Some of the ideas that Ferguson talks about are covered quite well in Gregory Clark’s A Farewell to Alms, a book that I’d used in the economic development class I taught this Summer at UC Berkeley. (For the curious, the Econ171 class blog may be of interest.)

Ferguson talks about “natural experiments” of the kind that were conducted in the two Germanies, and the two Koreas, after the second world war. One side got communism and the other capitalism. The resulting divergence speaks for the failure of one and the success of the other.

There is a similar natural experiment in the Indian subcontinent. It began in earnest after the British left in 1947 and the preliminary results are in but the end game — easily predicted — will take another decade or so. The end result will be the final proof that Islam as an ideology is a well-rounded failure in economic and sociological terms. The great divergence is not just limited to economic ideologies; religious ideologies matter more than what most observers are willing (or allowed) to admit.

Just the other day a friend was telling me how one major business house (starts with a B) used to give freebies to one of India’s prime ministers (starts with a N). N would be hosted and feted by B, and in exchange, N made sure that B got licenses for steel or some such commodity, and was protected from market competition.

That’s crony capitalism. The cronies are usually leftist politicians and big businesses. N got the game started and with time, the rot has spread.

India has suffered immeasurably from it. There’s of course the direct loss which arises from mis-allocation of resources, and under-utilization of capacity. Given protection from domestic and foreign competition, firms end up producing high-cost shoddy goods. The consumers lose in terms of quality and quantity.

India has been DUPed. DUP is an acronym for “directly unproductive profit-seeking” activities, authored by the venerable Jagadish Bhagwati (in a 1982 paper). Here’s a bit from his book “Political Economy and International Economics.” (MIT Press, 1991.)

Directly unproductive profit-seeking (DUP) activities are defined as ways of making a profit (i.e., income) by undertaking activities that are directly (i.e., immediately, in their primary impact) uproductive in the sense that they produce pecuniary returns but do not produce goods or services that enter a conventional utility function or inputs into such goods and services.

Typical examples of such DUP (pronounced appropriately as “dupe”) activities are (1) tarrif-seeking lobbying that is aimed at earning pecuniary income by charging the tariff and therefore factor incomes, (2) revenue-seeking lobbying that seeks to divert government revenues towards oneself as recipient, (3) monopoly-seeking lobbying whose objective is to create an artificial monopoly that generates retns, and (4) tariff-evasion or smuggling that that de facto reduces or eliminates the the tariff (or quota) and generates returns by exploiting thereby the price differential between the tariff-inclusive legal and the tariff-free illegal imports.

While these are evidently profitable activities, their output is zero. Hence, they are wasteful in their primary impact, recalling Pareto’s distinction between production and predation: they use real resources to produce profits but no output.

The above quote is (laboriously) copied from the google book cited above.

We have to keep in mind that perhaps it all starts innocently enough. Well-meaning people who are seriously ignorant of the basic nature of the world make policies that they believe will benefit society as a whole. Businesses soon enough realize that more profits can be made by gaming the system than by actually producing value and generating wealth. With time, the waters get sufficiently muddy that DUP activities become hidden from public view and finally entirely disappear from public consciousness.[1] The economy slides into poverty.

The world used to be divided into largely independent domestic markets. Now, however, with increasing globalization, DUP activities are international in character. One of the most profitable is the global arms market. The US arms businesses prowl around the world selling multi-billion dollar deals to Third World countries.

Rediff.com reports that the US government

has launched a concerted and aggressive campaign on behalf of United States’s fighter aircraft manufacturers to push for the ‘mother of all deals’– the $11 billion medium multi-role combat aircraft deal for 126 fighter aircraft for the Indian Air Force. The deal could give the ailing US economy a major boost in terms of both exports and thousands of jobs.

[Thanks to Yoga Saripalli for the link.]

These are truly weapons of mass destruction, as I have been saying for a while. The true weapons of mass destruction are the guns and fighter planes and subs and ships that are routinely sold. A few squadrons of fighter planes send millions to an early grave — not as dramatic as a mushroom cloud but more painfully through chronic starvation and disease.

Here’s a bit from a post from April 2009, “The War and the Circus.”

Perhaps most humans are congenitally belligerent and can be reasonably expected to get into fights. But it takes institutionalized big businesses to create a war machine that raises ordinary human belligerence to levels of superhuman insanity. The war machine — and one can argue that indeed there is only one such thing but with a global reach, even though its components are multinational in the sense that people from various nations participate in their creation and maintenance — is so pervasive that it seems to be as natural, unchangeable, and logical as the seasons. Like the seasons, the war machine dictates how people carry on with their lives unquestioningly. People generally accept the war machine as naturally they do the seasons.

But if one stops to think about it, unlike the seasons, the war machine is entirely man-made. The men (and they are overwhelmingly men, regardless of the color of their skins or their eyes) in charge of the military-industrial complex create the war machine for their own amusement and aggrandizement. They have the power to create ever more lethal, ever more expensive components of the war machine, and that power extracts ever more resources from the global economy to ratchet up the destructive power of the machine monotonically. The machine almost literally sucks up life out of the people who have no power over it but who eventually pay for it with their blood, sweat and tears. The men controlling the machine, however, get more of what motivates them — raw, naked, unimaginable power.

Every nation on earth is involved in this insanity, directly or indirectly. The desperately poor third-world nations starve their own people to buy ever more expensive weapons from the advanced industrialized countries. By keeping these nations fighting amongst themselves, the advanced industrialized countries achieve two goals. First, income.

The desperately poor third-world nations pay the advanced industrialized countries for weapons they cannot afford. If one side of a particular conflict involving two desperately poor third-world countries is unable to afford the weapons, the advanced industrialized countries give out “aid” to prop it up so that it does not lose and thereby end the conflict. The other side, to maintain balance, then has to become a paying customer and buy an equivalent set. This is a source of income for the advanced industrialized countries, and more damagingly, a transfer of wealth from the desperately poor to the amazingly prosperous.

Go read that post when you have time. It is depressing as all hell, even if I say so myself. And if you want more, go check out this old post, “Wars, Opium, Powerful Governments and Weak Nations” which is from December 2005.

Before I let you go, here’s another one on the same topic from long ago which I recommend. “Benefits of Weapons Trade” July 2005.

The US had passed its age of being a subsistence economy for a long time before it started on its path to developing weapons of mass destruction. Its agriculture was booming, it had a huge manufacturing base, its people were literate and educated, it had a massive stock of housing, its institutions were mature, and so on. Given that foundation, it could afford the luxury of going into the research and development of weapons, and built the most advanced and expensive military hardware in world. The unfortunate part is that there are countries like India which have hundreds of millions of people stuck in the subsistence phase of development. And the leaders of these under-developed countries eye the expensive military hardware and salivate. They are forced to attempt to keep up with their neighbors in their competition to get as many shiny nuclear-tipped missiles as possible.

If I was made the global dictator temporarily, and was given the power to make only one absolutely binding and enforceable global law, it would be to ban weapons trade altogether. If neither India nor Pakistan could buy nuclear subs and missiles, fighter jets and bombers, the ordinary people of these countries might have a better shot at a human existence.

From this point of view, the tragedy of the world is not so much that there are so many poor countries, but that there are those rich countries that have surplus resources to devote to developing weapons that ultimately starve the poor. And the leaders of these poor countries fall all over themselves in praising the foresight and the wisdom of the leaders of the rich countries for giving them the opportunity to buy these weapons.

Mark Twain had unusually praiseworthy words for India. He would have been pleased by the increased tries between India and the US. But I am sure that he would have been saddened by the irony in the celebration of some in India at the chance to buy American weapons.

NOTES:

[1] Go read “You can’t trust the Tatas, they are worse than others,” a post by Girish Nikam at “Indias Report.” (Thanks to Dinesh Dharme for the link.) Murky business. Who knows what’s going on in one of India’s most respected business houses. But we should not be surprised.

I clearly remember the moment when a light went off in my head [around 1996]. Brian Wright was teaching and we were talking about EV and CV. Equivalent variation and compensating variation, and the related concepts of “willingness to pay” and “willingness to accept.” As I had come to economics rather late in life, I had had the opportunity to figure out some of the basic concepts in my head. But I did not have the vocabulary to fully express the ideas. So when I got the vocabulary, it was an “aha” moment.

I remember Brian posing the question: so PG&E (the local gas and electricity utility company) is going to string up high-tension cables above your backyard. You know that that increases health risks. That is that there are externalities. How much are you willing to pay to stop PG&E from doing so? And how much are you willing to accept to allow PG&E to do so? Note that in the former case, the assumption is that PG&E have the right to string high-tension cables over your backyard and you wish to stop them; in the latter case, you have the right and can disallow PG&E from stringing wires across your backyard. It’s a matter of who owns the rights.

The willingness to pay is bounded by how deep your pockets are but the willingness to accept is open-ended. If PG&E owns the rights, then most likely you are out of luck because you will not be able to pay them enough to deter them from going ahead. If you own the rights, then you can make a pretty neat pile of cash by holding out.

Ronald Coase showed that regardless of who owns the property rights, if there are no transaction costs, then bargaining among the parties is sufficient for the discovery of the economically efficient amount of pollution.

Sometimes I wonder. I wonder if we would continue to have the kind of problems such as Nandigram if basic economics principles were better appreciated by a large percentage of the population. I think a lot of coercion and violence could be avoided. But perhaps I place too much faith in rationality.

Here’s a bit from that article in The Economist mentioned at the start of this post.

His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.

. . .

Mr Coase’s theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India’s Tata group and Turkey’s Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists.

That article goes into what the limitations of Coase’s work are. Worth a read, for sure. And now, here’s a bit on the Coase theorem from the Wiki.

In law and economics, the Coase theorem, attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasian bargaining.

This theorem, along with his 1937 paper on the nature of the firm (which also emphasizes the role of transaction costs), earned Coase the 1991 Nobel Prize in Economics. The Coase theorem is an important basis for most modern economic analyses of government regulation, especially in the case of externalities. George Stigler summarized the resolution of the externality problem in the absence of transaction costs in a 1966 economics textbook in terms of private and social cost, and for the first time called it a “theorem.” Since the 1960s, a voluminous literature on the Coase theorem and its various interpretations, proofs, and criticism has developed and continues to grow.

. . .

Coase’s main point, clarified in his article ‘The Problem of Social Cost’, published in 1960 and cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however, could not be neglected, and therefore, the initial allocation of property rights often mattered. As a result, one normative conclusion sometimes drawn from the Coase theorem is that property rights should initially be assigned to the actors gaining the most utility from them. The problem in real life is that nobody knows ex ante the most valued use of a resource and also, that there exist costs involving the reallocation of resources by government. Another, more refined normative conclusion also often discussed in law and economics is that government should create institutions which minimize transaction costs, so as to allow misallocations of resources to be corrected as cheaply as possible.

Transaction costs matter. See my posts on “It’s Transaction Costs All the Way” (Part 1 and Part 2) from July 2004.

So off we went. The lecture hall was packed to the brim. Prof Dixit’s lecture went over my head. He was talking about agency theory. I did not have the vocabulary to fully understand what he was talking about but still I got quite a bit of it because he is a great teacher. It has to do with principals and agents, etc. What I found delightful was his heavy Marathi accent. Later I went up to him and introduced myself saying that I too was from Maharashtra.

I have been recommending “Thinking Strategically” which Dixit co-authored for all who care to understand game theory and its applications for years now.

Recently, the Finance&Development site of the International Monetary Fund carried a profile of Avinash Dixit. (Thanks to Rajan Parrikar for the link.) I loved reading it.

It’s interesting that the article records that Dixit was drawn to game theory after reading Thomas Schellings The Strategy of Conflict. I was drawn to economics after reading that book. Later I read Micromotives and Macrobehavior by Schelling. You must read it.

Anyway, Prof Dixit has a great mind. Check out the profile. Here are a few excerpt, for the record.

Teaching game theory, he insists, must be fun—he has won awards for his teaching prowess—and he tries to illustrate key concepts with tales from films, books, and real life.

Dani Rodrik, professor of international political economy at Harvard, says Dixit was the best classroom teacher he ever had—he never treated anything as silly or obvious. “No matter how stupid a question seemed, he would stop, raise his hand to his chin, narrow his eyes, and think a long time about it, while the rest of us in the classroom would roll our eyes at the stupidity of the questioner,” said Rodrik. “Then he would say, “Ah, I see what you have in mind . . . ,” and he would roll out an answer to a deep and interesting question the student had no idea he had asked.”
“What makes him special,” says former student Kala Krishna, now an economics professor at Penn State, “is that more than anyone else I know, he sees economics as an inescapable part of life: from books, movies, negotiating with a taxi driver—everything has economic content. He truly loves economics, and you can see how much he is enjoying himself doing it.”

Others praise his wit. “Avinash Dixit is one of my favorite economists, in part because he has a trait that is extremely rare among economists: a good sense of humor,” said Steven D. Levitt, coauthor of the best-selling book Freakonomics.

. . .

He is also famous for his textbook on trade with Norwegian economist Victor Norman, The Theory of International Trade, which was enormously influential, and his work on oligopoly and industrial organization.

Path-breaking model

What became known as the “Dixit-Stiglitz” model underpins a huge body of economic theory on international trade, economic growth, and economic geography—a model tapped by Paul Krugman, who won the Nobel Prize in 2008.

The model, first published in 1977, became a building block for others in the new fields of endogenous growth theory and regional and urban economics—what journalist David Warsh described as “one of those economical and easy-to-use ‘Volkswagen’ models that were the hallmark of MIT” (Warsh, 2006).

Monopolistic competition was pioneered by Joan Robinson and Edward Chamberlin in the 1930s and was the stuff of basic economics for years. But Stiglitz—who went on to win a Nobel Prize in 2001 for his work with Michael Spence and George Akerlof on the analysis of markets with asymmetric information—and Dixit took it to a new level.

“The success of the Dixit-Stiglitz model of monopolistic competition might have come as a surprise to students of the history of economic thought, as it was by no means the first attempt to deal with imperfect markets or monopolistic competition,” said Steven Brakman and Ben Heijdra in a book analyzing what they termed a revolution in the analysis of imperfect competition.

“However, where the earlier attempts failed, the Dixit-Stiglitz approach turned out to be very successful and has the potential for ‘classic status.’”
Huge impact

The theory of monopolistic competition shook up modern trade theory, which Oxford economist Peter Neary attributed to “one factor above all others”: the development of the “elegant and parsimonious” model by Dixit and Stiglitz.

. . .

What drives development?

Dixit has spent the past decade watching what drives economic development, including governance and institutions, and has studied fragile states—poor countries recovering from conflict or disasters. “Governance was neglected by economists for a long time, perhaps because they expected the government to provide it efficiently. However, experience with less developed and reforming economies, and observations from economic history, have led economists to study non-governmental institutions of governance,” he says (Dixit, 2008).

To this he brings his habitual skepticism.

While Dixit acknowledges the importance of democracy, property rights, contract enforcement, and the provision of public infrastructure and services that support private economic activity, he is scathing about attempts to draw up a menu of items that underpin development in low-income countries.

“There’s a long, long tradition of people offering recipes which don’t work out,” he says. He stirred things up with a lecture at the World Bank in 2005 that he said he hoped would be provocative and critical, but “evenhandedly so.”

In many cases, he argued in that lecture, the accumulated research on the role of institutions in development stopped short of giving useful or reliable policy prescriptions. “I hope to give everyone some incentives to think further and harder.”

In a subsequent talk at the Reserve Bank of India (Dixit, 2007), he said that in general “bottom-up and organically generated reforms will work better than imposed top-down ones.”

The World Bank’s Philip Keefer, who was Dixit’s respondent at the 2005 lecture, said the Princeton professor was right to be skeptical, but “big ideas” could help guide a country’s reform agenda.

To work effectively, Dixit said, change must be coordinated and take place across several fronts. “The one recipe that works is what I call ‘strategic complementarities.’ That is, if 15 things need to be done, doing 3 of them is not going to get you 20 percent of the way there. It’s going to get you much less. You’ll need to get all 15, or at least 13 or 12, right before you start to see any big effect. So that’s one thing, strategic complementarities, and the second is luck.

“Napoleon supposedly said that the quality he most admired in his generals was luck, and the same goes for governments and countries.”

Go read it all.

Post script: When Rajan sent me that link to the IMF article, he wrote

“You won’t find the name in an India Abroad “Indians of the Year” list, or in the bozo chain emails Indians slosh around. He is ‘unknown’ except to those in the know. And unlike that imposter Amartya Sen, this is the real deal. Ladies & Gentlemen, Professor Dixit -”

Hear, hear.

Gross National Happiness, or GNH, was coined by the King of Bhutan in 1972. It was intended to measure the general level of well-being of the population. The idea was that measures such as Gross Domestic Product (GDP) are somehow inadequate and policy makers’ should focus on some more “holistic” indicator. I came to know of GNH in 2005 through a New York Times article, where it noted:

What is happiness? In the United States and in many other industrialized countries, it is often equated with money.

Economists measure consumer confidence on the assumption that the resulting figure says something about progress and public welfare. The gross domestic product, or G.D.P., is routinely used as shorthand for the well-being of a nation.

But the small Himalayan kingdom of Bhutan has been trying out a different idea.

In 1972, concerned about the problems afflicting other developing countries that focused only on economic growth, Bhutan’s newly crowned leader, King Jigme Singye Wangchuck, decided to make his nation’s priority not its G.D.P. but its G.N.H., or gross national happiness.

I am sure that some people do equate happiness with money but it is at all not certain that most people make that fundamental error. Extremely poor people may correctly surmise that if they had a reasonable amount of money, they would be materially better off and to that extent their welfare would improve. But my feeling is most people who are well-off enough already know that more money may translate into more comfort but not necessarily into more happiness.

It is true that advanced industrialized countries which are extremely wealthy relative to poor developing countries, are nevertheless not without their own problems. This is not any more surprising than the fact that no one expects rich people to have perfectly contented lives. In all economies — like in all lives — some rain must fall (or as we say in our semi-arid tropical country, some harsh sunshine must be endured.)

What I am puzzled by is the general contempt some people who are all thrilled about GNH feel about GDP. They are unhappy that the GDP is not a complete indicator of national well-being. Here I explain why dissatisfaction is not really warranted. I quote from a previous post of Oct 2005 on this blog. (It makes me happy to recycle stuff — even posts.)

When thinking about GDP and GNH, one has to be very careful about what one is aggregating. GDP is an accurate measure of what it measures: aggregate annual production of final goods and services in an economy denominated in monetary terms.

GDP does not aggregate cows, or beauty or whatever one may mistakenly think it does. Thus saying that the GDP does not accurately tell me anything about how many cows there are in the economy, or complaining that GDP does not tell me anything about “the total amount of beauty is in an economy,” is as silly as saying that GDP does not tell me whether the people in the country are happy or not.

So those who make that complaint are complaining that the tape measure is flawed because it does not help in figuring out the temperature of a liquid. It is not meant to do so in the first place.

Certainly there is something called happiness or satisfaction. A person can be said to be happy or satisfied. That is a feeling, a subjective experience. I can say that “I am happy” just like I can say “I am rich.” Those two look similar but the statements are qualitatively different. There is an objective validity to the statement “I am rich” because my wealth can be measured and verified externally. But happiness is subjective and does not allow interpersonal comparisons, while richness does. We can definitely say how A’s wealth compares to B’s wealth but cannot say how A’s happiness compares to B’s happiness.

If even interpersonal comparisons of happiness is mostly meaningless, attempting to define a measure which aggregates the “happiness” of millions of people clearly leaps over the bounds of the silly and lands somewhere in idiotic stupidity land.

I have never considered the GDP to be the end-all and be-all of an economy, any more than I consider the monthly income of a person to be the only relevant characteristic of a person. Perhaps some do, but then people believe in all sorts of silly stuff. Some economists do mess around with GDP growth rates and that is important, just like your tax accountant messes around with your income statements and your investments. Just because your income does not fully define you does not mean that your tax accountant is a myopic narrowminded individual or that the job of preparing your financial statement is meaningless.

I think that those who complain that GDP is not all that matters are making a valid but rather trivial complaint. I have yet to meet a single intelligent mature person–and most economists I have met fit that bill–who believes that GDP is anything more than a measure of economic activity and that too narrowly defined economic activity.

What I don’t understand is the attempt by the detractors of a measure at aping a measure which they have perhaps misunderstood. They are in effect saying, “GDP does not measure happiness. So we must come up with an alternate aggregate measure we will call Gross National Happiness which will be more appropriate.”

That is Gross National Silliness.

Here’s Kaushik Basu:

One often hears people claiming to be pro-market or anti-market. Such declarations are about as meaningful as a physicist’s claim to be pro-gravity or anti-gravity. “Market forces” in economics refer to a set of laws of aggregate behaviour. No matter what one’s ideology happens to be, these laws cannot be ignored.

The CPI(M) was right in making poverty removal and empowerment of the poor its primary objectives but wrong in thinking that the state could ignore individual incentives and suppress the laws of the market. What it ended up doing was to drive capital out of West Bengal. With this, the demand for labour fell and the ultimate loser was the working class. Seeing China’s pragmatism, which has resulted in sharp increases in real wages, the CPI(M) leadership is now trying to reverse its economic policy; but it has lost precious time.

Thorstein Veblen, who studied the rich with the zeal which anthropologists reserve for tribals, reached the conclusion that the rich are mean, vulgar and ostentatious. There are exceptions, but as a ballpark description this is quite accurate. Time and again, I have seen evidence of this and especially remember one occasion when, after giving a lecture to a certain chamber of commerce, I had to spend the evening socialising with the chamber’s president. I regretted not having had Bertrand Russell’s foresight. When he was asked to write for an American newspaper, Russell agreed on condition that he would not have to hobnob with the newspaper’s millionaire owner, William Randolph Hearst.

Especially in a nation as poor as ours, the consumerism and profligacy of the wealthy are jarring. But we must realise that in trying to curtail a rich person’s wealth we may hurt the conditions of the poor. When we stop the production of a luxury item, not only does this hurt the rich but also the poor worker who produces it. To divert money from the rich to the poor it is not enough to be well-meaning. It is not surprising that despite so much progressive rhetoric the poor remain so deprived in India.

One class of well-meaning people who could do with a lesson or two in economics are our judges. Given the widespread corruption and criminalisation in Indian politics, the increasing activism of our judiciary is welcome. I consider the judiciary (along with the press) among the most valued institutions of modern India and therefore worthy of special responsibility.

An important principle of economics, which the judiciary has repeatedly ignored — and journalists also frequently misunderstand — is the sanctity of the contract. To get the most out of the market, we need institutions which enforce voluntary contracts between individuals.

There are exceptions to this principle. We must make sure that the contract does not adversely affect uninvolved outsiders. Civil society also places limits on the range of allowable contracts. It will not, for example, tolerate giving away Draupadi as part of a contract. But subject to such limits, the feasibility of credible contracts is the backbone of a modern economy.

In the United States, graduate education is very expensive. Yet, lots of people acquire it. They manage this only because it is easy to get long-maturity loans. Banks give long-maturity loans only because they know the borrower is contractually bound to repay the loan.

If the judiciary were inefficient and took very long to book a defaulter or if it were “kind” and permitted borrowers to get away without repayment on a variety of grounds — such as that they are less well-off than the lender or that, in retrospect, the initial terms seem too harsh — then banks would either not lend or charge a very high interest rate to cover against default risks. In the end, it is ordinary citizens who would suffer.

One reason why the Indian worker is so much poorer than his east Asian counterpart is that our law and the judiciary make it so difficult for workers and employers to sign credible contracts which have a severance clause. Both parties know when the time comes to enforce such a contract, there are a variety of ways to renege. This inability to sign contracts has kept the demand for labour (and therefore wages) low in India.

True, statute laws cannot be changed in a hurry. However, to the extent that a lot of law in India is judge-made, our activist judges can help not only with the maintenance of law and order but also contribute to the progress of the Indian economy.

We ignore the fundamental lessons of economics — that incentives matter and markets work — to our own peril. Indian policymakers were either ignorant of economics or just ignored the lessons. The result of that is evident all around us.

Krugman explained that he’d become an economist because of science fiction. When he was a boy, he’d read Isaac Asimov’s “Foundation” trilogy and become obsessed with the central character, Hari Seldon. Seldon was a “psychohistorian”—a scientist with such a precise understanding of the mechanics of society that he could predict the course of events thousands of years into the future and save mankind from centuries of barbarism. He couldn’t predict individual behavior—that was too hard—but it didn’t matter, because history was determined not by individuals but by laws and hidden forces. “If you read other genres of fiction, you can learn about the way people are and the way society is,” Krugman said to the audience, “but you don’t get very much thinking about why are things the way they are, or what might make them different. What would happen if ?”

. . .
“What does it mean to do economics?” Krugman asked on the stage in Montreal. “Economics is really about two stories. One is the story of the old economist and younger economist walking down the street, and the younger economist says, ‘Look, there’s a hundred-dollar bill,’ and the older one says, ‘Nonsense, if it was there somebody would have picked it up already.’ So sometimes you do find hundred-dollar bills lying on the street, but not often—generally people respond to opportunities. The other is the Yogi Berra line ‘Nobody goes to Coney Island anymore; it’s too crowded.’ That’s the idea that things tend to settle into some kind of equilibrium where what people expect is in line with what they actually encounter.”

. . .
Krugman wrote his thesis on exchange rates, but another class, on international trade, inspired him. “There was this kind of platonic beauty to the whole thing,” he says. “I remember going through the two-by-two-by-two model—two goods, two countries, two factors of production. The way all these pieces fitted together into a Swiss-watch-like mechanism was beautiful. I loved it.” The traditional theory of international trade, first formulated by the British economist David Ricardo, two hundred years ago, explained trade by comparative advantage: a country exported the goods that it could produce most cheaply, owing to whatever advantages it possessed—cheap labor, climate, technological expertise, and so on. It followed from this theory that countries that were the most dissimilar should do the most trade—countries in the Third World dispatching labor-intensive goods to the First World, the First World selling technology- or capital-intensive goods in return. In the years following the Second World War, however, economists had noticed that much international trade didn’t follow this pattern at all. There was a large amount of trade between countries whose economies were extremely similar, and these countries traded goods that were virtually identical: Germany sold BMWs to Sweden and Sweden sold Volvos to Germany. People had speculated about why this should be so, but nobody had come up with a model that explained it in a rigorous manner.

Krugman realized that trade took place not only because countries were different but also because there were advantages to specialization. If one country was the first to begin manufacturing airplanes, say, it might accumulate an advantage in economies of scale so large that it would be difficult for another country to break into the industry later on, even though there might not be anything about the first country that made it particularly well suited to airplane-making. But why would countries trade goods that were almost the same? Because consumers like to have a choice, and, as Avinash Dixit and Joseph Stiglitz had pointed out a few years earlier, the same logic of increasing returns to scale that Krugman had identified as an essential dynamic in trade could apply to a single brand as well as to a whole industry. Krugman presented his theory to the world in the form of a paper at the National Bureau of Economic Research in July, 1979. “The hour and a half in which I presented that paper was the best ninety minutes of my life,” he wrote later. “There’s a corny scene in the movie ‘Coal Miner’s Daughter,’ in which the young Loretta Lynn performs for the first time in a noisy bar, and little by little everyone gets quiet and starts to listen to her singing. Well, that’s what it felt like: I had, all at once, made it.”

One implication of Krugman’s theory was that, contrary to economic orthodoxy, industrial policy might have its benefits. If the location of a new industry was essentially arbitrary, then a government, by subsidizing and protecting its emergence, could enable it to gain such a lasting advantage that other countries would find it difficult to catch up. But Krugman tried to discourage industrial strategists who cited him. For, while in principle industrial policy could be helpful, in practice, he believed, it was so difficult to determine which industry should receive government help, at the expense of all the others—so difficult to predict an industry’s future, and so difficult to determine merit when powerful interests would be trying to influence that determination—that in the end industrial policy would be likely to benefit mostly the owners of a few businesses and hurt everybody else. (Industrial strategists were not convinced. “You have the cases of Japan, Korea, Brazil, China, and, to some extent, France, and the counterfactual—let’s imagine that they didn’t have an industrial policy, would they have produced the same amount of growth?—is unimaginable,” Robert Kuttner, the co-founder and co-editor of The American Prospect, says. “But to be a conventional academic economist you almost have to swear an oath that governments can’t outguess markets in the allocation of capital.”)

Later on, Krugman became interested in economic geography, in the related question of why there were regional specialties—why, in the United States, for instance, were cars produced in Detroit, carpets in Dalton, Georgia, jewelry in Providence, and chips in Silicon Valley? Again, the answer turned out to be history and accident. Once an industry started up in one place, for whatever reason (the carpet industry in Dalton appears to have its origin in a local teen-ager who in 1895 made a tufted bedspread as a wedding present), local workers became trained in its methods, skilled workers from elsewhere moved there, and related businesses sprang up close by. Then, as more skilled labor became available, the industry could grow and benefit from economies of scale. Soon, as long as it didn’t cost too much to transport the industry’s products, the advantages of the place would be such that it would be impractical for someone to open up a similar business anywhere else. Many economists found the idea that economic geography could be so arbitrary “deeply disturbing and troubling,” Krugman wrote, but he found it exciting.

Again, as in his trade theory, it was not so much his idea that was significant as the translation of the idea into mathematical language. “I explained this basic idea”—of economic geography—“to a non-economist friend,” Krugman wrote, “who replied in some dismay, ‘Isn’t that pretty obvious?’ And of course it is.” Yet, because it had not been well modelled, the idea had been disregarded by economists for years. Krugman began to realize that in the previous few decades economic knowledge that had not been translated into models had been effectively lost, because economists didn’t know what to do with it. His friend Craig Murphy, a political scientist at Wellesley, had a collection of antique maps of Africa, and he told Krugman that a similar thing had happened in cartography. Sixteenth-century maps of Africa were misleading in all kinds of ways, but they contained quite a bit of information about the continent’s interior—the River Niger, Timbuktu. Two centuries later, mapmaking had become much more accurate, but the interior of Africa had become a blank. As standards for what counted as a mappable fact rose, knowledge that didn’t meet those standards—secondhand travellers’ reports, guesses hazarded without compasses or sextants—was discarded and lost. Eventually, the higher standards paid off—by the nineteenth century the maps were filled in again—but for a while the sharpening of technique caused loss as well as gain.

Go read it all. (Hat tip: Rajan Parrikar.)

I strongly believe that the only way India can sustain its long-term economic growth is by unleashing and harnessing the creativity of its grassroots entrepreneurs, especially in rural areas. But here is the challenge: these grassroots inventions don’t scale up. Indeed, most rural innovation initiatives such as DesiCrew and grassroots inventions like Mitti Cool, however impressive they may be, are sadly limited in their impact to a local or regional market of a few hundred customers, and end up employing no more than a dozen workers in the local community. What is missing is a mechanism to cross-pollinate and scale up these bright ideas among India’s 250-million-strong agricultural community which lives scattered across more than 600,000 villages.

I find the paragraph interesting. His belief that “the only way India can sustain its long-term economic growth . . . by unleashing and harnessing the creativity of its grassroots entrepreneurs, especially in rural areas” is approximately right. The bit that raises questions is “especially in rural areas.” Surely, “the only way” cannot be “especially in rural areas.” Rural areas and “sustained long-term economic growth” are incompatible and inconsistent. This is puzzling since in the same paragraphs he explicitly recognizes the limitation that rural areas have — a matter of scale.

We need to go back to the fundamentals, as always.

Generally speaking, economic growth arises from an increase in productivity (the amount of goods and services that an hour of labor produces). Productivity increases depend on the degree of specialization, a fact that is well-known since Adam Smith’s 1776 book “The Wealth of Nations.” The degree of specialization is limited by the size of the market. The smaller the market for a specific good (that is, the volume of supply and demand), the smaller degree of specialization it can support, and therefore the smaller the gain in productivity through specialization.

Rural markets are small because of fragmentation. The rural market is fragmented even though the rural population is huge. Integrating the fragmented markets is a big task and there are several approaches to it depending on the good or the service under discussion. For instance, for goods markets to be integrated, the transportation system has to be efficient. For services, if it is a service that can be delivered over a wire, a good telecom infrastructure can integrate the market. But if the service is non-transportable — such as a hair cut or plumbing service — then the only way is through aggregating the scattered rural population.

The natural way that markets become integrated is when the scattered village population moves to aggregate themselves into towns and cities. Cross-pollination of ideas and economies of scale (what Navi mentions in that paragraph), and hence the integration of markets, occurs naturally in dense aggregations of people.

The bottom line is this: India is heterogeneous along all dimensions, including people and places. There are leading and lagging places. The broad policy thrust has to be the development of people, not places. That means, the policy should be the development of people in the lagging areas, not the development of the lagging areas. The complementary policy for the leading areas is the development of the place.

Summary: Develop the people of lagging areas (policy A) and develop the infrastructure of leading areas (policy B). The policies A and B have to be implemented simultaneously. Policy A creates human capital who can (by migrating to the leading areas) become more productive given the infrastructure produced by policy B.

Grass-roots entrepreneurs, the ones mentioned by Navi, regardless of how clever they are, are likely to find limited success as long as they are forced to operate in small markets (that is, having to live in villages.) Larger markets are only available either in places with dense aggregations of people, or where the transportation and telecommunications infrastructure is efficient enough to provide integrated market even with scattered populations.

The long-term sustainable economic growth that Navi talks about in the quoted portion above is not possible in the context of rural areas. As long as rural populations are involuntarily restricted to rural areas, they will be forced to low productivity levels. India’s long-term economic prospects are linked to how effective India’s policies are in transforming the currently rural population into an urban population.

As the photoshopped image in my first post on this matter previously states, “I see stupid people . . . they don’t even know that they are dumb.” And now we note the furious back-peddling. I had noted in the followup post that the claim is that it was a typo. It seems that India’s Minister of State for Higher Education D Purandeswari’s claim that a $10 laptop was a reality was based on a simple typo, a dropped “0″. (H/t: Sudipta)

A fine invention — the missing zero — from the land which lays claim to have invented the zero.

It’s a sad commentary on the state of India’s governance that the minister of state for — hold on for this — “higher education” is so ignorant so as to be unable to reason and uncritically announces a near impossibility. Should anyone be even the least bit surprised at the sorry state of India’s education sector if its policy makers are so astonishingly disconnected with reason and reality?

I can imagine an illiterate person who has never seen an electronic device in his or her life being unable to estimate the cost (or the price) of a computer. He or she would have no basis for estimating the cost — it could be anything between Rs 1,000 or Rs 100,000 or more. But even the average high school student in India — who probably knows roughly the prices of cell phones, mp3 players, various electronic toys and gaming machines — would easily enough reject the notion that a laptop could cost as little as Rs 500.

You don’t need to have the smarts of a professor of quantum physics to know that some things are too improbable. For instance, most of us really don’t know how much a commercial airliner costs. For all we know it could be $50 million or it could be $500 million. We have no way of telling for sure. But if someone claims that they have recently built one for the astonishing $100,000, we would tell him to get a brain cell or two. We can do this because we know that a car costs around $20,000 and a commercial airliner is tens of times bigger and more complicated than a car.

I will not dwell anymore on this shameful display of ignorance. Let me review a bit of economics to take off the bad taste in my mouth left by having dropped my jaw too often lately.

The first fun fact is that most of the manufactured stuff available out there is produced by private firms in competitive markets. That implies that they have to make profits. How do they make profits? By reducing their costs. Because in competitive markets, if your costs are below what the prevailing price for your widget is, then you make a profit. But since all firms are simultaneously trying to cut costs, the price itself drops because firms reduce their own prices as much as they can while still making a profit so that they can sell more to the market. This leads to the situation that in competitive markets, prices track costs closely.

If you are getting a laptop for around $700 a pop (give or take a couple of hundred bucks), then you can be sure that the costs are around that. The margins are super thin. Laptops are almost commodities and there isn’t much room for super-normal profits.

The second fun fact is that manufacturing has “scale economies.” The more units of something you manufacture, the lower is your per unit cost. So what happens is that firms specialize in the manufacture of components.

Example: Intel makes processors. They make them by the millions. They spend billions of dollars in the design of a chip (that’s the fixed cost) but then manufacture tens of millions of those babies. That distributes the high fixed costs and so the average fixed cost is a few dollars per chip. The scale economies arise from the combination of high fixed costs and low variable costs (these are the costs of the silicon wafer and the fabrication of each individual chip.)

Then Intel sells these chips to others. These processors are intermediate goods, as opposed to final goods such as laptops. Much international trade is trade in intermediate goods. You see container ships carrying components from one country to another. The globalized world we hear so much about is held together by links that are essentially component manufacturing.

There are tons of intermediate goods. Just look around. The LCD display: made by a few large manufacturers like Samsung. Same goes for the hard drives in your computer. But let’s not restrict ourselves to computers alone. The windshield in your car is made by one of a handful of windshield makers, regardless of whether you drive a Suzuki or a Honda.

Every subsystem of a complex machine is actually produced by some firm specializing in the manufacture of that bit. The end product that you buy is an assembly.

What does this specialization imply? Obviously that you get stuff at prices that would have been impossible without it. The firms do the best they can, spending truck loads of money in research and development to figure out how to make their stuff cheaply. Over decades of this sort of learning and doing, the ones that manage to survive are the best of the breed. It is not easy to dislodge these firms. So if I have dreams of starting up a company which will knock Intel out of the ring, I should wake up and smell the coffee.

The bottom line is this: a computer is a complex bit of manufactured stuff, each subsystem of which is manufactured by firms at the lowest possible costs given the present state of the art, and it takes billions of dollars worth of investment to keep improving the technology and advancing the state of the art.

You can bet your bottom dollar that although things get cheaper over the years, there are no quantum leaps. (Here, I use the term quantum in the original sense of the word — a discrete step — and not in the sense that is generally misused as a synonym for “massive” or “big.”)

Things improve gradually. They evolve. Not just evolve, they co-evolve. To make something, it takes an ecosystem of firms all competing and all trying their hardest to cut costs and improve efficiencies. Last month I paid $100 for a 250 GB external (USB) hard drive. Two years ago, I had paid $130 for a 80 GB hard drive. Next year, I will perhaps pay $100 for a one-terabyte drive. But I will not be paying $2 for a 250 GB drive next year. That will not happen.

Why? Because there is a simple rule. There is a minimum cost dictated by the amount of stuff in a device. It is easy to arrive at that minimum cost. Just weigh it and then multiply the weight with the per kilo cost of the matter that went into it. By this device you can immediately put a floor on the cost (and therefor the price) of a car (weight multiplied by the cost of steel, say), or the floor on the cost of a bus. The latter minimum will be more than the former.

But note that this is a minimum. It says nothing of a maximum. A Porche sports car can cost a lot more than an average bus.

Also note that in many cases, the smaller the thing, the more expensive it can be. The Macbook Air costs a lot more than the average laptop.

The point is that one can reject the idea that a computer, however minimalistic in its design, can cost $10. It takes eye-popping ignorance to do otherwise. (Here we are not talking of a price. The price can be arbitrarily set by the government.)

Well, that is it for now. Got to go. Perhaps I will write more later.

The book, The Gridlock Economy, gets added to the growing pile of stuff to read.

Every so often an idea comes along that transforms our understanding of how the world works. Michael Heller has discovered a market dynamic that no one knew existed. Usually, private ownership creates wealth, but too much ownership has the opposite effect—it creates gridlock. When too many people own pieces of one thing, whether a physical or intellectual resource, cooperation breaks down, wealth disappears, and everybody loses. Heller’s paradox is at the center of The Gridlock Economy. Today’s leading edge of innovation—in high tech, biomedicine, music, film, real estate—requires the assembly of separately owned resources. But gridlock is blocking economic growth all along the wealth creation frontier.

And here’s Heller speaking at Google:

It is fairly well understood that information and communications technologies (ICT) tools expand choice. We all have access to a very large set of information and have the freedom to choose what we want to read, watch, listen to, etc., etc. ICT expands our “downstream” choice. What is not as well understood is that it expands our “upstream” choice also. It is a two-way medium, unlike say broadcast and print media which only allows us downstream choice: using ICT we send back information indicating our choice and thus guiding what comes downstream.

In other words, ICT expands the menu of options we have and also gives us the ability to change that menu. Options that are not exercised fall off the menu and this leads to more efficient outcomes since resources are not wasted on things that people don’t value. All this is trivially true and one can be guilty of stating the obvious except for the fact that we have yet to make full use of the power of upstream choice that ICT affords in scores of areas which would make economic and political freedom more meaningful.

Democracy 1.0

Democracy is often advertised as a system which allows political freedom wherein citizens have choice in electing public officials who then make public policy choices. That was a reasonable system in the sense that it was efficient. (Note the “was.”) It was neither expected nor possible for everyone to express their preferences on every matter on every occasion and have these preferences aggregated to arrive at the appropriate policy decisions on various matters. What was possible was to have occasional elections in which the public officials would be elected who would have the authority to determine public policy as they saw fit. If the elected chose an unpopular set of policies, they would be replaced in the next election cycle.

The actual implementation of democracy is constrained by the available technology. For instance, when the rules were framed for political institutions of the newly independent American states in the 1770s, the communications and transportation systems were primitive. You could not have instant voting on specific matters as and when the need arose: you could only have period voting in general.

If people value a democratic form of political organization, it must be because they value choice and the freedom they have in exercising choice. If democracy is good, it seems reasonable then that more democracy is better, and a way to achieve that is for people have the freedom to exercise more choices.

ICT gives us the means to implement an improved version of democracy by increasing our ability to express our preferences over a wider set of choices and drive policy more efficiently. This is, if you would pardon the construct, Democracy 2.0 as opposed to the previous version that we are still using. If Democracy 1.0 was an improvement on dictatorship, totalitarianism, feudalism, aristocracy, or whatever, then Democracy 2.0 is an improvement on the version 1.0.

Democracy 2.0

I will only give an operational definition of Democracy 2.0. Let’s start with an analogy. We know what Media 2.0 is and understand how it differs from Media 1.0. Blog posts are M 2.0 while newspaper columns are M 1.0; newspapers are M 1.0, whereas news aggregators are M 2.0; radio stations are M 1.0, while podcasts are M 2.0. The essential distinction is the choice you have and the freedom you have in exercising those choices. You decide what you want to read, watch or hear. More importantly, you decide if you wish to add your own two bits to the ever expanding choice set by writing on blogs, podcasting or YouTube-ing. You not only decide what but how much you consume and produce. You are the king and you through your choices determine what happens. M 2.0 is brought to you by the power of the web and the internet, the same two things that have the power to bring you D 2.0.

So let’s examine a hypothetical example of what D 2.0 could make possible. Under D 1.0, the prime minister decides that University of Cambridge would be given £3.2 million for the “Jawaharlal Nehru Professorship of Indian Business and Enterprise.” He, presumably under instructions from his boss, made that decision. It was not his own money, neither was it from his boss’s considerable fortunes – it was the money from average taxpayers like you and me. He transferred funds to a rich foreign university with money that was not given freely by me and, I presume, you. I had no choice in the matter even though part of that money was mine. The money he gifted away to Cambridge could have been used to fund the entire education of tens of thousands of poor Indians and given them a fair shot at a decent existence.

Under D 2.0, here’s how it would work. The government sets up a website for the specific purpose of funding a chair at University Cambridge, and publicises it. Then I – like millions of others – decide how much I am willing to contribute to it. It is my money and I choose how much of it I want to give away to UCambridge, not the prime minister or his boss. The technology is there for directly expressing my choice on this matter, which we must remember is a discretionary matter.

Routine Abuse

Unfortunately the government routinely spends taxpayers’ money on discretionary matters. I suppose most of us would agree that the state has no business in meddling with religious matters. The Indian government does. It, for example, provides a subsidy for Muslims to go on haj. Haj is a matter between Muslims and their maker, and the government of India has no cause to interfere in it. I believe that the haj subsidy should be abolished.

Or more specifically, the government funding of haj must be abolished. If I feel like subsidizing the haj, I can bloody well send in a check to a fund specifically created for sending people to Saudi Arabia. Better yet, I can do it from the comfort of my home by filling in a form with my credit card information on a “Haj Subsidy Website.” My involuntary contributions to haj through the coercion implicit in the taxes the government imposes on me is merely disguised jaziya, a tax that non-Muslims pay to their Muslim overlords. This is immoral, unethical, regressive and economically inefficient.

Here’s one more example: the funding of terrorism in foreign nations. See this post on funding Pakistani jihadis. In a follow up post in June last year, I had proposed a disintermediation mechanism:

. . . the government of India should bypass the government of Pakistan and the ISI and directly send the funds to the terrorists.

But then another thought occurred to me. The money eventually comes from Indian taxpayers. The chain is Tax-payers to Govt of India to Govt of Pakistan to the ISI to the terrorists. Why not just have a bank account for the terrorists in some Indian bank into which all of us taxpayers can simply deposit part of our earnings, and from which the terrorists could withdraw what they need at will?

Seriously, though, we have to make some systemic changes. ICT reduces transaction costs. In the past, there was no inexpensive way to ask people to contribute directly to various discretionary causes and no way to cheaply aggregate their contributions. Now all you need is internet access and a credit card or bank account.

Will it Happen

In the next part on this, I will explore whether the power of ICT to release Democracy 2.0 will be used or not. Any structural change necessarily changes the power structure and that means that there will be gainer and losers. If the required change threatens the power of the powerful in the existing order, they will block the change if it is within their power to do so. Let’s explore that next.

Update: Thanks to reader Ramakrishna Upadrasta for pointing out that the links were not working. I have fixed them.

It’s an economics truism that generally people respond to incentives. If you truly and deeply understand that, you know a fundamental truth about the world.

If the reward of doing something does not accrue to me, I will not be likely to work hard at it. This does not mean that there are no altruists or that everyone is a selfish clod who only cares about himself. It only means that most people will not do something which is good for society but which does not fully compensate them for their personal costs. In economist speak, if the personal costs cannot be compensated for by capturing at least some part of the positive externalities, the agent will not expend the effort.

Let me put it in concrete but hypothetical terms. Suppose I can do project X, at a personal cost PC, and a social cost SC, which will have the social benefit SB. Assume that SB >> (PC + SC). In other words, assume that total benefits are much much greater than the total costs. Suppose further that I can gather at most PB (personal benefit) from the SB. As a self-interested economic agent, only if PB > PC, I will undertake X, otherwise not.

Good Policy is Expensive

Good policies help with development. It is rarely that one does not really know or cannot tell good policies from bad ones. So why is it that bad policies usually trump good policies? (I take it as a given that in the case of all under-developed economies, that bad policies win more often than good policies. If it were otherwise, they would not be under-developed economies.)

Making good policy is personally expensive, its beneficial effects take a long time, and those benefits cannot be sufficiently captured to compensate for the personal cost incurred. Good policy requires hard work, is often politically unpopular, and by the time your dedication is recognized, you would have shuffled off this mortal coil.

That is why good policies are not made in India. Let’s note that the success of an economy is critically dependent on the quality of its policies. What policies do is prioritize activities and allocate resources accordingly. Prioritizing is important because sequencing of activities matter. You have to have the foundation built first, for instance. Or that primary education is a prerequisite for higher education.

Priorities

Time is the reason that we have to sequence our actions. As the wise man said, time is nature’s way of preventing everything from occurring all at once. Time is the binding constraint. But there’s a less important but equally binding constraint: resources. Choices have to be made. You cannot have your cake and eat it too.[1]

As in any individual’s case, society also has a large set of things that need done. Prioritizing is not trivial because they can be ranked along multiple dimensions, all of which are ultimately value judgments. Different people have different values and therefore their orderings differ. So in this regard as least, the individual has it easier than an economy: unless one is suffering from an extreme case of multiple personality disorder, he or she does not have the problem of aggregating the preferences of a large number of individuals to solve the ranking of things to be done.

Total Orderings

In any case, total orderings of things to be done is not possible. Most are incommensurable due to dimensionality issues and therefore the best one can do is partial orderings. How does one choose between two projects that differ in their importance and their urgency? What weighing mechanism should one use to rank them properly?

In the case of an individual, the consequence of the choices are usually limited to the individual. One makes ones bed and is forced to lie in it. But in the case of public choice, the people who do the choosing are merely agents acting on behalf of the collective, the principal. The standard principal-agent problems arise. The agents can and often do suffer from moral hazard: they choose to avoid actions that are costly for them but which would have been beneficial for the principal.

Bad Choices are Cheap

Now we can get back to the problem of why good policies are not chosen. It is assumed that good policies are within the feasible set. There would be no point in discussing whether or not to do something if that something was impossible to do. Moreover, it is not just that the feasible set is non-empty but also that it has more than one element. One has to choose between alternatives.

My conjecture is that good policies are not chosen by policy makers because the rewards for doing so are less than the rewards for choosing bad policies. Consider the issue of caste and religion based reservations in higher education. It is a bad policy but the rewards to the policymakers (politicians) is electoral success. Another religion related bad policy: subsidizing haj visits and madrassa education for Muslims instead of allocating those resources for a progressive secular education. Once again these bad policies provide immediate rewards at low personal cost but have immensely harmful effect on society in the long run. By the time society suffers the consequences of these harmful choices, the policy makers would have gone to meet their makers.

Choice Matters

Success is a series of good choices. That’s true as much for an individual as for a collective such as a large economy. In the case of collectives, the choosers are called policy makers. Policy makers are politicians, and in most cases are guided by a bureaucracy. Bureaucracies have their own objectives, their agenda, which is independent of and more persistent than the tenure of politicians. It is hard to tell whether it is the bureaucracy or the politicians who actually make the decisions. Most likely it is some complex strategic game that determines the outcome. But what occurs behind the scenes is not as important as the outcome. Generally, the result is not pretty and the evidence is all around us to see. The poverty of nations is never a pretty sight.

Prosperity and poverty are outcomes of a long series of apparently small choices, not something random falling from the heavens like gentle rain. Whether to spend scarce resources (and resources are always scarce) on sending probes to the moon is a trivially small matter when considered in the larger context. But trivially small matters add up eventually. As the poem reminds us, “little drops of water, little grains of sand, make the mighty ocean and the pleasant land.”

NOTES

1.

I have always found that saying to be confused. Every time I hear it, I think, “That’s really stupid. You have to have your cake before you can eat it. Only that you cannot eat your cake and have it as well because when you are done with eating it, you don’t have the cake any more.” But I have a more general point that I want to make. You can also eat your cake and have it too — provided you have lots of cake. Then you proceed to eat as much of it as you like and then you will have sufficient leftover to have later.

I would re-state that saying as: “You cannot eat all of your cake and have it too. But if you have so much cake that you cannot possibly eat it in one go, then you can eat as much as you can and have it too. So the trick is to get so much cake that you can eat your cake and have it too. The ultimate goal for the economy is that it produce so much cake that everyone can eat their fill and have leftovers for mañana.” [Return.]

At the shining bright core of our galaxy of ideas lie a bunch of super-massive ideas that are tightly bound to each other. The core’s gravitational attraction holds the galaxy together, draws in stuff and transmutes them into higher elements.

Exploring the metaphor a bit further is interesting. At the center of galaxies dwell huge black holes which destroy both matter and time. And like the great god Shiva — the Mahadeva as Nataraja, the king of dancers, dancing the Tandava, the cosmic dance of creative destruction — the galaxy core produces novelty and thus advances the evolution of the entire galaxy. Black holes, just like Shiva, destroy time. Curiously, the Sanskrit word for time is the same for black: “kala”. The universe evolves because ceaseless change is imposed upon it through the dance of creative destruction.

Evolution. It is hard to escape the gravitational pull of the idea of evolution. The idea goes back into antiquity. But it was only recently (in terms of historical time) in the mid-1800s that Charles Darwin (1809 – 1882) pondered the biological variant of evolution and figured out the mechanism. It was natural selection. That is one of the superstar ideas that populate the core of our ideas galaxy. Everything that is known about biological evolution can be explained through natural selection.

Natural Selection

Darwin had patiently observed nature and cataloged a heap of facts during his voyage on the HMS Beagle which ended in 1837. Then another idea pushed him to an inspired guess on the mechanism which produced the diversity of species in the world. That idea came from a professor of political economy and Fellow of the Royal Society, Thomas Malthus (1766 – 1834).

Malthus had considered the matter of how societies function and concluded that the struggle for food is critically important. The competition for food would result in winners and losers. Populations would increase till the standards fell to subsistence levels for the most fecund segment of society. The biological imperative to reproduce as profligately as possible lead inexorably to a situation where natural resource limits are reached and the weakest sorted out of the race. At the center of the drama of life was competition for resources.

Darwin had observed the natural world, pondered the evidence, and read Malthus. That’s what he needed to figure out natural selection. But then so had another contemporary of his: Alfred Russell Wallace (1823 – 1913). Like Darwin, he studied the natural world, pondered the puzzle of the diversity of species and he too had read An Essay on the Principle of Population (final revision published 1826), by Thomas Malthus, and arrived independently at natural selection. Darwin was about to be scooped by Wallace and rushed to publish On the Origin of Species by Means of Natural Selection in 1859.

Competition

The centrality of competition in the natural world is immediately understandable to anyone who has observed nature. Economists appreciate the power of competition and it is not surprising at all that natural scientists like Wallace and Darwin incorporated competition in their explanation of the biological world. (Darwin and Wallace were competitors!) They realized that there was no divine designer involved in the creation of variety in the natural world. There was no grand planner and consequently no grand plans.

The biological world evolves autonomously. There was only competition for resources and the universe was supremely indifferent to who were the winners and who the losers. Natural selection is the mechanism which all living systems rely on for their evolution.

The twin ideas of evolution through natural selection and competition are inseparable. I find it unsurprising that the central organizing principle of biology owes something to economics.

It should be noted that natural selection and competition are descriptive rather than normative features of the world. We are merely noting how things are, and no claim has been made so far on how they ought to be. The universe is neither moral or immoral; it is amoral. That eventually it gave rise to sentient beings that are capable of making moral judgments is itself a result of amoral processes.

In the rest of this essay I will argue that from a certain perspective, competition is good. That is clearly a normative statement and requires some support. My claim is that it is very significant that competition leads to outcomes that are on balance good and desirable.

Only Likes Compete

Let’s leave the biological world aside and for now focus only on the world of artifacts and manufactures. I am writing this on a laptop and using all sorts of hardware and software tools. I consulted the wikipedia, searched using google, used Firefox and Chrome. The tools keep improving. The Microsoft internet browser, Internet Explorer, was born retarded. Relentlessly, the competition has forced it to become much better. Why? Because in the struggle to survive, it has to compete. Absent competitors, Microsoft would have little incentive to invest resources in making IE better.

The iPod was pretty cool when it was first introduced. Yet the constant improvements that Apple made to it were not altruistically motivated. Today’s iPods are better than yesterday’s. Look around and note that improvement and competition go hand in hand. Note that where competition is prohibited, things don’t get better; they don’t have any reason to.

Let’s keep in mind that only likes compete. Only those entities that occupy the same ecological niche compete against each other. Predators compete with other predators; prey with other prey. Toyota does not compete with Pepsico or with Microsoft. Google competes with Microsoft, not with Delta Airlines. More generally, on one side of the market, producers compete with other producers, and on the other side of the market, consumers compete with other consumers. Producers and consumers don’t compete in the marketplace.

Producers Must Please

It is very important to understand this point. It is fatally wrong to imagine that producers compete with consumers. Socialist thinking is born dead because it does not understand that. Socialists imagine that the producers interests are opposed to the interests of the consumers. This is wrong. Producers and consumers appear to have divergent interests — producers want to sell as dearly as possible and consumers want to buy as cheaply as possible. To maximize the appeal of its products to consumers, however, a producer has to produce quality products and price them such that it wins against competing producers.

{I swear on everything I consider sacred and dear to me that I am not making this up. While I was writing that last paragraph, I received a spam message which begins thus:

See what I mean?}

Note this down. Producers don’t compete with consumers but rather producers compete for consumers. Producers compete with other producers for consumers. It is that competition that drives innovation and that is what evolution is in the artificial world of things. Competition in the world of things is fine and good. But what really matters is the competition in the world of ideas. Ideas trump things. The evolution of ideas through competitive pressures leads to innovation. That is what accounts for all human progress. I’ll come back to that shortly.

Societies that permit producers to compete develop good products. All monopolies are therefore harmful for society. It does not matter if the monopolist is a public firm or a private firm. If the producer does not face competition, it has no need to improve. Examples are legion. But just as an example for those who are familiar with India’s post-colonial history, consider the evils of Nehruvian socialism which restricted most competition in the private sector, and in many important cases created public sector monopolies. The result was widespread impoverishment of the economy and legendary levels of poverty. Material poverty in India is unquestionably the predictable outcome of not allowing competition.

Freedom from Control

Why the government did not allow competition is fairly easy to state. Monopolists collect super-normal profits (which economists call “rent.”) Rent-seeking by those who control the levers of government makes public sector ownership of important sectors of the economy very attractive. Furthermore, by handing out licenses to private sector firms, the government makes sure that it restricts competition in those sectors that would be the most valuable for extracting rents. The government of India thus directly controlled activities such as railways, power, steel, telecommunications, etc., directly and indirectly though license, quota, and permit requirements, controlled other aspects of the economy such as manufacturing, and services.

India is one of the least economically free countries in the world. You don’t need to go consult any well-researched academic report to conclude that: you merely have to walk around India with eyes open. The obvious poverty and economic backwardness could not be the result of economic freedom. Four out of five Indians subsist on less than $2 a day. That’s 800 million people — more than the combined population of the US and EU.

Want another telling piece of evidence that the Indian economy was (and indeed is still is) a slave economy and not a free one? Well, have you heard the prime ministers of India talking about impending or on-going “liberalization” of the economy? Surely, if the economy were not enslaved, there would be no reason for anyone to claim that they stand for freeing the economy. One would be very surprised if any Hong Kong politician were to proclaim that he would liberalize its economy because HK is already free.

Free people don’t need emancipation. Free economies don’t need liberalization.

India is apparently politically free (except for foreigners influencing India’s political fortunes), but India is not economically free. And until it becomes economically free, it will continue to remain what used to be called “underdeveloped” and which is now euphemistically called “developing.”

Ideas trump Things

So what exactly is the foundation on which a free economy rests? Free ideas. If you are free to think and free to express the results of your thinking, it leads to wealth. The preceding discussion about competition holds in the arena of thought. The heterogeneity of humans implies that different people will have different ideas. These will compete in the ideas space just as vigorously as products compete in the products space.

Gautama, the man who became the Buddha, said that all compound phenomena are impermanent and therefore all things must pass. I would add that all things are imperfect. Biological things evolve through natural selection and diversify and become “fitter.” All human-created things are imperfect but tend to become less imperfect as a result of evolution in the product space. Compare today’s cell phone with one of just a decade ago. Ideas — the product of human cognition and rationality — too are imperfect and tend to become less imperfect as the machinery of competition refines them.

The way to kill progress is to monopolize the production of ideas, or even worse to prohibit the creation of new ideas. The US is a shining example of a society which allows and encourages ideas. (There will always be aberrations from time to time, but I am speaking broadly.) The ideas compete and thus evolve. The better mouse trap is produced by a better idea about mouse traps. The browser continually gets better because somewhere someone is thinking up better ideas. Free people produce innovation because free people compete in the plane of ideas.

The Failed World

They call advanced industrialized countries the “first world.” There is another world which I call the “failed world.”

Contrast the American society (and more generally the Western European society) with its polar opposite: the Arab world. First fact: they are abysmally poor in general. Material poverty is endemic. There is a wealthy segment of the Arab world but that is not earned wealth. They did not produce it; due to a geographical accident, they found that they were sitting atop oil. But remember that the oil was fairly worthless till the non-Arab world developed the technology for using oil.

What prevents the Arab world from developing? It is their ideology. It is an ideology that is limited to what was known to a bunch of fairly ignorant people in the Arabian peninsula (even by the standards of 7th century CE world.) That ideology claims that it had been created perfect and therefore it cannot be ever improved upon. In fact, it prohibits at the pain of death any changes in it. All its ideas are frozen in time, and it arrests the development of any society that falls prey to the ideology. If one were to segregate and isolate the Arab world from the rest of the world, the Arab world will never see any innovation or progress. It is the constant infusion of goods (not ideas) imported from outside the Arab world that maintains it even at the low levels of existence. Without this “aid”, it would rapidly regress to the conditions that prevailed in 7th century Arabia.

India and its neighbors

Closer to home (speaking from an Indian perspective), there is a natural experiment that occurred in the Indian subcontinent. India used to extend to the east and west of present day India. Many centuries ago it even included Afghanistan, then a place of great learning and prosperity. Islam defeated the land centuries ago and now it is a place known better for relentless war and crushing poverty. Afghanistan is so poor that India sends it aid. Just a few years ago, the people of Afghanistan even destroyed the remnants of their illustrious past — the Bamiyan Buddhas — because Islam decreed it.

In more contemporary times, India’s borders shrank further with the creation of Pakistan (and Bangladesh.) The population of all three countries are similar in many respects and naturally so because they occupied the same geographical niche for millennia. Yet the fortunes of Pakistan and India have diverged significantly in the last half century. For all practical purposes, it is a failed state about to implode. That it lasted so long is thanks to the geopolitical strategic games of the post-cold war era. Now that Pakistan has outlived its use for the US, the US is discarding it with all the finesse of handling a used condom. What distinguishes India from Pakistan and Bangladesh is that they are Islamic states and therefore rigidly wedded to an ideology that does not permit ideas to flourish.

Market versus Command-and-control

What distinguishes the successful from the unsuccessful economies of the world is that the former are market-driven and the latter are command-and-control. By market driven is meant that there is competition among buyers and competition among sellers. This competition among producers and consumers is not limited to just the product space but extends more importantly to the ideas space. Exhibit A: the former Soviet Union and other communist states. They controlled what was to be produced by whom and in which quantities and when. More damagingly, they controlled who was to think what. Result: economic collapse.

Communism is an ideology that prohibits free enterprise. It wants a monopolistic control of the entire economy, not just bits and piece of it here and there. And it wants the monopolistic control to be in the hands of a select few. The same with monotheism. There is only One True God ™ and there is a book which has every truth eternally recorded in it, and the founder of the religion has absolute control over it for eternity, and no novelty is allowed. There is only one Lord and everyone has to submit to it — both in the here and in the hereafter. Submit now so that you can get your rewards in the hereafter. Pay now, travel later. Good to be in control of such a great scheme.

Monotheism

Monotheism in the ideas space is the equivalent of monopoly in the economic space. They are supremely harmful.

The market system, in contrast, has no central controlling authority. It is most significantly a marketplace of ideas. Sure many of the goods bought and sold are things, not ideas. But look under the hood, and you will see that the engine is an idea. All things are born first as ideas.

The market, like the dominant Indian faith, has millions of gods. There is no one authoritarian, vengeful, cruel god that you have to obey or else you get eternal punishment handed down from it. The non-monotheistic gods are like a competitive marketplace of ideas.

How did the Americans succeed in creating a market economy when traditionally they are followers of a monotheistic faith? They did that because the founders of the country were smart and built a wall of separation between the state and the church. It is the United States of America, not United Christian States of America. Some in the US are busy trying to bring down that wall but I am pretty confident that it cannot be done.

How about Western Europe? They don’t have a wall. True they don’t have the wall but they just ignore religion. They don’t need the wall because they are too smart.

The End

So where does all this lead to? Economic freedom is critically important for economic growth, which in turn is the basic for development. As long as a monopolistic control is in place — whether the State or monotheistic faith — there will be no marketplace for ideas. Lacking a marketplace for ideas, there will be no competition. No competition would mean no evolution and no innovation. No innovation means that progress will be impossible. But populations would continue to grow and bump against natural resource constraints and end up in a Malthusian trap.

Note that a marketplace where ideas compete is itself an idea, and it is a fertile idea. Monotheism is also an idea but it is a dead idea. It marks the end of all ideas because it prohibits a marketplace for ideas to compete in. It imposes a monopolistic control over human minds which is more pernicious than its control over the human body.

At the core of human civilization are a set of ideas so powerful as to thrill the prepared mind and give meaning and purpose to life. The idea of enlightenment and freedom expounded in the Indic philosophies like Buddhism, Jainism and Hinduism are the philosophical equivalent of the Western ideas of free markets and economic freedom. The two are natural allies and complement each other, just as monopolies and monotheism are natural allies and have similar outcomes in their respective fields.

Free markets and economic freedom is humanity’s destiny. Liberation from monopolies is as assured as the liberation from the prison of monotheistic mental prisons. It may take some time, however.

Below the fold I have quoted the last part of the essay. If you wish to skip the article, do read the last bit.

The Hydra-Headed Beast

Here is the real problem with the “greed is always bad, public provision is always good” perspective. As James Buchanan pointed out in “Politics Without Romance,” it makes no sense to assume that, under some circumstances (private buses), people are greedy, and under others (government buses), people are benevolent. The fact is that in both cases people behave purposively, pursuing their own goals filtered through the incentives and costs the system presents to them. Yet, the idea persists that removing profits and using government planning results in a kind of moral transubstantiation. Many planners think that profits are evil and would prefer a system that eliminates profits, even it means accepting substantial losses and no improvement in service.

No matter how many times this notion is killed off by experience and evidence, the hydra of planning grows another head, and political leaders trumpet the new reform in public service. Then, when the reform fails, commissions are formed, implementation is blamed, and budgets are raised.

The Transantiago bus reforms took an imperfect private system, operating without public subsidy and serving well over a million people a day, and “publicized” it. The expectation, almost pathetically naïve in retrospective, was that outlawing profits and demotivating drivers would change human nature. Worse, planners believed that they could dictate choices to commuters, who turned back to private automobiles instead. Why don’t they ever learn?

Fairness is the cornerstone of justice. It is unfair — and therefore unjust — for the government to force non-Muslims to subsidize Islam because ultimately it is not the government’s money but rather the taxpayers’ money that the government hands out to promote Islam through its haj subsidy. Once again, for an Islamic state to tax its non-Muslim subjects is understandable since Islam dictates that non-Muslims pay jizya — “a poll-tax levied from those who did not accept Islam, but were willing to live under the protection of Islam, and were thus tacitly willing to submit to the laws enforced by the Muslim State.” (Wiki.) The Indian government is not an Islamic one — at least not yet — and therefore must not impose jizya on its citizens.

From an economic point of view, subsidies and taxes are sometimes justified. For instance, revenues required for the provision of public goods have to be raised in some way and taxes are one way of doing so. There are welfare losses which arise from taxes but in the case of the provision of public goods, the derived benefits could outweigh those losses. There are good reasons for subsidies also. When markets under-provide some goods (such as is the case for some public goods), then subsidies are justified. Even then, from an economic efficiency point of view, the taxes required for balancing the subsidies should be paid by the beneficiaries of the public good in question.

Aside from public goods, one can make a case for the public provision of some good or service. (Note that merely because a good or service is publicly provided does not make it a public good. Private goods can also be publicly provided, just as public goods can be privately provided.) One such case would be due to high transaction costs, such as when it is too expensive to determine individual quantity used and apportion costs among a very large number of users. Collective provisioning of the service and funding it though taxes may be the most practical method.

The haj subsidy fails all of the tests above. I suggest that the Indian government should abolish the haj subsidy. I think that if people want to go on haj, they pay for it themselves, and if they cannot afford it, just as is the case for any other activity, ask for donations from those who wish to give voluntarily. Forcing people (such as myself) to pay for the haj is immoral and unethical.

Here’s a mechanism which I believe would be fair, reasonable and practical. Instead of the current practice of the government taking part of my tax money and allocating it to support the haj, the government should let me decide how much I wish to contribute to the haj and indicate it on my tax returns. Note that this amount is over and above whatever taxes I have to pay. That is, if my tax is Rs T, and I wish to contribute Rs H for the haj, then at tax time, I will pay Rs (T + H) to the government. Then the government can add up all the H’s in all the tax returns and use it to support the haj.

This way no one is forced to support an activity that he or she disapproves of. The best way would be to get the government out of the haj subsidy business entirely, of course, but this is just a way of ascertaining the collective will of the Indian taxpayers.

There is a larger principle here. I think charity should be a voluntary activity. The government should not be in the business of deciding for any citizen how much of that citizen’s resources should be allocated to charity. For instance, the government should not be handing out disaster relief funds to any foreign governments. (See Funding Islamic Terrorism and the followup.) The people are quite capable of deciding how much they want to contribute to disaster relief in whichever part of the world they feel like. Non-governmental organizations exist by the millions (this is not hyperbole — it is a fact) and they do collect donations for disaster and other relief work.

I hope that the case against the haj subsidy is decided soon and decided in favor of those who wish to see it abolished. I am going to request all my friends and colleagues who blog to raise this issue. It is time we started a “Stop the Haj Subsidy Movement” — banners for blogs would be good idea as well. OK, if you have design skills, please let me know.

The two broadest generalizations one arrives at from a study of economics are that markets work and that incentives matter. People respond to incentives because that is at the core of what it means to be rational. To the extent that humans are rational, their behavior is predictably in the direction that existing incentives point to. Trade between humans is rational because both parties in any voluntary trade benefit. The abstract mechanism which enables trade is called the market. Markets work in the sense that they maximize the gains from trade among an arbitrary number of entities. There are other methods of enforcing trade among people, such as the command and control mechanism often employed by communist governments. But they are at a distinct disadvantage relative to the market because the latter is based on the premise that rational actors respond to incentives.

An Example

An illustration of markets working and incentives propelling action is contained in a recent paper by Vivek Wadhwa of Duke University, et al, provocatively titled “How the disciple became the guru“. Based on the paper, Wadhwa wrote a couple of pieces in the popular press, published on 23rd July: the BusinessWeek article is “What the US can learn from Indian R&D“, and the Wall Street Journal one is “India’s Workforce Revolution“.

The authors note that in the past 15 years or so, Indian IT companies have developed competencies by learning how to compensate for poor infrastructure. Now Indian companies, not just in IT but also in global R&D, are doing well and are compensating for another major deficiency in India: India’s education system. In the popular press articles (both are essentially the same), Wadhwa reports that Indian companies are, in essence, educating their employees in-house. Workforce training is being used by Indian companies to correct for the failure of Indian high-schools and colleges in providing properly skilled graduates.

Wadhwa’s Lessons

Wadhwa, writing from an US point of view, draws lessons from the success of Indian firms despite being severely handicapped by the quality of the Indian education system and concludes his BusinessWeek piece with:

The achievements of companies in India show that employee investment, development, and empowerment are central and critical means to building and sustaining long-term competitiveness and innovative capacities in a global knowledge economy. The U.S. can learn and incorporate these lessons from India as it rethinks how to train and develop its workforce to maintain its global competitive edge. U.S. companies have long played the guru. Perhaps the time has come for the guru to learn from a disciple.

Wadhwa concludes his WSJ piece with:

The result of this workforce productivity is clear to see. In the aerospace industry, Indian companies are designing the interiors of luxury jets, in-flight entertainment systems, and collision-control and navigation systems for American and European corporations. In pharmaceuticals, Indian scientists are discovering drugs and performing clinical research for nearly all of the largest multinational drug companies. In the automotive industry, Indian engineers are helping to design bodies, dashboards, and power trains for Detroit vehicle manufacturers — and soon may develop entirely outsourced passenger cars.

The Indian experience highlights what can be achieved by investing in upgrading workforce skills. That lesson has implications for policy makers in the U.S. who worry about how the economy will adapt to globalization. If workforce training can take the output of an education system as weak as India’s and turn its graduates into world-class engineers and scientists, imagine what could be done with an American worker base that has received amongst the best education in the world.

Lessons for us

There are larger lessons we can take away from the paper and the associated reports. The first and the most obvious one is that incentives matter. The firms have an incentive — profit — to create the human resources that they need. It is profitable for them to invest in the training of people and do so cost effectively and efficiently. The training they do has to pass the market test of the benefits exceeding the costs. The corollary to it is that in their drive to seek profits, they are increasing the human capital of the society and therefore are contributing directly to economic development and growth. The corporations are obviously promoting the social good even though that is not their aim. Adam Smith’s invisible hand very much in evidence there.

The second lesson is that markets find a way around. The educational system is under a command and control regime and produces not surprisingly very faulty products. Yet the market given sufficient time figures out a way of recovering from the error the government system leads to.

The third lesson is that the private sector has the ability and the incentive to intervene positively in education. If allowed to, it can not only employ people but it can make them employable. This limited demonstration has a wider implication. Right now, only at the high end of the employment spectrum are firms engaged in creating the human resources they need. But there is only so much demand for high-tech research and development as in aerospace, pharma, automotive design, etc. There is a much larger untouched potential for employment in more mundane sectors of the economy.

Not everyone can be trained to do high-tech work. An economy not only needs a wide spread of abilities and skills, any large population has people with a matching wide range of abilities and who have to be trained appropriately. There’s a need for plumbers, mechanics, carpenters, other skilled craftspeople, and as there is a need for scientists, doctors, engineers, and teachers. Just as in the high-tech sectors firms where training is demand driven, in the other sectors as well one can reasonably expect firms will do their respective training provided that these skills are required in the organized sector.

That last clause — skills required in the organized sector — is important. The organized sector of the Indian economy is estimated to employ only around seven percent of the labor force. The overwhelming majority of the labor force in the unorganized sector is most likely not skilled and is probably poorly educated. Consequently their productivity is low. As the organized sector expands to include more activities within its sphere (retailing is a good example), it too will require trained employees. Here one can foresee the private sector once again stepping in to fill the required gap in the education sector.

As the spread of skills required widens, the private sector will widen the areas in which they do their own private training. The expansion of the organized sector, a natural consequence of market forces, will force a change in the human capital resource base.

Policy Implications

For me, the implications are simple and strong. First, liberalization of the education system. The private sector is quite capable of providing tertiary education. Tertiary education has very high private returns and therefore the market can be expected to provide it. Here’s how it works in short. Take an engineering degree, for example. The cost of the degree has to be less than the net present value of the future stream of earnings. If it were not so, then it is clearly not privately beneficial (nor socially beneficial) to gain the degree. Therefore if one desires and has the ability to gain an engineering degree, one should be able to pay for it as well, unless there is a credit constraint. If there is a credit constraint, then once again the private sector can step in and provide the loan.

What about secondary education? The middle class (and above) is quite motivated to educate its children, and also has the ability to pay for secondary education. Only the poor need financial assistance for secondary education. This can be publicly funded as the returns to secondary education are significantly social.

And what about primary education? The returns to primary education are mostly social and the return on investment is long term. Therefore, primary education has to be entirely publicly funded for the poor; the non-poor can and do pay for primary education.

If the government withdraws from funding tertiary education entirely, it will have funds for the public funding of primary and secondary education for those who require it. Here I would stress one thing: I am talking about government funding, not government provisioning. Providing the education should still be in the private sector. (See the post “How to make India 100 percent literate in three years” for more on this.)

Second policy implication is that there should be greater range of educational institutions. After secondary school, one should have the option of going to a four-year degree college or to going to a two-year “junior college” (the equivalent of a community college in the US.) The junior colleges can be the equivalent of vocational education institutions. These can teach freshly minted high school graduates or even people who want to update or learn some new skills.

The Market Driven Future

If I were to put on my predict-the-future hat, this is what I believe is going to happen. The private sector, driven by sheer necessity, is more or less on track to enter the tertiary education business. This it is doing in a disguised way, as reported in the Wadhwa paper. It is making the best of a bad situation. It would have been much better if India did have a good tertiary education system. But there are limits to how long this disguised education will go on. I strongly suspect that the private sector will eventually twist the arms of the government and force the liberalization of the education system. It is in their interest to see that the people they hire are as whole as possible–it is better to not have to fix damaged goods, so to speak.

The second change I see is the growth of junior colleges, or as I like to call them, “Advanced Basic College” or ABCs. It would take a person about 2 years after high school to become good at some vocation. The graduates of these ABCs will be younger than the graduates of current 4-year colleges and will be better prepared to enter the workforce. These ABCs will be privately owned and will turn a hefty profit. I also believe that they will use information and communications technologies rather intensively for training.

With the LAFIA Delegation

Last month I spent a week in Delhi and Chennai with a delegation from Australia on a program called “Leading Australia’s Future in Asia-Pacific” or LAFIA. It was comprised of senior government officials from Australia and NZ. LAFIA is a joint program run by the Australian National University and the Australian Public Service Commission which visits a set of countries each year to get an in-depth understanding. This year it was Singapore, India and Thailand. I got the opportunity to present my views of where I thought India was headed (and also got to meet and hear some interesting people across a wide spectrum of activities.)

Discussing India with LAFIA delegates was an intensely learning experience. It helped me figure out how I feel about India and it revealed to me what I knew subconsciously but that I had never articulated. What I figured out is this: that India is going to succeed. And that the success is going to be driven by the people of India — through the private sector. Remember that the private sector is made up of people, just like the public sector. It is the people of India with their entrepreneurial skills and their desire to do well that will end up with India doing well.

What I finally realized was that the government could have been a force for good but it isn’t and we have to live with it. The education sector is government controlled and it is bad. But eventually, at significant cost, that system will be made irrelevant. It will become irrelevant because it cannot be reformed. It cannot be reformed because the government won’t allow reform.

It has been observed by many that China’s growth is top-down, or government driven. India’s growth, to the extent that the government has allowed it to grow, has been enterprise and entrepreneur driven, or in other words people driven.

I suppose it was nationalistic pride in me when I was talking to the Australians that made me come to the defense of India. It was not they were attacking India; on the contrary, Prof MacIntyre of ANU who was leading the group, had observed India over a number of years and had been remarking on the positive trends that he saw. He was clearly optimistic. It was that I felt that I had to somehow give a more positive image of India than what was evident to the delegation — the inefficiency, the senseless bureaucracy, the evident poverty and crowding.

In Conclusion: India will be Free

In my concluding statements I told them that India is not really a lost cause because the people are becoming aware of their potential and that they are struggling to get free from the clutches of the government. The quest for freedom is an exponential process. The nature of exponential processes is such that eventually growth is rapid even though the initial changes are not that perceptible. The people through the private sector, as the main driving force behind the private sector, will overcome the limitations that are currently imposed by the government, and eventually overthrow the government where appropriate and make the government irrelevant in others. This can and will happen with a speed that will astonish.

That India of the Nehru rate of growth — 2 percent a year — is a thing of the past.

I read in Wadhwa’s paper a clear indication of what is to come. The story he told was meant for the Americans. He told them that they don’t have to worry too much about the US losing competitiveness as long as its corporations learn to train their workforce more effectively. The story that I took away from his paper is that what Indian corporations are doing in learning best practices from abroad and training their employees is just the thin edge of the wedge. Soon enough it will transform the Indian education system. India would have achieved freedom finally from a rapacious government.

It’s about time, don’t you think so?

Everything reminds me of India’s failed education system — and by extension — the stupidity of the government policymakers, bureaucrats and politicians included. Unlike Bob Solow, however, I cannot keep it out of my posts.

Consider the news item that India is developing a $10 laptop.

NEW DELHI: After displaying its prowess in developing the world’s cheapest car, India is on track to roll out the world’s cheapest laptop computer that could cost as low as $10, a top official said.

Minister of State for Human Resource Development D Purandeswari said research was being conducted to develop the laptop, especially for use by students, which will cost all of $10.

“Research in this direction is being already carried out at the Indian Institute of Science, Bangalore and the Indian Institute of Technology (IIT), Madras,” she told the e-India annual summit on information and communication technologies.

I wonder how anyone can sit and listen to such unadulterated crap — even if they are participants at an “e-India” summit. And the reporter — doesn’t one have to have the IQ of a cretin to report this without comment about the absurdity of the claim that there can be such a thing as a $10 laptop?

Like I keep saying, the Indian education system is really, truly, badly, irreparably broken. What else can one conclude from the expressed stupidity of a minister of state, a whole bunch of presumably educated people at a conference, a newspaper reporter and various editors, and hundreds of thousands of readers who let the stupidity go unquestioned?

So in the interests of sanity and public service, I will explain why the minister’s claim is idiotic. There is such a thing called the cost of making something. The price at which something is sold has a relationship to the cost of manufacture in the sense that the price is at least as much as the total cost of manufacturing (absent any subsidies.)

Now there is a general rule about the cost of a thing which should be known by every adult who is not, how shall I put it, mentally challenged. The heavier the thing, the more it costs to make. Simple but not fully appreciated by those who are mentally deficient. This is a general rule. A Volvo bus costs more to make than a Volvo car. A motorbike costs more to make than a bicycle. More weight, more costly: Tata Nano, Maurti 800, Honda Civic, Honda Accord, BMW 7series.

Basically, the floor of the minimum cost is dictated by the per kilo cost of the material that the thing is made of.

So what is the minimum cost of a car? Well, if 500 kilos of steel, plastics, and other stuff go into it, and if the minimum per kilo cost is say Rs 100, then you cannot produce a car for less than Rs 50,000. That a 500 kg car can cost a lot more than the minimum to make, or that it can be sold at a price that is multiple times more than its cost, is besides the point. What we are doing here is figuring out that there is a lower limit to the cost of anything.

Now suppose a laptop weighs 3 kilos. If anyone claims that it can be produced at a cost of say $10 (or Rs 400), then the claim is that the material costs are just over $3 a kilo. That is patently absurd. In fact, the more sophisticated a device is, its per kilo price goes up, not down. Its capacity may go up but the basic per kilo price does not go down but up.

What this means is that a one-kilo laptop with the same functionality and features as that of a three-kilo laptop will cost more. That means that per kilo, the lighter laptop will at least three times as costly as the heavier laptop.

So here’s the bottom line. An affordable laptop will be heavier than sophisticated but lighter laptop. And the heavier laptop cannot cost less than the per kilo production cost of the stuff that it is made up of. A laptop at $10 is an impossibility in any known reality. Sure you could have a $10 cell phone — you could have a 100 gram phone. But you cannot have a 100 gram laptop.

Back to our Minister of State and her pronouncements. I don’t suppose anyone will ever hold her to her statement. No one will call bullshit on her claims. And I suppose her IQ is matched by that of the media. So she need not worry that the media are going to challenger her.

Like I said, our educational system sucks.

In response to the president’s remarks, a ranking official in the commerce ministry, Jairam Ramesh, told the Press Trust of India, “George Bush has never been known for his knowledge of economics,” and the remarks proved again how “comprehensively wrong” he is.

I agree that GWB is not the sharpest knife in the drawer. But even a dull knife would do if all you are doing is spreading softened butter. Nothing that GWB said in this instance is contrary to reason or reality. Prices do move when demand and/or supply shift. Indeed, a change in price conveys absolutely essential information. Consumers get the signal that they have to make some changes in their demand pattern, and producers learn that they have to make changes in what they produce and how much.

The fact is that world demand for agricultural output has gone up. There are more people eating higher up on the food chain, and there are more uses for agricultural output such as for corn-based ethanol. If the supply does not expand sufficiently, the natural outcome is a rise in food prices. Apportioning blame for the rise in prices may make good political posturing but in the end it is pointless. It is like asking which straw broke the camel’s back: the last straw is as much to blame as the rest of it.

Once again, I am struck by the hypocrisy of the people decrying the rise in food prices. Bush (and people in the rich parts of the world) do consume a lot more than what would be considered their fair share if food were absolutely equally shared across the world. But why just stop at food? The rich do consume everything in above average quantities. So what else is new?

Indeed, you don’t even have to go all the way to the US to see that the rich have more of everything. Mr Kamal Nath, the commerce minister of India, surely consumes more of everything compared to the average Indian. So his (and other rich Indians’) outrage at Bush’s statement is also hypocritical. They should immediately reduce their own demand for goods and services to the average level in India and only then will they have to leg to stand on when complaining about Bush.

Here’s a bit from a World Bank site that sums up the causes of the food price hike:

While headline news about high food prices is a relatively recent phenomenon, the broader upswing in commodity prices began in 2001. Large structural shifts in the global economy—including growing demand in China and India—have been steadily reflected in commodity price increases, especially of metals and energy.

Food prices have increased in response to many factors: higher energy and fertilizer prices; increased demand for biofuels, especially in the U.S. and the European Union; and droughts in Australia and other countries. World grain stocks are at record lows and next year’s prices depend on the success of the next harvest in the northern hemisphere.

Wheat prices (US$) have increased by 200 percent, and overall food prices (US$) have risen by 75 percent since the turn of the century. Adjusting for exchange rates and domestic inflation reduces the price increases faced by developing countries—but these increases are still severe for millions of poor consumers.

“The increases in grain prices are not caused by short-term supply disruptions, as is the normal case, and it will likely take several years for supplies to increase to rebuild stocks and allow prices to fall,” said Don Mitchell, Lead Economist in the World Bank’s Development Prospects Group.

There is no arguing with the fact that India and China are large economies. Large economies can (and do) affect world prices. Saying that increased demand in large countries pushes up prices is not a moral statement. It is of course easy to take the moral high ground and tell the rich (countries or people) to consume less. But preaching to others exposes one to the danger of being preached to. The rich could turn around and say, “Why don’t you consider lowering your population? It is because there is an imbalance between the number of people you have and your ability to provide for them that causes poverty. You made your bed and so shut up and go lie in it. If you had any brains, you would have recognized decades ago that given the resources at your disposal, unrestrained population growth would the predictable consequence of a lot of hungry people.”

All this is not quantum mechanics. Years ago I had come to the conclusion that there is a very compelling reason why the rich do not have an incentive to see the poor becoming prosperous in a world with natural resource limits. Then simple logic pushed me to conclude that the rich nations would not like population reduction in the poor nations. A large population of very poor people uses less resources on aggregate than a much smaller population of very rich people.

So what is going to happen? Supply will respond to the increased demand but that response will be sluggish. That’s what markets do. But it is possible to mess with the market and make a bad situation worse by fixing prices and so on. It is absolutely predictable and certain that governments will try to stop the market from functioning. The governments will transform a minor tragedy into a major catastrophe. That’s just the way it is.

Poverty is a big word. It is multi-dimensional. It is complex in its causes, it is hugely complex in its implications, and it is perhaps the most intractable of all social challenges that humanity faces. Poverty has been the characteristic condition of humanity since its birth. It is not the existence of poverty that should surprise us but rather that some significant portion of humanity in the relatively recent history (about 100 years or so) are not living in poverty. Though it is not as inescapable as death, poverty has been much of human history’s most common condition. Ending poverty on a global scale will require a combination of technical ingenuity, enlightened political leadership, compassionate societies, and such on a global scale. Just technology alone cannot solve any problem as enduring and non-technical as the complex problem of global poverty.

You know that Monty Python skit involving a dead parrot. The character that John Cleese plays comes to the pet shop to return a parrot which he had “purchased not half an hour from this very boutique.” The problem was that the parrot was dead. The shopkeeper insists that the parrot — a Norwegian blue — is not dead. It is, he variously claims, merely resting; pining for the fjords; that it prefers to kick back. John’s character is frustrated and finally explodes:

“It’s not pining, it’s passed on. This parrot is no more. It has ceased to be. It’s expired and gone to meet its maker. This is a late parrot. It’s a stiff. Bereft of life, it rests in peace. If you hadn’t nailed it to the perch, it would be pushing up the daisies. It’s rung down the curtain and joined the bleedin’ choir invisible.

Viz-a-viz the metabolic processes, he’s had his lot. All statements to the effect that this parrot is still a going concern are from now on inoperative. This is an ex-parrot.”

I feel a bit like that guy. I repeatedly keep insisting that technology is not the answer to all of the world’s problems. Technology helps only on those aspects of a problem that are technical in nature. So here’s yet another of my attempts at explaining why I think technology cannot solve the problem of global poverty.

In its most general formulation, problems involve constraints and their solutions involve choices within those constraints. If there were no constraints in a system, there would be no problems. To the extent that any particular problem has a solution at all, the solution involves making choices. Good solutions are the consequence of correct choices. Technology often relaxes some constraints to some degree, and thus expands the choices available. This expansion of choices is good but it is not costlessly so: greater choice implies a greater burden in making the correct choices. In other words, when the choice set expands, the chances of making the wrong choices also goes up.

Specifically in the case of mobile phones, we can immediately note the constraints that it relaxes. It essentially makes long distance communication of information possible. But then so do carrier pigeons, smoke signals, semaphores, the telegraph, the pony express, and land line phones. Mobile phones have an advantage over those earlier technologies because it is better, cheaper, faster, more accessible. So the second constraint the mobile phone pushes back is financial. For a given amount of money, you get more capacity. Third, the technology is transferable and is easily adopted. You don’t need to be literate, and you don’t need expensive terminal equipment.

What economic function does the mobile phone serve? It reduces transaction costs, to put it in economics terms. When you use the phone to ask for directions perhaps, you save time that you would have otherwise wasted in going round in circles. When you call ahead to fix up a meeting, you avoid a wasted trip if the person is not available. Telecommunications is a substitute for transportation in many instances.

By reducing transaction costs, the efficiency of the process goes up. That is, increased productivity and therefore more production for the same effort. More production, in turn, means more stuff. More stuff for a given population means more stuff per person. Stuff, as you all know, is what it is all about. If a person has too little stuff, he is poor. To the extent that global poverty can be helped through increased production of stuff, and to the extent that more efficient communications helps in production, only to that limited extent can cell phones affect global poverty.

Technology is an amplifying mechanism. Another way of saying that is that technology enters the production function multiplicatively. You have to have something to amplify to be able to use an amplifier. If there is no signal, no matter how powerful the amplifier, there will be no output. The productive capacity is multiplied by technology but where there is any production going on and what is being produced is a consequence of choices that were made outside of technology. That is the bigger challenge because the ability to make the correct choices is something that cannot be as easily imported as the importing of technology.

In the end, affluence — which I define here as the absence of poverty — is a consequence of correct choices made deliberately and consciously over the long term. Affluence is the result of economic policies made by thoughtful and wise policymakers. The existence and the necessity of such people is independent of the level and sophistication of the available technology. To solve our problem of poverty, technology is definitely necessary but it is far from sufficient.

Related links:

(1) Stuff and Ideas.

(2) The Importance of Producing Stuff.

(3) The Tathagata’s Sermon on Economics.

What follows is a rough transcript of our talk.

Me: Prof Smith, the world has seen immense increase in the wealth of some nations since your time. What fundamentally explains the differences between the wealth of today’s nations?

AS: The world indeed has changed in the last couple of centuries. One word encapsulates the differing experiences of development among nations: Freedom. The human spirit’s ability to thrive in an atmosphere of freedom is enduring. Those nations that have granted themselves that freedom have developed. Lack of freedom explains the differences in development.

Me: So that raises the question why all people don’t grant themselves freedom. We must go into that a bit later. But I am puzzled by the Indian experience. India gained freedom from British colonial rule over 60 years ago in 1947. Yet, India has had only limited and qualified success in development and indeed in economic growth. What accounts for that?

AS: Political freedom, though important, is only one aspect of the much wider concept of freedom. The comprehensive freedom which allows individuals to flourish—and therefore groups to flourish—must include economic freedom. India’s lack of economic freedom undermines the potential gains that arise from political freedom. Colonialism is a package deal that denies both economic and political freedoms. Post-colonial India did not have economic freedom.

Me: Please speak a bit more on the nature of colonialism.

AS: Colonialism is motivated by the quest for wealth. Wealth is created by a process that combines natural resources with human agency. So you need not just a lot of land and its resources but also people to eventually create wealth. Compare and contrast the two distinct cases of colonialism in the 18th century: Bengal in India and Massachusetts in North America.

Massachusetts had land and other natural resources but had very few people. To translate the resources into wealth that you could later extract, you had to first get people to settle there. To attract people and for them to create wealth, the policies had to be development oriented. In other words, the policies gave settlers economic freedom, the freedom to create wealth.

Bengal, in contrast, already had people who were creating wealth. The policies for colonial Bengal were therefore designed to extract and exploit that already existing wealth. Therefore controlling economic activity through the denial of economic freedom was required. Command and control of the economy was a more direct route to exploitation. Doubtless, the consequence was similar to that of killing the goose that lays golden eggs. It is a short-term policy since by denying economic freedom, eventually wealth creation comes to a halt. When all the existing wealth is extracted, it is time to move out. Colonialism ended in India when the cost of extracting wealth became greater than the value extracted.

Me: Then why did not the post-colonial government of India immediately after political independence grant economic freedom to the population?

AS: The rulers of politically independent India inherited the entire institutional, administrative, and organizational structure of colonial India. The objectives of these did not change merely because the controls moved into the hands of people with a different skin color. The ability to command and control people is power that is hard to let go of. Private gains, however short-term, trumps long-term public gains. Human nature is hard to argue with. Self-interest is the key motivating factor in every human breast.

Me: But Dr Smith, it was you who pointed out that the self-interest of people gives rise to the public good that no one actively seeks. You wrote:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. … [Every individual] intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

The new rulers of politically independent India were self-interested as well. Why is that not a good thing?

AS: The distinction is between the self-interest of a few powerful people as opposed to the self-interested actions of the entire population expressed in an atmosphere of economic freedom. The former have the power to coerce others to do their will; the latter lack the power to command economic servitude from their fellow humans. The average person has to seek the economic cooperation of others in society by providing them with goods and services that they value. That is, they have to offer in trade something that others value. This impels the individual to produce something of value and which on the aggregate amounts to the wealth that society produces.

Me: Economic cooperation appears to be inconsistent with competition that is supposed to be the hallmark of a market economy. So is it cooperation or is it competition that we should be more in favor of?

AS: Both competition and cooperation are essential. People are heterogeneous in their inclinations, natural talents, and developed skills. By cooperating, a group of people becomes capable of producing more than otherwise would have been possible through solitary enterprise. Economic freedom allows a person to not only engage in an economic activity that it most suited to his or her talents but also allows the person to seek the cooperation of others with complementary skills. Any successful economy can be thought of as a large number of people voluntarily cooperating in the process of producing wealth.

The production of goods and services, which involves cooperation, is one side of the coin. The other side of the coin is trade. What an individual or a group produces is traded at the marketplace. That is where competition plays its critical role.

Me: So cooperation is critical to production. But how does competition in the marketplace help us all. Should they not be cooperating in the marketplace also?

AS: Markets are where people come to buy and sell, or in other words, exchange goods and services. They compete as sellers – selling to the highest bidder – and they compete as buyers – buying from the lowest priced seller. Through this process, the market determines how much of what is produced by the economy and by whom. This process of competition determines how society’s limited productive resources are allocated to meet the variety of wants that it has. The market is that invisible hand which guides self-interested economic actors to promote the social good without the need for a centralized command structure. The important thing to remember is that while the marketplace is impersonal, to successfully compete in the marketplace, one has to have sympathy.

Me: Sympathy? Surely, you mean selfish ruthlessness and not sympathy.

AS: No, sympathy is important for without it, a producer will not be able to put himself in the position of the buyer and thus be unable to divine what is it that the buyer will value.

Me: So for an economy to thrive, it appears that rather than command and control, what is needed is economic freedom for people to best use their skills in productive activities and a functioning market where voluntary trades can take place. From those generalities, I would like to move on to the specific case of India. What are the impediments to India’s economic development?

AS: As we have been discussing, economic freedom is central because the raw ingredients for economic development exist in India. It has a large population and considerable natural resources. Given economic freedom, people would naturally produce wealth. Liberalization—the notion that people should be economically free—is the key concept. Free people grow and realize their potential naturally.

Me: In the hunter-gatherer stage of human history, there was no central command and control structure. They were free to do as they pleased. Yet, we don’t consider them to be prosperous. What explains that?

AS: The stock of human knowledge explains the difference. Technology allows humans to amplify their abilities. For instance, technology allows humans to use energy from a wide variety of sources. Technology is embodied knowledge. The practical aspect of knowledge is how to do something; it is know-how. The hunter-gatherer society had a very small stock of knowledge.

Me: I agree that today individuals have access to a phenomenal stock of knowledge accumulated over centuries in all parts of the world. Indeed, the revolution in information and communications technologies such as the world wide web and the Internet, have reduced the cost of accessing information and consequently gaining knowledge. It is puzzling therefore that economic growth is still an elusive goal. What’s the major barrier to India’s growth?

AS: Having access to the stock of knowledge is a necessary but not a sufficient condition. One has to be educated to a certain degree to make meaningful use of knowledge. So the short explanation for India’s predicament is the lack of educated people and the lack of economic freedom.

Me: Perhaps you have been out of touch with Indian reality lately. The Indian education system is often held up as a shining example since India has become what is called an “IT superpower.” India does not lack educated people.

AS: Actually, I am familiar with the state of the education system in India. I grant you that there are some very globally successful people who got part of their education in India. But their numbers are not in proportion to India’s vast population of over a billion people, a sixth of all humanity.

The Indian education system is a throwback from a bygone era. It is extremely costly in terms of the resources it uses relative to what it produces. Only about 10 percent of India’s children pass high school and of its college graduates, only about one in four are employable. The real cost of the education system is the immense waste of potential human resources that never become sufficiently trained to become highly productive.

The lifeblood of the wealth of the nation is being bled away due to its dysfunctional educational system. Leave alone an educated population, nearly half of India’s population is illiterate. That is unforgivable after 60 years of self-rule. Fixing the education system is the first unavoidable challenge.

Me: Why is the educational system so important in the wealth of a nation?

AS: Because people are at the core of an economy. People matter because they are what transform the other resources into wealth. Educated people are more productive and therefore create more wealth. But educating people requires resources and the most efficient allocation of resources, as I have stated earlier, is through the market, and not through command and control. You can easily enough figure out that government control of education is responsible for its failures. I leave that as an exercise for you.

Me: I see your point, especially from the experiences of the United States and other advanced industrialized economies. What intrigues me is that their development is also accompanied with their populations becoming urbanized. Why is it that a population concentrated in cities is more productive than the same population living in villages?

AS: Urbanization is a cause and consequence of economic growth and development. If you recall, I had pointed out that specialization and the division of labor increases productivity and therefore greater production. Cities allow what we call economies of scale, scope and agglomeration to occur. In other words, resources are more efficiently used when a population is geographically concentrated. Most significantly, infrastructure is cheaper to provide per capita if the population were concentrated compared to if they were dispersed. People need infrastructural services – such as power, water, telecommunications, transportation, sanitation, security, medical, entertainment, etc. – to live productive and enjoyable lives. Cities are the natural outcome of the need to provide infrastructure as efficiently as possible.

Me: The economies around the world today have widely divergent standards of living. Which is another way of saying that some economies are more productive than others. What are the real constraints on an economy becoming wealthy, say, like the US?

AS: What you have to recognize is that wealth is produced by people. Where people are free to engage in activities that they themselves choose, they are good at it. More wealth is produced by free people than by slaves. So the first requirement is freedom. The Constitution of the US and the Bill of Rights guarantee its citizens freedoms that others outside the US rarely enjoy.

The second fortunate fact is that the US is big. Its land area is large compared to its population. Its endowment of natural resources is enviable. The third factor is that it developed a very large stock of human capital. The US learnt quickly as a young nation that education matters. It not only learnt from the Europeans about great universities but it improved upon them.

So the US had sufficient number of educated people, vast amounts of natural resources, and the freedom for the natural entrepreneurship of people to create wealth. Yet, there is one more factor that I did not mention till now. That factor is energy.

Using energy amplifies human capacity. All manufacturing depends fundamentally on energy. The US developed the technologies that made energy available for manufacturing. Most of the energy that the US had during its early development into an advanced industrialized economy was fossil fuel based. If the US had not developed the technology, it would not have access to the energy, and without inexpensive energy, it could not have become the pre-eminent nation it is today.

Me: Given the critical need for energy, the currently developing economies do need a source of energy other than fossil fuels because they are running. Besides they are polluting. So what is the way out?

AS: The US became rich because it developed technologies. It invested in research and development. That is the road to riches. If India needs an affordable energy source, it will have to develop the technology. The source of practically all energy on earth is the sun. India has to develop technology that will give it access to the solar energy.

Me: Dr Smith, developing technology is extremely costly. Hundreds of billions of dollars will be needed. India cannot afford that.

AS: It is a choice that India has to make. It could invest a few hundred billion dollars in developing the technology to use solar energy. Or it could continue to import increasingly costly fossil fuels, and when the fossil fuels run out, it could pay high prices for licensing the use of solar energy technologies developed by other nations. India has to decide whether it wants to be a leader or a follower in this regard. That is a political decision which its democratic system has to address.

Me: What do you recommend for India then?

AS: What India needs the most is for its citizens to achieve economic freedom. The people are entrepreneurial and inventive enough that they will figure out most of the problems by themselves. Education has to be freed from the control of the government.

The role of the government has to change from being a meddlesome overlord to one of facilitating development. The government has to become an institution that the people use for the provision of public goods. It has to stop attempting to control the economy because control is inimical to the creation of wealth.

India needs energy for development. The primary public good that the government has to facilitate is that of funding research and development of technologies for energy.

Me: Thanks much. Let’s see if we can figure out the details by ourselves.

I clearly remember the moment when a light went off in my head. Brian Wright was teaching and we were talking about EV and CV. Equivalent variation and compensating variation, and the related concepts of “willingness to pay” and “willingness to accept.” As I had come to economics rather late in life, I had had the opportunity to figure out some of the basic concepts in my head. But I did not have the vocabulary to fully express the ideas. So when I got the vocabulary, it was an “aha” moment.

I remember Brian posing the question: so PG&E (the local gas and electricity utility company) is going to string up high-tension cables above your backyard. You know that that increases health risks. That is that there are externalities. How much are you willing to pay to stop PG&E from doing so? And how much are you willing to accept to allow PG&E to do so? Note that in the former case, the assumption is that PG&E have the right to string high-tension cables over your backyard and you wish to stop them; in the latter case, you have the right and can disallow PG&E from stringing wires across your backyard. It’s a matter of who owns the rights.

The willingness to pay is bounded by how deep your pockets are but the willingness to accept is open-ended. If PG&E owns the rights,then most likely you are out of luck because you will not be able to pay them enough to deter them from going ahead. If you own the rights, then you can make a pretty neat pile of cash by holding out.

Ronald Coase showed that regardless of who owns the property rights, if there are no transaction costs, then bargaining among the parties is sufficient for the discovery of the economically efficient amount of pollution.

Sometimes I wonder. I wonder if we would continue to have the kind of problems such as Nandigram if basic economics principles were better appreciated by a large percentage of the population. I think a lot of coercion and violence could be avoided. But perhaps I place too much faith in rationality.

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.

I am not familiar with what is available and therefore I am not qualified to answer that question. I have read a few non-academic books on economics but they are the type that attempt to address the concerns that are usually macro in nature. I find macroeconomics only mildly interesting. But macro stuff (dare I call it nonsense?) is what you normally read in the popular press — stuff about the business cycles, interest rates, unemployment, inflation, etc. Pundits on TV and newspapers are always going on about GDP growth rates and how the developing economies are doing and what will happen in the year 2030 or some such remote date. I find it uninteresting because most of those stories are “just so” stories and everyone has his favorite.

What happens at the macro level is clearly dependent on what goes on in the micro level and that is where the more interesting concepts lie, in my opinion. Let me try an analogy. Epidemiology, the study of disease in large populations, cannot be divorced from an understanding of the germ theory of disease, and the causes and nature of health and sickness in individuals. You could spend the whole day reading about the statistical prevalence of, say, AIDS around the world but you will never know what needs to be done about the problem until you appreciate how a virus is involved and how it affects the human immune system. So also, simply being told about the movements of the macroeconomic variables is basically a lot of useless information unless you have some understanding of how they are the result of underlying micro variables.

Microeconomics is interesting because it helps one in making sense of what is going on around oneself. The world becomes a lot less mysterious and a lot more interesting when you not only know what happened but also know why it possibly happened. It is not that if you know the principles, you can predict everything and therefore it becomes boring. Surprises and twists in the tale do happen even when you are quite familiar with the personalities of the principal actors in a soap opera. If you did not know the characters, you would really not even care about what happens to them, anyway.

OK, enough of this. Let’s talk about learning micro. There must be great sources out there and one of these days I should really get off my butt and do a bit of research so that I can meaningfully answer the question of which sources to read. I have been writing about micro on this blog in fits and starts. There are lots of posts categorized as “Economics” and they present a somewhat coherent picture. As they are blog posts, they are neither self-contained nor complete. Still, if you were to read the entire lot, it would eventually make some sense. Gaps and dangling references can be dealt with separately later.

For starters, I would recommend these posts:

A set of useful tools.

I believe there is a small set of very powerful tools, or mental models, that can help us comprehend the dynamic world we live in. It is surprising that such a complex and complicated world is amenable to comprehension using only a small set of tools. But it is indeed true. The tools that I refer to are immensely powerful and flexible. That these tools exist is a powerful testimony to the ingenuity of humans. Seemingly innocuous and simple ideas have profound implications.

Take, for instance, the universal tool called arithmetic. Simple enough that even a five-year old can be taught to use it with ease. But profoundly powerful in the hands of a person who is trying to make sense of a world enormously complicated but often enough yields to a bit of arithmetic. Not using this tool is dangerous. Those who refuse to do arithmetic are doomed to speak nonsense. Not just speak nonsense, but wreak havoc by implementing policies that are patently harmful.

Reasoning economically.

Studying people exercising choice is what makes economics a study of behavior. Behavior – both human and non-human – has to do with rewards and punishments, gains and losses, in other words incentives. To some, the broadest generalizations that a study of economics leads to are, first, incentives matter, and second, markets work. The rest of economics is an elaboration and detailed arguments about those two generalizations. Recalls to mind what Ernest Rutherford had said about physics: “All science is either physics or stamp collecting.” That is, physics is central and the other bits of science are just a collection of facts that are peripheral and mere detail that one should not be overly concerned with.

How to study economics.

The point is that reading textbooks teaches you vocabulary. Vocabulary — precise meanings of words — is important because otherwise you cannot reason in the discipline. After you have learnt the vocabulary, you can read and comprehend sentences and paragraphs and thus follow an argument and figure out whether that argument makes sense or not. And more importantly, if you have the vocabulary, you will be able to figure out things for yourself and not just that, you will be able to express your point of view precisely for others to follow.

The Tathagata’s Sermon on Economics. That’s a light-hearted look at the big picture. Won’t quote from that piece because it has to be read in its entirety.

I will have to put some effort and collect all the bits that are scattered around on this blog and put it within the covers of a book one of these days. I will have to make sure that the bits fits properly without too many gaps and that they are properly cross-linked so that the pieces add up to a somewhat complete picture.

Let me end this one on a personal note. I came late to the study of economics. I only studied engineering (undergrad) and computer science (post grad) in India, and did not have the slightest inkling about economics. My study of economics was primarily motivated by the question “why is India poor?” I got around to asking that question only when I had been working in the Silicon Valley (at HP in product marketing, if you care). As I am the least disciplined person you are ever likely to meet, I could not study economics on my own. So I ended up doing my doctoral work in economics. That external discipline got me to where I think I understand the basics to some degree. Fortunately, I learned quite a bit of economics at the Cloyne Court in Berkeley, not just at school. I did eventually answer that question of why India is poor to my satisfaction. Which is what this blog is all about.

More to come.

Just off the expressway from Mumbai, on the road leading into Pune, you see huge billboards advertising new housing developments with fancy names like “Whispering Pines” and “Orchard View” crowding each other, promising idyllic lifestyles of lavish comfort. They convey very urgently a palpable sense of how rapidly the market for private luxury dwelling is blossoming thanks to increased salaries and easy housing loans.

These billboards reflect the increased aspirations of the growing upper middle-class in India. Curiously, one set spoke to a deeper and disturbing reality. One billboard said, “Power Cuts? No problem. We have 24-hour generator backup.” Another one down the road said, “Water Shortage? Have a shower. We have our own water supply.”

You see these billboards along narrow crowded roads that are often no more than stretches of uneven pavement littered with deep potholes. The contrast between the crumbling road and the beautiful picture of a luxuriously appointed home advertised is jarring. It is also a demonstration of some fairly simple economic principles which if sufficiently widely appreciated may eventually reduce the contrast.

Club Goods

Roads, homes, and privately provided utilities are all goods but of different types: common property resource good, private good, and club good, respectively. Broadly speaking, and under a set of conditions more or less generally satisfied, markets can be relied upon to efficiently produce private goods to meet the demand. A private good is rival in consumption meaning that the quantity consumed by one reduces the overall quantity available for consumption by others. They are also excludable in the sense that one can be prevented from consuming it.

Utilities such as power and water are generally widely available in all developed economies. They are supplied by large private or public corporations because they exhibit scale economies: the greater the quantity supplied, the lower the average cost of production. They have high fixed costs as they involve the use of high cost infrastructure such as large power plants, water treatment plants, wires and pipes. When such utilities are not available in sufficient quantity or acceptable quantity—which is the often the case in a developing economy like India—they can become what is called a club good: a good that is provided to a select homogeneous group who can pay the higher per unit cost of the utility.

Roads are generally a common property resource good and therefore have to be publicly funded. It is prohibitively expensive to monitor usage, apportion costs and collect user fees over a large set of heterogeneous users of roads. Tax revenues are therefore used for the provision of roads without user fees. The involvement of the government is unavoidable in the matter of funding of roads which are open access.

The growth in many Indian cities of a large number of housing developments with power and water supplied as club goods is a rational response to the failure of the government to supply those public utilities widely. So for a very small segment of the population of a city, those with very deep pockets, that government failure can be compensated for within the gated communities. Roads outside the gates, however, are still at the mercy of the government and that everyone, rich or poor, has to live with.

Public Goods

The role of the government in the provision of a physical infrastructure such as roads is critical. The government failure to adequately provide physical infrastructure is also correlated with broad failures to provide other public goods such as universal primary education, public health, dispute resolution institutions, security, and so on.

So the question arises: why are certain governments unable to provide those public goods that the market either cannot provide efficiently or can only provide them at a high cost and thus only to a select few? One of the basic reasons for the existence of a government is precisely the provision of public goods. What explains the failure?

Public utilities are important for any complex economy as they complement the use of private goods and assist in the production of goods and services. Therefore, government failure to provide public goods directly affects the productivity and production of the economy. Surely, there must be a reason why certain governments fail in that basic task and thus contribute to the failure of the economy. Public choice theory and agency theory inform that question, and that is what we explore here.

Benevolent and Predatory Governments

One can assume that the government is comprised of enlightened politicians whose altruistic objective is to maximize social welfare. In other words, the government is benevolent. Or one can take the more realistic albeit extreme position that governments are run by self-interested people whose venality compels them to maximize their private gains at the cost of social welfare. In short, the government is predatory. Still, depending on how long the time horizon of their predation is, predatory governments can be classified into “roving bandits” or “stationary bandits.” The former have a short-term outlook and do not “cultivate” the private economy to maximize their loot. Part of that strategy would be to steal the resources that would have provided public goods. In contrast, the stationary bandit would attempt to maximize the total output of the economy all the better to extract the most over a longer time horizon by providing public goods that complement private goods and private effort.

One can reasonably conclude that in India’s colonial British government was mostly predatory with a short planning horizon and was not benevolent. The interesting question is whether the governments after political independence were roving bandits or stationary bandits. Because India is a democracy of sorts where governments get voted out of office, it imposes a severe endogenously determined short planning horizon and therefore the governments are forced to play the roving bandit role. This could partly explain the lack of adequate amounts of public goods. Any government could reason that there is no point in spending money on public goods instead of just stealing the resources if the rewards of using public resources to provide public goods end up enriching some successor bandit government. This is the classic tragedy of the commons scenario.

Principals and Agents

The Indian story gets more interesting when considered in the light of agency theory. In any sufficiently large economy, the politicians cannot directly implement policy. They are forced to rely on a bureaucracy. Broadly speaking, the citizens are the principals and the politicians are their agents who are entrusted with the task of executing the desired goals of the citizens. The politicians, in turn, are the principals who employ bureaucrats as their agents to execute the policies.

This is analogous to the situation where the shareholders are the principals and the CXOs are the agents. The CXOs in turn are the principals and depend on their agents—the middle and lower level managers—to carry out the implementation of their plans. Regardless of whether the CXOs are benevolent or not, their agents have a role to play in the overall achievement of the objectives of the organization.

The basic problem called the “agency problem” is that the principal’s objectives and the agents’ objectives can diverge. Thus, the citizens’ objective would differ from their agents’—the politicians—and the politicians’ objectives differ from the bureaucrats’ objective. The principal’s objective can be served by actions that are costly to the agent and therefore unless the agent’s actions are observed and the consequences properly evaluated, the agent is likely to not take the costly actions that meet the principal’s objective.

There are mechanisms that create the proper incentives for agents to do the bidding of the principals, however. Which mechanism is appropriate depends on the nature of the principals and the nature of the agents. The politicians (as the principals in the government) could be either benevolent or predatory. The bureaucrats as the agents could be “professional” in the sense that they care about social welfare, or they could be “selfish” where their objective is to maximize their own incomes by extracting bribes from the citizens for the public goods. In this simple model, only one out of four possibilities yields the socially optimal amount of public goods—the case where the government is benevolent and the bureaucrats are professional.

Consider one of the other three cases: predatory government and selfish bureaucrats. The bureaucrats extract bribes from the citizens and also steal some of the resources meant for the provision of the public good. The bureaucrats then share part of those gains with the government based on some form of bargaining that reflects how easy or difficult it is for the principal (the government) to monitor the efforts of the agents (the bureaucrats) and the amount of bribes extracted by the agents from the citizens. If monitoring is costly, then the government has to take a smaller share of the earnings of the bureaucrats.

Uninformed Citizens

And that is not all. What if the citizens are wrong in their evaluation of what is socially beneficial and in their best interests? If they systematically err in their objectives, then even if those objectives were faithfully accepted by their agents (the politicians), and the bureaucrats as the agents of the political principals were to faithfully implement the policies consistent with those objectives, it could still lead to sub-optimal outcomes. Now we have eight alternative outcomes from the interaction of “informed” or “informed” citizens, “predatory” or “benevolent” governments, and “professional” or “selfish” bureaucrats. And in only one case out of those eight—informed, benevolent, professional—is the outcome a socially optimal quantity of public good. This analytical result stands up to empirical observation. In real life, the percentage of cases where the socially optimal outcome is obtained is extremely rare.

The above analysis can be illustrated with a concrete example: the provision of electricity by public sector undertakings in India. Chronic and acute shortage of power is the norm. The installed capacity is not only insufficient but the maintenance of the plants is inadequate for the plants to operate at capacity. Around 40 percent of the electricity generated is stolen through a complex mechanism which frequently involves the employees of the power company and users. This is written off as “transmission and distribution losses.” This loss severely impacts the resources available for plant maintenance and for increasing installed capacity. Furthermore, part of what is allocated for maintenance, is also lost through corruption. A chief engineer’s position in the power corporation in charge of purchasing supplies can go for crores of rupees (or, millions of US$). That money goes up the chain and a significant portion reaches the minister in charge of power in the state. That is an example of a predatory government and selfish bureaucrats systematically undersupplying a public utility, making significant private gains and leading to massive social welfare losses.

In this story, the citizens are of the “uninformed” type. They are against privatization of the power corporations, and that opposition is part of the larger opposition to the liberalization of the economy. Though it may appear harsh, it is accurate to point out that the citizens are ignorant of some basic economic truths: that there is no such thing as a free lunch. If they vote for politicians that promise them free power, they are basically complicit in the miserable outcome that they suffer. That they continue to be willing participants in what can only be called a kakistocracy – government by the most corrupt and the least principled – is partly because they don’t realize that alternative forms of governance and social order exist. And it is not in the interests of a predatory government to take steps to educate the citizens. Which incidentally could also explain the systematic neglect of universal basic education.

Finally, the lack of adequate supply of infrastructure is only one of a large set of symptoms of deeper systemic failures. Rectifying those failures can fix the system while all attempts at grappling with the symptoms are doomed to be in vain.

I think everyone deserves to know all the foundational truths about the world that have been so painstakingly discovered by some very smart people over the centuries. These are broad unifying principles, found in every major discipline, and every educated person should be totally comfortable in their understanding of them. For instance, regardless of whether you are a stock-broker or a nuclear physicist, you should know what the theory of evolution through natural selection is and how it explains the diversity of life on earth. Another example: one should know, even if one’s work is about literature and art, the atomic theory of matter and that only a hundred or so different kinds of atoms are involved in creating the universe we live in. Even more broadly, one should know what the scientific method is because we live in a world surrounded by artifacts that exist in some sense because the scientific method works.

I think that everyone should be familiar with the basics of economics because it matters in our daily existence. We all live in society and we interact with others. We in a sense create that society and how good that society ends up being depends on how we collectively understand how society functions. Our collective understanding dictates policy which in turn affects us all. Your ignorance of atomic theory does not materially affect you but ignorance of what the market is and how it works has profound consequences.

Knowing the basic elements of economics is good mental hygiene. It prevents infection by ill thought-out idea viruses and bacteria. To put it differently, it inoculates you against appearing stupid and behaving stupidly.

Enough of this. Let me just state what I consider the most important ideas we should all know related to economics. That all voluntary trade is good. It is good for both sides. That prices convey information that is otherwise either impossible or too costly to get. That incentives matter because people are motivated by self-interest. That people have differing abilities and differing preferences; which is why trade is possible. And a few other ideas that we could go into one of these days.

And lastly, it is never too late to learn a bit of economics.

[Go to Part 2 of this post.]

This is a response to the comments on the last post “Why is the US so Cheap?” I had argued that the US is more efficient in producing stuff compared to India. The people in the US are more productive because they don’t face as many hurdles – they have bigger and better machines, they use more energy, they have more economic freedom, and so on.

Economic freedom is a matter of policy. Policy is made by people who are entrusted to do so. Determining who the policymakers are in an economy is part of the political process. The political system evolved as a historical process from a set of initial conditions which are to a large extent a random draw. Smart people figured out the set of rules that the economy would play under. It is my belief that differences in the performances of economies arise from the differing set of rules that economies adopt. One set of rules may allow greater economic freedom to the people relative to the government; another set may allow the government control over most of what an individual is allowed to do. I believe that the US is successful (to the extent that it is) primarily because it got the rules worked out better (not perfectly, though) than the others.

Now on to the comments. Amit’s comments are interesting. He writes:

I’m no fan of socialism and agree with the ills you pointed out, but I’m puzzled as to why economists like you prefer to tout the “free market” while blithely ignoring its negatives and costs to the public. US is, at best a mixed economy (and not a pure free market economy – and thanks for that), though there’s much more entrepreneurial freedom than other countries.

Basic courtesy aside, it is prudent to read what is actually written in a post rather than reading things into it based on one’s prejudices and biases. It is not very productive to construct a straw man and then proceed to knock it down with gusto.

I did not claim that the US is a “free market.” If one goes around with a chip on one’s shoulder about those horrid free-marketeers, one may be seeing things that are not actually there.

Saying that the US is a mixed economy is accurate, of course, because every economy is. Every economy – even the most determinedly socialist – has to have markets at some level. After all, economies have people. And trade and barter is intrinsic to humans. Therefore markets. What is important is how far along the continuum, from total control to totally free markets, is an economy actually situated. It is important to ask in what activities does the market dominate, and what other activities non-market allocation is mandated. Only the simple-minded imagine that it is a dichotomous choice.

Markets Work — Often

Even the most basic of economic reasoning is sufficient to persuade one that (1) markets are extraordinarily good at allocating resources most efficiently; (2) there are well-recognized conditions under which markets don’t grind out the socially optimal solutions; (3) there are well-known mechanisms for correcting for market failures.

So you look at any decently functioning economy, you are guaranteed to find that it is market oriented for most tasks, but in some tasks the markets are lightly regulated, in some heavily regulated, and in some others markets are disallowed. Economists are neither ignorant of market failures, nor are they ignorant of the causes and circumstances under which markets fail, and certainly not ignorant of what needs to be done to correct for market failures.

What are markets, why do they work and when, whey do they fail, and how failures are corrected for is not arcane esoteric voodoo insider secrets. Anyone with a bit of patience and basic reasoning skills can sit down with an introductory economics textbook and understand what is what. It is a failure of our educational system that economic literacy is so abysmal that the average college graduate cannot reason economically (in all senses of the term.)

Subsidies

To take an example from the comments, consider the question of subsidies that the US provides to agriculture. That issue was raised in the comment for some reason that I could not fathom. My post was about the high productivity (and high production) of the US, and the claim I made was that economic freedom was somehow to account for this. The fact that the US provides agricultural subsidies is true but cannot be cited as a point against the argument that the US is extremely productive. Indeed, that the US can provide such enormous subsidies to agriculture is because it produces so much stuff.

The point is that you have to tax Peter to be able to subsidize Paul. Therefore the fact that the US can subsidize this that or the other to the tune of hundreds of billions of dollars just means that the US economy is productive enough.

(OK, there is the matter of the US having a huge trade deficit and that the Chinese are bankrolling the current US consumption, and that the US is the biggest borrow in the known universe. But the general thrust of the argument does not change.)

Here’s the low down on subsidies in a nutshell. Consider an economy with only two activities: agriculture and manufacturing. Early in its development sequence, most of the economy is agricultural. For some reason, they want to promote manufacturing. So they tax agriculture (that is take a part of the production of agriculture) and give it to the manufacturing sector. Manufacturing is thus subsidized. Later on in the story, it so happens that manufacturing becomes fabulously productive and produces lots of stuff. Now, what you do is take some of the production of manufacturing and give it to agriculture. Of course, you don’t literally take cars and computers and give it to farmers. What you do is from the general revenues of the government, you give money to the farming sector. The general revenues of the government is a function of what the economy produces. Great deal of production, great deal of general revenues.

While I am at it, I should mention that this is a basic lesson in development economics. At the early stages, since agriculture is the primary sector of an economy, it is also the only source of surplus. Initially, you can – and indeed you have to – take from agriculture to give a boost to other sectors. If there is no agricultural surplus, you cannot develop other bits of the economy (barring of course manna from heaven, massive amounts of foreign aid, etc.) Later, if manufacturing becomes very productive, you can take part of that surplus to help agriculture.

Promote Manufacturing to Help Agriculture

The farmers are in dire straits in India partly because Indian manufacturing is not the most productive and does not produce sufficient surplus. In other words, if economic policies help the manufacturing sector in India, it would produce the surplus you need to help the farmers. The simple way of stating it is this: when manufacturing becomes very efficient, it produces a lot of stuff at low cost. Low cost manufactures translates into low prices for manufactures. The terms of trade between agriculture and manufacturing improves. That is, farmers can buy more stuff in exchange for the food they produce. That is, consumers of agricultural stuff will be able to pay more to the producers of agricultural stuff.

It is sort of counter-intuitive to say that by removing hurdles from the manufacturing sector, you will help the agricultural sector. But I have a heuristic device, a simple rule of thumb to decide if something is likely to be true. I just ask myself, “What would the socialists do?” (WWTSD). I then just negate the answer to that question and I have a fairly good shot at making a policy recommendation that is correct. Try it out yourself sometimes. I call it the Amazing Negated WWTSD Mechanism for Guessing the Truth. AN-WWTSD-MFGTT.

Moving on, there is a very telling comment by bawaraa. He says that the US is not cheap in everything relative to India. He says drivers and masseurs, for instance, are cheaper in India. Thanks much. That is so juicy a topic that I will have to leave it for the next post.

But remember that you heard about the AN-WWTSD-MFGTT here first. Tell your friends about it.

So what is the NREGS? It is an “employment scheme.” It basically transfers a bit of money to people who have not had an income.

Generally (but not in all cases) people who have an income are employed in come activity that produces something. Part of that production is paid as wages. That is income. In general, aggregate income and aggregate production have to be the same. Of course, a person working in a shoe factory does not get paid in shoes. The usual accounting method used is called “money.” He gets paid in money which he can then exchange for other stuff. The money income he gets is not real income. The real income is what he can buy with the money he gets paid.

Let’s take a simple economy producing widgets. 100 people producing 1,000 widgets. Average real income: 10 widgets. If each worker is paid Rs 1,000, then that is the nominal income. The price of a widget in this simple economy is Rs 100 per widget (divide the total amount of nominal income — 100,000 — by the total number of widgets — 1,000). If you don’t change the production of widgets but double the nominal wages, each worker gets Rs 2,000 but the real income does not change as the total production does not change. The price level goes up, though. From Rs 100 per widget, it goes up to Rs 200 per widget. That is inflation but in this simple model, it does not matter as the real income remains the same. Money is nominal. It is a method of accounting. It is not a “real” variable. The real variable is “the number of widgets.”

Now suppose you find that there are 10 additional people in the economy who you did not know of. They are not employed and so you decide to give them an income. OK, so you decide that each of these 10 people will be employed in digging holes in the ground (as there are no more widget making jobs) and filling them up. For this totally pointless exercise, you will give them each Rs 200 a month.

So here’s the new arithmetic.

100 people producing 1,000 widgets.
Each widget worker paid Rs 1,000
10 people digging and filling holes producing nothing
Each hole-digger paid Rs 500
Total nominal income: Rs 105,000
Price of a widget: 105,000 divided by 1000 = Rs 105.

So there you have it. You have inflation of 5 percent because now a widget worker with his Rs 1,000 income can buy less than 10 widgets. His real income has dropped. But the real income of the hole-digger has gone up. The scheme transferred some of the income from the widget workers. This may be good or bad — it all depends on what the objectives of the economy is. But the fact is that if you transfer incomes from one group to another, there will be winners and losers.

Inflation happens when the total amount of money increases relative to the total amount of goods that are produced in the economy. If a scheme merely adds more money to the pot without increasing production, it will cause inflation. If you increase production and at the same time increase the total amount of money appropriately, there is not inflation.

If you do a pure income transfer, without raising the total amount of money, you do not have inflation.

So what is the NREGS doing? If it is merely printing money and handing it to unemployed people (who are not producing anything), then it leads to inflation. This inflation reduces the real incomes of people who are producing something. So in this case, it is a pure income redistribution scheme. Drèze knows this as he knows basic economics. But he cannot admit the truth because his job depends on being economical with the truth.

[Related Post:

Nov 2007 -- The National Rural Corruption Guarantee Scheme.]

A friend of mine in California asked me one of those questions which seem simple on the surface yet is anything but. One of the “top women in storage” as a leading business publication had rated her, she had gone home to Ireland for the Christmas holidays. In an email detailing how everyone was and what happened in Ireland, she concluded by asking, “So, Mr Economist, tell me why is the US so cheap?” The context of her question included the price-levels of various places she is familiar with such as the US, Western European countries, NZ, and Australia. My own comparison of Indian and US prices adds further validity to that question since I find that the US is cheap relative to India. Why is it so?

It is one of those questions that if investigated sufficiently in detail, it would involve the entire discipline of economics. You could start off with a study of Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations” (aka “The Wealth of Nations”), published in 1776, the same year as the American Declaration of Independence; and end with reading the papers of such people as Stiglitz, Krugman, and Romer. Or you could just take the quick and dirty route of figuring that it all comes down to how efficiently the US produces and distributes stuff.

A Simple Widget Economy

If you don’t like arithmetic, skip this section.

Let’s do some arithmetic. Suppose 100 people with their bare hands over one year produce and distribute among themselves 100 widgets. “Widgets” is economist-speak, a catchall for the generic good. Economists are always talking about producing widgets without really going into the details of what they are good for and how they are actually produced. Strange but that’s how it is. Anyway, the GDP of this 100-person economy is 100 widgets. The annual per capita income is therefore one widget, the same as the annual per capita production. Let’s underline that point: production and income are different ways of looking at the same thing.

Now imagine they suddenly (magically) come in possession of fancy machines that allow the same 100 people to produce 1,000 widgets in a year. The income per capita goes up to 10 widgets per year. Two important things have happened for that increase in productivity. First, the machines represent a technological change. The same amount of human effort is expended but given the machines, the output has increased 10-fold. Second, the machines use energy. So the production process now involves the use of non-muscle power and machines.

But machines don’t fall out of the sky like gentle rain upon the ground beneath. Someone has to make them. Say at some time, only 50 people are making widgets using machines (total production 500 widgets) and the other 50 are busy building the next generation of machines. The new machines increase productivity by a factor of 20. So now if you want to maintain the overall production of widgets to 500 per year, you need only 25 people to produce widgets and it releases 75 people to continue to build even more sophisticated machines.

The story is simple. The more efficient they become in producing widgets, the more people are free to innovate upon the machines. And as the machines improve, it allows further reduction in the number of people engaged in direct production of widgets. Note also that all this increase in production requires the use of machines which require external sources of energy. Figuring out new energy sources and developing the technology to use them also involves people. And people have to be trained for doing the job of inventing new machines, and the technologies for discovering and using energy. Let’s call that activity of training people “education.” At some point we can imagine this to be the structure of the economy:

100 people economy
10 people producing widgets 10,000 widgets a year using machines
Per capita annual income: 100 widgets
20 people involved in the manufacturing of machines
30 people involved in the research and development of machine technology
40 people involved in the education of the entire population so that some can do technology R&D, some work in factories making widget-making machines, and some who make widgets on the machines

The Big Picture

If you have skipped over the previous section, here’s what the main point is. Economies produce stuff. The more stuff they produce relative to the effort expended, the richer they are. The US is more productive than other economies because they use lots of machines, lots of energy, and produce a great deal of R&D. History and geography have been kind to the US, besides. Somehow they got lucky and had a bunch of smart people who figured out that both economic freedoms and political freedoms are important. Entrepreneurship flourished. Geographically, the US is huge with lots of natural resources. It was not always as rich as it is today. At one point it was on average as poor as say the people of Bihar today and had as little technology available to it. But the US developed quite well. Cars, laptops, the world wide web, and Google came much later. What the people of Bihar (and India in general) don’t have today and which the people of the US had from the birth of that nation was the smarts to figure out a set of rules and institutions that made the people more productive, not just the land and natural resources.

The US is cheap relative to India because it takes a lot less effort to get something done in the US than in India.

The Cost of Gas

Yesterday, I ventured out to get a cylinder of cooking gas. I had run out a couple of days ago, and after much inquiry I heard of a store that was willing to sell me a cylinder of LPG (liquefied petroleum gas). The store was about 2 kilometers away. I could have leisurely walked that distance in 20 minutes. But I had to drive as I had an empty gas cylinder weighing 16 kilos. It took about an hour to drive the 2 kilometers. Total time expended in acquiring a cylinder of gas this time: 3 hours. Cost of the gas: Rs 550 (or around US$15.) Over the last couple of years that I have been in Pune, I estimate that the effort in acquiring cooking gas was about Rs 1,500 and three full days of running around.

Anyone running a middle-class household in India knows that there is a shortage of cooking gas. Demand for it at the government mandated price far exceeds the supply. The price is around Rs 300 per cylinder but the cost to the manufacturer is around Rs 500. The government subsidizes the consumption of cooking gas. Mukesh Ambani’s household gets that subsidy, and so does any household which is not so poor as to not be able to afford the gas stove. That subsidy is not available to the really poor as they do not have the money to pay for the capital expenditure involved in using the gas. And besides, if you are not already a consumer listed with some gas supplier, you cannot get one as the supply is severely limited and it is not easy to become a new subscriber. I tried but I was told that the bribe is around Rs 6,000.

The perverse effects of controlling prices should be evident to the meanest intelligence. Which makes one wonder whether those who make these policies don’t even possess the meanest intelligence. Their claim is that subsidizing cooking gas is good for the poor. But it isn’t. Only the comfortably middle-class and higher actually get the subsidy. That subsidy costs the public treasury billions of dollars. Removing those subsidies will free up funds for things that would actually help the really needy – such as say education or health care.

In the end, markets figure out the solution. The distributors of gas cylinders price the gas cylinder to those who desperately need it and who can afford to pay for it at the market-clearing price. I paid Rs 550 for the cylinder which the distributor is supposed to sell at Rs 300. In effect, he pocketed the major part of the subsidy that the government gives to the consumers of gas.

Socialism suffers from the persist illusion that by lowering the price of something below the actual cost it somehow benefits the poor. That is arrant nonsense because a price ceiling pegged below cost of production is the best way to ensure a shortage of supply, and the limited supply can only satisfy the demand of those who have the deeper pockets, thus rationing the poor out. Socialism hurts the poor. Indeed, socialism creates poverty by ensuring that production suffers and thus incomes are low.

The US and the former USSR were similar in many respects such as the quality of the people (talented, educated) and the stock of natural resources. The major distinction was that the US was a free-market economy while the USSR was a socialist workers’ paradise. The average consumer in the US faced market price, and found shelves overburdened with goodies in their supermarkets. The average consumer in the USSR faced bare shelves of phantom goods—goods if they had been there would have been sold at affordable socialist prices.

The Road to Poverty

While sitting in creeping bumper-to-bumper traffic yesterday on my way to somehow get a cylinder of cooking gas, breathing the exhaust of diesel trucks, assaulted by incessant honking of cars, three-wheelers, and motorcycles, I wondered where it was all going.

Economics is called the dismal science. It does not get any more dismal than when you are forced to confront the absolute stupidity that leads to waste of human potential of such gigantic proportions that the Indian economy barely produces enough to keep its body and soul together. India is unable to feed all its children—about 50 percent of children below 5 years of age are malnourished. India does not produce enough to be able to provide a vast segment of its people decent housing, education, sanitation, health-care, and even a clean glass of drinking water.

I don’t wish to dwell on the obvious shortcomings of the Indian economy gratuitously. The intent is to force attention to the basic problem, which is that we have through our own stupidity not paid attention to what it is that makes people productive. Here’s one line of thinking. If people are forced to spend hours on end getting from one place to another, it leaves a lot less time to do productive work. The roads everywhere are congested because they are too narrow. There is a one-time cost to building wide roads or even for leaving sufficient space for building wider roads in the future. But the saving in building narrow roads is dwarfed by the cost incurred year after year of wasting time and fuel crawling along congested roads. It requires only a bit of foresight, only a bit of reflection to realize that so many people would need to move from this place to that and so the transportation system has to be designed such.

That brings us to an important point. People need transportation, not cars. Cars are a means of transporting oneself from point A to point B. Cars are not the end but only one of the many means of getting around. Roads are one obvious solution to urban transportation needs but not the only one. You could have light rail, for instance. And even if you do go in for roads, you could plan for a healthy mix of private cars, taxis, public buses, bicycles, and footpaths. The important point is that it involves planning, not just a random sequence of interventions made by ignorant policymakers.

Private firms are good at meeting the demand for private goods. That is what the market does so effectively: provide private goods. A car is a private good but it depends rather heavily on the availability of a complementary good: roads. Roads are not generally a private good. In the development where I live, Magarpatta City, they have internal roads which are wide and well maintained. The developer of the township owns the roads and has planned them to reflect the capacity of the township. There are no traffic jams within Magarpatta City. But step outside the gates, and you are forced to crawl along the roads of Pune.

Unlike private goods like cars, roads are “collective goods” and have public goods characteristics. The market does not provide public goods automatically in what is called “socially optimal amounts.” In the case of some public goods (such as pollution, a public “bad”), the market over supplies, and in others such as roads, it under supplies. Correcting for such market failures is the job of what is called the government. This does not mean that the government has to get into the business of supplying the public goods. It only means that the government has to make such rules that will correct for the market failures and thus nudge the market to produce the socially optimal amount of the public good in question.

Tata Motors about to market an “affordable car” – the cheapest car in the world, we hear. I suppose if one is only interested in owing a car and not really much bothered with the matter of whether it will take you anywhere, then it is a grand thing to have. Because irrespective of whether you have a BMW 740i or the Tata car, sitting in traffic does not get you very far. The existing roads of Pune will not magically expand to accommodate the additional affordable cars. The average speed will drop further and the total cost of transportation will go up appropriately. The total cost of transportation includes the cost of the car, the cost of the fuel, and the cost of moving along at 2 km an hour. I don’t think that the Tata car will be all that affordable.

Indian Cities are Expensive

The US is cheap because it is cheap to produce stuff in the US. Try doing a business in India. It will take months of hard work to figure out a route through the bureaucratic jungle to get the various permissions and permits required to get the business started. Running the business will require constant approval from a large number of interested parties. Much of this approval depends on how much you are able and willing to pay as bribes. A lot of effort in the economy overall is expended in either extracting rents from those who produce stuff or in minimizing the amount of rents a producer has to pay. The end result is that most of India is in what is termed the unorganized sector – a sector that suffers from low productivity because it cannot gain from the economies of scale and specialization. The organized sector accounts for about 7 percent of India’s labor force.

Even in the organized sector, the costs are high. The organized sector is necessarily urban based. The stock of urban locations is low and therefore the rents (here we are talking of rents as what you play for a place to live and work in, and not the rents that are bribes to those who control the economic activity) are high. A decent apartment in a good location in Mumbai or Bangalore can be upwards of Rs 100,000 a month. On top of that, you have to make your own arrangements for a basic utility such as electricity.

The Solution

If not the solution, at least the outlines of what should be a matter of public debate in India. I am not minimizing the progress that India has made in the last couple of decades. It is a matter of great personal satisfaction to me that India has moved out of its 3 percent a year “Nehru rate of growth” achieved by his wonderfully brilliant socialistic license-permit-control-quota raj. But I am concerned that for India to grow at a sustained double-digit, some fundamental changes have to occur.

The first is continued liberalization of the economy. Economic liberalization would allow the entrepreneurs of India to produce stuff. Not just stuff, it will produce the most important ingredient of all: education.

Second, India has to plan new cities. New cities will be cheaper to live and work in compared to stuffing even more millions in the existing cities. The existing cities were built for a time when the population of India was a tenth of what it is today. Furthermore, they were built for a time when practically nobody owned cars.

Third, India has to invest heavily into figuring out a way of having cheap energy. The US and other currently developed economies had the luxury of cheap fossil fuels. India does not have that. Joining the struggle to get a larger share of diminishing stocks of fuel worldwide is a loser’s game. Investing in research and development for alternate energy sources is something that the private sector cannot fund. It requires public policy and public funding.

The problem fundamentally boils down to why we cannot have a rational growth plan and enlightened public policy. My conjecture is that it is due to our political setup. I will go into that matter in the next bit.

[See the followup post -- The AN-WWTSD-MFGTT -- for responses to some of the comments below.]

The study of economics does not seem to require any specialized gifts of an unusually high order. Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy or pure science? An easy subject, at which very few excel! The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher–in some degree. he must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.

You might say he was describing himself. But he was referring to another master economist: Alfred Marshall.

Elegant models are amazing things. That is why economists do it with models. The study of the real world would be too confusing if it were not stripped of all inessential details. The hard part lies in figuring out which bits to retain and which to discard while creating the model. Model building is an art and the product is often a thing of spectacular beauty and elegance. They illuminate and enlighten; they capture the imagination and make accessible features of the real world that would otherwise be lost in a haze of misapprehension. It seems to me that learning simple models has to be part of a well-rounded education. Children should be exposed to simple models and then taken through the logical deductions that the assumptions imply. But I will not digress into models and our education system for now. What I want to do is quote a passage from Paul Krugman, an economist whom I especially admire for his clarity of thinking and exposition, about how serious economics is done.

A real economist starts not with a policy view but with a story about how the world works. That story almost always takes the form of a model — a simplified representation of the world, which helps you cut through the complexities. Once you have a model, you can ask how well it fits the facts; if it fits them reasonably well, you can ask what sorts of magnitudes, what sort of tradeoffs, it implies. Your policy opinions then flow from the model, not the other way around. . .

. . . Anyone who has ever made the effort to understand a really useful economic model (like the simple models on which economists base their argument for free trade) learns something important: The model is often smarter than you are. What I mean by that is that the act of putting your thoughts together into a coherent model often forces you into conclusions you never intended, forces you to give up fondly held beliefs. The result is that people who have understood even the simplest, most trivial-sounding economic models are often far more sophisticated than people who know thousands of facts and hundreds of anecdotes, who can use plenty of big words, but have no coherent framework to organize their thoughts. If you really understood my story about the baby-sitting co-op, congratulations: You now know more about the nature of monetary policy and the business cycle than 99 percent of the attendees at Renaissance Weekend. If you have taken the time to understand the story about England trading cloth for Portuguese wine that we teach to every freshman in Econ 1, I guarantee you that you know more about the nature of the global economy than the current U.S. Trade Representative (or most of his predecessors).

That passage is from his essay “Four Percent Solution” in his book “The Accidental Theorist” (1998). The story — the model, that is — of the baby-sitting economy occurs earlier on in the essay. You can read a version of it on Slate. It is well worth the time. Reading that story (and I have re-read it numerous times) should persuade you of the value of getting one’s fundamentals right. Let’s go on with a bit more from Krugman’s essay.

One thing that usually happens when I try to talk about the difference between serious economics and the kind of glib rhetoric that passes for sophistication is that people accuse me of being arrogant, of thinking that I know everything. I can’t imagine why. No, seriously — think about it. What someone like Felix Rohatyn is in effect saying is “I don’t need to make an effort to understand where the conventional views of economics come from; I don’t need to understand the stuff that’s in every undergraduate textbook; I’m such a smart guy that I can make up my own version of macroeconomics off the top of my head, and it will be much better than anything they have come up with.” Then along comes this irritating economist who points out a few gaping holes in his argument, basic errors that anyone who had bothered to understand the stuff in the undergraduate textbooks would not have made. And people’s response is “That Krugman–he’s so arrogant.”

Well, what can we do about this kind of thing? Let me be the first to admit that economists have not made it easy for smart people who don’t want to get too deep into the technicalities to understand the basics. Mathematics is a wonderful tool, but there are far too few attempts to explain the fundamental models of economics with a minimum of math; we need to make a real effort to write in English, and skip the differential topology. I’m trying, but the profession has a long way to go.

But it’s also important for non-economists — people who want to be sophisticated about economic policy without getting Ph.D.s — to make an effort. As I have said earlier, it is not a matter of time, it’s a matter of attitude. The biggest problem with many businesspeople, political leaders, and others is that while they are willing to talk and read about economics ad nauseam, they are not willing to do anything that feels like going back to school. They would rather read five books by David Halberstam than one chapter in an undergraduate textbook; and they absolutely hate the idea that they need to work their way through whimsical stories about cloth and wine and baby-sitting rather than get right into pontificating about globalization and the new economy.

But there is no way around it. If you want to be truly well-informed about economics (or anything else), you must go back to school — and keep going back, again and again. You must be prepared to work through little models before you can use the big words — in fact, it is usually a good idea to try to avoid the big words altogether. If you balk at this task — if you think that you are too grown-up for this sort of thing — then you may sound impressive and sophisticated, but you will have no idea what you are talking about.

I read Krugman very very slowly. And go back to school again and again.

Not to put too fine a point on it, but the law of supply and demand is a bitch. Stripped of all details it basically states that the price of something is determined by the interaction of the quantities supplied and demanded. Therefore (1) an increase of the quantity demanded, holding the supply constant, will increase the price; (2) an increase in the quantity supplied, holding the demand constant, will decrease the price; (3) a decrease in the quantity demanded, holding the supply constant, will decrease the price; and (4) a decrease in the quantity supplied, holding the demand constant, will increase the price.

Sing pretty songs, if you please, or dance nimbly invoking the gods, or pass sincere legislation to suspend the effects of that law. You would have as much success doing that as you would have in suspending the law of gravity and legislate against it effects. The law of supply and demand is not quantum mechanics and can be taught to the average 6 year-old with ease. Ignorance of the law should be a matter of shame, and willful disregard of the law by policymakers should be punished through public floggings.

Public Floggings

So why, you may ask, don’t we regularly enjoy the spectacle of public floggings of policymakers given that they frequently willfully disregard the law of supply and demand and legislate prices? Two reasons. First, the general public is shamefully ignorant of that law. They don’t know that the law is inviolable as it is not a man-made law. Second, the idea of public flogging makes them queasy. I am very much in favor of public flogging as punishment because it is equitable and wealth invariant.

Suppose you impose a monetary fine which is the same for everyone irrespective of the wealth of those being punished. The rich will be much less affected than the poor. But if you flog publicly, the rich and therefore the more powerful (and thus those who should be expected to be more responsible) would pay more in terms of loss of dignity and greater shame for their crimes, and it would have a greater deterrent effect. Imprisonment for most non-violent crimes is not a good idea because it is costly for society to maintain prisons and besides it robs society of any productive services that the criminal could otherwise provide.

I am rambling. But of course I am rambling. It’s my blog and if I want to build a solid foundation upon which to rest my argument, I have that privilege.

Poverty

I have arrived at the conclusion that poverty is a fact of life and will remain so for a while because the poor will be around for a bit longer. I should explicitly define what I mean by “poverty” and “the poor.” Poverty is a relative term and its definition varies across time and space. By US standards, most of the world is poor. Also by today’s US standards, most of the US of a hundred years ago was poor. Conversely, by the US standards of 1900, most of today’s India’s population is not poor.

That said, one could define something called absolute poverty. I would define it to be a degree of material deprivation which does not allow a person to obtain the most basic of food, shelter and clothing. From what I have seen first hand and know second hand from various published sources, by my standards (therefore naturally not objective), about 40 percent of India’s population – about 400 million — is poor.

LOSADS! Supply

Now let’s ask a very stupid question: Why does India have so many poor people? It’s the law of supply and demand, stupid! LOSADS.

So here’s what we will do now. We will let the simple model of supply and demand inform our investigation in the questions of why there are so many poor, how long will poverty (absolute or relative) persist in our world, what are the factors which tend to increase or decrease the number of the poor, and many other such matters. The subject, in this application of supply and demand, is people.

Wages correspond to “the price” which is jointly determined by the supply of and the demand for people. Let’s focus for now on low-skilled manual labor. Their wage is low in India because the supply is high and the demand is relatively low. So their price, or wages, though low is positive. That low positive price is sufficient for the continued supply of low-skilled people. In certain states of India and within a certain socioeconomic class, families produce half a dozen children or more. Without going into the details of the factors that lead to this fecundity, let’s just note that the supply is plentiful. Now let’s see the demand side.

LOSADS! Demand

On the demand side, there is sufficient demand for low-skilled manual labor to maintain a positive price which happens to be close to subsistence level. But the demand is not so little so as to drive the price to zero and therefore the wages below the subsistence level. In that case, the supply would contract. Also, the demand is not sufficiently high that it would raise the price such that the wages climb way above the subsistence level. Indeed, if the wages go too much above the subsistence level, the supply is sufficiently wage elastic that the higher wages would induce an increase in the supply so that the price is once again driven down to the subsistence level.

Derived Demand – Manufacturing

Demand for low-skilled manual labor derives from the usual domestic sources. For example, there is a great deal of construction going on around India. Labor and capital are to some degree substitutes in construction. You can use huge earthmovers (capital) or you can use an army of laborers armed with shovels. Firms will figure out their profit maximizing mix of capital and labor. As the supply of manual labor is plentiful, firms in India use labor preferentially over capital where it is feasible, such as in road-building or digging canals. But in high-tech manufacturing such as in semiconductor chip fabrication, substitution of labor for capital is not possible. Note that the amount of high-tech manufacturing going on in India is not very large. So relative to the supply to high-skilled labor, the demand is low and therefore the wages for high-skilled labor is low relative to, say, in Taiwan where the demand is high and the wages are high.

Derived Demand – Services

Another source of domestic demand for low-skilled labor is the services sector. Household servants in the cities and towns, for example. There is an apparently unending supply from the rural areas. The wages are really low but still they come to cities like Mumbai. Of course, they somehow have to subsist and therefore you have those mega slums. If demand for low-skilled manual labor were to magically disappear tomorrow, the slums will disappear just as magically without the need for bulldozing them.

Derived Demand – Foreign

In the world of the past, domestic supply and demand were all that mattered. Today’s more integrated global economy allows foreign demand to play in the domestic market. Once again, where possible, the profit maximizing decisions of transnational corporations take into account the substitution of domestic production with off-shore production, and also substitution of capital with low-skilled labor.

Thus Gap, the giant clothing manufacturer and retailer, could produce stuff in the US but the supply of low-skilled labor there is sufficiently low that the wages would be high, and since the job cannot be sufficiently automated, the possibility of substituting capital for labor is limited. Therefore they send the work off-shore and locate their sweatshops in poor countries where the supply of low-skilled labor is so abundant that the price (wage) is really low.

As long as there are things that people in the advanced industrialized countries need which cannot be made using only capital and high-skilled labor, there will be a derived demand for low-skilled labor in the world. And that demand for low-skilled labor together will continue to perpetuate the supply but at a subsistence wage level.

If the demand for low-skilled labor derived from foreign sources (such as Gap and Nike) were to magically disappear overnight, the immediate effect will be a drop in the price of labor. That will contract the supply till the wages once again hover around the subsistence level. At the new equilibrium price, the supply will contract appropriately.

LOSADS! Conclusions

Hence I reach the following conclusions. First, as long as the demand for low-skilled workers continues in this globalized economy, the supply of low-skilled workers in the third world will persist. In other words, the poor will continue to go forth and multiply. Poverty will be a fact of life and cannot be wished away. Children of the poor will be exploited in sweatshops and the monkeys will continue to wring their hands in feigned anguish while simultaneously saving fish from drowning (quite a feat, you must admit.)

It is easy to do the arithmetic to figure out that if the will existed, the poor and the attendant poverty could be a thing of the past. The world produces enough wealth, and the production of wealth continues to grow, that if only a relatively small percentage of it were distributed to the poor, it would be sufficient to eradicate extreme and absolute poverty. The reason it is not done is because with the eradication of poverty, the elastic supply of low-skilled labor would disappear. Why? Because only those who hover around the subsistence wage level display a degree of fecundity that is unmatched by those who are comfortably off. By eliminating poverty, those who are currently comfortably off would be worse off. Shoes currently produced in third world sweatshops would cost a lot more and so will all sorts of low-skilled labor intensive goods.

Second, the supply of low-skilled workers in the advanced industrialized economies will shrink further. I refer you to the “factor price equalization” theorem. Low-skilled labor wages would equalize around the world due to globalization. This low price (another word for wages in our context) would be sufficient to induce continued supply in the poor economies but be insufficient to induce supply in the advanced industrialized economies.

Third, it is rational for the rich to ignore the problem of overpopulation. Overpopulation is a good thing for them because it lowers the cost of low-skilled labor. As long as they need low-skilled labor, and the poor obligingly supply the fruit of their loins to be exploited in sweatshops, everything is hunky-dory. Of course, it makes good copy and sells newspapers whenever someone discovers that children from Bihar and Bengal as young as 9 years old have been sold into bondage and slavery to sweatshops in Delhi.

It gives everyone a great opportunity to feel morally superior and express their shocked outrage and righteous indignation. Celebrated journalists on the left write movingly about the horrible capitalist system; other celebrated journalists on the right write movingly about how overpopulation is just a figment of the fevered imagination of neo-Malthusian morons. The bullshit factories go into overdrive and the world sinks a little deeper into the ocean of stupidity that we have floundered into by not understanding the simple demand supply model.

It is all karma, neh?

Notes:

1. An excellent brief introduction to supply and demand is at ThinkEconomics. Do click the “Next” button on the interactive graph. You will find a little more detail here but you can skip it for now.

2. If you are easily disturbed by reports of very small children suffering inhuman treatment, I recommend that you don’t click on these links. But if you care to know how terrible the situation is, check out these: “Children Tricked into Industrial Slavery”, “Child Sweatshop Threatens Gap’s Ethical Image”, and “Indian Slave Children”.

My (almost) dispassionate analysis above is an attempt by me to maintain my sanity in face of the horrors that I can well imagine when I read those reports. Humanity has little claim to being human as long as injustice, poverty, and needless suffering is tolerated by us all.

It is not just an article of faith among economists (such as yours truly) that markets allocate resources most efficiently under a set of set of assumptions; it has been mathematically proved by theoreticians and empirically demonstrated in thousands of well-documented instances. However, that does not make the proposition that markets work better than other mechanisms – such as command and control – any more intuitive or easy for people to appreciate. It is easy to misunderstand, misinterpret, and often misrepresent.

When the set of conditions required for the market to work are not met, the market fails to grind out the optimal solution. The market failures and how they are to be dealt with are also fairly well understood by economists. The meta-failure is the failure of economists to clearly communicate their understanding to the general public in layperson’s terms. There are exceptions of course. In the popular press you can read economists such as Paul Krugman, Kaushik Basu, Jagdish Bhagwati, et al. But then they are not as widely read as they should be. I say “should be” because too many people are only too ready to make pronouncements from a position of partial understanding on matters economic. Somehow it appears to them that economics is a matter of opinion and should not involve any deep thinking or questioning before they take up a position. These same people would not dream of holding opinions on say radio-astronomy or nuclear physics. But economics is fair game.

Hardly Economics

Economics is hard. And I am not making a self-serving statement because I myself find it hard, and at the risk of sounding vain I claim to be a pretty smart cookie. Which reminds me of a passage from Robert Heilbroner’s book The Worldly Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers (1953).

Keynes was having dinner with Professor Max Planck, the mathematical genius who was responsible for the development of quantum mechanics, one of the more bewildering achievements of the human mind. Planck turned to Keynes and told him that he had once considered going into economics himself. But he had decided against it – it was too hard. Keynes repeated the story with relish to a friend back in Cambridge. “Why, that’s odd,” said the friend. “Bertrand Russell was telling me just the other day that he’d also thought about going into economics. But he decided that it was too easy.” (pp 250-51)

[Put TWP on your reading list if you are the least bit curious about the people who have had, and continue to have, a profound effect on our world. One needs to have at least a passing familiarity with those worldly philosophers. I am sure that many more of us know who Einstein was and what his claim to fame is than who Adam Smith was and why he matters to us.]

Coming back to the auxiliary fact that I was attempting to make: that economics is not very clearly communicated to the general public by economists. In general they are too busy talking amongst themselves. The public is lucky to have great popularizers in many other disciplines. Where are the Carl Sagans, the Richard Feynmans, the Richard Dawkins of economics?

What versus How

What brought this line of thinking on? Despair. I despair when I see Adam Smith’s ideas misrepresented. I am not going to attempt to explain Smith’s position here, of course, as I am neither the most competent writer nor an authority on Smith’s work. What I want to do here is point out a simple distinction between what and how.

“What should be done” is an entirely different matter from “How should it be done.” If you ask me, I will answer the latter question with: “Let the market do it. If, however, there are reasons to believe that the market will fail because of such and such reasons, then we have to use mechanisms to correct for the market failures. Take care to make adjustments and corrections but let the market get the job done.” The market is a mechanism, a means to an end. What that end should be, however, is something that you have to decide. The market does not auto-magically determine the end to which it can be employed. Saying that the market will decide the goal is like leaving it up to your car to decide where you should be going.

+++___+++___+++

The post on Tata’s Rs 1 Lakh Car mysteriously provoked a few to challenge my free-market credentials. It is as if I had advocated controlling the economy through socialistic planning. I had done no such thing. I had merely pointed out that cars are not the most efficient means of solving India’s transportation needs. I think Indian cities would profit from modern efficient public transportation systems. In those cities that are already so far gone that you cannot actually put a great public transportation system without impossible costs, I suggested that at least the new cities (that should be built) must have public transportation systems planned from the beginning.

I risk being a bore but let me reiterate that (1) I am for letting the market figure out the solution, (2) if there are market failures, then mechanisms must be used to correct them, and (3) what should be done is a decision that people make, not markets.

Before going any further, let’s just briefly touch upon one source of market failure in the context of transportation. Remember that market work to grind out the optimal solution subject to some set of conditions. Well, one of the conditions is called “No externalities.” In the case of private transportation, it is full of negative externalities such as air pollution and congestion. So unless that externality is internalized, the market will grind out a sub-optimal solution, and it does as seen in cities around the world.

Leadership and Vision

The answer to the question “what should be done” has to be given by society. The agents of society who have that job are the leaders, political or otherwise. They have to have the vision and the ability to do arithmetic. I should add that leadership is endogenous – it arises from within the society.

Ratan Tata is the “leader” in question when he decides that he will make the cheap car. Now he could have led alternatively. For instance, he could have called Mukesh Ambani, Aditya Birla, and other assorted movers and shakers of Indian industry and academia and said, “Guys and gals, let’s figure out what we need to do to solve India’s transportation problems. Let’s do the arithmetic and figure out which way we should go. And having figured it out, we push for that public policy to set that goal. And then we fight it out in the market to see who is most efficient and able to create the system. May the best companies win.”

I am not advocating socialism. What I am saying is that we should sit and think and talk and cogitate for a bit before we go off doing things. We should not do anything until we are reasonably convinced that it is a good thing to do.

My Car

Since I was asked, here’s my position. I don’t own a car. During my 20+ years of living in the US, I had to have a car because where I lived there was no public transportation system. Had I lived in NY City, I am sure that I would not have had a car because it is much more efficient to take public transit. But in California, you cannot survive without a car. That’s just the way it is. And had I been living there now, I would have bought a hybrid (most likely.)

I don’t own a car in India because I like cars too much and like driving too much. I feel distress (I am serious) when I see cars drive through torture test tracks (which is another description for Indian roads) and feel even more distress crawling around in bumper to bumper traffic in the cities.

Finally

I believe that the self-interest of people will make people use public transit systems – but they have to have that choice. Making that choice available is first a policy matter, and building that system is what the market is good for.

My first axiom derives from the Golden Rule. Do unto others what you would have others do unto you. Treat others as you would like others to treat you. The negative formulation of the same rule goes “Do not treat others the way you would not like to be treated yourself.” Abraham Lincoln used that rule to conclude “that as I would not be a slave, so I would not be a master” and opposed slavery. I do not want to be coerced into an involuntary trade, and therefore I refuse be the coercive party in any involuntary trade. If the taxi driver does not wish to ferry me for whatever reasons, regardless of what the law permits me to do, I will not force him against his will.

My second axiom is that adversarial laws are harmful and decrease social welfare. When a law pits one individual (or group) against another, it blocks many voluntary trades. All agents in society have interests that are congruent in some respects of other agents and divergent in others. If one’s interests were fully and comprehensively divergent from that of another, then any interaction between the two would be a zero-sum game: one can gain only at the expense of the other. But in reality, most people in society have some overlapping interests and any voluntary trade in those areas yields gains to both parties and thus is a positive-sum game.

My third axiom is that one has to be careful in evaluating the benefits of an action. One should not only look at action A’s benefits. Action A’s benefits have to be weighed against the “opportunity cost” of A: the benefits of action B which are foregone because A precludes taking action B. A corollary to this axiom is: be careful in noting both the long term and short term costs and benefits.

My fourth axiom is that one should arrange society on a minimal set of rules that are consistent and comprehensive. That a small set of simple rules can give rise to systems that are complex, sustainable, elegant, and beautiful is well known empirically and I believe that social systems which are free from very large and complex rule sets are more efficient and effective. Specifically in terms of the economy, a society that does not needlessly restrict free trade is one that prospers. Economic freedom leads to social good and effects a productive, efficient and sustainable society.

Starting with the last – as this blog is ostensibly about India’s economic growth and development – I believe that the lack of economic freedom is one of the major causes of India’s poor economy. Like in all things that matter, India’s lack of economic freedom traces its roots to its history of foreign rule. Colonialism is grounded on denying economic freedom to the colonized society so as to more efficiently exploit and extract resources from it. Economic growth and development are not the colonialists’ ultimate goal but enters into the calculus only to the extent that they promote the ultimate aim of maximizing the extraction of wealth.

Political freedom does not automatically translate into economic freedom. Indeed, political freedom and economic freedom are essentially distinct beasts and you can have one without the other. India has been politically free externally but it is economically in shackles and is kept so by its new political masters. Of course political freedom is a good in its own right, just as economic freedom is. How much people value political freedom over economic freedom is an empirical question. I believe that most people value economic freedom more than political freedom. The evidence? Check how many people migrate from nations where they have political freedom but lack economic freedom, to nations which are economically free (and therefore economically prosperous) but where they don’t have political freedom. Case in point: Indians that are capable do migrate to the US at the drop of a hat. Furthermore, the reverse migration of Indians from the US is powered by a corresponding rise of economic opportunities in India (thanks to a limited degree of economic liberalization) – often times those returning lack political freedom (such as their inability to vote in India, having relinquished their Indian citizenship during their sojourn abroad.)

Economic freedom is determined by the set of laws that constrain economic behavior. It is the entire set, not just any particular law. If the set contains a large number of what I call ‘adversarial laws,’ then inevitably they collectively introduce friction into the economic machinery and it grinds very slowly and inefficiently. The society produces little and the end result is poverty.

Adversarial laws pit one set of people against another. The one forcing tax-drivers to take any and all passengers is one such. Each such law introduces only a small inefficiency but a truckload of similar laws introduce inefficiencies which aggregated over time and space add up and create havoc. The reason that these adversarial laws are made is due to myopia and ignorance. Myopic because they trade small short-term gains for long-term costs; ignorant because finally they end up hurting those who are the supposed beneficiaries.

Examples of adversarial laws abound. Rent control, for instance. It is supposed to penalize the landlord and to favor the tenant. Perhaps good in intent but results in lack of affordable housing. Another example: labor laws that favor the employee in that the employer has to expend enormous effort to fire an employee. The result is that employers are reluctant to hire and the substitution of capital for labor leading to higher unemployment. Yet another example: disallowing large firms from producing certain goods and only permitting small producers. Result: costlier products that hurt the consumers.

I find it fascinating that there are phenomena in the world that are defy naïve intuition. For instance, how can the general welfare be advanced through the uncoordinated self-interested actions of a large number of people? Yet that is what happens, as suspected by Adam Smith in the 18th century. Economists have figured out why and how, and have enshrined the phenomenon in what is called the Fundamental Laws of Welfare Economics.

Naïve intuition says that limiting one’s own freedom voluntarily is a silly idea. But in reality it is often a strategically good idea. It allows a party to make commitments that are credible to the other party and hence allows trades that would have not occurred in the absence of that commitment.

The operative word is trade. Humans are distinguished from all other forms of life on earth by their capacity to trade. In general, we produce some stuff and consume some stuff, and exchange some of what we have with others in a place (sometimes a virtual place) we call a market. Sometimes what we exchange is our own labor, sometimes stuff that we have produced. The centrality of exchange in human affairs leads to the centrality of the market. That we produce stuff which is in excess of our own consumption needs is due to the remarkable but commonplace fact that we all differ in our preferences and our abilities. If we all had the exact same preferences and the exact same abilities, we would have no need to exchange. It is our human diversity that allows us to exchange stuff and thus have more stuff than what we would have had otherwise. It is that wonderful invention called the market that makes this exchange possible.

For the market to work as advertised (maximize social welfare) there is one very important caveat: that all trades must be voluntary.

So what about that taxi law? I think it is not a good idea. Sure it privileges me occasionally and I get a small gain but in the long run, it hurts me directly and indirectly. The damage that it mostly does is that it supports and reinforces the notion that it is alright to coerce people to do things that they perceive to be against their self-interest and that it is ok to force people to do things against their self-interest as long as it is for the “greater good.” I am vehemently against any coercion against my own self for the “greater good” and I have not yet met anyone who will acquiesce to being forced to do something for the “greater good.” Laws that are not consistent with economic freedom are bad laws and I am not willing to abide by them.

Why, I ask myself, do people agree to laws that are clearly bad for them? Perhaps because they mistakenly believe that the law does not apply to them. Take, for instance, the principle of free expression. It leads to social welfare gains in the long run but it could have the occasional short-term cost of nasty and hateful speech. I want the freedom to speak freely and therefore will accord the same right to everyone else, even those who I disagree with. I would like to live free of coercion and therefore will not coerce anyone else.

Responses to comments from the previous post.

Amit asks how should one deal with case of Muslim cab drivers who refuse to take passengers carrying alcohol.

I absolutely support the freedom of the Muslim drivers to refuse passengers without having to justify their action. Reciprocally, the passengers are also free to not ride in cabs driven by Muslim drivers. The market will decide if there is much need for Muslim cab drivers. If passengers refuse to hire Muslim cab drivers regardless of whether they have alcohol on them or not, the number of cabs driven by Muslims will be optimally determined. If there are too few non-Muslim cabbies at that airport, over a very short period that imbalance will be rectified by the greater demand for them.

Bongopondit comments that there is a shortage of cabs and hence the cabbies can dictate terms. Which brings me to an important general principle: that one should address the root cause of a problem rather than the symptom. It is pointless to force cabbies to take on fares when the real problem is that there is a shortage of cabs. Why are there too few cabs? Is it because of not sufficient people wishing to be cabbies because of too little profit in the business, or is it because government regulation limits the number? Needs investigation.

Sreddy comments that it is a union problem. Same as above: figure out the root of the problem instead of using a band-aid solution that masks the symptom.

I acknowledge Rishi’s comment and note that the matter of fixing fares deserves an entire post which I will go into later.

Tejas’ comment about discrimination likewise deserves a separate post. I am absolutely in favor of the freedom to discriminate by anybody towards anybody. I will write in praise of discrimination later.

Thanks to all who have bothered to comment and advance the discussion. I am grateful to those who disagreed with me for they afford me a chance to explore the topic.

Thank you, good night, and may your god go with you.

Do you know, Rickshaw & Taxi Drivers do not have a right to say NO. So remember that each time the rickshaw/taxi driver tells you a NO, take down his vehicle registration number, note the time date and place, please click on the following link and register your complaint.

We have had enough of these guys bullying us around, and refusing to ply specially when its urgent. They have been told that they cannot say a NO to any customer when their meter is FOR HIRE! not even for short or long distances. I’d suggest you stop asking them whether they will take you wherever you wish to go and rather tell them where you want to go. And if they refuse. REGISTER a COMPLAINT. Let’s teach these guys who’s the customer , and who’s the boss!

I did not care much for the tone of the email. It was needlessly adversarial. The ending suggests an unhealthy attitude of putting someone who is most likely struggling close to the bottom of the economic ladder firmly in his place. If one has any doubts about whether one has the upper hand in the taxi-driver/rider relationship, there is little room for debate. This rule needlessly imposes additional burden on the party that is already socially disadvantaged. Even more importantly, it makes no economic sense, as I argue below.

Imagine that you wish to travel south and the taxi driver you encounter wishes to go north for some reason (such as his home being in that direction or that he had previously arranged to pick up fare somewhere north.) Forcing that driver to take you south is wasteful because there may be other taxis which would be happy to travel south. The economic waste arises from the mismatch between the preferences of the parties involved.

Which brings us to the most important principle ever discovered by humans about economics: trade is welfare improving provided it is voluntary. Conversely, coercion in trade leads to avoidable losses. If any party is forced to participate in a transaction, the full gains from trade are unrealized. People should not be forced to sell their labor or their goods. This principle is not only good economics but it lies at the foundation of a free society. Involuntary servitude is characteristic of regressive regimes and socialistic societies.

My objection to the Mumbai taxi law (and I am assuming that it indeed is the law) arises from a matter of principle. A society which does not value individual freedom is doomed to poverty. Every one of us has to have the right to refuse to provide service to anyone without having to justify it. Yes, it would be inconvenient for me personally if the only taxi driver available is unwilling to be hired by me. But the possibility of occasional personal inconvenience has to be balanced by the greater threat that I face when society enlists me for involuntary servitude. It is a slippery slope and it is easy to slide from forcing taxi drivers to obey orders to people being forced to bake bread when they are more inclined to build furniture.

I recall a story which I had read many years ago in high school. I think it was by “Saki” and the title was (if memory serves) “All About a Dog.” It was a dark and stormy night and the driver of a bus notices that the lady who boarded the bus was carrying a small lap dog. He stopped the bus and asked the lady to get off the bus as the law was that no dogs were allowed on board. It was late at night and she would have had serious difficulty finding alternative transportation. The other passengers had no objections to the lady with the small dog and pleaded with the driver to please allow the passenger to continue. The driver refused to drive any further. I don’t recall how the story ended but the writer made the point that while the driver stuck to the letter of the law, he clearly violated the spirit of the law.

I am not sure how bad laws get enacted and how one can go about removing them from the books. I think that the taxi law should be removed. Personally, I always move on to the next taxi if one is reluctant to take me as a fare. In a small way, I feel a sense of satisfaction that I have not reduced social welfare and caused economic inefficiency by insisting that service be involuntarily provided even though that may be the law.

So what would I do if I really needed to go somewhere and the only taxi available refused? Actually, there is always a price — a ‘reservation’ price — above which the driver would be willing to drive me. If my need to get the service is sufficiently strong, I should be able to meet that price. Yes, I am a market economist and I will only enter into a transaction where both parties are willing and able. Otherwise we would be on the road to serfdom.

There is a trade-off in this situation but then there are very few, if any, situations in life that do not involve a trade-off. By disallowing the copying of a life-saving drug, there is a welfare loss incurred. That loss has to be considered in relation to the welfare cost of the drug not being discovered at all. In an ideal world – what I call a “first best world” – a firm could produce stuff costlessly and people would take whatever they needed without having to economize. Our world unfortunately is a “second best world” where there is no such thing as a free lunch.

Patent protection is a specific example of a more general notion called “intellectual property rights,” or IPR. Just like you have property rights over physical property – you paid for that car and it is yours – so also you have rights over non-material property such as the recipe for biriyani that your family has used for generations (which is a trade secret that you don’t disclose to anyone) or the poem you wrote (which is given copyright protection.)

Why should India honor patents that protect multi-national drug firms that sell life-saving drugs at prohibitively expensive prices? That is part of the trade-off that a country faces. By trading with the rest of the world, India gains. But it has to agree to abide by international trading rules which include the protection of intellectual property rights. India too has an interest in supporting IPR since India has IP itself. I suppose if one has no property, it is easy for one to disregard the whole notion of property rights.

Coming back to drug patents. The protection is for a limited time, generally around 17 years. The idea is that the monopoly power it provides is sufficient for the discovery costs to be recovered. It is to be expected that firms could cheat by making trivial changes to an existing drug which is about to go off patent and then apply for additional protection. Those sort of matters are dealt with at the courts and the outcome depends on a political bargaining process. Oftentimes the pharmaceutical firms have high-paid lobbyists and successfully buy their way into additional protection. The system, in other words, is far from perfect. But then given human imperfection, it is unreasonable to expect any human scheme to be perfect.

Are there alternatives to the patent protection in the drug business? Some have been proposed. One way would be for the government to buy the drug discovered by paying the discovering firm a fair price, and then to release the drug into the public domain for any firm to produce and sell competitively. This has the obvious advantage that once the drug is discovered, the public will have access to the drug at prices that reflect the actual cost of producing the drug and does not include the cost of discovering the drug or the markup above cost that any monopolist would include.

On the other hand, there are two problems. First, the government will have to fund the buying of the drug formula from the firm which discovered it. That purchase has to be funded from tax revenues. Taxes always introduce welfare losses and these welfare losses have to be considered in relation to the welfare losses associated with the firm’s monopoly supply of the drug. The second problem is how one arrives at a fair price at which the government will buy the drug. Let us suppose that the idea is to pay for the actual cost of drug discovery plus a reasonable amount to compensate the firm for the risk it took to discover the drug. The firm will have an incentive to inflate its costs. Furthermore, the firm can withhold selling the drug at a reasonable price and charge a monopoly price to the government itself. There lie major complications.

All the above was in the context of a single economy. What happens when you foreign firms? The story complicated. What if the consumers in the home country are poorer than the consumers of the foreign country (and the firm is a foreign firm)? Then it is possible for the foreign firm to “price discriminate” – sell the drug at a lower price in the poor country and at a higher price at home.

One can argue that this is possible and indeed welfare improving. Generic versions of branded drugs do precisely that.

I am sure that I have merely scratched the surface of this matter. Hope it somewhat answers the questions that my friend raised.

A head’s up from Rajesh Jain on an article Asia Times Online titled Why India’s Economy Lags Behind China’s got me thinking once again about popular misconceptions about development matters. Journalists are particularly susceptible to some of these. An example appears in the article.

The real bad news lies elsewhere. India’s agricultural sector, which continues to employ about 60 percent of the country’s workforce, has seen a real decline in terms of its contribution to GDP growth and its share of GDP.

I don’t know where to begin to unravel the illogic of that statement. Perhaps I should start off with an analogy.

Consider my grandmother’s GDP. She spent the bulk of her time in the kitchen and in rearing children (and later in her life, her grandchildren such as yours truly.) Her time in the kitchen was food-related and so let’s just call that her agriculture sector. Rearing children could be considered her service sector; and producing children, three boys and three girls, her manufacturing sector. I’d assign her GDP shares as

Agriculture:     50%
Manufacturing :     20%
Services :     30%

Now move ahead about 70 years and consider my sister’s GDP. She has two boys, works full-time managing a medical transcription service company, and spends a little bit of time in the kitchen after she gets home. Her sectoral output:

Agriculture:     10%
Manufacturing :     10%
Services :     80%

In other words, my sister spends most of her time working outside the home and very little time in the kitchen. Also, she has to rear only two children, as opposed to my grandmama’s half a dozen. Clearly the share of the GDP accounted for by “agriculture” has fallen dramatically as the generations progressed. Concluding from that that perhaps my sister’s family is starving would not be very clever.

In other words, the structural change in the GDP is a good thing. Lamenting it is somewhat idiotic, not to put too fine a point on it.

Anyhow, enough of that analogy. Let’s move on to the figures that India’s Tenth Plan states for shares of the GDP and growth rates.

Sector . . . . . . Growth rate .   Share of GDP
 . . . . . . .  2002-07  1997-02    2002-07  1997-02

   Communications   15.0     17.14      2.3       1.7
   Manufacturing     9.82     3.68     16.7      15.3
   Agriculture       3.97     2.06     20.5      24.7

The growth rate of the agricultural sector accelerates in the next plan. So in absolute terms it gains and there is no decline. That is good news. In relative terms, the decline of agriculture in the share of GDP from 24.7 to 20.5 is also good news. That decline implies that services and manufacturing are gaining share and that implies that we are moving away from a subsistence economy to one in which we may have some hope of improving our lot.

Of course, as a developing economy, agriculture is the core of the economy. No one is advocating a destruction of the core of one’s economy. What I maintain is that agriculture’s share in the GDP had better decline (but not a decline in the absolute value of the agriculture sector) if India is to ever develop. It is only very severely underdeveloped economies have high ag sector share of GDP.

For instance, here are some numbers of the share of agriculture in overall GDP of some nations. No prizes for guessing which are developed and which not.

 Country    % share of AG in GDP 1999 data

    Albania     54 (was 37% in 1990)
    Australia    3
    Bangladesh  21
    Belgium      1
    China       17 (was 27% in 1990)
    Ethiopia    49 (was 49% in 1990)
    France       2
    Germany      1
    Ghana       36
    Mali        47
    Nepal       41 (was 52% in 1990)
    Pakistan    26 (was 26% in 1990)
    India       28 (was 31% in 1990)
    Sri Lanka   21 (was 26% in 1990)
    Thailand    13 (was 12% in 1990)
    US           2 (was  2% in 1990)

The level tells you roughly if the country is poor or not. Albania, Ethiopia, Mali, Nepal, Ghana — economies with agriculture accounting for a large share of the GDP. Australia, France, Germany, US — agriculture accounts for low single-digit shares of the GDP. The trend is even more telling.

The direction of the change between 1999 and 1990 tells you whether the country is developing or not. See China, for instance. Compare that to Pakistan. Note that the trend for India is good. Sri Lanka is doing good and it will do even better when the civil war finally ends. Albania is a disaster zone and note that from 37%, Ag is now 54%. The US has the world’s largest agriculture sector — it can feed the entire world with only a bit more effort. US’s ag share of GDP is almost negligible.

For India to develop, its share of the ag sector has to decline rapidly (with an increase in the absolute size of the sector).

I think economics literacy must be mandatory in any society which fancies itself to be a democracy. Because otherwise people don’t understand the implications of the policies that they vote for and society enters a downward spiral. Ignorant people at the top making short-sighted policies, which makes the economy poor, which leads to a poor ill-informed citizenry that votes for bad leaders, who promote bad policies, . . . the spin cycle finally concludes when the whole wash goes down the tubes.

The special pleading of selfish interests is what makes an inherently difficult subject prone to numerous fallacies. The first paragraph of the Lesson makes that point clear. “Economics is haunted by more fallacies than any other study known to man. This is no accident. The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousandfold by a factor that is insignificant in, say, physics, mathematics or medicine–the special pleading of selfish interests. While every group has certain economic interests identical with those of all groups, every group has also, as we shall see, interests antagonistic to those of all other groups. While certain public policies would in the long run benefit everybody, other policies would benefit one group only at the expense of all other groups. The group that would benefit by such policies, having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case. And it will finally either convince the general public that its case is sound, or so befuddle it that clear thinking on the subject becomes next to impossible.”

Anytime you wonder why India is poor, wonder no more. Pay attention to the public policies that the fearless leaders of the land are advocating. And there you will find your answers as clear as broad daylight.

Read the book carefully. It may be a while before I write one for you.

If the property is public, then anyone can enter subject to the usual conditions such as that visitors will conduct themselves appropriately, maintain decorum, etc. If the property is semi-private, then the private owners of the property often reserve the right to refuse admission. So a restaurant owner has the right to stop drunken people from entering.

Is the Puri Jagannath temple private, public, or semi-private?

I think if we — Indians, Americans, Martians — learn to respect private property, we would have made progress.

However, my conclusion that SSRS is a “useful” person, just like you and I, did not go down too well with those who are persuaded that SSRS is God Almighty incarnate (whatever “God” is.) So I get nastygrams from these fairly regularly. But once in a while I also get letters from dissatisfied AoL customers. The curious thing is that the nastygrams from SSRS worshippers are pretty incoherent rants; and the dissastisfied customers are generally pissed off but coherent. Because I have published one recent incoherent rant from an SSRS worshipper, I am publishing one from someone who has an opposing point of view. Here it is, for the record.

Atanu,

I wish I had read your Web site, long before my fiancé and I were lured into registering for the Part 1 course of the Art of Living Foundation. We walked out on the last day of the course because we couldn’t stand it any longer. I couldn’t have written or explained the experience better myself. You have beautifully verbalized your opinion of the Art of Living Foundation.

I have lost my money permanently, and I am also, without permission, included as a statistic in the set of AOL “followers” of 20 million or so now, even though I strongly oppose the organization. I have to believe that are many others like me. Only about 30% of the Part 1 course was about breathing and the remainder was ear-splitting, fear-psychosis propaganda (for example, “A question is a hook that tears the brain”, and “Questioning SSRS’s principles and teachings can prove costly”), illogical analogies and anecdotes, and disguised pressure to encourage more people (friends and family) to give their credit card numbers to sign up for the course.

It is a totally for-profit, commercial, very well-marketed product and organization. I do see some token projects here and there in poor and tribal areas of India and around the world, the expenditure on such projects is negligible compared to the hundreds of thousands of dollars that the organization earns from a single “US tour” of a “specialist teacher” from India. I have not seen any document showing or even referring to exactly how much money the organization is really spending on building schools or hospitals for the disadvantaged, other charitable projects. Since the organization is so fond of shouting out the numbers of their followers and so fond of promoting themselves as a philanthropic organization, why not reveal how much they are actually spending on these philanthropic and charitable projects? Wouldn’t that make them more credible? Almost everyone that “works” for the organization does so on a voluntary basis. Almost every piece of land that the organization builds something on, is donated by the government or a wealthy but gullible member of the AOLF. So where is all the money that is collected from their members really going to? What is being done with the profits?

During several of our Part 1 propaganda sessions, we were told we would be the “privileged few” whose place would be reserved for the “coveted” Part 2 course, if we signed up right now. The whole six day course looked like a live version of one of those late night paid commercials that we were participating in and listening to. People from the class were picked on, randomly, to come up to the front and dance and sing, “so that all inhibitions would be vaporized and self-confidence would be developed”.

“Jai Gurudev” had to be the greeting instead of “good morning” or “good afternoon”. I cannot think of a better way to humiliate and control masses of gullible people than to make them do what is being commanded of them to do in front of uncontrollably laughing people. What upsets me more than my loss of money, is the sheer number of followers this organization has. When you can control a small class to dance on command, you can use that power to control the entire 20 million. SSRS is gaining popularity around the world, like never before and he loves to paste pictures of himself shaking hands with world leaders, on his Web site. “Wow, if he is shaking hands with world leaders, he must be good”.

He certainly falls in the “useful” category. Who is stopping all this madness?

Regards.
SG

Well, I sympathise with SG’s situation. But I don’t think that “this madness” has to be stopped. You pays your money, you takes your chances. SSRS and his Art of Living courses are products that are sold in an open and free market. Caveat emptor and all that. I am sympathetic towards those who get cheated but the burden has to be on the consumer to exercise proper care before forking out cash for a product.

My position arises from my conviction that free markets are best for all concerned. That is, everyone should be allowed to bring their wares to the marketplace and hawk them. There cannot be restrictions on what can be put out for sale. After all, who can decide if what is on offer is good or not? Surely not some bureaucrat or some self-righteous busy body. The consumer is the sovereign. Let the consumers decide if the product is good for them or not. So if the snake oil salesmen make a killing, so be it. It is part of the risk we take and part of the price we pay for the benefits that a free market delivers.

Advertising is the communication of a signal (information) with the express purpose of gaining advantage over one’s rivals in a competitive environment. That’s my definition of advertising in the broadest terms. In those terms, advertising is not limited just to the world that is human made. All sorts of life forms over evolutionary time scales have been in the business of advertising. In the natural world, advertising serves a very useful function, the end result of which is the astonishing appearance of beauty and diversity. A beautiful human face is not just an advertisement but also the result of successful advertising. Little wonder that beautiful people appear in advertising pictures.

A competitive environment is a must for there to be a need for advertising. If you are the only game in town, you don’t have to waste resources signaling that you are the best because you are the only one and therefore necessarily the best. It is only when you have competitors—whether in mating or in selling soap—that you have to signal that you have better genes than the others or that your soap cleans up the best. As the environment becomes more crowded, greater competition pushes up the need for more effective and efficient methods of signaling.

I have been thinking about advertising a bit lately. The world economy is growing rapidly and competition is heating up. Since advertising involves the communication of information, the sophisticated information communication technology available has made signaling cheaper. But that has the downside of too much information being pushed towards the receiver and instead of signal, the aggregated signal degrading to noise and the receiver blocking all signals. Information overload is going to be a major problem faced by people.

Perhaps that is not entirely true. One can never have too much information if information is defined as valuable data. It is an overload of irrelevant data—with respect to the receiver—or noise, that is the problem. Because information is lost if there is too much noise, and irrelevant data is noise, that we have a problem. Our challenge is to block the noise so that the signal can get through.

Competition

The economics of advertising is fairly simple. Consider any product, with its associated cost of production. That cost defines its supply. Then there is a perceived benefit from the use of the product. That benefit defines its demand. Since price is jointly determined by the interaction of supply and demand, if demand were increased, a higher price can be obtained and this means a larger profit for the producer. We must also keep in mind that profit is the difference between the price and the cost. Advertising increases the perceived benefits of a product, and therefore its demand. Firms compete to increase their profits through increased revenues and decreased costs. Competition has two distinct effects. On the demand side, competing firms induce an increase in demand with the goal of pushing up the price. On the supply side, firms try to lower their costs to below their competitors level. The interaction of these two drives in a competitive environment both prices and costs down.

This is plain Econ 101. Competition makes the world go around. If there were no competition in the marketplace, you would get only shoddy goods and services. If there were no competition in the natural world, we would not be here. Evolution is powered by competition between selfish genes. We, and everything that lives, are the product of that competition in the natural world. The diversity of goods and services we take for granted and enjoy is the product of competition in the commercial world.

Information

Back to the economics of advertising. Part of the profit that a firm earns, it earmarks for advertising. That is a cost. So if the cost of achieving an additional sale through advertising is lower than the additional profit arising from that sale, it makes sense to advertise. In concrete terms, if it costs me Rs X to advertise to get an additional sale of my super-duper widget[1], and my revenue from that sale is Rs X+Y, then my net profit is Rs Y, then I should go for it. Advertising costs are critical in the profit calculus. If that cost can be lowered, profits go up.

Information is communicated over a medium, or a channel. That channel can be cheap or it can be expensive; it can be broad or it can be narrow; it could have a high fixed cost and a low marginal cost; or it could have a low fixed cost and a high marginal cost. Take the town crier, for instance. It is cheap where labor is cheap; it is narrow, as voice can only reach a limited number of people who are within ear-shot; it has low fixed costs but high marginal cost (for each lot of people, he has to put in the same effort in delivering the same message). A TV channel, on the other hand, is broad (reaches a lot of people); high fixed cost (very expensive to build a TV station); low marginal cost (it does not cost much more to reach more people).

Let’s keep in mind two facts. First, advertising is valuable information and serves a crucial function in a market economy. Second, people pay for information. Advertising inherits all the properties of information goods. Since the channels for the transmission of information are becoming broader (think broadband and cell phones, not just print, TV, and radio), we are getting overwhelmed by advertising and the challenge is to reduce noise and increase the signal.

Increasing the signal implies that you as an advertiser have to figure out the characteristics of the receiver so that only those bits reach the receiver that is meaningful. Traditionally, in the print media, the information is broadcast and the receiver searches through the pile and takes the bits that matter. For example, the classifieds in a newspaper: you ignore all the ads except the ones listing apartments when you are looking for an apartment.

Advertising on print is expensive because the “real-estate” is limited. What happens when that limitation is removed, as in the case of web pages? The cost of advertising comes down, and therefore the volume of advertising goes up. To get the attention of the receiver, then, you have to “profile” the receiver and only send those bits that are significant. The receiver’s attention, rather than printed space, is the scarce resource.

The main point so far is that in a world where advertising is plentiful because transporting bits is cheap, and where there are zillions of firms competing to sell their wares to you with your limited attention, the problem of how to get your signal across all the noise needs to be solved.

Free Channels

Now we address a different matter. Advertising not only uses a channel but in many instances actually makes the channel commercially sustainable. The cost of production of a newspaper is much higher than the price it sells at. The difference—and a bit more for profit—is made up by advertising. In the case of commercial TV and radio, all of the costs are met by advertising and you receive the content for “free.” I write “free” because actually you do pay for the advertising by paying a bit more for the product than you would have had if the firm had not incurred advertising costs. There is nothing really free in the universe. Everything has a cost.

Up until recently, the main channels of advertising have been (in chronological order) print (newspapers and magazines), radio, and TV. The economics of radio and TV have been such that they can be entirely supported by advertising revenues. Briefly, these have high fixed costs. The infrastructure investment required is large. But once the fixed costs have been paid for, the marginal costs of serving an additional customer is very close to zero. In any large market, such as you would find in any urban area, the average cost of transmitting information is very low. It is low enough that the marginal revenue from advertising is lower than the marginal cost of the advertising. In the case of radio and TV, the total advertising spend exceeds the total cost of providing the channel and therefore the user gets content delivered free.

This is what we call marginal analysis. Around late 90s, another channel was added to the mix: the World Wide Web. made possible by the internet. The economics was similar: high fixed costs but very very low marginal costs. Because of very low costs of transmitting information, advertising again supported the cost of content delivery. Not just content, a plethora of services became commercially sustainable without the use of user fees. What began with free email (hotmail comes to mind) has now graduated to be a host of services which includes everything from word processing to social networking services. Google is the biggest game in town among other giants such as Yahoo! Brought to you by the advertising dollars of a gazillion sellers.

Mobile Phones

The newest kid on the block is mobile phones. Phones are essentially one-to-one communications devices. They are not a broadcast channel unlike newspapers, magazines, radio, TV, and the internet. Therefore, the question is whether the economics of phones—which basically means mobile phones—render an advertising supported free mobile service possible like free TV and radio services.

The answer depends on the cost of mobile communications. That is, if the cost per bit of information communicated on that channel drops below the marginal revenues from advertising, then advertising will make mobile communications free and the users will only have to pay with their attention, not money.

The economics of mobile phones is simple to state. The infrastructure required has very high fixed costs (although lower than landline infrastructure) but have very low marginal costs. In other words, the technology exhibits large scale economies due to very low marginal costs. Therefore the larger the market served, the lower is the average cost. Which partly explains why it is possible to price mobile communication so low in economies such as India. As the installed mobile user base grows (which is right now growing at an incredible 6 million subscribers a month in India), the average costs will continue to decrease. At some point, the average cost will become low enough that given a suitable advertising model, mobile communications will break free of the need for user fees altogether.

Free Mobile Communications

So far I have been painting the landscape. Now to place the object of my attention in there, which is, the matter of how and under what conditions will mobile phone use become fully advertising supported just like radio and TV.

The conditions first.

1. The average costs have to come down below the average revenues from advertising. Technological progress will lower the fixed and marginal costs. Together with that, increased installed base will reduce average costs. This is inevitable.
2. Average revenues from advertising have to increase. This will happen only if advertising information is delivered more efficiently. Merely broadcasting more advertising over the mobile channel will degrade the channel with too much noise and very little signal for the user. Targeted advertising is required.

Which brings us to the how. In the traditional broadcast media, the advertisers choose the content around which they will push their advertising message. The users then select from the available content and thus self-select which advertising messages they receive. Thus, Home Depot chooses to advertise on a home improvement show, and Nike advertises around the Super Bowl. Depending upon the choice of the show, the user reveals his profile and thus receives the advertising message. The user thus self-selects the message he or she wants to receive. Both the advertiser and the users meet around the chosen content.

In the case of a non-broadcast channel such as the mobile phone, the advertiser does not have the freedom to choose the content since the content is not known to the advertiser. The advertiser therefore has to somehow choose the user to whom they will send the message. For this, the advertiser has to know the profile of the user. Getting the user profile is therefore the most critical bit when it comes to advertising on the mobile.

There are broadly two ways of getting the user profile. One is to somehow give an incentive to the user to reveal his or her profile. This is difficult and costly as the users have an incentive to misrepresent who they are. The other is to opportunistically build the user profile by keeping track of what matters are of interest to the user. This is more accurate and I will call this method the “revealed preference” method of user profiling.

The revealed preference method is really an analog of the method that is used on radio and TV. The users subscribe to certain published content on the mobile web. The mobile web is an analog of the more familiar www with the important distinction that the mobile phone is the access device not the PC. So if publishers publish interesting content, and users choose which content streams to subscribe to, then once again advertiser and users can meet around those content watering holes.

That is what the whole (watering hole?) idea behind what Rajesh Jain calls the “publish subscribe mobile web.”

Prediction

To end this rather long piece, allow me to make a prediction. In the not too distant future, we will have the freedom to choose whether we wish to pay for our mobile calls or have it free. Soon enough we will be given a free mobile phone and be allowed to make and receive calls for free provided we are willing to pay with our attention to short advertising messages while using these phone. For instance, when we answer or make a call, before we get connected, we will hear the advertising message. This message will more than likely be of some interest to us because the advertiser would have information about who we are based on what content we subscribe to from the ocean of published content.

As for me, I will probably just choose to pay for my mobile calls and avoid the advertisements. I just don’t need any more information. My brain is bursting with too much information already.

To put a nice twist to the story, what if I am also concerned about equity? That is, although I have only one object X, I don’t want to be unfair to the other two who will not get the object X. What is the best way—the mechanism—to resolve this issue?

Of course, the answer changes if I don’t wish to give more than just the object X, as opposed to the case where I am willing to give more than X just for the sake of being fair to all three.

Finally, a real world situation. My siblings and I have inherited our parents’ property. The eldest occupies it, but the other three (including me), are waiting for our share. What is the most economically efficient way to distribute the value of the property if the property itself is indivisible?

Your views are solicited. Let’s see if we can find answers to the questions that we find satisfactory. And if we do, perhaps we will understand a little more about the question of how economies work. That is the beauty of economics. From seemingly trivial—though interesting—questions, one can gain insight into larger questions.

POST SCRIPT: I made the mistake of putting two entirely different scenarios on the same post. So there is much confusion. I wish to clarify that the “efficient allocation of an object X” is a seperate matter from the “fair and efficient distribution of an indivisible inherited property.” Conflating the two was not my intention.

Next day, the economist buys the paper. Across the front page is splashed: “CHICAGOITE KILLS FAMILY PET!”

[Source: Mises.org]

Milton Friedman, economist, died at the age of 94 on Nov 16th. To note the passing of that intellectual giant of the 20th century, here are a couple of extracts from an address by him titled “ECONOMIC FREEDOM, HUMAN FREEDOM, POLITICAL FREEDOM” delivered on Nov 8th, 2002.

In addition to economic freedom, Hong Kong has a great deal of human freedom. I have visited many times and I have never seen any evidence of suppression of freedom of speech, freedom of the press, or any other human freedom that we regard as important.

However, in one respect Hong Kong has no freedom whatsoever. It has no political freedom. The Chinese who fled to Hong Kong were not free people. They were refugees from the communist regime and they themselves had been citizens of a regime that was very far from a free society. They did not choose freedom; it was imposed on them. It was imposed on them by outside forces. Hong Kong was governed by officials of the British Colonial Office, not by selfchosen representatives. In the past couple of years, in trying to persuade the world that Britain has not done a dastardly deed in turning Hong Kong over to the communists, the British administration has tried to institute a legislative council and to give some evidence of political representation. However, in general, over the whole of that period, there has been essentially no direct political representa tion.

That brings out an enormous paradox, the one that as I said caused me to rethink the relationship among different kinds of freedom. The British colonies that were given their political freedom after World War II have for the most part destroyed the other freedoms. Similarly, at the very time officials of the British Colonial Office were imposing economic freedom on Hong Kong, at home in Britain a socialist government was imposing socialism on Britain. Perhaps they sent the backward people out to Hong Kong to get rid of them. It shows how complex the relationship is between economic freedom and political freedom, and human freedom and political freedom. Indeed, it suggests that while economic freedom facilitates political freedom, political freedom, once established, has a tendency to destroy economic freedom.

Consider the example that I believe is most fascinating, India. It was given its political freedom by Britain over forty years ago. It has continued, with rare exceptions, to be a political democracy. It has continued to be a country where people are governed by representatives chosen at the ballot box, but it has had very little economic freedom and very limited human freedom. On the economic side, it has had extensive controls over exports and imports, over foreign exchange, over prices, over wages. There have been some reforms in the past year or so, but until recently you could not establish any kind of enterprise without getting a license from the government. The effect of such centralized control of the economy has been that the standard of life for the great bulk of the Indians is no higher today than it was forty years ago when India was given its political freedom.

The situation is even more extreme if you consider that Hong Kong, which I started with, got zero foreign aid during its growth. India has been a major recipient; it got some $55 billion of foreign aid over the past forty years. It is tempting to say that India failed to grow despite foreign aid. I believe that it was the other way: in part, India failed to grow because of foreign aid. Foreign aid provided the resources that enabled the government to impose the kind of economic policies it did.

What is true for India is true much more broadly. Foreign aid has done far more harm to the countries we have given it to than it has done good. Why? Because in every case, foreign aid has strengthened governments that were already too powerful. Mozambique, Tanzania, and many another African country testify to the same effect as India.

To come back to Hong Kong, the only reason it did not get its political freedom is because the local people did not want political freedom. They knew very well that that meant the Chinese communists would take them over. In a curious way, the existence of the Chinese communist government was the major protection of the economic and human freedoms that Hong Kong enjoyed. Quite a paradoxical situation.

Hong Kong is by no means unique. Wherever the market plays a significant role, whether you have political freedom or not, human freedoms are more widespread and more extensive than where the market does not play any role. The totalitarian countries completely suppressed the market and also had the least human freedom.

[Emphasis added.]

It just makes one wonder: it is easier to achieve political freedom than to achieve economic freedom, as is clear in India’s case. Here’s more from Friedman. Note especially that markets can be free, not just private.

In order to understand the paradox that economic freedom produces political freedom but political freedom may destroy economic freedom, it is important to recognize that free private markets have a far broader meaning than the usual restriction to narrowly economic transactions. Literally, a market is simply a place where people meet, where people get together to make deals with one another. Every country has a market. At its most extreme totalitarian stage Russia had a market. But there are different kinds of markets. A private market is one in which the people making deals are making them either on their own behalf or as agents for identifiable individuals rather than as agents of governments. In the Russian market, the market existed and deals were being made all over the lot, but people were dealing with one another not on their own behalf, not as representatives for other identifiable individuals, but supposedly as agents for the government, for the public at large. A private market is very different from a government market. In a strictly private market, all the deals are between individuals acting in their own interest or as agents for other identifiable individuals.

Finally, you can have a private market, but it may or may not be a free market. The question is whether all the deals are strictly voluntary. In a free private market, all the deals are strictly voluntary. Many of the cases of private markets that I cited before were not cases of free private markets. You have a private market in many of the Latin American countries, but they are not free private markets. You have a private market in India, but it is not a free private market because many voluntary deals are not permitted. An individual can deal with anotherto exchange a good or service only if he has the permission of the government. I may say a completely free private market exists nowhere in the world. Hong Kong is perhaps the closest approximation to it. However, almost everywhere what you have, at best, is a partly free, largely hampered, private market.

A free private market is a mechanism for achieving voluntary cooperation among people. It applies to any human activity, not simply to economic transactions. We are speaking a language. Where did that language come from? Did some government entity construct the language and instruct people to use it? Was there some government commission that developed the rules of grammar? No, the language we speak developed through a free private market. People communicated with one another, they wanted to talk with one another, the words they used gradually came to be one thing rather than another, and the grammar came to be one thing rather than another entirely as a result of free voluntary exchange.

Take another example, science. How did we develop the complicated structure of physics, economics, what will you? Again, it was developed and continues to develop as a result of a free private market in which scientists communicate with one another, exchange information with one another, because both parties to any exchange want to benefit.

A characteristic feature of a free private market is that all parties to a transaction believe that they are going to be better off by that transaction. It is not a zero sum game in which some can benefit only at the expense of others. It is a situation in which everybody thinks he is going to be better off.

A free private market is a mechanism for enabling a complex structure of cooperation to arise as an unintended consequence of Adam Smith’s invisible hand, without any deliberate design. A free private market involves the absence of coercion. People deal with one another voluntarily, not because somebody tells them to or forces them to. It does not follow that the people who engage in these deals like one another, or know one another, or have any interest in one another. They may hate one another. Everyone of us, everyday without recognizing it, engages in deals with people all over the world whom we do not know and who do not know us. No super planning agency is telling them to produce something for us. They may be of a different religion, a different color, a different race. The farmer who grows wheat is not interested in whether it is going to be bought by somebody who is black or white, somebody who is Catholic or Protestant; and the person who buys the wheat is not concerned about whether the person who grew it was white or black, Catholic or Protestant. So the essence of a free private market is that it is a situation in which everybody deals with one another because he or she believes he or she will be better off.

The essence of human freedom as of a free private market, is freedom of people to make their own decisions so long as they do not prevent anybody else from doing the same thing. That makes clear, l think, why free private markets are so closely related to human freedom. It is the only mechanism that permits a complex interrelated society to be organized from the bottom up rather than the top down. However, it also makes clear why free societies are so rare. Free societies restrain power. They make it very hard for bad people to do harm, but they also make it very hard for good people to do good. Implicitly or explicitly, most opponents of freedom believe that they know what is good for other people better than other people know for themselves, and they want the power to make people do what is really good for them.

The recent absolutely remarkable phenomenon of the collapse of communism in Eastern Europe raises in acute form the issues that we have been discussing. There is much talk in those countries about moving to a free market, but so far very limited success. In the past, free markets have developed in all sorts of ways out of feudalism, out of military juntas, out of autocracy and mostly they have developed by accident rather than by design. It was a pure accident that Hong Kong achieved a free market. Insofar as anyone designed it, it was the colonial officials who were sent there; but it was a pure accident that they were favorable to, or at least not hostile to, a free market. It was an accident that a free market developed in the United States, nothing natural about it. We might very well have gone down a very different road. We started to go down a very different road in the 1830s when there was widespread governmental activity in the building of canals, in the building of toll ways, and the taking over of banks there were state banks in Ohio, Illinois, and so on. What happened is that in the Panic of 1837 they all went broke, and that destroyed people’s belief that the way to run a country was by government. That had a great deal to do with the subsequent widespread belief that small government was the best government.

While free societies have developed by accident in many different ways, there is so far no example of a totalitarian country that has successfully converted to a free society. That is why what is going on in Eastern Europe is so exciting. We are witnessing something that we have not seen before. We know and they know what needs to be done. It is very simple. I tell the people in Eastern Europe when I see them that I can tell them what to do in three words: privatize, privatize, privatize. The problem is to have the political will to do so, and to do so promptly. It is going to be exciting to see whether they can do so.

However, the point that impresses me now and that I want to emphasize is that the problem is not only for them but for us. They have as much to teach us as we have to teach them. What was their problem under communism? Too big, too intrusive, too powerful a government. I ask you, what is our problem in the United States today? We have a relatively free system. This is a great country and has a great deal of freedom, but we are losing our freedom. We are living on our capital in considerable measure. This country was built up during 150 years and more in which government played a very small role. As late as 1929, total government spending in the United States never exceeded about 12% of the national incomeabout the same fraction as in Hong Kong in recent years. Federal government spending was about 3 to 4% of the national income except at the time of the Civil War and World War I. Half of that went for the military and half for everything else. State and local governments spent about twice as much. Again, local governments spent more than state governments. In the period between then and now, the situation has changed drastically. Total government spending, as I said, is 43% of national income, and two-thirds of that is federal.

Moreover, in addition to what government spends directly, it exercises extensive control over the deals that people can make in the private market. It prevents you from buying sugar in the cheapest market; it forces you to pay twice the world price for sugar. It forces enterprises to meet all sorts of requirements about wages, hours, anti-pollution standards, and so on and on. Many of these may be good, but they are government dictation of how the resources shall be used. To put it in one word that should be familiar to us by now, it is socialist.

The United States today is more than 50% socialist in terms of the fraction of our resources that are controlled by the government. Fortunately, socialism is so inefficient that it does not control 50% of our lives. Fortunately, most of that is wasted. People worry about government waste; I don’t. I just shudder at what would happen to freedom in this country if the government were efficient in spending our money. The really fascinating thing is that our private sector has been so effective, so efficient, that it has been able to produce a standard of life that is the envy of the rest of the world on the basis of less than half the resources available to all of us.

The major problems that face this country all derive from too much socialism. If you consider our educational system at the elementary and secondary level, government spending per pupil has more than tripled over the past thirty years in real terms after allowing for inflation, yet test scores keep declining, dropout rates are high, and functional illiteracy is widespread. Why should that be a surprise? Schooling at the elementary and secondary level is the largest socialist enterprise in the United States next to the military. Now why should we be better at socialism than the Russians? In fact, they ought to be better; they have had more practice at it. If you consider medical care, which is another major problem now, total spending on medical care has gone from 4% of the national income to 13%, and more than half of that increase has been in the form of government spending. Costs have multiplied and it is reasonably clear that output has not gone up in anything like the same ratio. Our automobile industry can produce all the cars anybody wants to drive and is prepared to pay for. They do not seem to have any difficulty, but our government cannot produce the roads for us to drive on. The aviation industry can produce the planes, the airlines can get the pilots, but the government somehow cannot provide the landing strips and the air traffic controllers. I challenge anybody to name a major problem in the United States that does not derive from excessive government.

Can we extend the challenge to cover India as well?

Crime has been going up, our prisons are overcrowded, our inner cities are becoming unlivable all as a consequence of good intentions gone awry, the good intentions in this case being to prevent the misuse of drugs. The results: very little if any reduction in the use of drugs but a great many innocent victims. The harm which is being done by that program is far greater than any conceivable good. And the harm is not being done only at home. What business do we have destroying other countries such as Colombia because we cannot enforce our laws?

It is hard to be optimistic about how successful we can be in preserving our relatively free system. The collapse of the communist states in Eastern Europe was the occasion for a great deal of self congratulation on our part. It introduced an element of complacency and smugness. We all said, ” Oh my, how good we are! See, we must be doing everything right.” But we did not learn the lesson that they had to teach us, and that lesson is that government has very real functions, but if it wanders beyond those functions and goes too far, it tends to destroy human and economic freedom.

And here is the most important part that we all need to understand very very clearly.

I am nonetheless a long term optimist. I believe that the United States is a great country and that our problems do not arise from the people as such. They arise from the structure of our government. We are being misgoverned in all these areas but not because of bad motives or bad people. The people who run our government are the same kind of people as the people outside it. We mislead ourselves if we think we are going to correct the situation by electing the right people to government. We will elect the right people and when they get to Washington they will do the wrong things. You and I would; I am not saying that there is anything special about them.

The important point is that we in our private lives and they in their governmental lives are all moved by the same incentive: to promote our own self interest. Armen Alchian once made a very important comment. He said, “You know, there is one thing you can trust everybody to do. You can trust everybody to put his interest above yours.” That goes for those of us in the private sector; that goes for people in the government sector. The difference between the two is not in the people; it is not in the incentives. It is in what it is in the self interest for different people to do. In the private economy, so long as we keep a free private market, one party to a deal can only benefit if the other party also benefits. There is no way in which you can satisfy your needs at the expense of somebody else. In the government market, there is another recourse. If you start a program that is a failure and you are in the private market, the only way you can keep it going is by digging into your own pocket. That is your bottom line. However, if you are in the government, you have another recourse. With perfectly good intentions and good will nobody likes to say “I was wrong”. You can say, “Oh, the only reason it is a failure is because we haven’t done enough. The only reason the drug program is a failure is because we haven’t spent enough money on it.” And it does not have to be your own money. You have a very different bottom line. If you are persuasive enough, or if you have enough control over power, you can increase spending on your program at the expense of the taxpayer. That is why a private project that is a failure is closed down while a government project that is a failure is expanded.

The only way we are really going to change things is by changing the political structure. The most hopeful thing I see on that side is the great public pressure at the moment for term limits. That would be a truly fundamental change.

I want to close on a slightly optimistic note. About 200 years ago, an English newspaper wrote: “There are 775,300,000 people in the World. Of these, arbitrary governments command 741,800,000 and the free ones … Only 33 1/2 million… On the whole, slaves are three and twenty times more numerous than men enjoying, in any tolerable degree, the rights of human nature” [cited in Forrest McDonald, Novus Ordo Seclorum (Lawrence: University Press of Kansas, 1985), p.9]. I know of no such precise estimate for the present, but I made a rough estimate on the basis of the freedom surveys of Freedom House. I estimate that, while slaves still greatly outnumber free people, the ratio has fallen in the past two centuries from 23 to 1 to about 3 to 1. We are still very far from our goal of a completely free world, but, on the scale of historical time, that is amazing progressmore in the past two centuries than in the prior two millennia. Let’s hope and work to make sure that that keeps up. Thank you.

Thank you and goodbye, Prof Milton Friedman.

One day, a kind-hearted guy says to the village idiot, “You know, although a nickel is larger than a dime, it is only worth half a dime. You should pick up the dime.” The idiot says, “I know that. But if I pick up the dime, people would stop offering me the choice between taking a nickel or a dime, wouldn’t they? Who would be that stupid?”

What brought this joke to mind, you may ask. Well, yesterday I carelessly picked up the Sunday Times (the Sunday edition of the Slimes Times of India) and read a column that made me wonder if some village is missing its idiot. Surely, I said to myself, there is no such job description as the “Resident Idiot Columnist” for newspapers, unlike the well-known traditional job of “Village Idiot.” All was not right with the world when some village is missing its required idiot on the one hand, and on the other hand, there is a regular idiot’s column in a newspaper. It is not natural, I mused as I sipped my morning cup of coffee.

Is there is a point to all this, you ask. Yes, I was coming to that. And the point isn’t that one should not read the Sunday Slimes Times, nor that newspapers should not have resident idiot columnists. The matter I wish to discuss is rather serious: what exactly are the advantages of being a village idiot? The advantage is simple: you get offered a choice and you make a nickel out of the deal. So there: if you are a village idiot, you make a nickel, and which avenue for earning is not available to a person with average intelligence. That is the advantage of being an idiot.

Ah, I see that you are not very persuaded about this devilishly clever scheme of making a living. So I guess you will not be too persuaded about the sneakily brilliant tactic of being dirt poor so that you can make dirt poor wages as a result of globalization, as our favorite columnist recommends in his brilliantly argued piece called “The Advantages of Poverty”.

It is tiresome to have to point out idiocy and I don’t want this blog to be “Responding to Idiotonomics All the Time.” The last time I pointed out at great length the idiocy of claiming that the demographic dividend justifies uncontrolled breeding (see Demographic Cognitive Dissonance). I thought it was a one-time deal and it was fun poking fun at the guy who wrote it. But I should not make it a habit of skewering the guy regularly on this blog – unless of course there are other reasons for demonstrating what exactly is wrong with his argument. Of course there has to be something wrong first.

That is the point. One can argue against a guy who is wrong. But what if the guy is not even wrong. At one end of the scale is “right” and at the other end is “wrong.” But what if the guy is so off the scale that he is not even wrong? Even getting him on to the scale is going to be an uphill task, leave along dragging him to the “right” end of the scale.

Sometimes one just has to give up and be content to let villages with missing idiots be.

Perhaps, one conjectures, that the per capita availability of resources has something to do with the killing sprees that last decades in Burundi, with the Tutsi and Hutus slaughtering each other. It could be nature’s way of redressing the imbalance between people and resources. But I digress.

Canada’s GDP is around US$ 1 trillion and Burundi’s around US$ 0.74 billion. Per capita, Canadians earn about 300 times as much as Burundians. I don’t have an estimate of wealth differentials, but I would guess that Canadians are about 10,000 times wealthier than Burundians. I base this conjecture on the fact that if your income is consistently high over a long period, you end up with lots of accumulated wealth.

Burundi is tiny compared to Canada in terms of wealth and income. The only reason I started comparing them because in the CIA fact book tables, they appear close to each other. India, on the other hand, is not tiny. With nearly 200 times the population of Burundi, India’s GDP is US$ 735 billion. Still India’s GDP is lower than Canada’s even though India’s population is about 30 times Canada’s. Considering that India is about a third of the size of Canada, India’s population density is about 100 times that of Canada. However, around 55 percent of India’s land is arable (compared to only 5 percent for Canada); so per capita arable land in Canada is only 10 times that of India.

India has population/resource imbalance problems, of course, but not as acute as that of Burundi. This could explain at least in part why India is conflict free relative to Burundi. Of course, one cannot discount the pacific nature of the dominant ethic in keeping conflict at bay in India.

If you think about it, of the three countries, Canada is the “cheapest” and Burundi the “costliest” country, with India in the middle. Having lived in California (pretty place but not as cold as Canada) for many years, I often find myself recoiling with sticker shock in India. I find Indian prices totally unbelievable.

But naiveté induced shock is soon reconciled with reason, and it goes thus: of course, India is expensive. That is just another way of stating that people in India are poor. You are poor if you cannot afford stuff. Which means that the prices you face are too high for you to buy stuff. Therefore you are poor. Simple enough but misunderstood by many reasonably bright people.

I keep hearing “India is cheap” from people who are going around comparing some Indian prices while carrying US dollars in their pockets. But Indians don’t carry around dollars. They carry Indian rupees when they go to the market. To an American some stuff (and only some stuff) may be cheap in India. But then if the American is Bill Gates, everything is cheap. It is not the subjective experience of a person that I am concerned with here. I am concerned with whether the prices that a person faces in India is objectively higher than the prices a person faces in, say, Canada. Since prices one pays translate to costs one bears, it is important to measure costs to understand what it means that India is more costly than Canada.

I think I have figured out an objective measure of the cost of living. I will present that the next time.

[Continued in Part 2.]

What the heck do economists do is a question that does not baffle many people because they “know” what economists do. I know it did not baffle me. I was not taught economics in high school, and had an entirely forgettable few lectures ostensibly on economics sometime during my undergraduate in engineering. Given this ignorance, I had a vague notion that economics had something to do with money. I think I conflated economists with finance people and accountants. But I was not baffled because I was too ignorant.

Later, while reading popular non-fiction works related to ecology and economics, I slowly got introduced to the writings of economists. It started dawning on me that fundamentally economists study human behavior. Money is important but not central to the study of economics, I realized. Economists come in all different shapes and sizes and they provide various functions in an economy, just as doctors come in a wide variety of types and provide a range of functions in the theory and practice of medicine.

There are doctors who do pediatry, and there are doctors who do general practice, and there are surgeons, and there are cardiologists, and so on. Then there are institutions which have something to do with medicine such as hospitals, which employ doctors but they also employ accountants and administrators. Every one who works in the medical industry is not a medical doctor.

I think confusing economists with financial people and accountants is like mixing up doctors, pharmacists, and hospital administrators. Some economists work for banks and financial institutions, and so on. But that is not all that economists do by a very long shot. Also, some study aggregate national-level statistics of course (employment rate, inflation, GDP) and that is what is reported in the popular press. Perhaps this can explain the popular misconception regarding what economists do.

So the question is what exactly do economists do. The short and trivial answer is economists do economics. And the circularity involved in defining economics as what economists do does not help at all. Paul Samuelson’s definition of economics in his famous textbook Economics is a good place to start understanding what economics is.

Economics is the study of how people and society end up choosing, with or without the use of money, to employ scarce productive resources that could have alternative uses–to produce various commodities and distribute them for consumption, now or in the future, among various persons and groups in society. Economics analyzes the costs and the benefits of improving patterns of resource use.

Studying people exercising choice is what makes economics a study of behavior. Behavior – both human and non-human – has to do with rewards and punishments, gains and losses, in other words incentives. To some, the broadest generalizations that a study of economics leads to are, first, incentives matter, and second, markets work. The rest of economics is an elaboration and detailed arguments about those two generalizations. Recalls to mind what Ernest Rutherford had said about physics: “All science is either physics or stamp collecting.” That is, physics is central and the other bits of science are just a collection of facts that are peripheral and mere detail that one should not be overly concerned with.

Economics is all about codified common sense. I think that is what draws me to economics: I like common sense and I am appalled at the lack of common sense I see around the world. Setting aside the question of why common sense is called such when it is so uncommon, one may ask why economics is difficult if what it concerns itself with is apparently so commonsensical. I think it is difficult because its simplicity is deceptive.

To most bright people, the lessons of economics appear obvious and trivially true. The mathematician Stanislaw Ulam once asked Samuelson if there was anything in economics that was both non-obvious and true. Samuelson took several years to arrive at the answer that it was the theory of “comparative advantage.” He said, “That it is logically true need not be argued before a mathematician; that is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.” [Reference]

I have argued that the most important concept that underlies the lessons of economics is the notion of “opportunity costs” and that that is a fundamental feature of the universe which follows from the nature of time. Using the notion of opportunity cost, you can even support the central idea of comparative advantage and consequently the idea that trade is beneficial and thus support the idea that markets work and incentives matter, and so on.

Among the social sciences, economics appears to have great explanatory power, and holds the analogous position as physics does among the hard sciences. Economics has an explanation of pretty much any social phenomena. Once you know to how to reason economically, it all becomes obvious.

By reasoning economically, I mean two different things. First, the parsimony of the explanation. That is, what are the least restrictive set of assumptions one can make and yet derive a system which has explanatory and predictive power. Second, the reasoning based on a sound understanding of the basic principles of economics.

There is a very good reason to study economics: so that we can understand why the system is the way it is, and what it ought to be. We call the former positive analysis and the latter normative. The “is-ought” gap can be bridged only if one understands the nature of the economics universe. Otherwise one can end up meddling in a system one does not fully comprehend and behave like the monkey who tried to save a fish from drowning by putting it up on a tree.

Gautama, the Buddha, had enunciated the general truth that suffering arises from ignorance. A particular instance of that principle is that the suffering arising from the present state of our economy arises from the ignorance of those who have so far directed it. And as long as ignorant monkeys rule, we the fish will be constantly in danger of being saved from drowning.

Related post: How to Study Economics.

Each of us has a unique learning style, of course. Here is mine.

Learning economics better requires reading. But here is the rub: one could read disjointed stuff on the web all day long and still not understand what it is all about. In fact, reading too much on the subject which is more in the “news” category is detrimental to understanding. Even reading the Economist will not help one understand economics any more than reading a lot of hospital news will teach one much about medicine.

My recommendation would be to start off with a decent undergrad textbook on micro theory first and read it very carefully. Then pick up another decent undergrad textbook on micro theory and read it very carefully. This will take less time. Then pick up another decent undergrad textbook on micro and read it very carefully. This will be very quick. Now you graduate to reading a decent undergrad macro textbook and do the same. Then read a book which has an overview of economics as a field: let’s say “Economics Explained” by Thurow and Heilbroner. Read something by Galbraith.

The point is that reading textbooks teaches you vocabulary. Vocabulary — precise meanings of words — is important because otherwise you cannot reason in the discipline. After you have learnt the vocabulary, you can read and comprehend sentences and paragraphs and thus follow an argument and figure out whether that argument makes sense or not. And more importantly, if you have the vocabulary, you will be able to figure out things for yourself and not just that, you will be able to express your point of view precisely for others to follow.

I stress reading different textbooks on the same topic because each author has a different point of view. When you approach a subject — however seemingly simple — from different directions, you get a multi-dimensional understanding. Like the proverbial blind men’s description of the elephant needs to be integrated to get a better understanding of what an elephant is, you need to integrate a set of different viewpoints to arrive at a better approximation of the subject.

Now here is something that works for me. If I have 8 hours of study time for a specific topic, I read for about 4 hours on the topic at most. The rest of the time, I just sit and turn the ideas over in my head. During this “processing time” I just let my mind wander around the topic. Directed day-dreaming. How does it fit in with all that I know? How does it change what I already know? What implications does it have for other ideas? And so on.

If you take the time to think, you will understand. If you are doing stuff all the time, then you don’t have time to think and end not understanding and you may end up doing all sorts of silly things. So my advice is to read a little, think a lot, and as far as possible avoid doing much at all.

Related post: Reasoning Economically.

In brief, REGS does not increase the aggregate production of the economy, nor does it increase productive capacity; it merely redistributes incomes by giving money to those in the rural areas. The first order effect of this diversion of resources is that other projects which have the potential to increase production and increase productive capacity do not get done; that is, the opportunity cost of the REGS is very high. The second order effects are increased public corruption, making the population much more dependent, increasing population, etc. This means in the future, the economy will produce much less than it would have otherwise produced and thus more people would face poverty as a result of the REGS .The rest of this essay is an elaboration of this argument.

Reasoning from the basics, first we must understand what the words poverty, income, employment, and production mean and how they are related to each other. Given the widespread confusion of these basic words, it is not surprising that the reasoning comes out all warped and some rather silly notions are entertained by supposedly sane people.

Poverty is lack of income, fundamentally and essentially. Income is real and is not to be confused with money which is nominal. The confusion between income and money happens because income is denominated in money terms. One can have income without having money. For instance in a Robinson Crusoe economy, Robinson’s income is what he gathers from the forest and the sea, farms and manufactures through his labor. Income is the real stuff that he can eat, and wear, and save. The seeds he saves for the next season’s plantings are his investments. Whether Robinson is poverty stricken or not depends entirely upon how much stuff he produces through his labor, and what he gets without having to exert any labor such as coconuts falling of their own on his head.

A Robinson Crusoe economy is a simplified model of a real economy. In the RC economy, there are natural resources such as the ocean and forests (land), Robinson’s ability to do work (labor), a few tools (capital), and Robinson’s knowledge of how to do things such as making a fire, planting corn, making bread (technology). Robinson is the capitalist who owns the means of production. He supplies the labor, and he gets paid wages which are his income. Depending upon how good his technology is – such as knowing when to plant what, or how to make a fishing net; and how much labor he supplies – or how much leisure he enjoys; and how much of his income he consumes and how much he saves for future investment; and how good his tools are, all add up to a steady stream of stuff that is available to him and that is his income. If the amount of stuff he produces plus what nature gives to him without his exertions is below a certain level, he is poverty stricken.

Robinson could be fabulously wealthy without ever lifting a finger if nature provided all the goods he needed. That is, he would be totally unemployed and still not be poor because he would have an income without so much as moving out of his hammock. On the other hand, he could be toiling day and night and be fully employed 24/7 and yet produce so little stuff that he lives in dire poverty. You could be unemployed and rich if you get gifts, or you could be employed and yet be poor if you produce too little. To conclude this bit, poverty is lack of income, and income is stuff that you get to consume – whether it was produced by your labor or not.

Now getting back to the real economy, you have one major difference with the RC economy: the real economy has more people. All other bits remain the same. Income to a person then is that person’s share of the total amount of stuff produced in the economy. How he is apportioned his share of the total production of the economy – that is his income – is a matter that is determined by various factors. For example, he could own machines, which other people use to produce stuff and in exchange they give him some of the stuff produced. He then is a capitalist and enjoys an income without working. He is “unemployed” but not poor. Or he could be a laborer who works in a farm and gets to keep what he produces, or he could be a programmer and gets paid money which he uses to buy stuff. Or he could be just a bum and the government gives him a handout every month.

So here is absolute bottom line: people are poor when their incomes are below a certain level, irrespective of whether they are employed or not, whether they have money or not. Now the reason that a person’s income is low could be because the economy as a whole produces too little relative to the number of people among whom the production has to be distributed (the production-population imbalance), or it could be that the economy produces a huge amount of stuff but the person for some reason is unable to receive his fair share of the production (the production-distribution imbalance.) Of course, you could have combinations of the above two to get inadequate production coupled with poor distribution.

Just to underline one point that we need to keep in mind: no one, including me, wants employment; we want an income. Employment is a means to the end—the income—and not an end in itself. If we did not have to be employed but received an income, we would be free to enjoy leisure in which we could do what we pleased, from programming computers to raising corn or digging ditches. I would be happy to let robots create all the stuff that I need so that I can spend the entire time eating with nice people, drinking with nice people, and sleeping with nice people with a contented mind.

So far we have been trying to get the vocabulary straight. Now that I am done with the vocabulary bit, we can start to reason about the problem with REGS.

India has a poverty problem because some people have incomes far below what is considered adequate for a decent human existence. It is not an employment problem, it is an income problem. Guaranteeing employment when the actual guarantee should be income is asininity of degree one.

How one goes about solving a problem depends on the nature of the problem. Is the enormous poverty in India due to the production-population imbalance (too many people, too little stuff produced) or is it due to the production-distribution imbalance (enough stuff but badly distributed)? Let’s do some arithmetic.

India’s per capita production per year of stuff denominated in money terms is US$500 or so; that is, between a dollar and two dollars a day per head. (Let’s not go into the PPP measure of income which needlessly muddies the matter; it requires a separate chapter to fix that confusion.) Clearly India suffers inadequate aggregate production because even if that was distributed perfectly evenly, each one of the more than billion people of India would be desperately poor. While maldistribution of this inadequate aggregate production seriously compounds the problem that the poorest face, clearly the more fundamental problem is that India just does not produce enough for the population that it has to support.

Indians are poor because India’s aggregate production is inadequate and therefore the solution has to begin with increasing production. Let me repeat that: we don’t need increased employment; we need increased production. And only after having produced more, we need to distribute that production better so that those who have little income can get more. Any policy which increases employment and which decreases aggregate income is therefore the most insane policy that an economy can have. It is my contention that the REGS increases employment and decreases aggregate income. And that will lead to increased poverty, as I argue below.

The REGS aims to increase employment alone and is not aimed at increasing either production or production capacity. The REGS terms state that laborers cannot use any labor saving devices if they are being paid under the scheme. Basically, if a large hole needs to be dug, you could employ one person to use a mechanical shovel and do the job. Or you could have 100 people use hand-held shovels and do it. Or you could employ 1000 with tablespoons, or 10,000 people with toothpicks to do the job. In the end only one hole gets dug but you employ more people. If by digging the hole we increase our aggregate production of stuff by Rs 1000, then the income from the employment per capita is Rs 10 per shovel-wielding worker, Rs 1 per person with a tablespoon, etc.

If the REGS does not increase the amount of stuff produced, then it essentially is an income transfer scheme. If the economy was already producing what it needed to produce, and all it needed was proper distribution of the production, then an income transfer scheme is great. Otherwise, it is better to use the labor to increase production and use the increased production to raise the incomes of those who are poor.

If there are projects that are worthwhile – that is, they increase the production of stuff or increase the capital stock – then these should be undertaken and the labor needed employed. I take it for granted that India has such projects, from building the infrastructure to educating its masses. Resources are required for these projects. The opportunity cost of diverting resources (around Rs 50,000 crores, or $10 billion a year) to schemes that essentially produce nothing nor add capacity is the value of projects that will not get done as a result.

For $10 billion, for instance, you could educate the hundreds of millions who need basic literacy and numeracy. There are enormous benefits to doing this which otherwise don’t arise when you are merely using labor to dig holes in the ground using bare hands.

There are other insidious effects of the REGS. First, it makes the people dependent on the government. Everyone cannot live on handouts – someone has to produce stuff. Handouts depress initiative and drive. Second, it increases the opportunities for bureaucratic and political corruption. Third, sets a precedent for political parties to continue to make irresponsible promises to people to win elections. Fourth, it will compound the population problem because increased incomes at the subsistence level increases fertility.

In conclusion, the economy needs to produce more stuff if it has to lift people out of poverty. Stuff gets produced by intelligently combining land, labor, and capital on projects that are efficient and have strong backward and forward linkages. Digging holes in the ground bare handed does not make any real difference. The REGS guarantees further poverty.

Very broadly speaking, here is a thumb-rule I use to figure out what factors led to the Indian economic growth 1980s onwards. List every policy—domestic, international, industrial, education, health, banking, etc—that Nehru and his descendents imposed on the economy. Systematically reverse the policy and as you do so, you see the economy accelerating. In other words, if your goal is to create a set of policies that would ensure economic stagnation and deepening poverty of a large economy, the shortest route for you would be wholesale adoption of all the Nehruvian policies. Conversely, the quickest method of figuring out what to do to for economic growth, is to take any component of the Nehruvian policy prescription and apply the reverse.

To the extent that Nehruvian policies have been reversed, India’s economy is prospering. If the economy has not attained its potential growth rate yet, it is because not all of the mindless Nehruvian (but I repeat myself) policies have been discarded yet. I have no doubt that the nation will become slowly wise eventually. How many hundreds of millions will suffer poverty in the meanwhile is a question that is best not contemplated.

What got me thinking about the “Nehru Growth” rate is a recent paper in “IMFstaffpapers: A journal of the IMF” by Rodrik and Subramanian “From ‘Hindu Growth’ to Productivity Surge: The Mystery of the Indian Growth Transition.”

Before anything else, let me address a point about nomenclature. As far as I can tell, Nehru was vehemently anti-Hindu. He was by no stretch of the imagination a Hindu nationalist. So why is the growth rate arising from his policies labeled “Hindu growth” is somewhat of a mystery. After all, Hindus suffered as a result of Nehruvian policies seeing as that they comprise about 80 percent of India’s population. So labeling the Nehru growth rate as “Hindu” is adding insult to injury.

Also, what does it mean that a growth rate is “Hindu”? Does economic growth rate have a religion? We have never heard of the growth rate of the Indian economy in the first half of the 20th century as the “Christian growth” rate, have we? You may ask what was that Christian growth rate: it was negative 2 percent per year on average.

As a Hindu I am offended at the attempt by the Nehruvian apologists at transferring the blame to Hindus for Nehru’s failures. And it is not just Hindus that are the target of the defamation; the religion is at fault. Here is the opening paragraph of the IMF article:

India’s economic performance during the first three decades after independence in 1947 was christened the “Hindu” rate of growth, a term connoting a disappointing but not disastrous outcome and the acquiescence in the present that the religion supposedly imbues, because of its greater emphasis on the hereafter.

I am sure that the authors’ grasp of economics is much better than their feeble grasp on what Hinduism is.

Hindu bashing continues on pg 196 when they write:

A key fact that we establish at the outset of this paper is that the turnaround in this performance—the decisive break with the Hindu past—occurred around 1980 and not in the 1990s as most accounts have it.

I sympathize with the authors’ apparent desire for India to discard its Hindu past. The earlier Pope was much more direct in his condemnation of Hinduism when he publicly declared in India that the area of darkness that is India has to be illuminated by the cross.

The paper does have something of substance once the gratuitous insulting of Hindus and Hinduism is out of the way. The paper is about India’s growth transition which they claim began early in the 1980s rather than in the years following the macroeconomic crisis of 1991. They claim that there was a perception change in the private sector that the government’s attitude towards industrial licensing had changed. This shift resulted in large productivity gains because the economy was far below its income-possibility frontier.

To Rodrik and Subramanian, what is important is not whether the reforms started in the 1980s or not but how it happened. The reforms, they contend, was “probusiness in the sense that they boosted the profits of existing businesses without threatening them with real competition because external barriers remained largely in place” and not “proliberalization.” They make a distinction between probusiness and promarket/procompetition and they claim that the latter has a greater focus on internal reforms and was the approach adopted in the 1990s.

About the reforms of the 1990s, they argue that “[it] may well be that the performance of the 1980s would have run out of steam and that the “true” reforms of the 1990s were essential to keep productivity growth alive.” The conclude:

The reforms of the 1990s were, of course, triggered by the crisis of 1991. The quick rebound fro the crisis has been almost entirely attributed to the decisive break from the dirigiste past. But if the 1980s experience was as successful as we think it might have been in creating a strong base of manufacturing and productivity growth, it is hard not to draw the conclusion that the quick rebound was also rendered possible by the strength of the 1980s performance. In some ways, although India was reforming in response to a macroeconomic crisis, it was reforming from a position of strength in the real sector of the economy.”

I liked the paper by Rodrik and Subramanium. I generally agree with their conclusions. But TN Srinivasan, as a discussant of the paper opens his comments thus:

This is a disappointing paper. It sees a mystery and fails to convince through analysis why it does. Had the authors been familiar with Indian economic literature, they might have note written it! The literature has not only noted the growth acceleration in the 1980s but has also questioned its sustainability on the grounds of its possibly being debt-led and fueled by employment and real wage expansion in the public sector.

TN is always very incisive and rarely minces his words. The comment is worth reading, as is the original paper and the response to the comments by Rodrik and Subramanium. Here is TN at his most generous:

The only new idea in the paper is the anecdotal hypothesis that around 1980 there was an “attitudinal shift” toward private business on the part of the national government,9 which triggered a permanent change in the growth process.

But then he quickly trashes one of the important points that R&S make by writing:

The distinction between promarket and probusiness orientation is overdrawn and incoherent. The authors consider trade liberalization an archetypal market-oriented policy without considering the implication of the facts that trade liberalization covered only imports of intermediate goods and equipment, and that industrial licensing remained in place. Clearly, such liberalization, by allowing greater flexibility in the use of their licensed capacity, favored incumbent producers but not consumers and potential entrants. By the same token, any policy (for example, reduction of corporate taxes) that raises the profits of incumbents also raises those of potential entrants, if they are allowed to enter. In short, the distinction made by the authors has no economic logic behind it.

I think TN is just being contrary for the record. The most surprising line I have recently read belongs to TN when he says that “[a]t independence on August 15, 1947, India had an incorruptible political leadership committed to development and an efficient, independent civil service.” Incorruptible? Possibly. Incompetent? Absolutely. I cannot agree more with his last statement—

By sticking to a dysfunctional development strategy for far too long, India’s policymakers ensured that the Indian economy performed far below its potential and that India’s poor remained poor for an avoidably long time.

Well, that is not the end of that debate, as I said earlier. R&S respond to the comments by TN.

They first note the areas of agreement between TN and them:

(1) India’s economic growth rate rose significantly around 1980, and the pace of economic expansion and productivity increase during the 1980s was on the whole indistinguishable from that experienced during the 1990s. (This may have been well known to economists in India, but it certainly has not been common knowledge among reasonably well informed analysts of economic growth and economic reform elsewhere.)
(2) India’s major liberalizing reforms came after 1991. Before that date, India was a practically closed economy.
(3) While there was some liberalization during the latter part of the 1980s, it was not significant enough to have been the driving force behind the higher growth of the 1980s.
(4) Manufacturing played a key role in the increase in growth in the 1980s.
(5) The quality of India’s institutions can support a much higher level of income than what the country had until recently.

They address TN’s objections of course. I’d like to quote them on the distinction between promarket and probusiness policy orientation:

We are puzzled by the discussant’s claim that the distinction between promarket and probusiness policy orientations is incoherent. It seems to us that the distinction is analytically quite clear, and in practice quite useful. Suharto’s economic policies were probusiness, but hardly promarket. We made clear that policies that would help incumbents without allowing newcomers to share in the increased profitability would count as probusiness rather than promarket. We do not disagree with the discussant’s point that “any policy … which raises the profits of incumbents also raises that of potential entrants, if allowed to enter” (our emphasis), but we maintain that it is possible to enhance incumbents’ profits without allowing entry (a possibility that the discussant himself allows with his qualifier).

One can learn a lot from an academic paper. But for real learning, it is good to follow the debate among serious academics. It is not only instructive, but it is also entertaining.

Just as a followup, I would recommend Brad DeLong’s post on the subject and the comments following it.

Crossposted at IndianEconomy.org.

I have recently, thanks to my colleague Saee at Netcore, added in the right hand column a list of blogs which I read. They are a mixed bunch but have one thing in common: their authors have the good sense to consider me worth reading (ha, ha!) Seriously now, the list is under construction and I would get it all done in a few more days.

Searching for a place to call home is not an easy task. You cannot refer to a directory of places available for rent because there is no such central depository of information. What information exists is fragmented and incomplete. There are listings in local newspapers but you would have to consult many sources published over an extended period. Given space limitations in newspaper classifieds, the information for any specific place is incomplete. You would have to call and/or visit to see for yourself what is on offer. Search costs add up and makes the market for rental housing needlessly inefficient. Where there are information imperfections of this kind, specialized services emerge. Rental property brokers step into the picture as specialized agents bridging information gaps manually.

Brokers have specific areas of the city that they operate in and have inside information on available places. To increase my chances of finding a suitable place, I had to engage through various sources, a set of brokers. Each has about a dozen properties to show. The process is time-consuming and frustrating because of a number of reasons. First, there are numerous levels of indirection. The broker is one link in a network of relationships. Broker A, for example, will call up an intermediate B who will in turn call up C who has the key to the apartment. When you go to see the property, a confluence of events have to occur such as the presence of B and C for you to actually look inside. At places, I have spent over an hour just waiting, while the actual seeing of the place took only about two minutes.

The second reason for the frustration is cultural, the inability to say no. I have a set of very specific criteria about the place I wish to rent. Somehow I get taken to see properties that don’t come anywhere close to what I have clearly stated I want. Why do they do that? Don’t they waste their time as well as mine? There has to be a rational explanation. I conjecture it has to do with conveying an impression that they have earned the commission they charge.

Brokers charge about two months’ rent as commission. If they were to show only those properties that meet the specifications, they would perhaps be able to show only one or two places. If that means you rent a place through a broker after he (or she) shows you only a couple of places, the impression could be that the commission is disproportionate to the work done.

The third reason for the frustration is structural. The market is fragmented. Information which could have been aggregated and made searchable is only present as knowledge in heads of various agents. The asymmetric information—renters don’t have information on the complete set of available properties—gives rise to ‘rent-seeking’ opportunities, the commission charged for the deal. Dis-intermediating in this situation would involve aggregating the information (which is currently held as private knowledge) and making it searchable but would result in a loss of income for those agents.

Imagine, for a moment, a more efficient system. Let’s say there is “Craigs List” type platform where landlords list their properties in detail including pictures of the insides and of the surroundings. The technology exists for making this list accessible and searchable to prospective renters from anywhere in the world at very lost costs. In a few minutes of searching, one identifies a set of properties and invests in going over to check out the places. If such were the case, I would have only seen three properties and spent about half a day. Instead, I have spent four days and seen about a dozen properties only two of which I would even remotely consider renting.

Is there a point in this renting story? Yes, a general point. The availability of technology is only a small part of the story of development. It is a necessary part but very small and far from sufficient. The technology has to be adopted. There are barriers to adoption of technology which go beyond affordability and appropriateness: adopting technology could hurt the entrenched interests of the existing system.

Using a web-based system to remove information asymmetries in most markets would eliminate rents that information brokers (and property rental brokers are information brokers) currently enjoy and therefore they can be relied upon to resist such an efficiency enhancing change. But then you may ask, how does any efficiency enhancing change come about at all when in practically all cases the vested interests would prevent the change? The answer: If the vested interests can find alternate and better roles in the new system, the change can occur. That is, if they can move up the value chain. Even after the implementation of an efficient web-based system, people would be required to help with the creation and maintenance of the list, of vetting prospective renters, etc.

Efficiency implies that less labor would be required, however. So instead of a dozen agents, I would need only one agent. In short, if the market does not expand, then there will be mass unemployment among property agents. But the market may indeed expand, both due to lower transaction costs and due to increasing population of tenants and landlords. Then again, in an expanding economy, there will be other opportunities for those who used to be property brokers. It is an old story repeatedly told: fewer secretaries when printers and word-processors became the norm but more programmers. What you lose on the swings, you gain on the slides.

So what about “Magarpatta City”, you may ask. I was coming to that. Tomorrow, shall we say?

Economic change is a process, and in this book I shall describe the nature of that process. In contrast to Darwinian evolutionary theory, the key to human evolutionary change is the intentionality of the players. The selection mechanisms in Darwinian evolutionary theory are not informed by beliefs about the eventual consequences. In contrast, human evolution is guided by the perceptions of the players; choices — decisions — are made in the light of those perceptions with the intent of producing outcomes downstream that will reduce uncertainty of the organizations — political, economic, and social — in pursuit of their goals. Economic change, therefore, is for the most part a deliberate process shaped by the perceptions of the actors about the consequences of their actions. The perceptions comes from beliefs of the players — the theories they have about the consequences of their actions — beliefs that are typically blended with their preferences.

From Understanding the Process of Economic Change, Princeton University Press, 2005.

The principle that exposure to economics should convey is that of the spontaneous coordination which the market achieves. — James M. Buchanan

The last time I was out having lunch with my economics guru, I pondered the question that is foremost in the minds of most Indians. “What,” I asked the great guru, “explains the shoddy quality of goods and services that one finds in India generally?”

“That I can tell you in one word: competition.”

“How so?” I said. “Isn’t competition supposed to ensure lowest prices, and highest quality instead?”

“Certainly. But you have to remember that a market has two sides to it. There is the supply side. And then there is the demand side. It is the competition in the supply side that ensures high quality and low prices. But if for some reason, there are barriers to entry in the supply side of the market, then you have a problem.

“Here is how it works. Suppose you restrict the entry of firms into the market by decree such as done in the “License Permit Quota Control Raj.” Suppose this leads to low quantities supplied relative to the demand. Then on the demand side, there is competition for the limited quantity supplied. So the quality goes to hell in a hand basket and the price goes up.”

I sort of realized the problem. But I needed a ‘fer-instance.’ “For instance?” I asked.

“Competition in the demand side is what drives out quality and pushes up the price. You do recall that not too long ago, the telephone system was the sole preserve of the government. No private sector firm could enter the market. What was the result? If you wanted a phone, you had to wait for years on end, sometimes as long as eight or ten years. Given the enormous waiting lines, the public sector firms supplying telephony were assured customers who would be willing to put up with shoddy phone service because the demand far exceeded the supply even at the exorbitant prices being charged.

“In those bad old days, you had competition on the demand side. Compare that to today. The competition has shifted to the supply side of the telecommunications market. Now private firms compete with each other to provide phone service. The years of waiting time has been entirely eliminated and now you can get phone service in a matter of hours.”

“Are there any other examples?” I asked.

“Lots and lots. Whenever you see shoddy services or crappy goods, ask yourself where the competition is. You will invariably notice that the competition is on the demand side. Train service? Government monopoly and therefore poor quality. Air transportation? Used to be shoddy but now it is much better because there is at least limited competition.

“Excess supply of goods and services is rarely a problem in over-populated underdeveloped economies; it is always excess demand.”

“So what was the reason for not allowing entry into the markets? Why restrict entry on the supply side in the first place?” I said.

“Greed. If you restrict entry, you have monopoly power. That allows you to collect monopoly rents. Here is how it works. Suppose you want to collect the monopoly rents from, say, the two-wheeler market. You decree that for a firm to manufacture two-wheelers, it has to obtain a license. How much will a manufacturer of two-wheelers be willing to pay for a license to produce and sell them? Almost as much as they will make by charging a high price in a non-competitive marketplace.”

“Who gets these monopoly-like rents? I have not heard of any rule that seeks a hugh license fees from manufacturing licenses,” I said.

“Well, you don’t have to have an explicit rule. You just have discretionary powers as to who you hand them out to. For instance, as the Minister for Two-wheelers (assume there is one), you will hand it out to the firm that pays you a lot of black money and also fills up the coffers of your political party. Corruption of the political process is a handy by-product of the license quota permit control raj.”

“Damn,” I said. “That explains to things in one shot. First, why we have lousy quality high price goods and services. Next it explains why it is so hard to get rid of the license permit quota control raj. Is there a way out?”

“Yes, there is. But it won’t happen till the last politician is strangled with the entrails of the last bureaucrat.”

Some have advocated the creation of a single world disaster relief fund. The Aid Charade by Jody Beihl suggests:

how about creating a single world disaster relief fund. Rather than one-upping each other with bids every time a disaster strikes and competing “beauty-contest-like” for top marks, each country could simply pitch in a yearly amount — say a percentage of their gross national product. The funds could then be drawn on when disaster strikes. That would rid us of what is starting to look like a charade of bidding and perhaps insure that real help comes on time, both when and where it is needed.

The idea is not new, of course. There is nothing is new under the sun. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations (published in 1776) informs us of one such scheme carried out in on a smaller scale. Galbraith is my guide to Adam Smith and he writes:

… were it not for Smith, we might not know that after a bad storm, or “inundation,” the citizens of the Swiss canton of Underwald (Unterwalden) came together in an assembly where each publicly confessed his wealth to the multitude and was then accessed,pro rata, for the repair of the damage.

{Source: The Essential Galbraith (pg 157) Houton Mifflin Company 2001.}

The idea is that of spreading the cost of recovery across the entire population of the globe. A sort of insurance payment where the premium is paid according to the ability to pay of various parties. There are two problems. First, how do you ensure that people pay. Second, what about moral hazard? It is a well-known problem that if one is insured against loss, then one may not exercise due caution and take unnecessary risks. If, for example, the government insures people against flood damage, then people will build on flood-prone areas knowing that they will be bailed out in case of disaster. This is normal human behavior. Moral hazard examples abound. Drivers take more risks in cars which are fitted with air-bags and seat-belts.

I have worked out an ingenious way around the problem of moral hazard. It will have to wait, however. I want at least a few people to buy the book. ***insert appropriate emoticon here***

Remarkable results follow from exploring the idea of opportunity costs. The whole theory of comparative advantage — the fundamental reason why trade is a win-win game — pivots around the idea. One could do worse than to sit and consider opportunity costs whenever one contemplates doing something.

In fact, I would go so far as to claim that economics at its most fundamental is the careful systematic study of opportunity costs. Opportunity costs implies choices and tradeoffs, and is itself the consequence of a fundamental physical characteristic of the universe that we live in. That fundamental fact is that this universe has limits. Each one of us has a limited amount of time and other derivative resources at our disposal.

Economics is about making choices and economic policy is about policy choices. How an economy performs depends on the economic policy choices made by whoever is in charge of making choices. All this should be glaringly obvious and you may have started wondering where all this is leading to. I was coming to that.

The last time I wrote about the craziness of the ICT for development brigade. ICT tools are of course relevant for development in certain cases. But mindlessly applying ICT in each and every place is worse than doing nothing. If you spend scarce resources buying PCs for rural areas, you neglect other more relevant areas where those resources would have helped.

Adult education, for instance, is a crying need in rural India. You can, of course, use a variety of means of achieve that, ranging from blackboard and chalk, to radio and TV, to PCs with literacy software. Examining the economics of the situation could well reveal that blackboard and chalk is the most appropriate means. For a total capital expenditure of Rs 500 and an operating expenditure of Rs 1000 per month, you could make 20 adults literate in 6 months. Per capita cost would then be about Rs 325 (about $7.) Let’s do the numbers if you were to use a PC. Cost of hardware and software Rs. 20,000; power supply for the PC: Rs. 20,000; trained manpower and maintenance per month: Rs 3,000. Total cost: Rs 58,000. Per capita cost: Rs 2,900 (about $65.)

Of course, one could always use the PC for a number of uses, not just adult education. Instead of just educating 20 people, one could use it more intensively by say using it 12 hours a day and thus train 5 batches for a total of 100 people. Still, the PC method would cost Rs 70,000 and the blackboard method will cost Rs 25,000. By using the low-tech method, you save Rs 45,000. Here is an idea. Give Rs 450 as an incentive to the people: become literate for free and when you complete the course, you take home Rs 450. Total cost to the state: Rs 70,000, the same as the high-tech solution. Same expenditure but guaranteed different outcomes.

In the low-tech scheme, you give money to the rural adults. This is an incentive to them and better still, they in turn, spend the money locally which stimulates the local village economy. They buy food perhaps which helps out the farmers. Compare that to the high-tech scheme. The money goes to the manufacturers of hardware and software, which basically means Intel, Microsoft, HP and so on.

I hasten to add that rural India has a wide range of problems. Saying that not all of them are amenable to a high-tech solution also means that there are some problems that are the properly addressed by high-tech solutions. Point to point communcations of all sorts — voice, text, video — are best done using high-tech methods. Compared to carrier pigeons and even POTS (plain old telephone system), wireless WiFi and VOIP (voice over IP) will be cheaper.

Here is the point that I am laboring to make. Here is a simple prescription on how to solve problems.

1. First, identify the problem as precisely as you can. For instance, too many illiterate people in rural areas, for example.
2. Diagnose the problem. This step is most often glossed over. What is the cause of illiteracy? Is it because they do not have PCs? Or is it because they don’t have teachers? Or maybe because they don’t have time to go sit in a class because they have to earn a living by toiling in the fields? Or is it because the upper caste people prevent the lower caste people from going to class?
3. Apply the appropriate remedy that fits the diagnosis of the problem. If it was really a lack of PCs in that village that led to illiteracy, then by all means get those PCs Fedexed immediately. But the vast majority (about 99.99recurring percentage) of humanity has become literate without the aid of PCs. So it is unlikely that the lack of PCs is the cause of the illiteracy. It is more likely something else.

There is nothing wrong with very good headache medicine. But very good headache medicine would do fancy little for you if you have an upset stomach. Psychological counseling is great but will not help a broken car. Administrative problems cannot be solved by technological means any more than casting spells fix a balance of payment deficit.

I am delighted that so many NGOs, pundits, and governments are so gung-ho about the use of ICT for development. More power to them. But if their spending on ICT diverts scarce resources to unproductive silly ill-conceived wasteful exercises, it is a pity that the same sort of idiotcracy still exists that brought the country to the sorry state that we find it in today.

Shariputra asked The Blessed One, “What is the chief lesson that one can learn from a careful study of economics?”

Avalokiteshwara, the Bodhisattva Mahasattva, the Buddha of Infinite Compassion, etc, responded (because the Tathagata often lets others have a go at mundane questions) by saying, “O Shariputra, a careful study of economics reveals to a son or a daughter of a noble family the First Minor Noble Truth.”

Shariputra, the son of a noble family, then asked, “And the First Minor Noble Truth is exactly what?” Then Avalokiteshwara, the Bodhisattva Mahasattva etc etc said, “The First MNT is that Incentives Matter.”

Beholding incomprehension written large on the face of the noble Shariputra, the Compassionate One continued. “Aggregate human behavior in the realm of Samsara is very predictable. At its very core, that is what the study of economics is–the study of aggregate human behavior. Given the right incentives, people who are bound to the Wheel of Becoming, who have not yet gone across, behave accordingly.

“If you want them to be good, then reward them for good behavior and they will behave well. If you want them to stop bad behavior, then give them negative reinforcement and they will reduce their bad behavior. The former is called the carrot approach and the latter is called the stick approach. That’s about the sum of it: carrots and sticks.

“Noble Shariputra, if you consider this for a moment, it is quite simple really. People are motivated by selfish desires in the realm of Samsara. Of course, in the realm of Nirvana, motivation and incentives don’t matter because one has gone beyond, gone completely beyond the Wheel of Becoming.”

Shariputra began to see the light. He then asked, “Avalokiteshwara, I sort of understand that now. But, what is the principle mechanism which coordinates the behavior of the masses so that their aggregate behavior is socially beneficial even through their individual behavior is selfishly motivated?”

Avalokiteshwara, the BMBIC, replied thusly: “Shariputra, SoaNF, the mechanism is called the market and that is the Second Minor Noble Truth: Markets Work. Seemingly enlightened behavior emerges from apparent individual selfish actions–actions that bind one to Samsara and the escape from which was outlined by the Blessed One, the Tathagata, the One Who Has Gone Beyond, in his major work The Four Noble Truths which you may recall if you were paying attention the last time. But we will not digress into them right now because we are discussing the Minor Noble Truths of Samsara.”

Shariputra, clearly the bright-eyed curious student forever questioning the Avalokiteshwara, the BMBIC, said, “But do the markets always work? Are there any conditions under which markets fail and therefore don’t deliver the goods that one would expect? Under which set of conditions do the Fundamental Theorems of Welfare Economics hold? Indeed, what are the Fundamental Theorems of Welfare Economics?”

Avalokiteshwara, with a very weary look but patiently still answered, “O Shariputra, check the World Wide Web and google for those answers in about 2500 years. In about 2500 years, a bunch of bright guys would have mathematically proved the FTs of WE. If you are really interested, get yourself a few credits of economics courses. For now, let me give you a glimpse of what you will learn.

“You will learn that market failures are common because the conditions under which the fundamental welfare theorems hold are rather strict. Information imperfections, for instance, is one of them. But when information technology advances sufficiently, then markets will become more efficient. Of course, the markets will become bigger also. So the information requirements will also increase. All this increase in market size will be due to globalization and globalization will create its own discontents.”

Shariputra was silent for a moment. Then he asked, “Yabbut, in the real world, markets fail. Is there some remedy, however imperfect?”

Avalokiteshwara spoke thus: “O Shariputra, SoaNF, it is the role of an enlightened government–the state– to gently correct for some of the failures. I think that the best governments must use light-handed regulations to fix market failures. Of course, in the real world, government failure is often more harmful than market failures. But that is an imperfect solution in an imperfect world. Why so? Because goverments are not a collection of Buddhas, enlightened beings who have transcended their desires. Governments are not comprised of Bodhisattvas, those enlightened beings who vow to delay their own departure until all sentient beings have attained Nirvana. Quite to the contrary, actually. Governments are collections of equally deluded people generally.

“Talking of people, don’t forget that today we have only 300 million people in the whole planet. In about 2500 years, you will have 6000 million all of whom will be interconnected in a complex web of commerce (some of it on the Internet.) An important side-effect of increase in the number people and increase in market size is that governments will have to increase. In a primitive economy, say the Robinson Crusoe economy, government size can be zero. But in a modern economy, the more complex the market and the economy, the more government is needed.”

Shariputra said, “What you are saying, if I understand you correctly, is that an ideal government would be able to intervene in cases of market failures but that in the real world, ideal governments are as rare as unicorns. And further, that the market usually delivers the carrots and sticks that drive people to behave well but in case the market fails to do so, then the government has to get into the carrots and sticks business. But, according to you, the problem is that governments themselves need carrots and sticks so that they can continue to govern well. Isn’t that a bit of a problem?”

“Quite so, O Shariputra. Use the same principles and apply them to governments. Just like market participants are rewarded for bringing good stuff to the market, so also government employees should be rewarded for delivering good governance and if they fail to do so, they should be given the stick without delay.

“See we are sitting in Bihar, the state that will in about 2000 years become one of the most misgoverned pieces of real estate on the planet. If you take the leaders of the government of the state of Bihar and force them to live for a year under the conditions that the bottom 10 percent of the people of Bihar live, they will quickly come to their senses. It is simply because they who misrule don’t get subjected to the pain of those whom they cause pain to, that they continue to misrule. String up the corrupt bastards and you will soon fix the problem.”

Shariputra was shocked. Avalokiteshwara, the Buddha of Infinite Compassion was advocating summary execution? He could not believe his ears. “O Avalokiteshwara, how can stringing up corrupt officials be a compassionate thing to do?”

Avalokiteshwara, the BMBIC: “O Shariputra, son of a noble family, do you send your children to school and does it not cause them pain at times? But you still do that because of your compassion. You cause them pain now but they will grow up to be worthy citizens and thank you for educating them later. So also, by stringing up the corrupt officials, you are hastening their journey to buddhahood. Not just that, by shortening their present stay in Samsara, you are helping them by not allowing them to accumulate more negative karma. And finally, if they cannot continue their corrupt ways, millions of ordinary citizens will lead more human existences once the corrupt ones have departed this mortal coil. So you will string up say half a dozen of the biggest offenders. Big deal. But that will put the fear of God (imaginary being that many deluded people think exists and who they believe takes a personal interest in their silly matters) into them, to use an expression and deter many from getting started down the road to perdition at all. In short, governments will again be staffed with people who are into doing good stuff, not by people who are in there just to make a fast billion and stash it away in some Swiss bank account.”

At that point, the Blessed One, the Tathagata raised a flower in his hand and said, “Very well said, O Avalokiteswara. You have expressed some of the Minor Noble Truths for now. We should continue to examine this very fascinating subject later. But now it is time to pick up our begging bowls and head off for something to eat. The people of Rajagriha turn in early these rainy days and once they shut the doors, we cannot seek alms and we will have to go to bed hungry. You don’t really want that, do you?”

Hearing the Buddha bring this session to close was a great relief and everyone–the gods, the asuras, the monks–rejoiced.

Thus have I heard.

A moment’s reflection should convince us that the world around us is definitely complex and we cannot really fathom what the consequences of our actions will be. The best we can do is to try to learn from our previous bouts of “bounded rational” actions and try to avoid being unboundedly stupid.

Here is where one starts wondering what is it that I am going on about. I was coming to that.

It all began when recently my friend Dr Malpani emailed me about the Employment Guarantee Act, the details of which you can find here.

There seems to have been some sort of convention (details) where they adopted a resolution outlining the “non-negotiable” features of an acceptable EGA. These include–

a permanent and universal work guarantee, extension to the whole of India within three years, payment of minimum wages in all circumstances, central government funding, safeguards for the interests of women, decentralised implementation, and full transparency at all levels, among other features.

More about this later. But now, let’s go to Niger, the second largest country in Africa. Extremely poor and definitely overcrowded. Soil erosion, desertification, frequent famines, flash floods, lack of water — the usual laundry list of mini-disasters. So what did they do? They decided to dig trenches and wells to stop the flash floods and thus prevent further soil erosion which was causing desertification. Then they realized that it was actually leading to more desertification, instead of less. They had to cut back on their policy of digging wells for farmers to water their cattle.

A Niger government official explains:

Wells attract animals. Animals eat the vegetation. Because the wells attract so many animals, the vegetation never gets a chance to grow back. Which is the beginning of desertification, the very process that the wells were designed to prevent.

[Source: Peter Biddlecombe, "I came, I saw, I lost my luggage" pg 210.]

Considered in isolation, having wells for increased vegetation is a good thing if you want to prevent soil erosion. The problem occurs when there are other confounding factors such as too many animals. If the system has multiple distortions, trying to address one of those distortions without regard to the others, could lead to unintended undesirable outcomes and make the system worse off than before.

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Here is another one from a different part of the world. A world with cars and computers, and roads and highways. And often heavy traffic congestion. It would be clear to the meanest intelligence that to ease traffic congestion, you have to build new roads and highways and widen existing ones. Except that sometimes doing so only worsens the congestion. Totally counterintuitive.

Why building new roads does not ease traffic congestion:

There is no shortage of hard data. A recent University of California at Berkeley study covering thirty California counties between 1973 and 1990 found that, for every 10 percent increase in roadway capacity, traffic increased 9 percent within four years’ time…This phenomenon, which is now well known to those members of the transportation industry who wish to acknowledge it, has come to be called induced traffic…

The mechanism at work behind induced traffic is elegantly explained by an aphorism gaining popularity among traffic engineers: “Trying to cure traffic congestion by adding more capacity is like trying to cure obesity by loosening your belt.”

Here the confounding factor is that there is supressed demand for more road transportation and as the supply of the road network expands, the demand is expressed to the point where the roads are once again as congested as before and therefore the private cost of using the road once again exceeds the benefit and people stop using the road.

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One more case in point. This time from the development literature. Urban unemployment is a common feature in underdeveloped economies. Both in the organized (or formal) sector and in the informal sector, urban unemployment leads to a whole host of symptoms such as gigantic slums, urban crime, etc.

Once again, the no-brainer solution is simple: increase employment opportunity in urban areas so that the unemployment rate goes down and thus cure the associated problems. Unfortunately, it is not that simple. By stimulating job creation in the urban sector, one can make the unemployment levels actually increase. How does that come about?

The confounding factor is that there is a vast pool of labor in the rural sector and the average wages in the rural (agricultural, mainly) sector is lower than the wages in the urban (modern) sector. This leads to rural-urban migration. By raising the probability of finding employment in the urban sector through policies that create more urban jobs, it accelerates rural-urban migration and perversely raises urban unemployment. (For details, see the Todaro model.)

The Todaro model has strong policy implications regarding development strategies. For example, efforts to reduce urban unemployment by stimulating job creation in the urban modern sector are likely to be stymied eventually, in that they will raise the likelihood of finding a good job and hence induce a greater flow of rural migrants. Todaro has argued far and wide that the best strategy to reduce urban problems in developing nations is to seriously promote rural development (economic opportunities plus amenities like health care and education).

Which brings us back to the Employment Guarantee Act.

It is a no-brainer that the EGA will make the poor better off all across the length and breadth of India. It will raise hundreds of millions out of poverty. India will finally become a wonderful developed economy. Oh why didn’t we think of this before?

If you believe that, I have a red-colored bridge across the Golden Gate which I would dearly like to sell to you for a throw-away price of only $10,000. Send me a check and I will Fedex you the title to the bridge. It is a very nice bridge. The view is totally incredible. People come from all over the world and take tons of pictures. You will not regret your purchase. Money back guarantee if you are not fully satisfied with your purchase. To the first 100 people who send in their checks, I will throw in the Bay Bridge as a free bonus in the whole deal.

Here, I will go out on a limb and predict that if ever this EGA is implemented, it will actually increase the level of poverty and the number of poor in India. It will drag those at the margins of poverty deeper into poverty. The only guaranteed effect will be an absolute increase in the amount of corruption and some politicians will make obscene amounts of money.

As they say on TV, stay tuned. Details at 11.

[See "The National Rural Employment Guarantee Scheme" and "The Importance of Producing Stuff".]

Kling takes Krugman to task saying that he should eschew M arguments and concentrate on C arguments to make his point. Economists, Kling claims, have always employed C arguments to evaluate public policies and that is what Krugman should stick to.

Here is what I believe. Public policies are made by humans. Humans are motivated by self-interest. It is therefore important to understand the motivations of the humans involved in policy making to comprehend why a certain policy was advocated. In most cases, the consequences of a policy are not completely known a priori and there is considerable uncertainty in the actual outcome of a policy. Depending upon the motivation of the policy maker, the policy maker has the freedom to claim that a particular consequence would necessarily follow. By identifying the motivation of the policy maker, one can control for the biases in the claimed benefits of the policy.

My position is not that C arguments are worthless when evaluating policies. It is rather that C arguments are not sufficient when it comes to understanding why a certain course of action is actually taken from a menu of choices.

To take a specific example, consider the so-called US “war on terror”. Suppose one were to make the C argument that “invading Iraq would not stop terrorism, but instead would intensify terrorism by inducing more Islamic terrorism.” Would that argument be sufficient to deter those advocating the invasion of Iraq? It would be if those people were indeed ignorant of the possibility of inducing more Islamic terrorism and having heard the C argument, would change their minds. But those who pushed for the invasion of Iraq are not stupid. They would have already worked out C argument for themselves, anyway. Yet, if inspite of understanding the consequences of their chosen policy, they still go ahead of with the invasion of Iraq, then one has to ask what their motivations are for doing so. If one finds that the benefits of an invasion (to the policy makers) is greater than the cost of the war (which the policy makers do not bear), then one can explain comprehensively why the invasion was undertaken.

In a purely academic environment, debating the pros and cons of a specific policy is best undertaken with C arguments. But in the real world, people are motivated by self-interest and have a certain amount of control over what course of action to take, rather than being dispassionate observers of a world that they don’t have any control over.

A diverse set of issues — from why the Bush administration invaded Iraq, to why worthless expensive PCs are foisted on poor rural Indians — can be better understood by the simple device of following the money and asking what is in it for the advocates of a particular policy and how it benefits them.

Consider this. BBC News on Sept 3rd 2004 carried an item: Solar plan for Indian computers. Some excerpts:

Authorities in the Indian state of Uttar Pradesh have drawn up a pilot project to use solar power to run computers in village schools…

Many have to use kerosene lamps for light and most government-run primary schools have no power at all.

It is hoped the plan will help schools cope with the rural power crisis.

Last year, the Uttar Pradesh Education for All Project Board bought about 1,000 computers for selected primary schools in all 70 districts.

The schools were selected in villages which had no power lines, and teachers were given special training for computer-aided education.

Consider the typical village school in UP: totally strapped for resources, teacher absent most of the year, perhaps not even a blackboard, students unable to afford books and most likely malnourished. Why, one asks incredulously, would anyone be spending money on computers when there are more important needs that are crying out for resources?

The report goes on to say:

A further 1,000 computers are to be purchased this year for village schools, but most of these will not work because there is no power available.

The mind boggles at the waste of resources which a poor state can ill-afford. Funds for rural public education are severely limited and yet they are wasting it buying computers that will serve no apparent purpose. These funds could have been used more effectively in paying teachers living wages, buying supplies such as books and blackboards, perhaps food for the starving students. Why?

Here is my explanation. Some time ago, I had pondered the question of why telephones, radio, and TVs don’t make the conference circuit. The vendors of PCs have an incentive to push their wares and they are a powerful lobby. Couple that with the avarice and corruption of the “authorities” mentioned in the BBC report, and you have the answer. When tens of millions of rupees are spent in bulk purchases of computers, there are kickbacks. The authorities make their pile, never mind that the computers end up being expensive non-functional display items in the villages without power.

But wait, it gets better. No power for computers? No problem: use expensive solar power to power them. And you will find the vendors of solar power panels eagerly getting into the game of rural development. They make hay while the sun shines.

It is disgusting, all things considered. Last Friday I made the mistake of driving about 10 kms on Mumbai roads. It took an hour and a half. We were stuck at a T-junction for about 20 minutes because of a deadlock. Vehicles had moved into the intersection and there was no way any vehicle could move. I had described a similar situation earlier in a post entitled Seduced by ICT:

Recently I came across a news item which said that they are looking at solving Mumbai’s traffic problems by making Mumbai roads “electronic intelligent roads.” I don’t have the slightest doubt that it would involve huge outlays to the tune of millions of dollars and lots of people will make lots of money up and down the line providing expertise and hardware and software for this hi-tech venture. I am also convinced that it will not make the slightest effect on the congested Mumbai roads because it is not the roads that need the intelligence but the people designing the roads that need to be intelligent.

Close to where I live in Kandivali, a suburb in North Mumbai, there is an intersection that is almost always caught in a grid-lock. The intersection is like an “H” with bi-direction flow of traffic along all the sections and it has one traffic signal at one of the points where the horizontal section meets the vertical sections. Traffic gets log-jammed around 300 meters of this intersection and it takes about a half hour to cross this bit every evening. Hundreds of autorickshaws, buses, cars, trucks, two-wheelers, and whatnots spew exhaust fumes and honk continually and people suffer. It is astonishing that the traffic people have not figured out that the simplest thing to do would be to paint some part of this intersection with the “KEEP CLEAR — DO NOT BLOCK” sections and put a couple of traffic cops to teach the people to keep off these sections. It would be a simple effective system which would cost very little compared to the enormous price that everyone pays throughout the day due to the congestion.

Instead, the Mumbai municipal corporation is investigating ways of using electronics. Why not better road markings and so on? Because there is not much money involved in a simpler but more effective system. Simpler may be better but there is not much profit in it. A blackboard, a teacher, and a dozen slates and some chalk may be simpler and better for adult education, but there is not as much profit as in putting PCs with literacy programs to teach adults how to read in rural areas.

That is all there is to it. Expensive solutions are proposed because those in control of the spending benefit. This is a universal phenomena, not restricted to poor overpopulated corruption ridden third-world people. Doctors in the US freely sometimes recommend unnecessary heart-bypass surgeries instead of recommending life-style changes. They make more money performing by-passes and don’t make any money if the patient changes his life-style.

The power of incentives is awesome. Look carefully at the roots of persistent poverty and you will see that someone makes money and therefore it is in the interests of the person to perpetuate that poverty. This is not even limited to the economic sphere alone, of course. Mother Teresa’s goal was religious glory and her incentive was therefore perpetuation of overpopulation because people are the fodder that the church feeds on. Is there a way out? I think there is. Stay tuned.

“The time has come,” the Walrus said,
“To talk of many things:
Of shoe–and ships–and sealing wax–
Of cabbages–and kings–
And why the sea is boiling hot–
And whether pigs have wings.”

An item titled the economics of software caught my eye on Rajesh Jain’s blog. Rajesh quotes from an article by Bryan Cantrill which begins with:

Software is like nothing else in the history of human endeavor unlike everything else we have ever built, software costs nothing to manufacture, and it never wears out. Yet these magical properties are arguably overshadowed by the ugly truth that software remains incredibly expensive to build. This gives rise to some strange economic properties: software’s fixed costs are high (very high — too high), but its variable costs are zero…

Clearly, Mr Cantrill is out of his depths when it comes to basic economics, and consequently his analysis of the economics of software is fundamentally flawed. Ignorance of basic economics is bad enough when one takes on the task of explaining the economics of software but what is worse is that he is mistaken about some facts as well. For instance, he asks rhetorically, “… doesn’t it strike you as odd that your operating system is essentially free, but your database is still costing you forty grand per CPU?”

Which planet are you on?

One wonders if he has heard of that obscure little company called Microsoft which makes a decent living out of selling operating systems. As far as I can tell, they don’t give them away for free. And I suppose that he has not heard of MySQL which is database software and for which you have to pay a lot less than forty grand — zero, to be precise.

Sorry, Mr Cantrill, but it will take us too long to fix all the bugs in your analysis. So I will just write the analysis from scratch. Here is a short introduction to the economics of what is called “information goods” to which class computer software belongs.

Of goods and services and information

To start at the top, there are things called goods and there are things called services. Services are things such as haircuts, transportation, heart surgeries, operas, and psychoanalysis. Goods are stuff such as cd players, cars, toasters, shirts, and books. Most goods are ‘hard’ in that they are kickable. Then there are goods that are not kickable. An idea or a thought or a receipe is not kickable because it is not made up of matter. Note however that to convey, store, transmit, and use the idea or receipe, it has to be incorporated into some physical medium which is kickable. But the information good itself is not a material entity unlike a car or a desk.

The distinction between the information good itself and the material object used to store, retrieve, transmit and use it is vitally important. The idea or the receipe is ’software’ while the stone tablet or book or the cd in which it is found is the ‘hardware’. The cost and economics of hardware follow the usual economics of kickable goods. So it may be good to review those basics quickly before we look at the economics of software.

Costs — fixed, marginal, and average

To produce stuff (hardware), you need labor, capital, and other stuff. Let’s say we need to make a car. We need to buy some humongous machines, make parts, put them together and we get a car after some time and cost. Even before we get one car out of the shop, we have to spend money — put the factory up and pay people to design the car, etc. Those are fixed costs. For every car we produce after we have paid the fixed costs, it costs some money. That is the variable cost. The more the number of cars, the higher the variable costs because you need more parts. The difference in the total cost of producing n+1 cars and n cars is called the marginal cost of producing that n+1th car. Finally, the total cost (sum of the fixed and variable costs) divided by the number of cars gives us the average cost.

Supply and demand

Usually, the marginal cost decreases as the number of units produced increases, and at some point it starts rising for reasons that need not detain us now. The upward sloping supply curve is actually the rising part of the marginal cost curve and it represents the fact that as you produce more and more of some good, it costs more to produce the next unit than to produce the current unit. This is true for most kickable goods but not so in all cases and definitely not so for software as we shall see.

Then there is a demand curve which is usually downward sloping (on a price-quantity graph where the y-axis is used for the price and the x-axis is used for quantity). This is so because of a number of reasons. For a consumer, each additional unit of a good delivers diminishing additional utility. This diminishing marginal utility or benefit implies diminishing willingness to pay. So the demand curve is a marginal utility curve or a marginal benefit curve.

Markets

If you draw the marginal benefit curve (aka demand curve) and the marginal cost curve (aka supply curve) on the same price-quantity space, they may intersect and if they do that point of intersection is called the equilibrium which represents a market-clearing price and quantity. The equilibrium condition is that the marginal cost equals the marginal benefit. Markets determine this equilibrium and under idealized conditions (which do not obtain in the real world but are realized approximately in many instances), this is welfare maximizing.

Which brings us to a very important point that is relevant to our goal of understanding the economics of software. We have to know something about competitive markets and how they maximize welfare and under which conditions. Markets are competitive if a bunch of conditions are met which include, among others, (1) zero fixed costs (implying no scale economies), (2) no externalities, (3) perfect information, (4) no public goods, and so on. In a competitive market, the price determined is welfare maximizing and the price is equal to the marginal cost of production. Whether real world markets achieve efficiency, that is, whether they arrive at this welfare maximizing price or not, depends on whether the conditions for competitive markets are met or not.

Marginal Cost Pricing

One last thing we need to keep in mind before we continue on. For economic efficiency (in other words, for maximizing social welfare), price has to equal marginal cost. That is, the additional cost of producing the marginal unit (that is, the next unit) has to equal the marginal benefit from the consumption of that unit. So if the marginal cost of production is zero, the economically efficient price is zero. But here is the catch. You could have zero marginal cost of production but have a very high fixed cost. In which case, you still have a positive average cost. Granted, this average cost decreases as the total number of units produced grows. But pricing the good at marginal cost will leave you unable to recover the fixed cost. You could of course price the good at that average cost but then it will not be maximally efficient — it will lead to dead weight losses. Alternatively, you could have the government or your rich uncle subsidize the fixed cost component and price your good at the marginal cost of zero.

Economics of Software

Now let us move to software. First order of business, what is software as used in this analysis. I define software as anything that is an organized collection of information. Examples of software: receipes, stories, driving direction, computer programs, population statistics, exam results, poems, instructions on how to achieve enlightenment, a movie script, and such. Let us lump these in the generic group called information goods (IG). Every IG requires some amount of intellectual effort and unlike the production of hard goods (HG), the cost of production is totally front-loaded and the cost of producing additional copies of an IG is zero. In other words, the cost of producing one IG is the same as the cost of producing a billion copies of the IG.

Distribution Costs

Note however that merely producing something is not enough; you have to distribute the stuff before you can use it. The cost of distribution is an important and significant component of the total cost of IG. This is distinct from the case for HGs. To take an example, producing a car costs say $100 million, producing each additional unit costs (marginal cost) say $20,000, and the cost of distribution for each car through a dealer network is $1,000. The distribution cost is therefore only 5% of the marginal cost of production.

Now consider IGs. Take the case of an operating system or a database system. It costs umpteen hundred million dollars to produce the first unit, if you are a Microsoft, but it costs next to nothing if you are an open source collaborative project. So the range of fixed costs of production extends from very high to practically zero. Marginal costs in any case for IGs is always zero. Then comes the distribution costs. If you were to distribute your software on punched paper tape or cards, you have to hire a fleet of 18-wheeler tractor trailers to deliver one copy of Microsoft Windows XP to one customer and it will cost you $19,500. If you were to use a set of floppy discs and mail it to the customer, it will need a shoebox-full of floppies and your distribution costs will be $40 per customer. Not as bad as the fleet of tractor trailers, but still not as good as using a few cds and cutting your distribution costs to $4. And it gets really sweet when you can just have your customer download it from your site for about $0.04 total cost to you. (But the sweetest thing of all is when you can charge your customer $300 for the download.)

Summary

To sum up the discussion so far, depending upon the size and complexity of what a software program does, you have to employ a bunch of programmers and have some computers for them to do their stuff on. That is the fixed cost of producing the software program. That fixed is high in the case of operating systems and huge database programs if you have to pay programmers fat salaries. If you got a whole bunch of people to collaborate and produce software for free, then you have low fixed costs. The latter is what mostly happened in the case of Linux while the former is what happens in a commercial shop like Microsoft.

Once you have produced the software program with whatever fixed costs — high, low, or intermediate — you then make a certain number of copies. Depending on the cost of the medium you use to distribute the software, your variable costs (and therefore the marginal costs of distribution) is determined. If you use punched cards or paper, marginal cost of distribution is high; if you use cds, it is low; it is lowest so far if you send it over electronically by wires or wirelessly. Because electronic distribution of software is so cheap over the internet, you can say that the marginal cost of production as well as distribution comes pretty close to zero.

Is software really different?

Information goods are essentially different from material goods. That is so because of two reasons. First, the nature of information goods itself. And second, the cost of production of IGs. IGs have public goods characteristics, they have externalities, and have high fixed costs. All these are deviations from the conditions required for competitive markets. Thus markets will not deliver the social welfare maximizing outcome. All sorts of distortions will result such as the presense of monopolies. Monopolies, like everyone and his brother, maximize profits and since they have market power, they can charge whatever suits their fancy. So they can price an operating system at $300 a pop which is way above the marginal cost of production (exactly $0) and the marginal cost of distribution (nearly $0).

So is the economics of software essentially different from the economics of other goods? Not really. There are differences in their associated costs (fixed, marginal, average) and the ways in which they deviate from the conditions required for a competitive market. But the fact remains that there is nothing surprising about the way the market for software behaves if one were to understand the nature of software and the nature of markets. Like shoes and ships and sealing wax, they follow predictable pathways in the marketplace. Pigs don’t have wings and the sea is never boiling hot.

In the concluding bit of this piece, I will explore some of the issues that follow from this preliminary analysis. Later, alligator.

“Are there possibilities where a large population is not ridden with poverty?”

Yes, casual empiricism demonstrates that there are large populations in the world that are not ridden with poverty. Take, for instance, approximately 300 million in North America (US and Canada, primarily.) Or the 500 million in Western Europe. Taken together, the population of US, Western Europe, Japan, the Asian Tigers, and Australia are above a billion people who are not poverty stricken.

Poverty (P) is a function of not just population (p) alone. In mathematical notation, P=P(p) is not the correct formulation of the P, the poverty function. Instead, the poverty function is P=P(p, t, r, i) where p is population, t is technology, r is resources, and i is institutions. The greater the population p, the greater is the poverty, all other things being equal. Hence p enters positively in the function. The greater the technology t, the lower the poverty function. So t enters negatively in the poverty function. Therefore, we can denote the poverty function as P=P(p+, t-, r-, i-).

A poor third world country has high population and relatively low t, r, and i. Compare that to that of an advanced industrialized economy: low p, but high t, r, and i.

The important thing to recognize is that it is not the raw population numbers that matter. It is what can be called the ‘normalized’ population numbers which we can denote as ‘np’. The normalization has to be done with respect to the other parameters t, r, and i. So np=np(p, t, r, i). Again in mathematical notation, P(p, t, r, i) = P(np(p, t, r, i)) = P(np).

The last bit is shorthand for “poverty is a function of normalized population figures.” More compactly, P = P(np+) which means that the higher the normalized population, the higher the poverty.

How does one arrive at the normalized population figure? The first step is to take the raw population figure p and divide it by the resource numbers r. Note that the resource r is a vector. For instance, it would include scalars such as total arable land area, the total amount of fresh water, the stock of physical capital such as roads, power stations, stock of fossil fuels, the stock of renewable energy resources, factories and farms, and so on. Then you do the same for the other parameters, technology and institutions and arrive at the normalized population figure.

The bottom line is that raw population numbers don’t amount to a hill of beans. Indeed, any raw number is essentially meaningless. We need to normalize the raw numbers before they can be meaningful. For instance, India is the largest producer of milk and produces 38,945,021 gallons of milk a year as compared to Denmark with only produces 1,045,983 gallons a year. India therefore produces 30 times more milk than Denmark. But that is meaningless unless one also knows that India’s population is 300 times that of Denmark. The proper normalization in this case is per capita milk production and consumption. That is, you take the raw milk production numbers and divide it by the respective population numbers to get the meaningful statistic that Indians only produce 10 gallons per year per capita while Denmark produces 100 gallons per year per capita.

It is simple arithmetic and those who refuse to do arithmetic are doomed to speak nonsense.

(Disclaimer: All the numbers above are straight out of a hat. They are definitely not accurate. They are for illustrative purposes only. The exact numbers are left as an exercise for the interested reader. For all others who are basically lazy like me, the fake numbers should suffice. You gets what you pays for.)

“Considered that population and poverty are positively correlated, how can it be shown that solving the population problem alone will solve the poverty situation. Are there other causal factors to consider?”

It would be silly to posit that solving the population problem alone will solve the poverty situation. That line of thinking will arise from a failure to distinguish between necessary and sufficient conditions.

Solving the population problem is a necessary condition but not a sufficient condition for poverty alleviation. Necessary conditions are — umm — necessary. If you don’t meet that condition, what you expect to happen won’t happen. But if you do meet the condition, what you expect may still not happen. That is so because while the condition is necessary, it is not sufficient for the event to occur.

So some conditions are both necessary and sufficient, some are necessary but not sufficient, some are sufficient but not necessary, and some are neither necessary nor sufficient.

Taking the horse to the water is a necessary condition for the horse to be watered. It is not sufficient because the horse has to do the drinking. If the horse doesn’t want to drink, fulfilling the necessary condition is clearly not sufficient for the horse to be watered. On the other hand, the horse may want to drink but if it not led to the water (the necessary condition), the horse will not be watered.

Not having shackles on one’s leg is a necessary condition for winning the marathon but it is not sufficient.

I would leave the rest of the discussion of necessary and sufficient conditions for the aforementioned interested reader. For now, here is the bottom line. Solving the population problem is a necessary condition to address the poverty issue but it is far from sufficient. Having a very high normalized population number is like wearing shackles during a marathon. Removing the shackles is a necessary condition but merely removing the shackles will not assure you victory; you will have to run faster than the others to win.

In California, you can buy a loaf of bread for about $2. The basic materials that go into the making of the bread — wheat, primarily — is about $0.07. Then there is some energy required for baking it and transporting it. Add a dime for that. The total material cost is therefore about 17 cents. The difference between the cost of the inputs and the price of the product is the value added. In our case, it is $1.83. That is, about 92% of the price of the bread is value added.

How do you allocate the value added in this case? Most of it has to be assigned to services — from the marketing of the bread, to the stocking of it in the store shelf. The cost incurred in bringing a loaf of bread to the market (less the cost of the material, the fuel and labor involved in the baking and transportation) is transaction costs.

Of course, costs seen from a different angle are revenues and incomes. And part of revenues are profits (if prices exceed costs.) The generalization of these costs are transaction costs.

Transaction costs are ubiquitous. Consider what happens in any organization, say a car manufacturing firm. Cars are produced by people using machines to transform steel and other stuff. If you add up the costs — labor, material, and machines — the car would not cost all that much. But when you add the fact that there are other people employed by the car firm who have nothing to do with the manufacturing of cars, you realize that they represent transaction costs. For instance, you have managers, and accountants, and secretaries, and human resources divisions, … the list goes on. They all represent transaction costs. And the greater the transaction costs, the higher the cost of production. Why do firms exist? Because they reduce transaction costs.

Ultimately, one can explain pretty much all organizations as an attempt to systematically reduce transaction costs. Economies of scale, scope, and agglomeration themselves arise from the reduction of transaction costs.

Information and communications technologies reduce transaction costs. Here is a simple demonstration of that. The next time you make a phone call, ask yourself what it would have cost you if you could not have made that call.

For instance, I called the store to find out if they had indeed installed the AC in my apartment. (They had not.) If I could not have made the call, I would have had to spend at least two hours and a lot of money to travel to the store to find out that information.

I will continue to ramble on the transaction costs theory of the universe in the next few posts. As they say on the radio, stay tuned.

This week, I would like to address myself to that question in detail. The answer can be succinctly stated as: It reduces transaction costs. It will take a pretty long time to explore that answer. But first a few personal experiences to set the stage would be appropriate.

Today I called up a local store which sells “white goods” (major appliances such as washing machines, etc.) I wanted to order an air-conditioner. Could I order the AC over the phone, I asked when the phone was finally answered by someone. I was told that I had to come down personally and bring cash. Will they accept a debit card? No. Will they deliver today? They can’t tell me that until I had paid and only then will they check to see if the department that does the delivery has the capacity to deliver today.

I drove to the bank to withdraw the cash. At the bank, the line for withdrawing cash was immensely long. I could not use the ATM because the amount I needed was above the ATM cash withdrawal limit. It took me a half hour before I had the cash in hand.

Next step: drive to the store. The closest branch was in Shivaji Nagar. I told the driver the address and we proceeded to drive the four or five kilometers to the store. It was on ‘L.J.’ road. The traffic was bad, as usual. The driver did not know where L.J. road was. We asked for directions from various taxi drivers. We traveled with hope thinking that this time the directions were right. In about 45 minutes, we had reached the store. It was closed because that branch of the store is normally closed on Mondays. I could not have found this out without going to the store. This was in Mumbai, the commercial capital of India.

I had spent about 2 hours in trying to buy something that in a different setting (for instance in California) it would have taken me all of 5 minutes and that too from the comfort of my home: I would have checked the prices of ACs on the web and ordered it online and paid for it with my credit card. Instead, after about 2 hours of frustration, I was still without what I wanted.

This little episode is indicative of a depressingly large set of similar experiences. The features of this set almost always include having to spend an inordinate amount of time searching. The search cost of locating a place is non-trivial. Street addresses don’t exist. You could be looking for a place with an address with reads “122/1/B Lajpat Nagar II”. You reach 121/1/B. And then you discover that 122 is not adjacent to 121 but is somewhere else altogether. Sequential numbers are not physically close. The house numbers are in the order in which the plots were registered, for instance. Once I spent about an hour hunting around for a place in Lajpat Nagar in Delhi. I am sure that I was not the first — nor I was the last person — to waste time and energy (gasoline) trying to locate an address there.

Another feature common to all the episodes includes transportation. On Saturday last, I was invited for dinner at a house that was about 5 kilometers (3 miles) from the Andheri local train station. I took a bus from the station. It took about 50 minutes for the bus to cover the 5 kilometers. Traffic moves about 8 kms an hour in the city of Mumbai, and at the breakneck speed of 18 kms an hour average on the nation’s highways.

Traffic is not the only thing that is slow. The movement of payments is an important function in any economy. I had to pay my brother Rs 25,000. I mailed him a check to Nasik without asking him first. He called to say that it will take about 3 weeks for that check to clear and so it would be good if I could send him cash or do a wire-transfer.

Cash is inconvenient to handle and carrying large sums is stressful. For furniture shopping, the only acceptable form of payment appears to be cash. Part of the reason is of course tax avoidance. But the slowness with which checks clear could have something to do with it as well.

There are a few things that one can do at a macroeconomic level to push the economy towards its potential such as fixing the monetary and fiscal policy. But they are limited instruments. Fundamentally, what really puts the brakes on the machinery of the economy is a very large number of very small grains of sand which are individually ignored but together form a very potent force. These grains of sand arise from what can only be said to be the overall culture of the economy.

It is an unfortunate fact that the Indian “economic culture is dismal and unless that changes, India’s economy cannot reach its potential. Becoming aware of the problem is fundamental to the solution, of course.

In the next piece, we will explore what ICT can do to remove the sand from the Indian machinery.

[Continue reading part 2 of "It is transaction costs all the way".]

In the context of economic development, I totally agree with the latter bit, but strongly disagree with the former bit. If we don’t sweat the small stuff, we don’t have much hope of managing the big stuff since the big stuff is exactly what arises from an aggregation of all those small bits of stuff.

I just went out to lunch in the neighborhood of where I work. A passerby stopped me to ask me where a certain company was. I said I don’t know but if he had an address, I could perhaps direct him. He only knew that it was close to the ‘Empire Building’. We spent some time trying to locate it and then finally gave up. I don’t know how long he spent walking around in the noon-day sun trying to get where he wanted to go. Perhaps he just wasted an hour, a lot of shoe leather, sweated in the heat, and when he arrived, he was tired. The opportunity cost of his trying to find a place is small but non-zero. He could have spent more time with his family or done some productive work. Add the cost of millions of people spending non-productive time searching, and soon you get a significant amount of loss.

That streets should have a name and locations along a street should have a number is a concept that should be evident to the meanest intelligence, one would expect considering that it is not exactly rocket science and that many parts of the world have had that innovation for generations, if not centuries. Yet it is a rare exception when you can find a place in India without an algorithmic description of how to get to it. A typical letter in a typical developed world would read:

Ramesh Singh
123 Gandhi Road
Pune, Maharashtra 44123

In India, it would be

Ramesh Singh
Networld Building
Opp: Star Cinemas
Vasant Sagar Complex near Local Station
Deccan Gymkhana
Pune, Maharashtra 44123

I have spent frustrating hours of my life searching for places in unfamiliar places such as Mumbai and Delhi, going round and round in circles in a cab asking people for a location. I assume that I am not alone and that in a country of a 1,000 million people many of whom find themselves in unfamiliar surroundings in the course of daily living and working, the story of spending time and energy needlessly is repeated a few tens of millions of times daily. Add that up for weeks, and months, and years, and decades — and soon you have a huge amount of wasted time and energy.

I have a prediction to make: that in about 10 or 20 years at most, Indians would have figured out this whole new-fangled thing called street addresses. We are bone stupid but not that abyssmally stupid that we cannot learn from others that street numbering saves time and energy. Since I am at it, I will make another prediction: that in about 10 years time we will learn the benefits of a standardized telephone numbering system and even learn that it is easier to read a long string of number when written thusly 408-083-2543 instead of thusly 4080832543. One may say that it really is a very minor matter. But it is not. Misdialled calls, numbers you cannot easily remember or copy down without errors, having to wonder if you need to add a 2 before you dial this number or should you add a city code or whatever is a needless aggravation.

Enough about phone numbers for now. The larger point is that standardization matters. It eases the friction that accompanies transactions which increase as an economy develops into a more complex web of interactions. Reducing transaction costs is what increases the pie because transaction costs are sheer losses (or dead-weight losses) that benefit no one. In a village economy, street addresses are not needed because everyone knows where everyone is and what he is up to today. In a city of a few million people and a few hundred square kilometers of buildings, one has to be more systematic.

It is all the small stuff, really, that end up making life miserable. Went to the bank yesterday. There were 20 people waiting huddled up near the teller’s counter. Surely it does not take an Einstein to figure out that handing out a number to each person waiting for a teller would ease the bother of having to keep standing in line.

I could go on and on ad nauseum about little innovations that have been around for ages and which we can adopt costlessly. I could fill volumes, honestly. There is a more important point all this is leading up to. That is, we need better technology, not necessarily ICT with its computers and cell phones and internet and world wide web. By technology I mean know-how — how to do stuff. The know-how exists. One just has to observe and learn and adopt. But observing, learning, and adopting takes thinking and effort; it is not as easy as simply buying a bunch of computers and firing off Microsoft Windows.

I am not a Luddite and I am not against hi-tech. Some of my best friends are techies and my education is in computer sciences and engineering and my salary is paid by a technology company. I just happen to believe that hi-tech needs a foundation and that foundation is made of lo-tech. Hi-tech without the lo-tech is about as useful as a car with a fancy engine but no wheels. Hey, that is a good analogy. A car with a fancy engine ain’t going anywhere in a hurry without wheels. And even if you do figure out that wheels are needed, you can’t go far if you don’t get round wheels. Square wheels just won’t do. Then even if you get round wheels, if the tires are not inflated, you get around with a lot of loss of fuel and in discomfort. That is, without air in the tires, your transaction costs are higher.

As a development economist, I have often asked myself what are the invariants that underlie development. I know for sure that high technology (computers, internet, cell phones) are neither necessary nor sufficent for development. Most of the developed economies of the world developed at a time when all those were not yet invented. I believe that one invariant is the ability to adopt innovations.

Post script: Here is a followup post The Tathagata on “It’s the Small Stuff, Stupid.”

But maybe the issue will not go away. Perhaps legislation willbe passed which will restrict the free trade of services offered remotely. Legislation can impede markets and it generally hurts the economy. Sufficient amounts of restrictions add up to impoverish a nation, one such case in point being India. India is poor due to poor legislation of the type I call the “head in the sand” legislation. Legislation which tries to avoid facing inconvenient truths has a long and cherished history all over the world. One US state (I forget which) even went to the farcical extent of legislating the value of pi to be exactly 3 and did away with all the inconvenience of handling an irrational
number.

Markets were invented by humans because it affords some advantages to parties that participate in them. The prime engine that drives markets is human nature with its drive for profits. One cannot legislate a change in human nature any more than one can legislate a more convenient value for pi. It is of course possible to make some activity which is otherwise socially beneficial illegal because of special circumstances. But people will find a work-around in time. In a world of networks of networks, it is difficult to keep barriers up for too long.

The bottom line: legislate all you can but the Samuelson-Stolper factor price equalization theorem cannot be overturned by fiat.

An attitude to life which seeks fulfillment in the single-minded pursuit of wealth –in short, materialism– does not fit into this world, because it contains within itself no limiting principle, while the environment in which it is placed is strictly limited.
E. F. Schumacher in Small is Beautiful

THE ETHICS OF POLICY

Economist Thomas Schelling defined the ethics of policy ‘as what we try to bring to bear on those issues in which we do not have a personal stake.’ It can be convincingly argued that there are no issues in which we do not have a personal stake. Every action in an interdependent global system has far-reaching consequences. My desire for cheap hamburgers could translate however indirectly to rainforest destruction.

One has to grapple with the notion of social obligations and what we owe to the poor and the disadvantaged who have legitimate claim to the resources that are required for a decent human existence.

THE POLITICS OF POWER

Over the basic subsystem of population, environment and resources, is the supersystem of another triad: the political system, economy, and the technological system. The political system, according to Lester Milbrath of Univ of NY Buffalo, is that its central focus is on power and domination. He writes: “Our civilization is a dominator civilization; that means it is oriented toward allowing some people to subjugate others. We no longer condone outright slavery, but the many forces of domination have the effect of bending the will of weak creatures to serve the desires of the powerful. Power is ingrained in our thinking that most humans believe they have a right, even an obligation, to dominate nature.”

The question of sustainable human activity is a very complex problem which needs to be examined very carefully. The temptation to assign blame should be firmly resisted for it will only be a useless exercise which can only hinder consensus building which is the only way to creating a solution acceptable to all.

A SUSTAINABILITY PARADIGM

Natural ecosystems are models of sustainability and it would be pleasantly ironical that we could learn from a system that we would otherwise in our ignorance destroy. Wider identification with the diversity of life on earth can mitigate against technological hubris implicit in the faith that human technological ingenuity is sufficient to solve all problems.

Natural ecosystems characteristically:

1. Avoid pollution and resource depletion by recycling.
2. Use a renewable source of energy.
3. Maintain stable populations.
4. Maintain biodiversity.

It is important to note that all the above desired characteristics correlate positively. The study of natural ecosystems corresponds to studying healthy systems. The study of ecosystems disrupted by human activity would constitute the pathological side of investigation. Both the study of health and pathology would contribute to the formulation of a computer simulation model. This model can be used to study the evolution of the system under varying circumstances and predictions made which can guide policy.

{To be continued}

… We are such stuff
As dreams are made on; and our little life
Is rounded with a sleep.

    Shakespeare’s The Tempest

Writing in the Dec 28th, 2003 edition of The Week, President Kalam says, “In the 21st century, knowledge is the primary production resource instead of capital or labour.”

I have been unable to fully comprehend that insight, fundamentally because it does not make any sense. Sounds profound but makes no sense. What is a ‘primary production resource‘? Did Kalam imply that once upon a time capital and labor were primary production resources but knowledge wasn’t? What changed so that labor and capital got displaced and now knowledge holds that position?

We need to understand that production has always required capital and labor primarily, and that knowledge (or know-how) has always been an essential ingredient. The production process ultimately uses these three elements multiplicatively. By that I mean, if even one of those are at a zero level, the product is zero. There is some substitutability among them, of course. You can use more capital and employ less labor to get the same amount produced, for instance. Or you can use more knowledge (ie, better technology or know-how) to use capital and labor more efficiently. Knowledge increases what is called the production possibilities but for that to happen you have to have production in the first place.

The last point bears repetition: you have to have production before you can use technology to increase the efficiency of production. IT (information technology) is an efficiency enhancing technology. It enters the production function multiplicatively, not additively. You have to have something going there before you can obtain gains from IT use.

All this talk of India becoming an IT Superpower is a lot of nonsense because India cannot become an IT superpower without it first becoming a Stuff Superpower. India has to produce stuff that you can lay your hands on — does not matter what it is. It could be food, or it could be manufactured stuff or whatever. But it has to be stuff. The reason is that we exist on stuff — we eat stuff, we wear stuff, we get transported on stuff. We are made of stuff. We cannot exist on ‘knowledge’. We are not dream stuff even though we are such stuff that dreams are made on.

We are poor not because of lack of information — there is tons of it in every conceivable place in the world. You can get all the information you need in a neat little tiny 100 GB harddrive. It would do little to alter the fact that most of us don’t have enough to eat. The hard part is to convert the information into knowledge, and then use the knowledge to convert some stuff (we generically label them land and labor) into more useful stuff (such as food, education, factories, etc.)

Let’s get back to basics. What is poverty? Poverty is lack of income. What is income? Your income is that share of stuff produced that you get to take home for yourself. Let’s not confuse money with income. Income is often denominated in monetary units but in real terms, income is what you get to keep from what is produced overall. Per capita income is therefore a ratio: a ratio of what is produced (the numerator) to the total number of people (the denominator). You can increase income by either producing more or by reducing the number of people. If the rate of growth of production is lower than the rate of growth of the population, you will have a falling per capita income. In time, you would have deepening of poverty.

To repeat that point: we are poor because the amount of stuff we produce is low relative to the number of people we have to distribute the stuff to. Information technology (IT) can help increase the amount of stuff produced but IT can never be a substitute for stuff. So India has to become a STUFF SUPERPOWER because we are a PEOPLE SUPERPOWER. If you divide STUFF INFERIORPOWER with PEOPLE SUPERPOWER, you get poverty-ridden India. On the other hand, if you divide STUFF SUPERPOWER with PEOPLE INFERIOR POWER, you get stuff-rich USA.

I have a little secret that would like to share with everyone tomorrow. It is a secret because no one in India seems to have a clue about this. I scanned the speeches of movers and shakers in India and realized that my secret is safe. But I think, January 1st 2004 would be a good time to get started on revealing the secret.

I wish you a very Happy New Year 2004!

Let’s step back a bit and look at an economy from a macro viewpoint. Economies are usually subdivided into three sectors: agricultural, manufacturing, and services. At the earliest stages of an economy’s development, agriculture is the dominant sector. It is low productivity initially and therefore low wages prevail. Since most of the population is engaged in low wage agriculture, income inequality is low.

Then manufacturing starts to grow, which is high productivity relative to agriculture. Manufacturing wages are therefore high relative to agricultural wages. Income inequality grows in the economy. The mechanism for this income inequality was first explained by Kuznets in 1955 in his paper Economic growth and income inequality. Here is an introduction to the paper from a World Bank site:

The process of industrialization engenders increasing income inequality as the labor force shifts from low-income agriculture to the high income sectors. On more advanced levels of development inequality starts decreasing and industrialized countries are again characterized by low inequality due to the smaller weight of agriculture in production (and income generation).

In other words, there is an “inverted-U” relationship between income inequality and per capita income. At the two extremes of very low and very high per capita incomes, income inequality is low; at intermediate per capita incomes, income inequality peaks.

There is a fractal nature to this “inverted-U” phenomenon in that this relationship holds at different scales of organization. It is definitely true for the rural and urban regions of an economy. The income inequality exists not just at level of an economy, it exists at the global level as well. Early on in the history of the world economy, various parts of the globe had similar income levels, since all were pretty much in subsistence agriculture. Then, as some regions industrialized before others, income inequality grew. In some future time, all regions will become industrialized and once again income inequality will fall. So also, urban regions of a country will initially have higher incomes relative to rural regions. But in time, rural areas will become urbanized and income inequality will fall.

In the long run, income inequality will eventually decrease to zero. But, as John Maynard Keynes observed, in the long run we are all dead. What I understand from that is that the ‘long run’ is really very uninteresting. Interesting things happen in the short- and medium-run time frames. And that’s where we are today — in the intermediate stages where income inequality is high in the global arena.

I will not go into the reason for the differential emergence of industrialization in some regions of the globe. For now, I will take that as a given and thus also take as given the income inequality. It is interesting to ask what accounts for the maintenance of that inequality. Primarily it is the cost of population migration from low income regions to high income regions. By ‘cost’ we mean barriers both natural such as distance, and man-made such as laws against migration. The natural barriers can be lumped together as ‘transportation costs.’ With technological advances, transportation costs come down. However, man-made barriers continue to exist and therefore labor migration is still not possible.

However, since transportation costs have come down, it makes possible what I would call virtual labor migration which is achieved through trade between the various regions. Virtual migration takes place because labor is embodied in the goods that are traded. A Chinese laborer virtually migrates when the goods produced in China are sold in the US. This virtual migration of labor is a factor that puts pressure on wages so as to equalize them across the two regions. To use a mechanical analogy, if the income levels in the two regions were seen as two containers with different levels of liquid in them, then the lowering of transportation costs can be seen as a pipe connecting the two containers: the pipe allows equalization of the fluid levels.

The trade in goods is just a way for labor in the manufacturing and agricultural sectors of low income countries to be available to high income countries. What about the services sector? Services are categorised as tradeable and non-tradeables. In the latter category is included services such as haircuts and house-cleaning and transportation: the production and consumption of which is local. For these, transportation costs are so high that they can almost never be ‘traded’: the cost of haircut in NY is $20 but the cost of a trip to Mumbai is $1000 where a haircut is only $1. Unless transportation costs (and times) come down to $5 (and half hour), haircuts will continue to retain their price differentials.

For those services whose transportation costs have dramatically reduced, trade becomes possible. With the advances in information and communications technologies (ICT), certain services have become tradeable and thus the phenomenon of business process outsourcing. Income inequality between regions is what drives the BPO phenomenon and one can no more wish away the BPO phenomenon than wish away the income inequality underlying it.

Just like the trade in goods, trade in services will tend to equilibrate wage levels across the trading regions. Programmers in the US are paid multiples of wages earned by Indian programmers. With fewer H1-B visas and lower costs of transporting bits, instead of physical movement of Indian programmers to the US, you will have Indian programmers doing work for US firms off-site for lower wages. With perfect substitutability between American and Indian programming skills, the wages will tend to “equalize” after adjusting for average wage levels in the two countries. This adjustment will always keep Indian programming wages lower than American wages and therefore at least in the medium run, programming will continue to get done in India, just as manufacturing will be done in China.

Time to conclude this one. BPO is a consequence of income inequality just as much as off-shore manufacturing is. Both are here to stay until the other end of the Kuznet’s curve is reached.

I think we will need to create the large domestic markets for the affordable computing solutions.

I totally agree. And I am thankful for one positive factor in India’s favor.

The most significant positive factor in India’s favor is its size. It is what we economists call a “large economy”. Large economies have the luxury of changing parameters which define the market itself. In comparison to that, “small” economies have to take those parameters as given (or ‘exogenous’) or external to them or outside their control. In a way, you can consider a large economy to be have some sort of ‘monopoly power’. Monopolies have the power to change one parameter (price) at will which firms in competitive (or oligopolistic) markets don’t have — the latter are ‘price takers’ in that they cannot dictate prices and take whatever price they can get.

So India is large enough to be able to change ‘world prices’. Suppose you were to create a widget which is suited to Indian conditions. Assume that the cost of production of these widgets exhibit economies of scale — that is, fixed costs are extremely high and marginal costs are very low, and hence average costs continue to decline as the volume produced increases. In such a case, given India’s enormous population, the number of widgets required would be high, and thus the average cost will be appropriately low, and therefore the market clearing price for widgets will be low and quantities will be high.

Now replace ‘widgets’ in the above with whatever — “COMPUTING SOLUTION” for instance. Get the hardware that is appropriate for the Indian market developed and get the software developed for the same. Concentrate on the needs of India alone to begin with. Note that hardware and software meet the criteria of high fixed cost and low marginal cost. Marry the hardware and software to create the computing solution, price it just above average cost, and voila! YOU HAVE LIFT-OFF!!

Do we need to create the large domestic market? If by creating you mean bringing the solution to the market, then yes. However, all the ingredients exist. We just have to judiciously put them in them together using the right recipe. I suspect that we are more than up to that job.

Another fact: any of the factors can be inefficiently utilized.

Final fact: we are not living in a perfect world. Therefore there are immense opportunities for efficiency gains.

Labor comes from people. People are critical for production. Wasting labor — especially highly productive labor — is a crime and we pay for that crime in terms of poverty.

India is one such place where you cannot throw a stone without hitting an opportunity for improving the system with the most minimal of effort. Take the recent CAT affair. Apparently, the Common Admissions Test which is held for the Indian Institutes of Management (IIMs) hit a snag — the questions were leaked. No surprise there. The stakes are high since about one in nine applicants gets to attend the coveted IIMs. The incentives exist for gaining some advantage, by fair or foul means.

Now it is all a big mess. About 125,000 students will have to retake the exam. Imagine the economic loss. Students taking exams, and institutes spending resources for selecting students is part of the transaction costs which I keep harping on. If one can reduce these costs, production goes up and consequently meet the necessary condition for reducing proverty.

Coming back to the CAT. Where could the problem manifest itself? At the printing press to begin with and in all the intermediate locations till one gets to the exam hall. Do we still need to rely on printing the question paper at a centralized location and then have complicated logistics of safely transporting these to dozens of examination centers and guard against leaks? Clearly there are cheaper alternatives. My proposal is to use ICT. Here is what you do.

Publish the CAT exam paper on the internet.

That way you don’t have to print it centrally. Just download it from the web to your local computer an hour before the exam. Then print out the question paper and hand it over to the students and there you have solved the problem of leaked exams. Waitaminnit is what you would say. OK, I say, I left out an important bit of the solution.

Put an encripted version on the web. So everyone has the question paper and only one person has the key. An hour before the exam begins, the key is sent out and used. Any publicly available encryption software would do. I leave the details of the implementation as an exercise for the reader.

I have been reading in newspaper reports that management school applicants appear for five to eight different entrance exams. So evidently the CAT is not so common. Assuming that about 100,000 students appear for about five exams on average to get into one of the management schools, you have half a million extra exams with its attendent cost. Assuming the total cost of each extra exam to be a conservative Rs 5,000, that represents a loss of Rs 2.5 billion or about US$ 55 million.

Management schools are not the only type of schools for which the competition is so fierce with its attendent multiple exams and consequent losses. There are medical schools and engineering schools and so on. A few billion rupees of waste here, and a few billion rupees of waste there, and soon you would be talking of waste on a colossal scale. All these wasted resources finally add up to poverty. Little drops of water and little grains of sand, etc…

So the solution is rather simple: have common testing exams and use the results to determine who gets admitted. The solution is not rocket science. In fact, the model exists in many other not so remote parts of the world. Most people in the education business must know about GRE, GMAT, LSAT, and so on. What we have to do is merely imitate them. (Pet gripe: we import all the junk from these countries — notice the wrestling and MTV channels and the Michael Jackson wannabees.) But we are particularly blind to the good stuff that we should be imitating.

In the end, it is all about transaction costs. We need to reduce the cost of doing stuff — be it for deciding who gets to attend which school, or for increasing market access for locally produced goods. The use of ICT is particularly suited for reducing transaction costs. We need to pay attention to that if we are concerned about India’s economic growth.

{Followup: See a simple encrypted exam questions system (SEEQS).}

US programmers cost approximately $80K per year. Contract programmers from India cost about $40K per year (although the programmer gets a lot less because the jobs are intermediated through firms that have to have piece of the action.) The market for programmers worldwide is not maximally inefficient — that is, it is not a fragmented market. So naturally, the law of one price is going to hold. In other words, Competition rulz.

Here is an excerpt from the tail end of that piece:

What if other companies begin taking the same approach — offering Indian-style wages to American workers? On the positive site, we could begin to solve our job-creation problems. But on the negative side, America’s standard of living would inevitably decline. There’s only one way to find out for sure how it all might shake out, and that is for other executives to replicate Jon’s experiment. The results could be quite interesting.

The implicit assumption in the question above is that GOD has decreed that the American standard of living is sacrosanct. The Americans must continue to consume a disproportionate share of the world’s resources and thus maintain their standard of living. Other people — Indians, for instance — should be content with a meagre share of the global resources. All the breast beating about the grave threat to the American standard of living is grotesque when one sees the pitiable living standards of a couple of billion humans who don’t happen to be Americans.

Transaction costs are all over the place. When I travel to talk with someone, the cost of the travel in terms of time and money is the transaction cost of the talk. I could use the phone to have a talk. That reduces the transaction cost of having the talk. Telephones are a lower cost substitute for transportation in this case. This is one way that information and communications technologies reduce transaction costs. It is cheaper to move electrons than to move molecules.

All technological progress is an attempt to reduce costs and reducing transaction costs presents great opportunities since transaction costs account for a very large share of the total costs of stuff.

Now turning to the issue of developing countries and the use of ICT, the matter central to our discussion. Developing countries are resource constrained and therefore reducing transaction costs is a great way to stretch resources. Instead of a costly bus ride, use the phone. Ironically, it is often the case that in developing countries bus rides are cheaper than phone calls — because phone calls are senselessly priced too high leading to efficiency losses.

A high-quality always-on widely available affordable communications network is an absolutely essential part of the infrastructure for any economy, especially a developing one. Since this requires significant fixed costs and since there are immense positive externalities (network and consumption externalities), the market will underprovide communications networks. Therefore, the provision of a communications network should be subsidized for achieving the socially optimal solution. Conversely, taxing the provision of a communicatins network would have negative consequences. And that is what short-sighted money-grubbing developing country policy makers do: they tax the sector instead of subsidizing it.

India is poor because of the totally insane public policies. Heavily taxing communications technology is perhaps one of the most eggregious example of such brain dead policies. For many decades, the government of India in its infinite wisdom considered phones to be a luxury and priced it out of the reach of nearly 100% of the population. That is why the department of telecommunications was able to install on an average half a million phones a year for about 40 years of its existence. Now we add half a million phones in a week.

We will continue to explore the use of ICT for development in the future.

How do you allocate the value added in this case? Most of it has to be assigned to services — from the marketing of the bread, to the stocking of it in the store shelf. The cost incurred in bringing a loaf of bread to the market (less the cost of the material, the fuel and labor involved in the baking and transportation) is transaction costs.

Of course, costs seen from a different angle are revenues and incomes. And part of revenues are profits (if prices exceed costs.) The generalization of these costs are transaction costs.

Transaction costs are ubiquitous. Consider what happens in any organization, say a car manufacturing firm. Cars are produced by people using machines to transform steel and other stuff. If you add up the costs — labor, material, and machines — the car would not cost all that much. But when you add the fact that there are other people employed by the car firm who have nothing to do with the manufacturing of cars, you realize that they represent transaction costs. For instance, you have managers, and accountants, and secretaries, and human resources divisions, … the list goes on. They all represent transaction costs. And the greater the transaction costs, the higher the cost of production. Why do firms exist? Because they reduce transaction costs.

Ultimately, one can explain pretty much all organizations as an attempt to systematically reduce transaction costs. Economies of scale, scope, and agglomeration themselves arise from the reduction of transaction costs.

Information and communications technologies reduce transaction costs. Here is a simple demonstration of that. The next time you make a phone call, ask yourself what it would have cost you if you could not have made that call.

For instance, I called the store to find out if they had indeed installed the AC in my apartment. (They had not.) If I could not have made the call, I would have had to spend at least two hours and a lot of money to travel to the store to find out that information.

I will continue to ramble on the transaction costs theory of the universe in the next few posts. As they say on the radio, stay tuned.

This week, I would like to address myself to that question in detail. The answer can be succinctly stated as: It reduces transaction costs. It will take a pretty long time to explore that answer. But first a few personal experiences to set the stage would be appropriate.

Today I called up a local store which sells white goods. I wanted to order an airconditioner. Could I order the AC over the phone, I asked when the phone was finally answered by someone. I was told that I had to come down personally and bring cash. Will they accept a debit card? No. Will they deliver today? They can’t tell me that until I had paid and only then will they check to see if the department that does the delivery has the capacity to deliver today.

I drove to the bank to withdraw the cash. At the bank, the line for withdrawing cash was immense. I could not use the ATM because the amount I needed was above the ATM cash withdrawal limit. It took me a half hour before I had the cash in hand.

Next step: drive to the store. The closest branch was in Shivaji Nagar. I told the driver the address and we proceeded to drive the four or five kilometers to the store. It was on ‘L.J.’ road. The traffic was bad, as usual. The driver did not know where L.J. road was. We asked for directions from various taxi drivers. We traveled with hope thinking that this time the directions were right. In about 45 minutes, we had reached the store. It was closed because that branch of the store is normally close on Mondays.

I had spent about 2 hours in trying to buy something that in a different setting (for instance in California) it would have taken me all of 5 minutes and that too in the comfort of my home: I would have checked the prices of ACs on the web and ordered it online and paid for it with my credit card. Instead, after about 2 hours of frustration, I was still without what I wanted.

This little episode is indicative of a depressingly large set of similar experiences. The features of this set almost always include having to spend an inordinate amount of time searching. The search cost of locating a place is non-trivial. Street addresses don’t exist. You could be looking for a place with an address with reads “122/1/B Lajpat Nagar II”. You reach 121/1/B. And then you discover that 122/1/B is somewhere else altogether. Sequential numbers are not physically close. The house numbers are in the order in which the plots were registered, for instance. Once I spent about an hour hunting around for a place in Lajpat Nagar in Delhi. I am sure that I was not the first — nor I was the last person — to waste time and energy (gasoline) trying to locate an address there.

Another feature common to all the episodes includes transportation. On Saturday last, I was invited for dinner at a house that was about 5 kilometers (3 miles) from the Andheri local train station. I took a bus from the station. It took about 50 minutes for the bus to cover the 5 kilometers. Traffic moves about 8 kms an hour in the city of Mumbai. In India, trucks move about 18 kms an hour on the nations highways.

The movement of payments is an important function in any economy. I had to pay my brother Rs 25,000. I mailed him a check to Nasik without asking him first. He called to say that it will take about 3 weeks for that check to clear and so it would be good if I could send him cash or do a wire-transfer.

Cash is inconvenient to handle and when one is carrying a large sum of money, one is under stress. For furniture shopping, the only acceptable form of payment appears to be cash. Part of the reason is of course tax abvoidance. But the slowness with which checks clear has something to do with it as well.

There are a few things that one can do at a macroeconomic level to push the economy towards its potential such as fixing the monetary and fiscal policy. But they are limited instruments. Fundamentally, what really puts the brakes on the machinery of the economy is a very large number of very small grains of sand which are individually ignored but together form a very potent force. These grains of sand arise from what can only be said to be the overall culture of the economy.

It is an unfortunate fact that the Indian “economic culture is dismal and unless that changes, India’s economy cannot reach its potential. Becoming aware of the problem is fundamental to the solution, of course.

In the next piece, we will explore what ICT can do to remove the sand from the Indian machinery.

A couple of UC Berkeley economists, Ashok Bardhan and Cynthia Kroll, estimate that 14 million white-collar jobs are at risk of being outsourced, or about 11 percent of the total, by 2015.

I find nothing surprising about that. Consider the structural transformation of any economy. First, you have 100% of the labor in agriculture and you have a subsistence economy. Somehow agricultural productivity increases. Labor gets released from agriculture and moves to manufacturing. With time, the share of labor in agriculture declines, and share of labor in manufacturing increases. With manufacturing producitivity increase, that sector also releases labor so that the services sector grows in the labor share. Finally, agriculture and manufacturing share of labor reach very low numbers and the rest of the labor force is in the services sector.

The US had 40% of its labor in agriculture in 1900. A hundred years later, that number is only 2%. With time manufacturing will also shrink to about 5% of labor. Then the US economy will have 90% of its labor in services.

In a world where trade is possible, the old story of comparative advantage continues to hold. So tradeable services — such as BPO, programming, research, etc — will migrate to countries which have a comparative advantage in providing them.

The US does not have a comparative advantage in those services which are tradeable; India has. The good news is that India has a comparative advantage in those BPO and programming services; the bad news is that India does not have an absolute advantage in those services. We have a comparative advantage only because the average productivity of India is so abyssmally low. Low average productivity translates into low average wages. So programming wages and other wages are low in India. Therefore, if on average the productivity of Indian programmers is somewhat comparable to the productivity of US programmers, then India can potentially enjoy a comparative advantage in programming (and it does.)

Here is a related report form the NY Times of November 7th The Great Job Machine by Cox and Alm which talks about the structural change in the US economy.

A century ago, 40 of every 100 Americans worked on farms to feed a nation of 90 million. Today, after one of history’s most brutal down-sizings, it takes just two agricultural workers out of 100 workers to supply an abundance of food to a nation more than three times as large.

Likewise, the telecommunications industry employed 421,000 switchboard operators in 1970, when Americans made 9.8 billion long-distance calls. Thanks to advances in switching technology, telecommunications companies have reduced the number of operators to 78,000, but consumers ring up 98 billion calls.

…during the past decade total United States employment has risen to 130 million from 91 million since 1980, a net gain of nearly 40 million jobs. Productivity, measured by output per worker, increased a staggering 56.2 percent.

To the question of what is wrong with the US economy with regard to the ‘jobless recovery’, they answer, “Nothing.” I agree with them. There is a shift in the pattern of production. The services sector is not a monolithic entity. Different parts of it are tradeable and thus have the same dynamics as other tradeables such as cars and TV or steel. Just like the manufacture of cars shifted to Japan and then Korea, so also some services will shift to India and China and Russia.

It is as inevitable as the change of seasons. But as Robert Frost asked

When was is it to the heart of a man
Ever less than a treason
The change of a love or a season?

ICT presents an opportunity for developing countries to make more efficient use of the available resources. However, ICT is neither necessary nor sufficient for economic development. The advanced industrialized countries were underdeveloped (by today’s standards) once upon a time and their transition from subsistence to a modern exchange economy did not involve modern ICT.

In contrast to the experience of the advanced industrialized countries, the developing countries find ICT available to them at a much earlier stage of their development. These economies don’t have highly optimized economies and the use of ICT has the potential to help them transit from a subsistence to an exchange economy relatively rapidly. For this to happen, ICT must be targeted for domestic use, and not just seen as an avenue for foreign exchange earnings.

ICT is arguably strategically important for economic growth of all less developed countries (LDCs). However, government policies tend to emphasize only the export-led growth potential of ICT. India’s success in the IT-export sector is often used as an example to be emulated by countries similarly placed along the development spectrum. It is important to recognize that while IT export-led growth is an attractive goal, it is not as relevant for sustainable economic growth for rural India. However, a policy that stresses the use of ICT within the country could lead to the development of a domestic IT industry that can serve as an engine of growth by its direct contribution to job creation and GDP growth in rural India, in addition to its contributions to the urban economy. (Needless to say, other appropriate technology can also have a multiplier effect on resources available.)

Production versus Use

The production of IT related products and services targeted for export markets is generally done in high-technology enclaves. The benefits of the production and the use of IT is therefore limited to the small number of producers in the LDC while the majority of the benefits accrue to the users of the IT products and services in the importing developed countries. The products address the needs of the importing countries and they gain significantly from the use of IT produced at low cost in the LDCs.

Increasing the Income Divide

While the IT-export sector may be earning foreign exchange through IT production, there is no benefit from the use of IT products and services to the country as a whole. The vast majority of the people are completely unaffected and do not obtain any gains from the use of IT; only the producers of the IT products increase their human capital. Consequently, the income inequality within the country itself grows which has adverse macroeconomic consequences.

ICT for Sustainable Economic Growth

For economic development to be sustainable, it has to be broad-based. IT-export led growth alone cannot result in broad-based growth because the knowledge-goods produced by the country are targeted not to a domestic market but to an export market.

Economic growth models emphasize the importance of capital – both human and physical – state of the technology and the dependence of growth on the size of the market. We view IT in this context as an enabler of delivery of services. Domestic demand for IT products and services will spur the domestic production of IT and knowledge-goods. There are important forward and backward linkages in the domestic consumption of IT products and services that go beyond the benefits attained by IT exports alone. For instance, the use of IT in the education and health sectors will provide a large user base which will not only have access to new technology but also participate in the information economy.

Evidence of the effect of ICT on Economic Growth

Is there any hard evidence that ICT has an effect on growth? Most of us believe that the ICT does have a positive effect on growth. In a recent book, Matti Pohjola reports that The Working Group of the United Nations Commission on Science and Technology for Development recommends that each country establish a national ICT strategy aiming at maximizing the benefits of ICTs and minimizing their risks. He concludes that

“… in recent years IT has had a strong influence on economic growth in industrial countries and at least in those newly industrialized countries (that is, Korea and Singapore) studied in this volume. Admittedly, however, developing countries seem to have neither invested in IT nor benefited from such investments to the same extent as industrial countries. There is concern that information is becoming a factor, like income and wealth, by which countries are classified as rich and poor. To prevent this from happening, developing countries need to formulate national IT strategies to promote the use of these new technologies.”

It can be argued that more than the production of IT goods and services, the use of IT goods and services is more critical for economic growth. The question whether ICT contributes to growth or not is akin to the question whether transportation contributes to growth. Both are instrumental and provided that they are used appropriately, growth enhancing. Investment in ICT for developing countries is not anymore an option than investing in a transportation network is an option. It is absolutely necessary, although it is far from sufficient to ensure growth.

The two most important functions for ICT are these. First, improving the functioning of markets. What to produce, how to produce, what to sell, how to sell, where to sell — all these are critical questions that directly affect growth. Clearly ICT is indispensable for this function. The second function is in the area of production and delivery of educational content. When the majority of the population is illiterate, the resources needed for educating them (and not just making them literate) is formidable. ICT provides the only hope of leveraging limited resources to address this problem.

The proximate causes of poverty can be seen as two gaps: the ideas gap and the objects gap. The objects gap is the lack of physical resources – too little land, too little capital stock, etc – that contributes to persistent poverty. The ideas gap is the lack of know-how about how to make the best use of the resources one has. It is the ideas gap that ICT can most effectively bridge.

The Case for India

India has had a reasonable amount of success in the export of ICT products and services. But until IT is used, it is hard to predict what exactly the impact will be. However, it is a reasonable expectation that IT cannot but have a beneficial effect by its use.

Domestic ICT use must be given the attention it deserves because only through broad-based ICT use can the benefits of modern technology be made available to all and bridge the income divide. Domestic use will have important linkages to the supply of human capital required for the export of ICT products and services.

For a large country such as India, domestic demand for ICT products and services can provide the necessary base for sustaining the industry and to shield it from external shocks. Therefore, India must create the institutions that encourage the use of ICT domestically.

He answered, “Well, growing corn in my field requires pollen from the neighboring fields. If they don’t have good corn in their fields, I will never be able to grow good corn myself. So I distribute the good corn seeds.”

The benefits of positive externalities (or the harm from negative externalities) lead to social benefits (or social costs) that eventually benefit (or cost) all. What goes around, comes around, as the saying goes. In Indian terms, it is all karma, neh?

Rajesh Jain recognized the positive externality of his Emergic Blog intuitively. He therefore puts his best ideas there. Each day that blog has around a thousand visitors. They all gain from his fine presentation. But eventually, in ways completely unforeseen, he reaps an even richer harvest of new ideas that develop through his interactions with other minds on the web.

Ideas matter. Ideas are primary. Ideas are the ultimate public good in that they are totally non-rival: my use of an idea does not diminish your capacity to use it as well. Ideas can pass from one human mind to another and set up a chain reaction that has the power to transform the world. Everything that you see around you — the good, the bad, the ugly — everything was just an idea in some mind. (Some Hindus claim that this universe is just an idea in the mind of God.)

How to harness the power of ideas for the social good is the challenge that we have to undertake.