This is a follow up to the post on Indian spending on education abroad.

The actual spending may not be $13 billion annually but the argument does not change even if the figure was much lower. What matters is that it is indicative of a problem and we should be concerned about it. It should be noted that this spending is an outflow of resources. That in itself is not a bad thing, however. We need to ask if this is a net outflow in the education sector. That is, what is difference between the inflow and outflow.

Suppose that the outflow were $13 billion a year but the inflow were $20 billion. The net outflow then would be -$7 billion. That just means that there is a trade surplus in favor of India to that extent. In an increasingly integrated world, cross-border trade in services is a good thing. It indicates a healthy system since it implies that there are comparative advantages among the trading partners and therefore trade is welfare enhancing for each party engaged in trade.

I will briefly touch on the benefits of having a large domestic market for education. Large domestic markets allow an economy to achieve scale economies, and efficiencies through learning-by-doing, and therefore gain comparative advantage. India has a potentially very large domestic market in education. It is only potential and not actual because the supply is deliberately not allowed to expand to meet the demand. As I have touched upon the reasons for this elsewhere on this blog, I will not repeat them here. Here I will only note that if free entry were allowed into the sector, it would reduce costs and therefore reduce prices, while raising quality, and inducing efficiency in the sector.

Competition for the market and in the market

Let me take a brief digression into markets and competition. Entities — individuals, firms, groups, whatever — compete against others for gaining something that they value. This drive is hard-coded even at the most basic level of existence. Genes compete in making copies of themselves. This induces competition for resources. At the broadest level of analysis, we see nations compete for resources such as land, water, and energy. They go to wars for this. Competition cannot be avoided given finite resources.

It is generally true that economic agents (individuals or firms) compete in the marketplace for profits. As profits are the difference between costs and prices, there are two avenues for increasing profits: reducing costs and increasing prices. You would do both if you could but in most cases where you have little power to dictate prices, you have to reduce costs. If even after doing your best in reducing costs, you still cannot make a profit at the prevailing market prices, you exit the business. Other low cost producers survive and the game continues.

Memorize this line: competition IN the market leads to the elimination of the high-cost producers until such time that only the remaining (that is, the lower cost) producers are able to meet the demand.

That line appears to be trite. But there is a reason for memorizing it. Competition in the market is a cut-throat business and no one would like to face competition. If only you could somehow have a captive market, you would not have to deal with pesky competitors. Is there a way out? Yes, there is. Here’s what you do: you carve out a space in the market where you do not allow others to intrude into. In other words, you become the sole supplier, the monopolist. Then you can set the price by determining the profit-maximizing quantity, and only supply that quantity.

Excellent idea, that one. But wait. Others would also like to have that deal, wouldn’t they? So that gets us to the other line which is worth memorizing.

You can reduce competition IN the market by competing FOR the market.

That’s the truth: you cannot escape competition. You can merely move it elsewhere. For reducing competition in the market, you need to move up the hierarchy and compete for the market.

Where there is free entry into the market, competition within the market essentially guarantees that there are no huge profits to be made. So how much is it worth to you to be the monopolist in that market? How much would you pay to compete for the market? The maximum you would be willing to pay is the maximum profits you can make as the monopolist. If every year you could make $1 billion, well then that is the maximum. If you can buy the right to be the sole supplier to that market for anything less, that is money in your bank.

It’s competition all the way up

This idea of competition for markets can be generalized. Here’s how. Let’s take a concrete example. Imagine free entry into the mobile space of a certain region. Suppose you could only make $1 million a year profit when you face competition in that market, but you could make $100 million a year if you were the sole supplier. So, if there is someone, let’s call him Big Guy, who can guarantee you monopoly control, you would be willing to pay him up to $99 million (your excess profit.)

Now it is a game between you and the Big Guy. You tell him that you are willing to pay $10 million a year as a “license fee.” You negotiate back and forth and finally settle at $20 million. The Big Guy could have made the same deal with your competitor, however. So, you sweeten the deal for him. You say you will give him $2 million on the side into his personal Swiss bank account. But so is your competitor. So negotiations go on till your competitor has dropped out in the competition for the market. Finally, you pay the license fee of $20 million to the Big Guy above the table, and below the table you wire $10 million to the Big Guy’s swiss account. Then you go into the market, provide mobile service, charge the price that maximizes profits, thus recover the license fees and the bribe, and all is well. Note, however, that the consumers eventually pay a price that is higher than what they would have paid if there had been free entry into the market (that is, no license fees) rather than the competition for the market which involved a license fee.

So let’s go up one level, the level of the Big Guy. At some point, he was not the Big Guy. He had to compete with others who also wanted to be the Big Guy. So how did he become the Big Guy? He bought the right to be the Big Guy. And how much did he pay? First, he estimated how much his personal Swiss bank account will grow by if he were to become the Big Guy. And then he paid something less than that to become the Big Guy. Suppose he estimated that his wealth would go up by $100 million, he took a gamble and spent say $50 million on his election campaign to become the Big Guy.

The moral of the story: the more there is at stake, the more you are willing to pay to be the Big Guy.

A corollary: the more stuff you can control, the more stuff you have the power to license, the more you are able to tilt the game from being a competition in the market to a competition for the market. The more competition for the market, the more money you can make. So it should come as no surprise that Big Guys want to get into the game of License-Control-Quota-Permit business. That’s where the moolah is.

Government control of the economy allows the functionaries of the government (politicians and bureaucrats) to reap private benefits. That is why they have in incentive to increase the scope of the government.

Back to education

Education is heavily controlled because the ones who do the control make out like bandits. If all license requirements were to be entirely eliminated, then suddenly the profits will disappear because it will mean competition in the market. The market will guarantee that the inefficient suppliers will exit the market.

What about quality? The quality is guaranteed in a competitive marketplace for the simple reason that if a supplier does not meet the consumers’ expectations, no one will buy from that supplier.

I have noted previously that there is a role for the government in a liberalized education sector. But I will write more the next time.