Economics involves the study of choices under conditions of scarcity. Whereas traditional economics assumes that choices are from among peaceful alternatives, conflict economics recognizes that some alternatives are violent or potentially violent. In this chapter we continue the move from traditional economics to conflict economics by sketching a simple economic model of conflict. The graphical model presented here is due originally to Hirshleifer (1995, pp. 172–175); more formal versions are available in Skaperdas (2006) and in Appendix B. Because the model is broadly consistent with what is known in political science as the bargaining (or rationalist) theory of war (Fearon 1995), we refer to it hereafter as Hirshleifer's bargaining model. Although by no means complete, the model provides a simple but effective framework for thinking systematically about the elements of conflict, some of the prominent explanations for war, and the possible effects of third-party intervention.

Elements of Conflict

Suppose that a disputed resource is to be divided between two players A and B. The players might be nation-states disputing territory, a government and a rebel group clashing over natural resources, or a government and a terrorist organization competing for control of a population. The players begin by diverting secure resources into arms, and then they divide the disputed resource either by fighting or by peaceful settlement. For simplicity, assume that each player chooses a level of arms that is the same whether fighting or settlement is anticipated.

As described in Chapter 1, international terrorism is a significant form of extra-state conflict, while domestic terrorism is a frequent mode of intrastate conflict. In this chapter we present data on worldwide patterns in international and domestic terrorism incidents, casualties, targets, and tactics. We then apply principles of economic choice and game theory to terrorists' resource allocation decisions and governments' counterterrorism efforts. Selected empirical studies of the risks and economic effects of terrorism are also summarized.

Defining Terrorism

There is disagreement among scholars regarding the distinction between terrorism and other forms of violence, such as armed robbery or nation-state warfare (Hoffman 1998, ch. 1). For the purposes of this chapter, we adopt Enders and Sandler's (2006a, p. 3) definition of terrorism as “the premeditated use or threat to use violence by individuals or subnational groups in order to obtain a political or social objective through the intimidation of a large audience beyond that of the immediate victims.” By this definition, terrorism is fundamentally political or social in the sense that terrorists desire to “change the system,” something that is not a priority for criminals (Hoffman 1998, p. 42). The political or social goals of terrorists coupled with their desire to intimidate a large audience lead terrorists to operate outside the usual rules of warfare. Hence, terrorist incidents often involve hostage taking of diplomats, execution of kidnapped military officers, and attacks against civilians (Hoffman 1998, pp. 34–35).

Modern economies are highly complex. In the United States economy in 2006, for example, 145.8 million workers combined their labor with $23.1 trillion worth of capital to produce $13.2 trillion worth of goods and services. Fortunately, the concepts and principles that guide economists' understanding of economic activity are relatively simple. In this chapter we explain selected aspects of the economics of production such as the production function, scarcity, production possibilities, opportunity cost, efficiency, comparative advantage, and gains from trade. We then apply these principles to better understand the economic costs of conflict, the effects of defense spending on economic growth, and the depressed state of North Korea's militarized economy.

Production Possibilities Model

Production Function

Assume that an economy produces two types of goods: military (M) and civilian (C). Military goods include tanks, fighter aircraft, and the like, while civilian goods encompass food, clothing, shelter, and so on. In economics, military goods are often called “guns,” while civilian goods are called “butter.” The production of military and civilian goods requires inputs such as labor (L) and capital (K), where the latter refers to physical assets like buildings and machines. A production function specifies the maximum amount of a good that can be produced with any given combination of inputs under the current state of technology. Technology is the scientific and organizational knowledge available to transform inputs into outputs.

For many people, in many places, violent or potentially violent conflict is part of the human experience. Headline stories of civil strife, insurgency, nation-state warfare, terrorism, and the proliferation of weapons of mass destruction document the prevalence of conflict as a basic fact of life. Less dramatic indications of conflict include deadbolt locks, gated residential communities, electronic security systems, and handgun sales, to name a few. At first blush, it might appear that economics has little if anything to say about life's harder side. Economics textbooks typically restrict their attention to the peaceful behavior of consumers, producers, and governments in the marketplace. Thus, it might seem that potential and actual violence over resources, goods, and political power lie outside the domain of economics. But this is a misperception, as is demonstrated by the rapidly developing field of conflict economics.

What Is Conflict Economics?

Conflict economics has two defining characteristics. First, it maintains that the concepts, principles, and methods of economics can be fruitfully applied to the study of conflict activities. Thus, diverse phenomena like war, arms races, alliances, and terrorism are analyzed and understood as outcomes of purposeful choices responsive to changes in underlying incentives. As just one example, economics explains how consumers shift purchases from one good (say orange juice) toward another (say grape juice) when the price of one rises relative to that of the other.

A strategic interaction wherein outcomes are systematically determined by the combination of players' actions is called a game. By this definition, poker and baseball are games, but so are wars and arms rivalries. Because outcomes in games are jointly determined, players' well-being depends not only on their own decisions but also on the decisions of others. This interdependence can greatly complicate any attempted rational choice by the players. It also makes game theory, the formal study of such strategic interaction, both challenging and fascinating.

Basic Concepts

Elements of a Game

Games consist of certain elements, the specifics of which distinguish the different games. The players may be individuals or groups, including nations. Explicit and/or implicit rules control the feasible actions, order of play, available information, and determination of outcomes. Preferences over outcomes in turn determine players' payoffs or utilities. In basic game theory, players are assumed to have common knowledge of the rationality of all players and of the elements of the game, including payoffs. When these assumptions hold, the game is said to be one of complete information.

To illustrate these elements, consider a simple game that we will refer to as the aggression game. The game involves two players called, generically, A and B. Player A moves first and can either Aggress against player B or Refrain. If B is aggressed against, then B can either Retaliate or Appease.

Throughout recorded history, violent conflict has been a conspicuous aspect of the human experience. In recent decades, terrorism, civil strife, nation-state warfare, and the proliferation of weapons of mass destruction have dominated the headlines. It might at first appear that economics has little to say about such realms of conflict. After all, most economics textbooks restrict their attention to the behavior of consumers, producers, and governments operating peacefully in secure environments. Fortunately, however, the rapidly developing field of conflict economics can contribute greatly to an understanding of conflict in two important ways. First, conflict economics rigorously applies the concepts, principles, and methods of economics to the study of diverse conflict activities. Second, conflict economics treats appropriation as a fundamental economic activity, revealing how conflict both shapes and is shaped by the traditional economic activities of production and trade.

This book provides the reader with an accessible overview of the basic principles and major themes of conflict economics. Following an introduction to the field in Chapter 1, Chapters 2 through 4 survey many of the economic concepts and methods applied in subsequent chapters. These chapters will be useful to readers who either have no formal training in economics or would like to review economic principles with a focus on conflict.

As documented in Chapter 1, wars within states have become far more numerous than wars between states, especially in recent decades. Over the period 1990–2006, for example, the Uppsala Conflict Data Program/Peace Research Institute, Oslo identified 23 war onsets within states compared to three between states. In this chapter we present theoretical and empirical perspectives on the onset, termination, and consequences of violent intrastate conflicts, particularly civil wars and genocides.

Definitions

For the purposes of this chapter, we draw on Marshall, Gurr, and Harff (2001, p. 5) and Sambanis (2002, p. 218) to define civil war as violent conflict within a country between a government and one or more internal opposition groups, with sizeable fatalities on each side. Scholars differ over the level of violence that qualifies as a civil war, but for coding purposes a fatality threshold of 1,000 is sometimes used. To distinguish it from a massacre, a civil war must entail sizeable fatalities on both sides. The Correlates of War Project, for example, requires that the stronger side's fatalities be least 5 percent of the weaker side's fatalities to qualify as a civil war (Henderson and Singer 2000, pp. 284–285).

An internal opposition group is generally identified by political, ethnic, religious, or cultural characteristics, and its objective might be to overthrow the government, seize power in a particular region, secede, or obtain major changes in its political, economic, or social status (Marshall, Gurr, and Harff 2001, p. 5).

Born in the tense early years of the Cold War, conflict economics has long been interested in arms rivalry, proliferation, and arms control. In this chapter we provide a summary of key principles and research results in this historically important branch of conflict economics. We begin with definitions followed by an empirical overview of military spending, weapons of mass destruction, and arms control treaties. We then return to the historical roots of conflict economics by sketching the seminal arms race models of Richardson and Intriligator and Brito. To these we add a rational choice model that highlights the interdependence of economics and security in issues of defense spending, arms rivalry, and arms control. Applications to historical and contemporary arms rivalries are presented, including possible proliferation of nuclear weapons to Iran, strategic implications of deployment of US antiballistic missile technology in Europe, and decay of the Soviet economy during the Cold War. We also briefly survey selected empirical studies, focusing on the structure of interstate arms rivalries, arms racing and the risk of war, and risk factors for nuclear weapons proliferation.

Definitions

An arms rivalry is a competitive increase in the weapons quantities or qualities of two or more parties. Arms rivalries are typically thought of as occurring between states, but they can also occur within states and can involve transnational groups.

Agreements wherein parties pledge various forms of military cooperation are common in the international system and are often prominent in conflict settings. In 1949, for example, the United States, Canada, and numerous Western European states formed the North Atlantic Treaty Organization (NATO) to counter the threat of attack by the Soviet Union. In turn, the Soviet Union and various Central and Eastern European nations formed the Warsaw Pact in 1955 to counter threats from NATO. Since the end of the Cold War, the Warsaw Pact has dissolved while NATO has remained in force and expanded its membership. Article 5 of the NATO Charter specifies that an attack against any member state will be considered an attack against all member states. Following al Qaeda's attack against the United States on September 11, 2001, Article 5 was invoked for the first time. The United States and its NATO allies then cooperated in an invasion of Afghanistan to overthrow the Taliban, who had supported al Qaeda. US-led forces also cooperated militarily with the “Northern Alliance,” an intrastate coalition of Afghan groups fighting against the Taliban. Meanwhile, various transnational terrorist groups and criminal syndicates have been reported to cooperate with al Qaeda in ways that appear to constitute non-state alliance behavior.

The scholarly literature on alliances is vast, encompassing both theoretical and empirical research, with extensive coverage of political and economic determinants and effects. In this chapter we focus primarily on economic aspects of military alliances.

In this appendix we present a linear mathematical version of Hirshleifer's bargaining model of conflict introduced in Chapter 5. We derive a peaceful settlement equilibrium and then show how fighting can emerge as the predicted outcome based on inconsistent expectations, preemption, or preventive war. Throughout the appendix we assume that each player is risk neutral and that an interior solution holds.

Basic Model of Resource Conflict

We begin with the resource conflict model of Chapter 12, which is a variation of a model due originally to Skaperdas (2006). Assume players A and B have respective holdings of secure and undisputed resources RA and RB, but they dispute control of a fixed resource. The players divert MA and MB units of their respective secure resources to produce military goods, which in turn can be used to fight over the disputed resource. Each diverted unit generates one unit of military goods, and fighting destroys a fixed proportion δ of the disputed resource, where 0 < δ < 1.

Net Resource Functions under Fighting

Let pA be A's conflict success in the resource dispute, with pB the same for B. We assume conflict success is measured by the proportion of the disputed resource controlled by a player, although it could be interpreted as the probability that a player controls the entire resource in a winner-take-all contest.

Economic analysis of conflict normally rests on either or both of two organizing principles, namely, rationality and equilibrium. Rationality pertains to how actors choose purposefully among alternatives, while equilibrium involves how the choices of different actors are coordinated. We highlight the two principles by reviewing in turn the economic models of consumer choice and supply and demand. Along the way, we explore several issues in conflict economics, including the fungibility of foreign aid and military goods, the ban on land mines, the difficulties of controlling small arms trade, and the liberal peace hypothesis.

Rational Choice Model

Rational choice theory assumes that an actor has consistent preferences over alternatives and chooses from among the best alternatives available. The actor might be a consumer, producer, voter, politician, insurgent, terrorist, nation-state, or any number of other entities. Here we sketch a basic consumer choice model, so we assume that the actor is a consumer. Specifically, we suppose that the consumer chooses among alternative combinations or baskets of two commodities labeled X (say food) and Y (say housing). He operates with a fixed income I per day, which he spends completely on the two commodities at prices PX and PY. His rational choice problem is to choose the most preferred basket that he can afford given his budget. The two basic elements of the problem are then his preferences and his budget constraint, which we can treat separately before combining them to determine his optimal choice.

Standard economics treats individuals and groups (including nations) as enriching themselves through specialized production and trade. These are presented as peaceful activities because the resources used and the goods produced and traded are implicitly assumed to be secure from appropriation. We have seen in this book, however, that conflict over resources and goods abound. While previous chapters modeled conflict as a choice and considered the interdependence of economic and conflict variables, this chapter adds a new premise, namely, that appropriation stands coequal with production and trade as a fundamental category of economic activity. The chapter begins with an overview of the conflict success function, which is a key element of the theory of appropriation possibilities. We then present a model of conflict over a resource, which reveals, among other things, a paradox of power and incentives for peaceful settlement. The resource conflict model is then integrated with an Edgeworth box model of production and trade, showing how various economic variables are affected by appropriation possibilities.

Conflict Success Functions

A central building block for introducing appropriation possibilities into mainstream economic models is the conflict success function (CSF) (Hirshleifer 1995, Garfinkel and Skaperdas 2007). A CSF specifies how the weapons or fighting efforts of players combine to determine the distribution of a contested resource or good. Suppose, for example, that players A and B employ MA and MB units of military goods to determine the holdings of a resource such as land, oil, or water.

Statistical analysis involves populations, samples, luck of the draw, and systematic inferences. This appendix provides an informal and somewhat intuitive introduction to the basic statistical methods used in conflict economics.

Populations and Samples

A population is just a collection of relevant objects. A simple example might be the citizens of a country. Associated with the citizens are variables that measure attributes like income, age, gender, political opinion, and so on. Thus, populations can be thought of as collections of values of various variables of interest. Summary measures of these population values are called parameters. Suppose the variable of interest is income. Then the parameters might include the mean μ and the standard deviation σ of income. The mean is just the arithmetic average of the citizens' incomes. The standard deviation measures dispersion and indicates how far the income values typically lie above or below the mean. Alternatively, suppose the variable of interest is citizens' political opinion. Then a key parameter might be the proportion π of citizens who oppose the current regime.

While the full population is of ultimate interest, researchers usually work with a subset of the population called a sample. To the extent that the sample is representative, it provides useful information about the larger population. Corresponding to population parameters are sample statistics. Just as parameters summarize the values in the population, statistics summarize the values in a sample.