhoon; Concorde). The aerospaceindustry is permeatedwith uncertainty,which is reflectedin thenature of aerospacefirms. Thisthesis assesses the economicsof the UK aerospaceindustry from a transactioncost approachusing verticalintegration as a basisfor analysis. The complexnature of aircraftdevelopment and production creates uncertainty due in part to technologicalchange. The core propositionin this thesisis that the issueof complexityand uncertaintycan be assessedthrough the transactioncost approach. Namely,it is predictedthat assetspecificity, frequency, uncertainty, complexity and smallnumbers exchange combine to causethe inherentproblems in the UK aerospace industry. On this basis,the key characteristicsof aerospaceproduction appear most appropriatefor a transactioncost analysis,in termsof the make-or-buydecision and the choiceof contracttype. Alternativehypotheses are presented including monopoly powerarguments, a principal-agentapproach and game theory. The transactioncost approachcertainly can be viewed as complementarywith the conceptof principal- agent, but monopolypower argumentsdo not fully capture the complexityof aerospaceindustry relationships and game theory is too generalto assessthe research problem. The mainpurpose of this thesisis to examinethe UK aerospaceindustry as a basisfor testingempirically the relevanceof transactioncost economics. This is achievedusing an originaldatabase from a questionnairesurvey of the UK aerospaceindustry. Ile thesiscomprises three parts. PartI presentsan overviewof theUK aerospaceindustry anda surveyof the transactioncost literature, with particularattention to the empirical studiessince 1975. Part 11describes the methodologyof the researchand empirically teststhe transactioncost models, with specificanalysis on the paradigmissue of make- or-buyand contract type. Part III bringstogether the theoreticaland empirical work to presenta setof conclusionsand final recommendationsfor furtherresearch. The thesishas generatedtwo piecesof publishedwork by the author. Firstly, the analysisof theUK aerospaceindustry in ChapterTwo hasbeen published as a Chapter viii in the book Arms Trade, Security and Conflict (2003) edited by Paul Levine and Ron Smith. The Chapter is titled "The supply-sideimplications of the arms trade: UK aerospaceindustry, economic,ad ustmentand the end of the Cold War" and it assesses the uncertaintyin the UK aerospaceindustry over the decadeof the 1990s. Secondly, the analysisof the aerospacefirm in Chapter Eight has been publishedas