The structural characteristics of the United States defense market depart significantly from the neoclassical model of perfect competition. Because the Department of Defense (DoD) is the primary, and frequently the sole, domestic purchaser of advanced military hardware and national security technologies, the acquisition landscape is fundamentally defined in economic literature as a ‘monopsony’. [1, 2, 3, 4] In the major weapon systems segments—including military aerospace, naval shipbuilding, armored vehicles, and missile defense—this monopsonistic demand side interfaces with a highly concentrated supply side dominated by a small number of prime contractors, creating a “bilateral monopoly” or highly concentrated oligopsony. [4, 5, 6]
A substantial body of academic research, defense economics literature, and empirical policy studies has investigated how this government monopsony, combined with its unique regulatory and cost-auditing powers, shapes and potentially undermines the financial health, efficiency, and innovative capacity of the defense industrial base (DIB). This report synthesizes these theoretical frameworks, empirical findings, and the ongoing scholarly debate surrounding the economic consequences of U.S. government procurement practices.
Theoretical Foundations of Defense Monopsony and Bilateral Monopoly
The academic study of defense procurement economics has long recognized that the acquisition of highly specialized military hardware operates outside standard market-clearing pricing mechanisms.[3, 4] In a classical monopsony, as defined in standard microeconomic theory, a single buyer exploits its market power to restrict purchase quantities, thereby forcing competing producers to lower their prices.[3, 7, 8] However, academic research highlights that when applied to the U.S. defense sector, this theoretical model requires substantial refinement due to three unique institutional and structural characteristics.
First, the government’s demand is dictated by external geopolitical threats and domestic political mandates rather than market-clearing efficiency.[3, 9] Consequently, the DoD often exhibits highly inelastic, inflexible demand for specific quantities of restricted military hardware.[3, 9] Academic analyses demonstrate that when the quantity demanded is rigid, the DoD loses its monopsonistic pricing power, and the inflexible quantity requirement can actually create higher unit prices as producers require premiums to offset the additional costs of rapid, non-commercial production scale-ups.[3, 9]
Second, as analyzed through the lens of New Institutional Economics (NIE) and transaction cost economics, defense firms are defined not by their specific products, but by their specialized, scarce competency in navigating the highly stylized rules, cost accounting systems, and regulatory oversight of the government procurement process.[4, 10] This specialization creates a deep mutual dependency between the monopsonist buyer and the specialized suppliers.[4, 10]
Third, the government operates not merely as a buyer, but as the regulator of the market.[11, 12] Through the Federal Acquisition Regulation (FAR) and Defense Federal Acquisition Regulation Supplement (DFARS), the government dictates corporate cost structures, limits profit margins, restricts international licensing, and mandates strict oversight, transforming defense firms into heavily regulated private entities akin to public utilities.[11, 13, 14]
This relationship was historically shaped by the rapid post-Cold War consolidation of the defense sector.[1, 15] In July 1993, Deputy Defense Secretary William Perry convened defense industry executives at a dinner subsequently known as the “Last Supper,” where he communicated that shrinking budgets would no longer support the existing pool of suppliers.[15] This explicit government directive catalyzed massive horizontal mergers, reducing the number of major aerospace and defense prime contractors from fifty-one to just five.[15, 16] By 2023, these five firms—Lockheed Martin, Northrop Grumman, Boeing, General Dynamics, and RTX—acted as prime contractors on over seventy-four percent of major defense acquisition programs.[15] This consolidation has had a profound impact on output; for example, the annual output of military aircraft for U.S. Armed Forces plummeted from 3,085 units in 1970 to 664 units in 1990, and down to a mere 150 units by 1998.[1]
Empirical Assessments of Financial Health: The Great Divergence
A central debate within defense economics literature lies in the assessment of the DIB’s financial health. A sharp divergence exists between industry-sponsored policy analyses and empirical academic or government-led studies regarding whether government monopsony power actively undermines the financial viability of defense contractors.
The Industry and Advocacy Perspective: Monopsony as a Depressant
Industry advocacy groups, such as the Lexington Institute and the Aerospace Industries Association (AIA), argue that government procurement regulations and monopsony power systematically disincentivize private investment and erode corporate financial health.[2, 13, 17] This perspective emphasizes that profit margins on government contracts are contractually limited and capped (typically between 10% and 15% under FAR Section 15.404-4), which yields substantially lower operating margins than those observed in high-performing commercial sectors.[16, 17, 18]
Furthermore, advocacy research highlights that the defense acquisition environment has grown increasingly confrontational, with the government shifting financial risk onto contractors through fixed-price development contracts, demanding access to proprietary intellectual property (IP), and threatening downstream aftermarket revenues by opening up sustainment and upgrades to subsequent competition.[17] Consequently, these studies argue that the DIB has suffered from depressed market capitalization, lower credit ratings near “junk” status, and a systemic “Global War on Contractors” that deters commercial entrants and starves the sector of innovative R&D.[2, 17]
This decline is often contextualized within broader national industrial trends.[19] Manufacturing accounted for just 10 percent of U.S. gross domestic product (GDP) in 2024, down from 16 percent in 1997.[19] A considerable share of this industrial decline has been concentrated in the defense sector; defense-related employment fell by 2.1 million between 1985 and 2021, representing approximately 40 percent of total U.S. manufacturing job losses over that period.[19]
The Academic and Empirical Perspective: Low-Risk, High-Return Performance
Conversely, comprehensive empirical analyses—most notably the April 2023 Department of Defense Contract Finance Study, which incorporated independent university-led academic research, and a landmark 2022 study led by Martin Bollinger—conclude that the publicly traded corporations within the aggregate DIB are financially robust, highly profitable, and exceptionally low-risk.[16, 20, 21] These studies demonstrate that while absolute operating profit margins are lower in defense than in elite commercial technology firms, this gap is more than offset by much lower asset and capital investment requirements.[18, 20] The government heavily subsidizes defense contractors by providing contract financing (such as progress and performance-based payments), covering independent research and development (IR&D) expenditures, and funding specialized manufacturing facilities.[4, 18, 22, 23]
As a result, defense firms generate returns on net assets (RONA) and returns on the market value of shareholder equity that substantially exceed commercial analogs and broad equity market indices like the S&P 500.[20] Bollinger’s empirical analysis of defense stocks from 2000 to 2019 reveals that the DIB delivered significantly superior risk-adjusted rates of return.[16, 20] Because the government acts as a highly reliable, counter-cyclical customer, defense firms exhibit exceptionally low volatility.[16, 20] This structural stability allows defense primes to optimize for cash generation, returning the bulk of their free cash flow to shareholders via dividends and share repurchases rather than reinvesting in internal capital expenditures or breakthrough R&D.[20, 22, 24]
| Financial and Operational Metric | Defense Specialists (e.g., Lockheed Martin) [16, 20] | Commercial Analogs (e.g., Apple, Google) [16, 18] |
| Operating Profit Margins | Moderate and stable, typically ranging between 11% and 13%.[18, 20] | High and variable, often exceeding 40% in tech sectors.[16, 18] |
| Return on Assets (ROA/RONA) | High, driven by exceptionally low corporate asset and capital investment requirements.[20] | Moderate, requiring substantial ongoing private capital reinvestment.[20] |
| Risk and Equity Volatility | Exceptionally low; insulated by government progress payments and cost-plus contracts.[16, 20] | High; exposed to consumer market shifts, pricing pressure, and technological disruption.[20] |
| Cash-Flow Allocation | Highly shareholder-centric; cash returned via dividends and buybacks at the expense of internal R&D.[20, 22] | Innovation-centric; substantial cash reserved for high-risk capital expenditures and internal R&D.[22] |
| R&D Funding Mechanism | Heavily subsidized; IR&D costs are largely reimbursable expenditures funded by the taxpayer.[4, 18, 22] | Self-funded; entirely dependent on private corporate reinvestment and commercial success.[22] |
Causal Mechanisms of Monopsony-Induced Inefficiency: The Rogerson and Kovacic Frameworks
To explain the operational and structural inefficiencies observed within the DIB, Northwestern University economist William P. Rogerson developed a highly influential body of research analyzing defense profit regulations and overhead allocation systems.[25, 26, 27]
Overhead Allocation and Labor Distortions
A central contribution of Rogerson’s research is his mathematical and empirical analysis of how cost-based defense contracting distorts corporate incentives.[28, 29] In typical industrial manufacturing, firms produce multiple products and group indirect, non-traceable costs into corporate overhead pools, which are subsequently allocated to individual products or contracts in proportion to direct labor usage.[28, 30]
If a contractor allocates indirect overhead costs O across multiple contracts based on direct labor L, the overhead rate θ is:
θ=∑jLjO
The total allocated cost Ci for a specific contract i, including direct material costs Mi, is represented as:
Ci=Li(1+θ)+Mi
Rogerson demonstrated that because defense firms operate both in sole-source segments (where the negotiated price is highly responsive to accounting costs) and in competitive or commercial segments (where the price is set by market forces and is non-responsive to accounting costs), firms have a powerful economic incentive to distort their direct labor usage.[28, 30] By systematically overusing direct labor on cost-responsive sole-source government contracts, a contractor can artificially shift a disproportionate share of corporate overhead costs onto the government buyer, thereby subsidizing its competitive or commercial divisions.[28, 30]
This dynamic leads to profound structural inefficiencies, such as:
- Under-Automation: Firms substitute away from capital and toward direct labor on sole-source contracts to maintain a larger base for overhead allocation, resulting in suboptimal levels of automation.[28, 30]
- Bloated In-House Production: Firms reduce outsourcing and subcontracting (which are categorized as material costs and do not carry direct labor overhead) to keep work in-house, even when external suppliers are more efficient.[28, 30]
Rogerson’s empirical analysis of cost pools from major aerospace contractors calculated that for every $1.00 of extra direct labor incurred on a well-funded sole-source procurement, a contractor generated between $1.20 and $1.44 of extra revenue through the automatic shifting of corporate overhead.[28, 30]
Competitive Rivalry and “Prizes for Innovation”
Complementing Rogerson’s work, legal scholar and former Federal Trade Commission (FTC) Chairman William Kovacic analyzed how horizontal mergers and antitrust policy interface with defense procurement.[5] Kovacic highlighted that as the defense supplier base shrinks, horizontal mergers feature acute tension between claimed efficiencies (such as cost reduction through consolidation) and the weakening of competition as a procurement discipline.[5]
Historically, this was observed in the 1992 case where Alliant Techsystems proposed acquiring the Olin Corporation’s ammunition division.[15] At the time, they were the only two manufacturers of 120-millimeter tank ammunition for the U.S. Army.[15] Despite internal DoD support for the deal to manage excess capacity, the FTC sued to block the acquisition in federal court to preserve competitive rivalry, illustrating the friction between industrial stabilization and competitive pricing discipline.[15]
Furthermore, Rogerson formulated a regulatory theory of defense R&D, arguing that profit regulation of defense contractors is structured as a system of “prizes for innovation”.[14, 27] Because direct profit margins on initial R&D and design phases are strictly regulated and capped, the primary financial incentive for a firm to invest in groundbreaking defense technology is the expectation of receiving a highly lucrative, sole-source production contract.[14, 27]
However, as analyzed by Rogerson and echoed in subsequent studies by the National Academies, this “getting well on production” model has largely collapsed in the post-Cold War era.[2, 14] As defense procurement shifted toward extremely small production runs, rapid prototyping, and software-centric architectures, the traditional “prize” of a massive, long-term production run disappeared.[2, 31] Consequently, the lack of substantial downstream production opportunities has severely diminished the incentive for firms to invest their own retained earnings in high-risk, frontier defense innovations.[2, 18]
Distortion of Intellectual Property, Cumulative Innovation, and Commercial Isolation
The interaction between intellectual property (IP) rights and government monopsony has been a focal point of recent academic legal and economic research. In typical commercial markets, patent rights grant an innovator temporary market exclusivity, allowing them to charge supra-competitive prices to recoup high upfront R&D costs.[6, 11] However, in a 2025 study published in the Duke Law Journal, scholars Roy Baharad and Gideon Parchomovsky challenge this conventional paradigm when applied to monopsonistic industries.[6]
Bilateral Monopoly and Patent Suppression
Baharad and Parchomovsky demonstrate that when a patent holder confronts a monopsonist, the market structure shifts to a bilateral monopoly.[6, 11] Because there is only one relevant buyer, the patent holder cannot unilaterally dictate prices or exploit its legal monopoly.[6, 11] The dominant government buyer possesses overwhelming bargaining leverage, which it exerts through its dual role as regulator and sole purchaser.[6, 11]
In this bilateral monopoly, the monopsonist’s purchasing power can suppress prices to near-competitive levels, but this introduces severe market distortions [6]:
- “Winner-Takes-All” Risk: Because only one design is selected for procurement, losing a contract represents “the end of the road” for an inventor.[4, 6] In competitive markets, secondary or tertiary innovators can still capture positive returns; in defense monopsony, there are no “consolation prizes,” which heavily disincentivizes patent holders from entering the sector.[6]
- Suppression of Cumulative Innovation: Innovation is naturally cumulative, requiring multiple firms to maintain a market presence to iterate on technologies.[6] When the monopsonist selects a single standard and rejects alternative designs, unsuccessful inventors cannot establish a market “toehold,” leading to the collapse of parallel, follow-on research paths.[6]
- Strategic Avoidance: High-caliber commercial patent holders actively avoid participating in the defense procurement system, choosing instead to focus their research on commercial sectors where they can maximize their patent rights across a diversified consumer base.[6]
This dynamic is reflected in military innovation metrics.[19] On a quality-adjusted basis, the United States received fewer than 400 military patents in 2019, representing a steady decline from 2015.[19] In stark contrast, China’s receipt of military patents experienced significant growth over the same period, highlighting a widening gap in defense-specific IP generation.[19]
The Compliance Moat and Sectoral Isolation
The government’s extensive use of its regulatory power has created what researchers call a “compliance moat” that isolates the defense industrial base from the broader commercial economy.[16] To contract with the DoD, firms must implement specialized cost accounting systems to comply with FAR Part 31 and Cost Accounting Standards (CAS), undergo exhaustive audits by the Defense Contract Audit Agency (DCAA), and meet complex cyber and information security requirements.[32, 33, 34] For purely commercial firms, the administrative burden and legal risks of establishing these specialized compliance systems far outweigh the potential financial upside of defense contracts.[16, 17]
To quantitatively measure the effects of this isolation, economists Sabrina T. Howell, Jason Rathje, John Van Reenen, and Jun Wong (2021) conducted a causal analysis of U.S. defense research procurement.[35] Their study compared the outcomes of traditional, highly specified “Conventional” topics within the Small Business Innovation Research (SBIR) program against reformed, decentralized “Open” topics introduced by the Air Force.[35] Traditional topics are narrowly defined by government program managers, effectively restricting participation to incumbent defense specialists.[35] Open topics, conversely, allow non-traditional firms to propose any commercial technology with potential military utility.[35]
The causal findings of the Howell et al. study demonstrate that the traditional, top-down monopsony procurement model actively stifles technological spillover and commercialization, whereas bottom-up reforms successfully lower barriers to entry and catalyze innovation.[35]
| Innovation Outcome Dimension | Conventional SBIR (Top-Down Monopsony Model) [35] | Open SBIR (Bottom-Up Reform Model) [35] |
| Probability of Securing Venture Capital | Statistically zero effect; fails to attract private venture capital.[35] | Increases subsequent VC funding probability by 5.4 percentage points (68% of the mean).[35] |
| Subsequent Operational DoD Contracts | Statistically zero effect; fails to transition technology to operational military use.[35] | Increases operational contract probability by 7.5 percentage points (51% of the mean).[35] |
| Patenting Rates and Originality | No significant positive impact on long-term patenting rates or citations.[35] | Causal patenting likelihood doubles; significantly increases patent originality and citations.[35] |
| Firm Demographic Characteristics | Reaches older, larger, traditional defense incumbents (“SBIR mills”).[35] | Reaches younger, smaller, non-traditional software-centric firms in tech hubs.[35] |
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Multi-Tiered Supply Chain Fragility, Regulatory Moats, and Downstream Capital Controls
While major defense prime contractors successfully navigate the government monopsony to secure stable, low-risk returns, this financial health does not uniformly extend down the multi-tiered defense supply chain.[23, 36] The true vulnerabilities of the DIB are concentrated in the lower tiers—consisting of thousands of highly specialized subcontractors and component suppliers.[36, 37]
The Flow-Down of Monopsony Pressures
Subcontractors and lower-tier suppliers operate in an environment of extreme asymmetric bargaining power.[36] They are frequently small, capital-constrained firms that must absorb the flow-down of complex government regulations passed down by the prime contractors.[24, 38] Unlike the primes, these smaller firms do not possess the administrative scale or financial reserves to manage these compliance burdens.[36, 38]
Furthermore, lower-tier suppliers are highly vulnerable to cash-flow squeezes.[23, 36] While prime contractors benefit from favorable contract financing and prompt government payments, these cash-flow benefits historically fail to pass down efficiently to subcontractors, leaving them dependent on commercial debt or internal capital to fund long-lead production.[23, 36]
This fragility is compounded by the sheer scale and complexity of the defense supply chain, which the DoD estimates includes a global network of over 200,000 suppliers.[39] Due to decades of consolidation and under-investment, many critical weapon systems are dependent on single-source, highly fragile lower-tier suppliers for specialized materials, microelectronics, and sub-assemblies (such as solid rocket motors).[15, 19, 36, 40] Disruptions at these deep levels often remain unseen by the DoD until they cascade upward, halting production or delaying the delivery of critical systems.[36, 39]
Modern Regulatory Pressures and Capital Controls
The regulatory environment continues to introduce complex screening and capital controls that alter the financial risk profile of the supply chain.[24, 38]
In May 2026, the Department of Defense published a Proposed Rule extending Foreign Ownership, Control, or Influence (FOCI) screening beyond classified contracts to uncleared lower-tier subcontractors holding agreements valued above $5 million.[38] The DoD estimates that up to 37,740 entities may be affected within one year, of which approximately 57 percent are small businesses.[38] While critical for national security and supply chain integrity, this rule creates meaningful acquisition friction and administrative compliance costs for non-traditional and lower-tier vendors.[38]
Simultaneously, the White House issued an Executive Order, “Prioritizing the Warfighter in Defense Contracting,” which directly intervenes in corporate capital allocation.[24] This policy prevents major defense contractors from conducting stock buybacks or issuing dividends if they fail to invest sufficient capital into necessary production capacity, demonstrate slow production speeds, or underperform on critical weapon contracts.[24] The order directs the Securities and Exchange Commission (SEC) to consider restricting underperforming contractors from the “safe harbor” provisions of Rule 10b-18 for stock buybacks.[24] These penalties also extend to ceasing government advocacy for the contractor’s Foreign Military Sales (FMS).[24]
While designed to force capital reinvestment and accelerate production, such direct interventions in corporate governance and executive compensation introduce significant regulatory subjectivity.[24] This may increase compliance risk, complicate capital access, and ultimately drive downstream production pressures and enforcement terms through multilayered subcontracting tiers.[24]
To manage these capital-intensive production cycles, the DoD relies heavily on contract financing.[23, 41] In fiscal years 2022 and 2023, the DoD provided over $100 billion in contract financing to help stabilize contractors’ cash flow and reduce their need to borrow from commercial sources.[23, 41] In fiscal year 2023 alone, this financing was structured as approximately $28 billion in progress payments (paid as a percentage of costs incurred) and $22 billion in performance-based payments (paid upon completion of milestones).[23, 41]
Nuanced Conclusions and Policy Pathways
Academic and empirical research establishes that the U.S. government monopsony, combined with its highly stylized regulatory framework, does not undermine the aggregate financial health of major defense prime contractors in terms of shareholder returns.[16, 20] Instead, the government’s role as a low-risk, counter-cyclical buyer effectively shields these firms from market volatility, delivering superior risk-adjusted equity returns.[16, 20]
However, this monopsonistic structure severely undermines the structural health, efficiency, and innovative capacity of the defense industrial base.[5, 6, 16] The regulatory “compliance moat” isolates defense specialists from the dynamism of the commercial economy, while cost-based pricing rules create powerful incentives for corporate inefficiency, capital under-investment, and labor bloating.[16, 28] Furthermore, the winner-takes-all nature of monopsony procurement suppresses cumulative innovation and drives high-caliber commercial inventors away from national security priorities.[6]
To address these systemic distortions and revitalize the defense industrial base, academic literature and empirical policy studies suggest several critical pathways:
- Acknowledge and Manage Bilateral Monopoly Dynamics: Recognize that standard antitrust rules designed for competitive commercial markets are insufficient for a defense sector dominated by a single buyer.[5, 6] Rather than treating mergers with blunt legal instruments, the DoD must strategically design procurement programs, funding levels, and acquisition strategies to actively preserve contractor rivalries and keep technological alternatives viable.[5, 6]
- Lower the Compliance Moat via Commercial Item Procurement: Streamline cost-accounting standards (CAS) and FAR auditing requirements for non-traditional commercial suppliers, utilizing and expanding FAR Part 12 (commercial item procurement) to facilitate the rapid integration of dual-use technologies.[16, 42]
- Transition from Cost-Based to Value-Based Pricing: Shift away from cost-plus and profit-capped pricing models, which mathematically incentivize direct labor over-utilization, under-automation, and bloated in-house production.[18, 28, 30] Profit margins should be reasonable, but higher profit levels must be tied directly to superior contractor performance, production speed, and unit cost-reduction achievements.[16, 18]
- Scale Bottom-Up, Decentralized Procurement Models: Expand reformed, “Open” topic pathways within R&D and SBIR programs.[35] These decentralized procurement models succeed in crowding-in private venture capital, stimulating high-originality patenting, and transitioning commercial innovations to operational military missions, successfully bypassing the rigid constraints of traditional monopsony procurement.[35]
- Protect Subcontractor Cash Flow and Mitigate Fragility: Rigorously implement and enforce the payment protections and streamlined contract financing policies outlined in the 2023 Contract Finance Study.[23, 41] Ensuring that cash-flow benefits pass down efficiently to lower-tier subcontractors is essential to alleviate systemic supply chain fragility, reduce foreign dependency, and prevent single-source failures.[23, 36, 39]
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