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The fundamental element of a successful military is a complete and competent array of personnel. Though the required number of personnel and their required skills change over time, the necessity of the military to attract and retain service members is unchanging. As a result, attention must be paid to personnel policies in an attempt to maximize program effectiveness.
Continual increases in costs to recruit and retain military personnel provide another impetus to review the personnel pay structure. While bonuses account for a small fraction of military personnel spending, it is an area worthy to address given the large impact it can have on military members' individual choices. As a result, the way bonuses are structured can lead to changes in behavior that impact other costs, such as training and education, as well as recruitment, when valuable service members choose not to continue their military careers.
Bonuses serve as valuable tools in attracting and retaining Naval officers, although their use is not always cost-effective. For instance, when commercial pilots are in high demand, thus increasing competition in the job market for existing pilots, the Navy's aviation bonus and special pays can be seen as effective because of the significant costs required for the Navy to recruit and train new pilots to replace those who leave for the private sector. On the other hand, when commercial pilots are not in high demand, the bonuses and special pays that aviators receive can be seen as ineffective since the Navy likely could have retained those pilots with a smaller bonus.
This article proposes an innovative approach to bonus payments that would use auctions to establish the value of bonus payments. Before reviewing alternative bonus methods, however, it is important to define some terminology.
Forward Versus Reverse Auctions
The most commonly recognized auction is one with a single seller of a good and multiple buyers competing to buy that good. This is called a forward auction; it is often used for selling individual items. For this type of auction, the "winner" is the bidder willing to pay the seller the highest price for the item.
There also exists a less-well-known form of auction with one buyer in search of a good or service where there are multiple sellers vying for the right to provide that good or service. This type of auction is called a reverse auction; it is used by governments for contracting services to build weapon systems, erect buildings, and establish labor contracts. In this form of auction, the winner is the bidder willing to sell the good or perform the service at the lowest cost to the buyer.
Types of Auctions
Ascending Bid
Often called the oral auction, this is the most commonly applied and recognized type of auction. In an ascending-bid forward auction, bidders successively raise the offered price until only one bidder is left willing to pay the proposed price. Once this point has been reached, the remaining bidder is said to have "won" the auction and, upon payment, takes delivery of the item or service for sale.
Descending Bid
Commonly called the Dutch auction, the descending-bid forward auction is a form of auction whereby an initial price is proposed by an auctioneer and is successively lowered until a bidder willing to pay the price makes known his desire to do so. In effect, it is the first bidder that wins because of the declining-price nature of the Dutch auction. In practice, Dutch auctions are used in Canada for selling tobacco, in the Netherlands for selling cut flowers, and in Israel for the sale of fish. (1)
First-Price Sealed Bid
In the first-price sealed-bid auction, buyers submit bids that are sealed and, therefore, unknown to the other bidders. The winning bidder is the one who has the highest or lowest price, depending on the set criteria. Bidders have only one opportunity to submit a bid and are unaware of what rivals are bidding. This type of auction is used for government procurement contracts. (2)
Second-Price Sealed Bid
Second-price sealed-bid auctions are similar to first-price sealed-bid auctions in that prospective buyers submit sealed bids on an item or a service for amounts that are unknown to other bidders. The winner of the auction, when conducted as a forward auction, is the bidder who bids the highest price; however, the winner pays a price equal to the second-highest bid. In effect, the winner pays the price of the first losing bid.
Bidding Strategies
First-Price Sealed-Bid Auction
In a first-price sealed-bid auction, the winning bidder pays what he bid for a forward auction (or gets paid what he bid in a reverse auction). His surplus depends entirely on his bid. A bidder in a forward auction who bids below his valuation and wins receives a profit. (The bidder in a reverse auction who bids above his reservation price and wins receives a surplus). The bidder, however, must estimate what others are likely to bid to maximize his chances of winning. In the case where there are multiple winners in a first-price auction, each bidder will still pay (receive) an amount equal to his or her bid. One can base bidding decisions on the number of items up for auction and the number of bidders. A bidder can use this information to bid an amount that provides the most profit or surplus, knowing that his or her bid directly controls the amount of profit or surplus received. In the end, in the first-price sealed-bid auction, "the bidder bids some amount less than his true valuation [in a forward auction]: Exactly how much less depends upon the probability distribution of the other bidders' valuations and the number of competing bidders." (3) The opposite is true for a reverse auction; bidders will bid above their true valuation based on expectations of how others bid.
Second-Price Sealed-Bid Auction
In a second-price sealed-bid auction, the winning bidder pays an amount equal to the second-highest bid in a forward auction. Likewise, in a reverse auction, the winner is paid an amount equal to the first nonwinning bid. In this case, the bid is used only to determine the winner. The amount that the bidder pays (or is paid) depends only on the bids of others. If a bidder decides to raise his or her bid above the valuation in a reverse auction, this will change the outcome only if this bid is higher than someone else's bid and makes his or her bid the first nonwinning bid. In such a situation, the first bidder has affected the outcome but is not a winner in the auction. It, therefore, is in the bidder's own interest to bid an amount equal to his true valuation, knowing that if he or she wins, he or she will be paid more than the bid. The opposite is true for a forward auction. In either case, for a second-price sealed-bid auction, "each bidder's equilibrium strategy is to submit a bid equal to his own valuation of the item." (4)
Application of Auctions to the Navy
Auctions applied to Navy officer bonuses would be in the form of a reverse auction, composed of multiple sellers and a single buyer. In this case, active duty unrestricted line officers would be sellers bidding for the right to sell their labor to a lone buyer, the Navy. The most suitable format for implementation is the sealed-bid auction. This would allow bidders to submit bids over time, as scheduling and mobility permit. The Navy then would select the number of officers needed for any given warfare community, and there would be that quantity of winning bidders, each of whom would be eligible for continued service in the Navy. However, a decision would be required whether to conduct a first-price or a second-price auction.
Implementing a first-price sealed-bid auction would mean that each winning bidder would receive a bonus equal to the price. This likely would provide the Navy with net cost savings, since some officers would be willing to accept bonuses below the current level. This would, however, result in officers of equal rank and tenure potentially earning different amounts, which contrasts with current Navy practices.
On the other hand, a second-price sealed-bid auction alone might not provide significant departure from the Navy's experience today. Remember that in a second-price reverse auction, the winning bidders would be paid an amount equal to the first losing bid. Effectively, the offered bonus would have to be just high enough to keep the next marginal bidder. The current policy creates the same result. As retention rates tend to drop off below the desired level, bonus amounts are increased to induce enough officers to remain in their respective warfare communities, without offering a larger bonus whereby too many officers would be willing to remain in service.
Signaling
The concept of auction theory deals with information asymmetry. Sellers don't know what buyers are willing to pay, and buyers aren't sure what other buyers are willing to pay. The application of auction theory to Navy officer bonus programs, by definition, would lead to the retention of a sufficient number of officers. There is another means of addressing hidden information that gives insight into the problem of job applicant quality in the job market: Signaling Theory.
Job market signaling is a concept brought to light by Michael Spence in an article in The Quarterly Journal of Economics in 1973. It can be used to resolve information asymmetry between an employer and a prospective employee. Prior to hiring an employee, an employer has very little information on which to base a decision. In fact, for some time after hiring a new employee, individual productivity can remain a mystery during training and/or an initial familiarization period common to many occupations. How then, can an employer better judge potential job applicants? The article addresses a way for employers to differentiate between potential job applicants based not only on unalterable characteristics called indices (for example, age and gender) but also on attributes, called signals, that can be controlled by the applicant but require some invested time, effort, or money. (5)
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