Sunday, January 16, 2011


Why Firms Exist

To lessen transaction cost.
Resource-based theory of the firm.

Friday, December 04, 2009


Indian IT Sector - Strategic missteps

The Indian IT Sevices industry has made super-normal profits over the last few years. Howeve the fat profits that the IT organisations have made based largely on arbitrage, these have become notoriously risk-averse. They have not really invested in creating effective front-ends in their larger markets which say an organisation like Cognizant has done reaping the rewards now. The arbitrage model itself puts pressure to continue to send people from India (even in the front-end S&M functions) . Now I do not want to take away anything from the Indian professionals - they have done a remarkable job but they really cannot be expected to front-end with a Anglo Saxon customer base. Eventually selling has to be local. That is the lessons even American multinationals leaned when say they were expanding in countires outside their home country. For example IBM Japan is run by japanese and Indian manages sell sugared cola to Indians. Consequently the customer fails to bond with them and continues to percieve them as suppliers of cheap bodies. Since this model has served the Indian companies well bring in 30 % plus growth rates and reasonable margins, the organisation were never really forced to set up the required front-ends.
So the ga-ga years went by without enough investment in the front-end (which typically takes years). Companies became notoriously risk-averse with the 'if-it-aint-broke-dont-fix-it" mindset.
The technical capabilities did not increase as the model discourages people from becoming 'non-billable' and hence commercial dead-weight. The'onsite' assignement is a not-so-subtle part of the recrtuitment pitch for the average employee, since these companies cannot be the best paymasters in the market. The onsite assignement is willy nilly one of the more potent tools that they have to attract people and the same is projected as a pot of gold at the end of the rainbow. Coming with that recruitment pitch, there is tremendous pressure and expectation in the employee population about going 'onsite'. Over years the indians become more entrenched in the western markets largely comfortable with long onsite-assignments without any signficant increase in their capability. They continued do the mind-numbing grunt-work that came along their way - largely templatized and process-driven. They become comfortable and unwilling to come back. For companies too, it was a happy marriage in keeping the 'client' satisfied by ensuring continuity in an assignment.
Net-net, without key selling skills or technical skills it is highly undiffrentiated industry. Everyone tom-toms their quality initiatives and what-not. But at the core barring organisational DNA, they are remarkably same. And most start folks in the industry knows that the model has a shelf-life but nobody is willing to cry wolf. Nobody consciously wants to be the first in brining their margins down (and being hammered by the stock market and losing their crores of ESOPs). We have to realise that the era of super-normal profits will not continue forever. Margins have to in the long run need to be brought in line with global services companies margins. But nobody is willing to do things differently. In effect, all the firms are metaphorically frogs-in-a-soup with the temprature rising gradually eventually destined to extinction.

Wednesday, February 11, 2009


Fear, Hope and Greed

There are only two emotions that govern the economic world : Fear and Greed. And there are only perhaps two emotions that work in the political world : Fear and Hope.
How ?
In Economics, we go through phases of fear and greed. If the stockmarket is doing well, people get greedy and make irrational bets. The party continues "till the music stops". Often the question is asked that if the downfall was inevitable to everybody, why did someone not call wolf and get out of the game when the going was good. I believe that the reason why this does not happen is because the cost of being the first to withdraw are huge. You may be the biggest fool to cash out when the chips are good and since no one has really seen the future, it is better to continue playing than give up. It is a little like the global warming debate. We know that the world will eventually become a wasteland but no one is willing to stop their own development for that uncertain distant future. The cost of stopping for a single country are huge. However, if we dont all stop, we are inexorably moving towards the abyss. When however it happens, everybody asks the question - if everybody sway it coming, why did not someone stop. It is the old problem of the commons.

I would like to spend a couple of minutes on the Indian softwae services industry. The industry has made super-normal profits over the last few years. However the fat profits that the IT organisations have made based largely on arbitrage. Over the years, these organisations have become notoriously risk-averse. They have not really invested in creating effective front-ends (domain and sales) in their larger markets. The model of offshoring itself puts pressure to continue to send people from India. This is because an "onsite" assignement is a not-so-subtle part of the recrtuitment pitch. Also, since these companies cannot be the best paymasters in the market, the onsite assignement is willy-nilly projected as a pot of gold at the end of the rainbow. Once that is there, the model itself puts pressure to send Indians to do the jobs onsite. And over years the indians become more entrenched in the western markets largely unwilling to come back (espcially at the higher eschelons). Now I do not want to take away anything from the first generation Indian professionals - they have done a remarkable job but they really cannot be expected to front-end with a Anglo Saxon customer base. Eventually selling has to be local. That is the lessons even American multinationals learned when say they were expanding in countires outside their home country. For example IBM Japan is run by japanese and Indian manages sell sugared Cola to Indians. If the management remains largely expatriate, the customer fails to bond with the company. In the software services domain the customer continues to percieve the Indian vendors as suppliers of cheap bodies. Since this model has served the Indian companies well in the past to bring in 30 % plus growth rates and fat margins, the organisation were never really forced to set up the required front-ends. And front-end not only from a sales perspective but from a domain perspective. (it is not really fair to expect an Indian who has worked in LIC for 3 years to project him as a global insurance domain expert).
So net-net, everybody knows that the model has a shelf-life but nobody is willing to cry wolf and consciously trying to bring it's margins down and fundamentally prepare the organisation for the long haul. They have to realise that the era of super-normal profits will not continue forever. Margins have to in the long run need to be brought in line with global services companies margins. So everybody will continue to dance till the music stops.
Ditto for political dialogue. All broad political pitches fall in two categories : It is either fear (and hatered) for somebody or the hope of a better tomorrow. All great politicians from Lincoln, Hitler, JFK have harped on one of these two enduring themes.

That brings us to the three fundamental human emotions : Fear, Greed and Hope.

Friday, May 09, 2008


The debunking of comparative advantage

Conventional wisdom says that comparative advantage is a good thing. And that one must stick to it as it is the only enduring economic doctrine. What is comparative advantage ? Simply put it means that nations can benefit by mutual trade. And that a nation must stick on to a commodity which requires it minimum sacrifices relative to producing other commodities. Mind you that it is not related to absolute advantage. The principle of comparative advantage shows that even if a country has no absolute advantage in any product (ie. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production. Essentially it means that the less advantaged country should only specialise in things in which it is only a little worse off than the bountiful country. This arrangement will maximise output and through trade both countries will be richer.

Now while this is all rational, it is perhaps self-destructive in the long run. In the pursuit of comparative advantage, a country might only produce which has the minimum opportunity cost. Suppose for a given country the most competitive products are primary products (agricultural/nature's bounty). Now acting rationally the country should continue to produce the same. The other sectors may be startegic and might propel the counties on the path of riches in the long run. So sticking to primary sectors is easier - but then industrialisation will never occur. A country may be stuck in exporing raw products without processing them which lead to substantial value-add and moving up the chain. HOwever, moving into other sectors is inevitably attendent with some pain. Moving to other sectors requires moving out of the comfort zone of what is easy. But it has to be done as other sectors might be more strategic - heavy industry, armaments and all sorts of sectors which give a country much more 'power' than agriculture. Not moving beyond the 'rational choice' of competitive advantage may lead a country of efficient farmers and nothing else. So - Comparative advantage is a good theory when one is referring to a static, peaceful and a just world. It aint gonna happen and hence countries need to move beyond comparative advantage.


Why is a country rich

A country is rich when it's labour productivity is higher. What is 'labour productivity' ? Simply put labour productivity of a country is its output divided by the number of people involved in producing it. So a rough approximation is GDP divided by population. Any country which produces more 'stuff' (output) using the minumum number of people will be rich. Simply, the surplus will account for the 'richness' of the country.

Lets take an example and the most intuitive one i have come accross is one by Atanu Dey ( While you can go and read the full text at his site, i will lay out the essential points. Suppose a 100 person economy produces 100 units of stuff. The average income of such a population will be 1. Now say 2 people from this population do some research and find out ways/invent machines which enables the population to make 300 units using only 90 people. The average income will jump to 3 with 8 more people freed up for further research. Now these 10 people working find out better ways of making 1000 units of stuff using 75 people...The average income will jump to 10 - a ten-fold rise over the first case where the average income was 1.

The miracle lies in the fact that machines can increase the productive capacity of humans manifold. This is an immutable truth and there is no escaping this. One can argue that the same amount of stuff can be produced by substituting labour for capital. While that will increase production, it will not increase productivity. So while more stuff is being produced, it is produced by a proportionate increase in the number of mouths to feed and thus average income remains static - i.e. the country does not grow richer. Richness is determined by productivity of a country.

Now the classic question arises : Should a labour-excessive country focus on policies that promote employment or productivity ? Maximising employment is promoting more of status-quo. In fact the country might become poorer in the future if more number of people are producing the same amount of stuff (more mouths to feed with the same output). A country therefore has to focus on production - and here not absolute production by employing proportinately more labour but more capital. Why ? As machines and technology are the ONLY way in which production can be boosted manifold increasing incomes for all as we saw in the example. Technology has only a positive 'arrow of time'.

Also to support this constant improvement in technology, there has to be more and more education and R&D efforts. In our example we saw that the average income could not improve without technological innovation. Innovation and improvements do not drop from the sky but they have to be painstakingly built grounds-up. It requires systematic and widespread education. And it also requires an ecosystem. The hardware of this ecosystem can be the universities, academies, centers-of-excellence etc. But more importantly innovation feeds on freedom. It also requires free thinking - and challenging authority. It requires incentives for innovation. It also requires a society tolerant of disruptions as any technological adaptation will involve change. Knowledge cannot thrive in an environment which is completely closed to new ways.

So without going into ideologies, a society can be richer (higher labour productivity) if it has the following characteristics :
1. Able to master techniques of production (including intangibles like services) employing technology
2. Able to transfer these techniques in some systematic manner in subsequent generations (widespread education) and also have an ecosystem of improvement. This ecosystem should both have the 'hardware' and 'software'
3. Able to best utilise talents of entire workforce -including women - and allocate people according to merit. (the non-employment of women seriously hampers prosperity as the number of mouths to feed goes up without full productive engagement)
4. Have a socio-cultural-political organisation geared to maximum production :-
- provide property rights to encourage investment and saving
- reduce transaction costs of doing business by having relatively honest public institutions
- have a continuity in economic policies i.e. political consensues on economic issues

Any society which is able to do the above will be on it's path of richness.

India performs poorly on almost all counts in the above analysis. Without going into details of every one of them, the most fundamental problem is that Indian polity and policy makers have not yet grasped the fundamental point : If we want to be rich, it is not employment that needs to be maximised but production (and hence productivity). Also india traditionally scores low on the 'software' required for innovation : a free thinking society, attitudes to women, being suspicious of wealth and woefully corrupt public institutions.

Sunday, February 25, 2007


Capitalism is not Market Fundamentalism

While i am big fan of free-markets and competition, i am also of the view that "Unbridled" capitalism is bad in the long run. Yes, there are some self-correcting mechanisms in capitalism but I believe captialism cannot be some sort of American Football without a refree. There is a point-of-view which postulates that the "Market" is the most-efficient and final arbiter of everything. That the market is beyond criticism - the only pristine thing. This is Market Fundamentalism, which i seriously dispute.

My contention is that so long as intervention (Govt. or International) is benign to keep the ills of capitalism at bay - it should be fair and be allowed. In effect - Market Fundamentalism is not the holy cow that is made out to be.

I will give two fatal flaws of capitalism which describe how capitalism can be self-defeating :
Wealth Distribution : Take the cost of labour in overpopulated, badly governed countries (say India). Regardless whether a given commodity is human/inanimate, capitalism insists on putting a price to it. India is an overpolulated country. Consequently the marginal cost of labour tends to zero. Thus wages are kept at a subsistence level. This tends to a lessening of 'eqaulity of opportunity' (the poor who can barely eat at a subsistence wage cannot send their kids to school). Consequently the progeny of the poor remain poor in a global world. The example is common accross the world. So capitalism is focussed on creating more "OVERALL" wealth and does not have any incentives for "DISTRIBUTION" of the wealth. It's simply nobody's job. One may argue that wealth distribution is the Government's job. Fair enough. But then the govt (or any other agency) should have the power to intevene which may lead to some 'market inefficiency'. Communism, despite it's ideological garb was just a reaction to the atrocious conditions of workers in the nineteenth-century industrial hovels of Europe. Then, as now in India, the marginal cost of labour in Europe was near-zero. Capitalists took advantage of this as there was no incentive to distribute wealth. This lead to the temporary triumph of communism. Eventually communism failed as it took the pendulum to the other extreme where the incentive of individual profit was killed - with the forced central egalitarianism. It smeared over the diffrences of the innate capabilities of individuals and killed incentive and creativity. Such a system was bound to fail eventually. However it took a century and countless lives for capitalism to regain its ground.

No incentive to allocate "collective" costs : A very life-threatening example of this is - Global Warming. It is the biggest example of the failure of market fundamentalism. How so ? The costs of polluting the world should have been allocated to the industrial countries who polluted the world for the last two centuries. Nobody , then considered that the new gas-guzzling cars and the aerosols were harmful for the environment. Nobody was penalised as these costs were not borne by any one agency.* Now that we have reached the critical point, where further damage will be irreversible for EVERYBODY on the planet, the rich countries want the poor countries to stop polluting. The poor countries contend that they have as much right to pollute the earth as their rich counterparts in the past. They have as much right to be rich as them and if pollution is the way to do it - then so be it. This is a Hobson's choice and we are stuck. If the poor countries continue to pollute, the whole world self-destructs - and the blame must squarely lie at capitalism's door. Capitalism forces all countries to compete on cost of production - without anybody necessarily having to pay the collective cost of pollution at that time. If a producer uses cleaner technologies, albeit with a higher cost, it will lose out in a brutal global marketplace. Capitalism insists on the maximisation of the individual interest. So while everyone was fulfiling their own economic destinies - COLLECTIVELY we ended up destroying the only planet we have got. Again, in capitalism, there is no incentive to allocate collective costs efficiently so long as the costs are widely distributed.

Philosophically, the philosophy of balance - of duality is the only viable alternative. Capitalism is good but only so much. The moment it becomes a holy cow - which cannot be discussed rationally, it becomes like American Football without any referees - a bloody sport in which everyone eventually loses.

*Reminds me of the "Fate of the commons"

Saturday, January 27, 2007


Indian Economic Inequality

Recently i read that as per the Gini Index, India has lesser inequality than the likes of China, US, Brazil etc. I am not an economist and am willing to accept the verdict at face value. But the armchair-economist in me postutates that rather the inequality itself the unique problem in India is that countless millions receive less than subsistence income. Though income distribution is a study of "spread around the average", if the average itself is very small, then vast swathes will not even earn enough to get by. The lesser problem in India is the relative spread of income
itself, but the fact that millions are below a "subsistence income" and see no hope for the future

A society with a similar income distribution (similar inequality) will have a lesser problem given that a small population is below substince income. If most bellies are full, the danger of anger over income inequality spilling out is lesser, than in a country where majority go home hungry every night. (see figure below)

We all know that everybody needs a minimum subsistence income. Beyond that they need income to have the means to progress, means to equip their children to climb out of the quagmire. They want some semblance of "equality-of-opportunity" for the future if not current equality of income. There is a greater danger in India of growth and globalisation being viewd as 'only for some'. The problem is that those with low incomes also do not have access to decent education (public education is a joke in India) which leads to their childrent being further left behind.

Those who have the means, educate their children and they will do well in an increasingly global economy, thus accentuating the inequality. The simmering-swirling anger in the millions of those untouched by progress is that do even see a way of joining the economic mainstream. Even for their children a genration ahead. And that is certainly an alarming situation. Hence i believe the most important priority in India is reform in the public school system.

Wednesday, October 11, 2006


The 'Psychopathic' Organisation

Recently i read a popular history of the British East India company and it brought back a few of the old questions. If we look at the modern organisational form of the "limited liability multinational" it is a very recent advent. Hardly a couple of hundred years old. It may be argued that the industrial revolution is only two centuries old and hence this is no surprise. Other forms - partnerships, properitorships, trade guilds, trust-based co-opratives are on the decline with the modern corporation ('Big Money') obliterating virtually all other viable organisation models at a global level.

However there are some problems with this almost-universally accepted organisational form :- The modern multinational is 'psychopathic' by design. A 'psychopath' is someone who does not have the power to diffrentiate between the the right and the wrong. This does not mean that the person is 'evil' or 'bad' instrinsically. A psychopath simply does not have the 'ability' to recognise something is bad...The modern organisation is 'psychopathic' by design. Why ? Essentially the single minded quest for profit. The modern mulinational is supposed to be this ruthless efficient profit-making machine. It is rewarded handsomely if it does so and is reviled as a failure if not. In this complete and total quest for profit, it rarely has the time or the energy to look at the 'means'. The pressure is all the more if the organisation is not doing well. A profitable corporation is perhaps able to 'afford' values. A loss making entity just does not have that luxury in order to survive in this era of global cut-throat competition.

Digging deeper - Why do organisations become 'psychopathic' ?
In my view two basic reasons :- the agency problem and market fundamentalism.

Agency Problem : Today's corporations are 'limited liability' by design. This means that ownership is diffused and ownership and management is separated.
By limiting the liability of the corporation, it's actions cannot be attributed to a single person. Since it is so easy to invest in a company without being actually responsible for what it does, an investor feel strangely 'insulated'. This is also a kind of 'moral insulation'. For example, due to the policies of the East India company, around 10 million people died in Bengal of a completely man-made famine in the 1770s. However, a commoner in London was free to trade in the company stock without feeling in the least morally obligated to own up this human tragedy. So long as the company was paying an above-market dividend, it was just a smart investment choice.

In separating ownership and management, also lies an intrinsic risk of losing one's moral compass. Since most of management's renumeration is linked to the performance of the organisation, a manager will go to almost any length to make the company successful. One of the ways to earn super-normal profits is to possess 'market power' through whatever means. While today great attention is paid to the "legal" legitimacy of the means, nobody thinks about the 'moral' legitimacy. In this scenario there is no self-correcting mechanism. Managers go on a path which promises them greater compensation and the owners (investors) silently egg them on in their hope to earn return on their investment. An unholy nexus is created. Simply put there is no mechanism to promote moderation, assess the damage the organisation may be doing to the wider community. 'Conscience' in a manager is taken as a sign of weakness and 'Emotions' are dubbed unprofessional behaviour. The unsaid message the manager gets is - "If you are too squeamish to do the job, we will get somebody else".Down the line, junior managers simply employ the Nuremberg defense - We were following orders as our jobs were at stake.

A second reason why organisations become psychopathic is our almost blind alligience to the market. We seem fundamentalists in our defense of the market. Naively believing that the market is the ultimate arbiter of economic success. Any form of govt. intervention/regulation is deemed 'unnecessary' and 'growth-hampering'. What the markets cannot handle is the propensity of human greed and excess. Take Enron or Worldcom. Think artificial stock market bubbles and crashes. Or the gross inefficient allocation of capital done by some of the smartest minds on Wall Street. This mentality of the 'sanctity' of the market blurs our moral sensibility. Just because the market rewards something does not make it 'right'. Organisations measure their sucess through the lens of the market making them psychopathic.

Organisations try to apply band-aid solutions to fend off these psychopatich tendencies. There are audit and ombuds committees, formal whistle-blowing channels, community feedback forums and hotlines to the top management. But the bigger issue of organisation design and economic organisation will not be solved by taking a few credits on "Business Ethics" in MBA schools. Or the self-indulgent MDP junkets on Corporate social responsibility for senior management. There are no easy solutions here. Realistically the modern corporation is too vital and entrenched to discard it. But constant education and vigiliance of all might alleviate some of the risks.

This page is powered by Blogger. Isn't yours?