Upside down pricing in payment services

Some Indian banks charge for services that are cheap to execute, and offer for free expensive services 

Last week I enddd up spending some time waiting at a teller counter at a bank. This was due to some mess up with a cheque I had received. During my time at the teller counter I had the opportunity to observe other people at the same counter. 

There were a few people depositing cash into their business accounts. A few others were depositing cheques. What caught my attention, however, was this guy from a nearby business who came to deposit a large number of cheques. 

He had an entire book of challan leaves (banks regularly issue those to business customers), to each of which was stapled a cheque. As I watched, the teller would put a seal on a cheque, its corresponding challan and another seal on the counter foil. This process was repeated for each challan in the book. 

And this process was only to accept the cheques. Later on there would’ve been further effort on behalf of the bank to cash the cheque and actually execute the fund transfer. And then add in the effort of writing out all those cheques, writing out all those challans (they’re hard to print) and then take them to the bank. 

It was a rather laborious process all round, on behalf of all parties involved. Yet, banks mostly execute this function for free for most customers. 

On the other hand, they charge for account to account transfers, and the amount isn’t particularly small. Like this morning I was moving money from one account  to another, a process that took me a minute and that wouldn’t have cost the bank any human minutes. And icici bank decided to charge me for it. 

It seems like banks have their pricing and the valuation of their own effort all wrong. For electronic payments the cost is direct – what the banks have to pay the payments systems and any per use software costs. And this makes it easier to value and charge for such services. 

The effort in transacting through cheques, on the other hand, is not directly measurable (though by no means an impossible exercise). There are back offices that do the job whose cost is easy to measure, but several employees who also do other things spend time processing cheques. And this difficulty in measurement means that most banks just don’t charge for cheques. 

Around 2000 when foreign banks expanded their branch networks in india there was an attempt to charge customers for walking into the branch – customers were encouraged to do their business at ATMs or over the phone, instead. This was in recognition of the costs of customer walkins into branches.  

Banks would do well now to do something similar for cheques as well – despite the cheque truncation system (CTS), the effort involved in organising payments through cheques is massive for the bank. 

There is only one upside to cheques – and this is a downside for customers. Cheques result in money going into limbo. The payer doesn’t know when the funds will leave his account and can’t use the funds. The recipient can’t use it either until he has got it. So for the duration that the amount is “in transit” (and this duration can vary significantly) banks can happily use these funds without them being called. 

It’s possible that the benefit to the banks from this float more than compensates for the pain of processing cheques. If not, cheques have no business existing any more! 

The purpose of reunions

So later today and tomorrow, the class of 2006 at IIMB is going to have a reunion. Reactions to this have been mostly mixed. Some people have been excited about it for months together. Some have been dismissive, loathing the idea of meeting some people they used to know. Most have gone along with the flow, quietly registering and promising to turn up.

As I’ve dealt with people showing all these reactions, I was thinking of why reunions make sense. I had even tweeted this last year:

As the reunion has come closer, though, my views have become more nuanced. Yes, I’ve kept in touch with all those batchmates I’ve wanted to keep in touch with. However, transaction costs (have I told you I’m writing a book on that topic? Just wrapped up third draft) mean that it’s not been possible to meet many of them.

It is not feasible, for example, to schedule a trip all the way to London because a handful of people you want to meet live there. Nor is it possible that even if you visit Mumbai, regularly, you are able to put “gencu” with everyone you have intended to put gencu with.

And so it remains, that you keep putting off meeting those people you want to meet until a time when transaction costs are low enough for you to be able to meet.

There are transaction costs that operate in other ways as well – a scheduled bilateral meeting is a commitment to exclusively talk to each other for at least close to an hour. And sometimes when you want to meet someone for the purpose of catching up, you aren’t sure if you can spend an hour with them without either of you getting bored. And so you put off that gencu.

The beauty of a scheduled reunion is that it takes into account both these costs. Firstly, by ensuring a large number of people congregate at one place at one time, it amortises (among all the counterparties you meet) the cost of having travelled to the meeting. Secondly, given that there are so many people around there, you don’t have an obligation to talk to anyone beyond the time when it’s pleasant for both of you (sadly, IIMB has outlawed alcohol on campus during the last decade so “i’ll go get a refill” trick of walking away won’t work).

The other great thing about a scheduled reunion (organised by the Alma Mater’s alumni office) is that it acts as what Thomas Schelling termed as “focal points“. Focal points are basically solutions to coordination games where each player plays in a natural or obvious way, expecting others to play the same way as well, so that they coordinate.

Now let’s say that the IIMB Class of 2006 decided to all meet sometime during the course of the year. Coordinating on a date would have been impossible, with any arbitrarily chosen date attracting too few people for network effects to take effect.

With the alumni office proposing a date and venue, it now becomes an “obvious solution” to everyone coming together and going through a process on that date (anchoring is also involved). People are willing to make the investment to meet on that date because they expect others to be there as well. So I’ve registered for this weekend’s event with the expectation that a large number of my batchmates would have done so as well, and each of them would have in turn registered for a similar reason.

Over the next couple of days I expect to spend a lot of time with people I’ve anyway been in touch with over the last 10 years. I might also spend a small amount of time with people I don’t really want to meet. But there is a large number of people I want to keep in touch with, but can’t due to transaction costs, and that is where I expect the reunion to add most value!

The effect of fall in petroleum prices

As I was driving away after having filled petrol in my car, I was wondering about the steep drop in petrol prices. Not so long ago, you would get only about 12 litres for Rs. 1000 in Bangalore. Today I paid the same amount and got close to 15 litres – almost a fourth more than what I used to get not so long ago!

I started thinking of the economic impact of the fall in petroleum prices. The obvious effect is the direct effect in that products for which petroleum is an input (this includes pretty much any good that is transported) see a fall in prices to the extent of the contribution of petroleum to their final prices. That, however, is only a small part of the impact on the economy.

The more important impact on the economy from the fall in petroleum prices is that it results in a drop in transaction costs (costs borne by buyer of a good/service which don’t accrue to the seller)! This is because transporting anything now has become a lot cheaper (by about 20%, which is significant), so goods and services that were not being traded earlier because of the transportation cost being prohibitive have a good chance of being traded now!

This graph shows the impact of transaction costs (tax is a special case) on the clearing price and quantity. Notice that a fall in transaction cost (mentioned as “tax” in the figure) leads to both increase in traded quantity as well as lower prices

The fall in transaction costs means that economic activity will increase, and given that the fall in transaction costs in this case is rather sharp (20% is no joke), the corresponding increase in economic activity should be significant! My personal take is that analysts are grossly underestimating the impact of falling petroleum prices on GDP growth in India.

Why app based taxi services should not be banned

The move towards banning Uber and other app-based taxi services is devoid of logic on several counts

Writing during the Takshashila Hudson conference on India’s growth I had argued that an easy way to increase the level of business activity in the country, and thus GDP was by means of reducing transaction costs. Transaction costs are costs borne by buyers of a good or Service which don’t accrue to the seller.

The thing with transaction costs is that they introduce friction in the market – the cost ends up reducing both the market clearing price (as it accrues to the seller) and the market clearing quantity. And transaction costs are usually to no ones gain and thus reducing them is a quick and pareto optimal method of boosting GDP.

In this regard, the government must encourage all means that result in reduction of transaction costs. For example better road and rail network significantly reduce the transaction cost of moving goods and people. Removal of interstate taxes on goods and services results in more optimal setups of warehouses and plants.

Similarly apps such as Uber play an important role in reducing transaction costs in the local taxi market. By reducing the distance and time to be traveled by the driver, and by reducing the amount of the the passenger has to wait for the cab, these services significantly reduce the cost of local transport and benefit drive and users alike.

Thus moves such as banning such services are utterly brainless and devoid of logic. Moreover such moves will dampen investor sentiment in India and kill off any positive vibes that have been generated ever since the current government came to power.

I hope better logic prevails and the government focuses on improving law and order (a public good that can further reduce transaction costs) rather than knee jerk actions like banning taxi services which seek to reduce transaction costs.

Revisiting fundamentals of GDP growth

In light of the ongoing Takshashila-Hudson conference on Shaping India’s Growth Agenda, it is instructive to revisit some fundamentals of GDP and GDP growth.

  • Real GDP grows when there is more economic activity in the region in this time period compared to the last time period (the “real” aspect of GDP growth means that growth due to changes in price levels is stripped out)
  • We can have more economic activity in two ways – we can have more of existing economic activities, or when new economic activities get created
  • An example of the former (increase in economic activities) is if say the production and consumption of mangoes in India rises from 100 units last year to 110 units this year. This implies that there is an increase in the economic activity of production and consumption of mangoes
  • In terms of new economic activities, I will take the example of my own business of quantitative management consulting – I help companies use data and quantitative methods to improve their business. I’m providing a service which (say) didn’t exist previously. Thanks to my services, my clients can improve the quality of their business, and their gains from these improvements are more than my fees. Thus my services have resulted in more economic activity
  • Every time a policy is proposed that is supposed to “increase GDP”, ask yourself how it will actually result in an increase in GDP – whether it aids more economic activity in existing goods and services or if it supports the growth of new economic activities
  • Taxation results in increased clearing price and decreased clearing quantity (Econ 101).
    The effect of tax/transaction cost on clearing price and quantity

    Once can argue that a reduction in taxes can thus foster greater economic activity. However, it must be remembered that taxation is what funds the government. Hence it is not prudent to reduce taxes too much

  • Decrease in transaction cost (cost paid by buyer but that doesn’t go to seller) leads to increased quantity of economic activity (it works exactly the same way as the tax graph above). Decrease in transaction cost is usually Pareto optimal. Any measures that decrease transaction costs can help foster greater economic activity
  • Transaction costs can occur due to multiple ways. In commodity (including food) markets, they can be seen in terms of a high bid-ask spread. Transaction cost, however, is not necessarily monetary. If you need to travel for a transaction, that is transaction cost. If you have to stand in line to buy something, the time spent again is transaction cost. Time spent by goods waiting for customs or octroi clearance is transaction cost
  • Focusing on eliminating transaction costs is a sure fire way to spur economic growth. This is why measures such as the GST (which cuts waiting time of goods at inter-state borders, among other things) are important
  • It is also important to take measures that allow entrepreneurs to take risks and try and create new classes of goods and services which were hitherto not traded. Thus we need policies that reduce the cost (monetary and otherwise) of starting a business. This includes the time taken to set up a business. This also includes policies that allow an unsuccessful business to be wound up quickly so that the capital and labour hitherto employed can be more profitably employed elsewhere

I can go on (and I realize I’ve gone beyond fundamentals here), but I think this does enough to set the agenda for today’s discussions, so I’ll stop here. Just one last thing – a phrase that is likely to be bandied about a fair bit in today’s conference is “this measure can add X% to the GDP”. Whenever someone says that you need to ask the question of whether it is a one time increase in the GDP or if it can lead to a sustainable increase in GDP growth (that’s the “resident quant” bit for this blog post).

Baptists and Bootleggers: Karnataka Edition

“Baptists and bootleggers” is a popular concept in economics. It is used to illustrate that in the absence of sound economic thinking, good intentions don’t count for much. According to this concept, baptists want to ban the sale of alcohol on Sundays because it is the day of the lord, and they don’t want people to be drinking that day. And this plays out directly into the hands of bootleggers – who make a living supplying people their booze on Sundays.

So by calling for the sale of liquor to be banned on Sundays, baptists are essentially encouraging an illegal activity and an illegal trade. If not for the baptists, people would be able to buy their liquor legally on Sundays, and bootleggers would be out of business.

There is also a social cost to policies like this – by pushing an activity (such as the sale of liquor on Sundays) underground, you encourage nefarious elements to get into business, rather than keeping it in clean hands. And this is likely to increase the overall rate of crime.

Thus, by their supposedly moral position that alcohol should not be sold on Sundays, baptists actually end up unintentionally encouraging crime!

A similar story to this has been playing out in Karnataka in the last twenty years. For whatever reason, in 1993, the government of Karnataka decided to freeze the total number of liquor licenses in the state. Since 1993, if you want to open a bar or a liquor shop, you need to purchase a license from the secondary market. Effectively, for every new liquor outlet, some outlet somewhere in the state has to close down (whether such closure is usually voluntary or not is left as an exercise to the reader). This increases the cost of liquor intermediation in the state and leads to higher prices for the consumer.

While higher prices may be desirable for “sin goods” such as liquor, there is a better way for the government to increase consumer prices – by levying higher taxes, which ensures that the additional money thus paid by the consumer flows into the government coffers. By limiting the number of licenses, however, the government doesn’t get extra revenue.

Instead what this encourages is illegal sale of liquor! That there is a limit on the number of liquor licenses doesn’t push down people’s need for liquor. And they end up buying liquor from illegal sources and bootleggers, and it becomes difficult to maintain quality and hygiene standards on such sales. And with a bar having to close down for every new one that needs to open, you might imagine the kind of characters that might get involved in the process.

Back in 2008, a friend was trying to start a lounge bar, and he mentioned that he had to pay up to the tune of Rs. 30 lakh to get his license, while the official price is about a tenth of the amount. It is obvious that not all the money he paid for his license went to the government’s coffers.

Where do the baptists come here? Because every time there is a proposal to increase the number of liquor licenses, you will have a wave of morality which protests this decision. They are the baptists who keep Karnataka’s bootleggers in business.

Also read this piece on the funny rules of Karnataka’s liquor licensing regime.

Generalists and specialists

So you have generalists and specialists. Generalists are fundamentally smart people who can do a variety of things. They take a look at a problem, take some time to understand the basics, and then go about solving it. They get bored easily, and move from problem to problem. Generally, they don’t dig deep but are well equipped enough to solve most problems.

Specialists, as the name suggests, dig deep into a particular problem. They are the kings of all they survey within their domain, and know every little trick in the book. However, they are usually unaware of the world outside of their wells, and suffer from the hammer-nail problem (to a man with a hammer, everything looks like a nail). They are also deeply insecure – for if their area of specialization gets invaded by generalists, they are likely to lose their livelihood. So, they are incentivized to build walls, and make it harder for generalists to invade. Generalists don’t have any such problem. Given their nature, if one fort gets invaded, they can soon go ransack another.

The world is dominated by specialists, and they continue to build walls around themselves. Artificial barriers to entry get created (such as “experience requirements”). While this keeps their domains safe, it leads to an increase in transaction costs and overall decrease in efficiency.

Take accounting as an example. In principle, it is not a particularly hard practice. What makes it particularly hard for aspiring accountants is the way you go about becoming an accountant. You need to pass an exam, set by the association of accountants, and then intern under an already qualified accountant (who pays you less than minimum wage) and pass another exam (again set by the association of accountants) in order to practice accounting. The exam and internship are rigorous enough that you need to devote two or more years of your life (full time) in trying to get your charter. All for a profession that is fundamentally fairly intuitive. So that the specialists’ turf is protected (of course the accountants have every incentive to keep the requirements to the charter prohibitively tough – for more chartered accountants would mean more competition and hence less margins).

Another example is in math papers. They are so formula and jargon ridden that it is prohibitively difficult for anyone who is not a full-time mathematician to make much sense of them. While some of the rigour may actually be justified, most of it is for the sake of preserving the mathematicians’ turf. The same applies in general to all peer-reviewed paper publication journals and conferences.

Social scientists are afraid of economists. Financial traders (from a commerce background) are afraid of engineers. In business schools, “marketing students” are afraid of “finance students” (more on this in another post). Their only defence is raising barriers, forming cliques and spewing jargon.