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.

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.

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.

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.”

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).}

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.