Rickover and the "Nickle Letter"

Today's quote comes from page 53-54 of the 1968 Senate hearings on Economy in Military Procurement, Part 2, featuring Admiral Hyman G. Rickover.

"Admiral Rickover. I reccall a recent experience with this type of thinking "the nickle letters." In August of this year the Navy proposed to place a $50 million contract with a company at a profit of 2.29 percent.

"Chairman Proxmire. Let me understand the 2.29 percent figure. Was that the percentage of profit to sales or to cost?

"Admiral Rickover. It is 2.29 percent of estimated cost. That may sound like a low profit -- 

"Chairman Proxmire. It does indeed. In testimony yersterday, the Department of Defense witness said that the average profit on defense work was 9.4 percent.

"Admiral Rickover. Actually, it was quite adequate under the circumstances. The contract incolved no risk for the company and almost no investment, and the Navy has been working on the same terms with this company for many years.

"In any event, because of the amount oof this contract, it had to be approved by higher authority. When I submitted the contract for approval, I received a formal letter stating the contract was disapproved because the profit was too low....However, in order to have the contract approved, I was willing to increase the fee on this $50 million contract from $1,147,023 to 1,147,023.05 -- and increase from 2.29 percent to 2.29000001  percent."

The nickle letter from Rickover shows the DoD's obsession with profit because it have no understanding of value. Rickover quoted Oliver Cromwell who said: "I beeseach you, in the bowels of Christ, to think it possible you have been mistaken." He had to fight the Navy to let a contract that the firm already agreed to!

Today, there does not seem to be the exact same issue. For example, in billion dollar service contracts where there is little or no risk, there is no question the government will pay a small fee in percentage terms, but a huge one in dollar terms.

As Rickover later showed, almost all of the contract to the prime would be subcontracted out. The prime would only incur $1.473 million in labor costs and receive $1.147 million in profit. Of course, the prime's overhead costs outweighed its labor costs. But that's closer to 50% profit on capital invested. Not too shabby.

The general popint is that the meaningful measure of profitability is the percentage profit on invested capital, and not total sales. Retailers such as Amazon or Wal Mart may make far less profit in percentage terms to their total sales because they are not as "vertically integrated" as, say, commodity producers are. They contribute little end value to the item, so their profits should be lower.

This outcome is natural in market competition, but needs to be willfully imposed in the non-market environment of defense procurement.

It appears forgotten in Rickover's biographies just how sophisticated he was in contracting and procurement. In this hearing, Rickover had no preparation (because he was not initially aware they were occuring) and he still provided an absurdly detailed discussion on a vast array of issues.

Models and the Economy

"I often say that when you can measure something that you are speaking about, express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of the meager and unsatisfactory kind: it may be the beginning of knowledge, but you have scarcely, in your thoughts advanced to the stage of science, whatever the matter might be."

That was from Lord Kelvin. But how does this translate to economics? The uncertainties surrounding human action and society are difficult to model precisely, and it would appear not a problem of "getting more data" because the interactions themselves can change over time. Here is how Nobel laureate Lars Hansen thinks about model uncertainty:

"I like to think about there being three different components to the concept of uncertainty. [.... First,] suppose I write down some model and the model has what economists would call shocks, distributions attached to these shocks and the like. That model, when fully specified, will tell you probabilities of all the future events, what's in the domain of the model. You've got a full--there's uncertainty out there, but it's certainty under which you've got a model that just tells you all the probabilities of everything. And so once you've got the model, it's done. So, I like to think of that as risk. Like, if I fully embrace this model, there's the risk component. 

[....Second,] there are different models out there. Even a given model, I might not know all the details of it--the so-called parameters of the model. There may be multiple models out there, and the like. So now, for me to assign probabilities on the future I have to start say, well how much weight do I want to put on this model versus that model? Each distinct model and the like. So this issue about how I want to weight, how much confidence I put in the different models out there--once I take a specification of that confidence and continuous assign probabilities to things, that process of assigning probabilities across models--there I think of that as a potential source of ambiguity. I'm not really sure how to do that. And how do I confront that component of uncertainty.

There's a third component that I think is probably the hardest part, but I think maybe that in many respects the most important part is all the models are in some sense wrong. How do I use models in sensible ways, in ways that are in some sense robust to different forms of misspecification? I acknowledge that they are wrong, but if I knew exactly how they are wrong, I'd just fix them. So I have to somehow confront that form of uncertainty, as well. So, those are the different pieces that I can think about when I think about uncertainty."

That was from a discussion on EconTalk. So there's uncertainty as to what the model output will be, there are competing models with different inputs, and there is the epistemological problem that all models are wrong in some way. I actually see this quite akin to the uncertainty facing the natural sciences, especially the more detailed or aggregated we look at the universe.