Tag: transaction costs

Ronald Coase, Scott Adams and Intrapersonal Vertical Integration

I have a new HR policy. I call it “intrapersonal vertical integration”. Read on.

I

Back in the 193os, economist Ronald Coase wrote an article on “the nature of the firm” (the link is to Wikipedia, not to the actual paper). It was a description of why people form companies and partnerships and so on, rather than all being gig workers negotiating each piece of work.

The key concept here was one of transaction costs – if everyone were to be a freelancer, like I was between 2012 and 2020 (both included), then for every little piece of work there would need to be a piece of negotiation.

“Can you build this dashboard for me?”
“Yes. That would be $10000”
“No, I’ll only pay $2000”
“9000”
“3000 final”
“get lost”

During my long period of freelancing, I internalised this, and came up with a “minimum order value” – a reasonable amount which could account for transaction costs like the above (just as I write this, I’m changing videos on Youtube for my wife, and she’s asking me to put 30 second videos. And I’m refusing saying “too much transaction cost. I need my hands for something else (blogging)” ).

This worked out fine for the projects that I actually got, but transaction costs meant that a lot of the smaller deals never worked out. I lost out on potential revenue from those, and my potential clients lost out on work getting done.

So, instead, if I were to be part of a company, like I am now, transaction costs are far lower. Yes, we might negotiate on exact specifications, or deadlines, but price was a single negotiation at the time I joined the firm. And so a lot more work gets done – better for me and better for the company. And this is why companies exist. It might sound obvious, but Coase put it in a nice and elegant theoretical framework.

II

I’ve written about this several times on my blog – Scott Adams’s theory that there are two ways in which you can be really successful.

1. Become the best at one specific thing.
2. Become very good (top 25%) at two or more things.

This is advice that I have taken seriously, and I’ve followed the second path. Being the best at one specific thing is too hard, and too random as well – “the best” is a sort of a zero sum game. Instead, being very good in a few things is easier to do, and as I’d said in one of my other posts on this, being very good in uncorrelated things is a clear winner.

I will leave this here and come back later on in the post, like how Dasharatha gave some part of the mango to Sumitra (second in line), and then decided to come back to her later on in the distribution.

III

I came up with this random theory the other day on the purpose of product managers. This theory is really random and ill-formed, and I haven’t bothered discussing it with any real product managers.

The need for product managers comes from software engineers’ insistence on specific “system requirement specifications”. 

I learnt software engineering in a formal course back in 2002. Back then, the default workflow for software engineering was the so-called “waterfall model”. It was a linear sequential thing where the first part of the process goes in clearly defining system requirement specifications. Then there would be an unambiguous “design document”. And only then would coding begin.

In that same decade (2000s), “agile” programming became a thing. This meant fast iterations and continuous improvements. Software would be built layer by layer. However, software engineers had traditionally worked only with precise specifications, and “ambiguous business rules” would throw them off. And so the role of the product manager was created – who would manage the software product in a way that they would interface with ambiguous business on one side, and precise software engineers on the other.

Their role was to turn ambiguity to certainty, and get work done. They would never be hands on – instead their job would be to give precise instructions to people who would be hands on.

I have never worked as either a software engineer or a product manager, but I don’t think I’d enjoy either job. On the one hand, I don’t like being given precise instructions, and instead prefer ambiguity. On the other, if I were to give precise instructions, I would rather use C++ or Python to give those instructions than English or Kannada. In other words, if I were to be precise in my communication, I would rather talk to a computer than to another human.

It possibly has to do with my work history. I spent a little over two years as a quant at a top tier investment bank. As part of the job, I was asked to write production code. I used to protest, saying writing C++ code wasn’t the best use of my time or effort. “But think about the effort involved in explaining your model to someone else”, the higher ups in the company would tell me. “Wouldn’t it be far easier to just code it yourself?”

IV

Coase reasoned that transaction costs are the reason why we need a firm. We don’t need frequent negotiations and transaction costs, so if people were to get together in the form of a firm, they could coordinate much better and get a lot more work done, with more value accruing to every party involve.

However, I don’t think Coase went far enough. Just putting people in one firm only eliminates one level of transaction costs – of negotiating conditions and prices. Even when you are in the same firm, coordinating with colleagues implies communication, and unless precise, the communication links can end up being the weak links in how much the firm can achieve.

Henry Ford’s genius was to recognise the assembly line (a literal conveyor belt) as a precise form of communication. The workers in his factories were pretty much automatons, doing their precise job, in the knowledge that everyone else was doing their own. The assembly line made communication simpler, and that allowed greater specialisation to unlock value in the firm – to the extent that each worker could get at least five dollars a day and the firm would still be profitable.

It doesn’t work so neatly in what can be classified as “knowledge industries”. Like with the product manager and the software engineer, there is a communication layer which, if it fails, can bring down the entire process.

And there are other transaction costs implied in this communication – let’s say you are building stuff that I need to build on to make the final product. Every time I think you need to build something slightly different, it involves a process of communication and negotiation. It involves the product manager to write a new section in the document. And when working on complex problems, this can increase the complexity multifold.

So we are back to Scott Adams (finally). Building on what I’d said before – you need to be “very good” at two or more things, and it helps if these things are uncorrelated (in terms of being able to add unique value). However, it is EVEN MORE USEFUL if the supposedly uncorrelated skills you have can be stacked, in a form of vertical integration.

In other words, if you are good at several things that are uncorrelated, where the output of one thing can be the input into another, you are a clear winner.

Adams, for example, is good at understanding business, he is funny and he can draw. The combination of the first two means that he can write funny business stories, and that he can also draw means he has created a masterpiece in the form of Dilbert.

Don’t get me wrong – you can have a genius storyteller and a genius artist come together to make great art (Goscinny and Uderzo, for example). However, it takes a lot of luck for a Goscinny to find his Uderzo, or vice versa. I haven’t read much Asterix but what I’m old by friends is that the quality dropped after Uderzo was forced to be his own Goscinny (after the latter died).

At a completely different level – I have possibly uncorrelated skills in understanding business and getting insight out of data. One dovetails into the other and so I THINK I’m doing well in business intelligence. If I were only good at business, and needed to keep asking someone to churn the data on each iteration, my output would be far far slower and poorer.

So I extend this idea into “intrapersonal vertical integration”. If you are good at two or more things, and one can lead into another, you have a truly special set of skills and can be really successful.

Putting it another way – in knowledge jobs, communication can be so expensive that if you can vertically integrate yourself across multiple jobs, you can add significant value even if you are not the best at each of the individual skills.

Finish

In knowledge work, communication is the weakest link, so the fewer levels of communication you have, the better and faster you can do your job. Even if you get the best for every level in your chain, the strength (or lack of it) of communication between them can mean that they produce suboptimal output.

Instead if you can get people who are just good at two or more things in the chain (rather than being the best at any one), you can add significantly better value.

Putting it another way, yes, I’m batting for bits-and-pieces players rather than genuine batsmen or bowlers. However, the difference between what I’m saying and cricket is that in cricket batting and bowling are not vertically integrated. If they were, bits and pieces players would work far far better.

The Downside

I’ve written about this before. While being good at uncorrelated things that dovetail into one another can be a great winning strategy, liquidity can be your enemy. That you are unique means that there aren’t too many like you. And so organisations may not want to bet too much on you – since you will be hard to replace. And decide to take the slack in communication and get specialists for each position instead.

PS: 

I have written a book on transaction costs and liquidity. As it happens, today it is on display at the Bangalore Literature Festival.

Cross posted on LinkedIn

Freelancing and transaction costs

In the six years of running my own consulting business, I’d forgotten about an essential part that you need to endure as part of a job – piecemeal work. It is fairly often when you’re working for someone else that you get work that is so tiny or insignificant that you can hardly take ownership of it. The best strategy for dealing with it is to quietly get it over with and hope you won’t get such stuff again.

However, sometimes you can get caught in a rut of continuously getting this kind of work, and start wondering what you actually signed up for. And this is one thing I hadn’t expected to encounter when I got back to full time working earlier this year.

Thinking about why I never had to encounter such stuff during my consulting life, I realised there’s a fairly simple explanation – transaction costs.

Being a consultant is high transaction cost business. Every time you need to take on a new piece of work, you need to go through the charade of negotiating specifics with the client, pricing and drawing up a contract. All put together, the effort is not insignificant.

Moreover, in the line of work that I used to do, there was this massive overhead cost of understanding, cleaning and getting comfortable with the client’s data  – the effort involved in that meant that after a particular point in time I stopped taking work that wasn’t chunky enough. For a while I started refusing such work, but then got smarter and started pricing myself out of such work (though some clients were generous enough to meet that price to get their little tasks done – effectively I’d passed on the transaction costs to them).

The downside of this, of course, was that there was a fair amount of money I could have made taking up small works which I didn’t since the transaction cost was too high – this can be thought of as potential lost revenues. The upside was that whatever work I did was of high quality and (hopefully) made a big impact on the client’s business.

In the nature of the firm, Ronald Coase wrote that the purpose of the corporation was that transaction cost of dealing with co-workers can be eliminated. But then, I realise that sometimes this transaction cost can also be a good thing!

Oh, and obligatory plug here – my book Between the buyer and the seller deals with transaction costs, among other things. It’s available for sale (both in print and digital) on Amazon.

 

The nature of the professional services firm

This is yet another rejected section from my soon-t0-be-published book Between the buyer and the seller. 

In 2006, having just graduated from business school, I started my career working for a leading management consulting firm. This firm had been one of the most sought after employers for students at my school, and the salary they offered to pay me was among the highest offers for India-based jobs in my school in my year of graduation.

The elation of being paid better than my peers didn’t last too long, though. In what was my second or third week at the firm, I was asked to help a partner prepare a “pitch deck” – a document trying to convince a potential client to hire my firm for a piece of work. A standard feature in any pitch deck is costing, and the cost sheet of the document I was working on told me that the rate my firm was planning to bill its client for my services was a healthy multiple of what I was being paid.

While I left the job a few months later (for reasons that had nothing to do with my pay), I would return to the management consulting industry in 2012. This time, however, I didn’t join a firm – I chose to freelance instead. Once again I had to prepare pitch decks to win businesses, and quote a professional fee as part of it. This time, though, the entire billing went straight to my personal top line, barring some odd administrative expenses.

The idea that firms exist in order to take advantage of saving in transaction costs was first proposed by Ronald Coase in what has come to be a seminal paper in 1937. In “The Nature of the Firm”, Coase writes:?

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of ‘organising’ production through the price mechanism is that of discovering what the relevant prices are.

In other words, if an employer and employee or two divisions of a firm were to negotiate each time the price of goods or services being exchanged, the cost of such negotiations (the transaction cost) would far outstrip the benefit of using the price mechanism in such a case. Coase’s paper goes on to develop a framework to explain why firms aren’t larger than they were. He says,

Naturally, a point must be reached where the costs of organising an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market.

While Coase’s theories have since been widely studied and quoted, and apply to all kinds of firms, it is still worth asking the question as to why professional services firms such as the management consulting firm I used to work for are as ubiquitous as they are. It is also worth asking why such firms manage to charge from their clients fees that are far in excess of what they pay their own employees, thus making a fat spread.

The defining feature of professional services firms is that they are mostly formed by the coming together of a large number of employees all of whom do similar work for an external client. While sometimes some of these employees might work in teams, there is seldom any service in such firms (barring administrative tasks) that are delivered to someone within the firm – most services are delivered to an external client. Examples of such firms include law firms, accounting firms and management consulting firms such as the one I used to work for (it is tempting to include information technology services firms under this banner but they tend to work in larger teams implying a higher contribution from teamwork).

One of my main challenges as a freelance consultant is to manage my so-called “pipeline”. Given that I’m a lone consultant, there is a limit on the amount of work I can take on at any point in time, affecting my marketing. I have had to, on multiple occasions, respectfully decline assignments because I was already tied up delivering another assignment at the same point in time. On the other hand, there have been times (sometimes lasting months together) where I’ve had little billable work, resulting in low revenues for those times.

If I were to form a partnership or join a larger professional services firm (with other professionals similar to me), both my work and my cash flows would be structured quite differently. Given that the firm would have a reasonable number of professionals working together, it would be easier to manage the pipeline – the chances of all professionals being occupied at any point in time is low, and the incoming work could be assigned to one of the free professionals. The same process would also mean that gaps in workflow would be low – if my marketing is going bad, marketing of one of my busy colleagues might result in work I might end up doing.

What is more interesting is the way in which cash flows would change. I would no longer have to wait for the periods when I was doing billable work in order to get paid – my firm would instead pay me a regular salary. On the other hand, when I did win business and get paid, the proceeds would entirely go to my firm. The fees that my firm would charge its clients would be significantly higher than what the firm paid me, like it happened with my employer in 2006.

There would be multiple reasons for this discrepancy in fees, the most straightforward being administrative costs (though that is unlikely to account for too much of the fee gap). There would be a further discount on account of the firm paying me a regular salary while I only worked intermittently. That, too, would be insufficient to explain the difference. Most of the difference would be explained by the economic value that the firm would add by means of its structure.

The problem with being a freelance professional is that times when potential clients might demand your services need not coincide with the times when you are willing to provide such services. Looking at it another way, the amount of services you supply at any point in time might not match the amount of services demanded at that point in time, with deviations going either way (sometimes you might be willing to supply much more than what is demanded, and vice versa).

Freelance professionals have another problem finding clients – as individual professionals, it is hard for them to advertise and let all possible potential clients know about their existence and the kind of services they may provide. Potential clients have the same problem too – when they want a piece of work done by a freelance professional, it is hard for them to identify and contact all possible professionals who might be able and willing to carry out that piece of work. In other words, the market for services of freelance professionals is highly illiquid.

Professional services firms help solve this illiquidity problem through a series of measures. Firstly, they acquire the time of professionals by promising to pay them a regular income. Secondly, as a firm, they are able to advertise and market the services of these professionals to potential clients. When these potential clients respond in the affirmative, the professional services firms sell them the time of professionals that they had earlier acquired.

These activities suggest that professional services firms can be considered to be market makers in the market for professional services. Firstly, they satisfy the conditions for market making – they actually buy and take on to their books the time of the professionals they hire, giving them a virtual “inventory” which they try to sign on. Secondly, they match demand and supply that might occur at different points in time – recruitment of employees occurs asynchronously with the sale of business to clients. In other words, they take both sides of the market – buying employees’ time from employees and selling this employees’ time to clients! Apart from this, firms also use their marketing and promotional activities that their size affords them to attract both employees and clients, thus improving liquidity in the market.

And like good market makers, firms make their money on the spread between what clients pay them and what they pay their employees. Earlier on in this chapter, we had mentioned that market making is risky business thanks to its inventory led model. It is clear to see that professional services firms are also risky operations, given that it is possible that they may either not be able to find professionals to execute on contracts won from clients, or not be able to find enough clients to provide sufficient work for all their employees.

In other words, when a professional joins a professional services firm, the spread they are letting go of (between what clients of their firms pay the firms, and what professionals draw as salaries) can be largely explained in terms of market making fees. It is the same case for a client who has pays a firm much more than what could have been paid had the professional been engaged directly – the extra fees is for the market making services that the firm is providing.

From the point of view of a professional, joining a firm might result in lower average long-term income compared to being freelance, but that more than compensates for the non-monetary volatility of not being able to find business in an otherwise illiquid market. For a potential client of such services also, the premium paid to the firm is a monetisation of the risk of being unable to find a professional in an illiquid market.

You might wonder, then, as to why I continue to be a freelance professional rather than taking a discount for my risks and joining a firm. For the answer, we have to turn back to Coase – I consider the costs of transacting in the open market, including the risk and uncertainty of transactions, far lower than the cost of entering into a long-term transaction with a firm!

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.

Tear Down The Wall! TEAR DOWN THE WALL!! TEAR DOWN THE WALL!!!