Markets Work, Incentives Matter
The two broadest generalizations one arrives at from a study of economics are that markets work and that incentives matter. People respond to incentives because that is at the core of what it means to be rational. To the extent that humans are rational, their behavior is predictably in the direction that existing incentives point to. Trade between humans is rational because both parties in any voluntary trade benefit. The abstract mechanism which enables trade is called the market. Markets work in the sense that they maximize the gains from trade among an arbitrary number of entities. There are other methods of enforcing trade among people, such as the command and control mechanism often employed by communist governments. But they are at a distinct disadvantage relative to the market because the latter is based on the premise that rational actors respond to incentives.
An illustration of markets working and incentives propelling action is contained in a recent paper by Vivek Wadhwa of Duke University, et al, provocatively titled “How the disciple became the guru“. Based on the paper, Wadhwa wrote a couple of pieces in the popular press, published on 23rd July: the BusinessWeek article is “What the US can learn from Indian R&D“, and the Wall Street Journal one is “India’s Workforce Revolution“.
The authors note that in the past 15 years or so, Indian IT companies have developed competencies by learning how to compensate for poor infrastructure. Now Indian companies, not just in IT but also in global R&D, are doing well and are compensating for another major deficiency in India: India’s education system. In the popular press articles (both are essentially the same), Wadhwa reports that Indian companies are, in essence, educating their employees in-house. Workforce training is being used by Indian companies to correct for the failure of Indian high-schools and colleges in providing properly skilled graduates.
Wadhwa, writing from an US point of view, draws lessons from the success of Indian firms despite being severely handicapped by the quality of the Indian education system and concludes his BusinessWeek piece with:
The achievements of companies in India show that employee investment, development, and empowerment are central and critical means to building and sustaining long-term competitiveness and innovative capacities in a global knowledge economy. The U.S. can learn and incorporate these lessons from India as it rethinks how to train and develop its workforce to maintain its global competitive edge. U.S. companies have long played the guru. Perhaps the time has come for the guru to learn from a disciple.
Wadhwa concludes his WSJ piece with:
The result of this workforce productivity is clear to see. In the aerospace industry, Indian companies are designing the interiors of luxury jets, in-flight entertainment systems, and collision-control and navigation systems for American and European corporations. In pharmaceuticals, Indian scientists are discovering drugs and performing clinical research for nearly all of the largest multinational drug companies. In the automotive industry, Indian engineers are helping to design bodies, dashboards, and power trains for Detroit vehicle manufacturers — and soon may develop entirely outsourced passenger cars.
The Indian experience highlights what can be achieved by investing in upgrading workforce skills. That lesson has implications for policy makers in the U.S. who worry about how the economy will adapt to globalization. If workforce training can take the output of an education system as weak as India’s and turn its graduates into world-class engineers and scientists, imagine what could be done with an American worker base that has received amongst the best education in the world.
Lessons for us
There are larger lessons we can take away from the paper and the associated reports. The first and the most obvious one is that incentives matter. The firms have an incentive — profit — to create the human resources that they need. It is profitable for them to invest in the training of people and do so cost effectively and efficiently. The training they do has to pass the market test of the benefits exceeding the costs. The corollary to it is that in their drive to seek profits, they are increasing the human capital of the society and therefore are contributing directly to economic development and growth. The corporations are obviously promoting the social good even though that is not their aim. Adam Smith’s invisible hand very much in evidence there.
The second lesson is that markets find a way around. The educational system is under a command and control regime and produces not surprisingly very faulty products. Yet the market given sufficient time figures out a way of recovering from the error the government system leads to.
The third lesson is that the private sector has the ability and the incentive to intervene positively in education. If allowed to, it can not only employ people but it can make them employable. This limited demonstration has a wider implication. Right now, only at the high end of the employment spectrum are firms engaged in creating the human resources they need. But there is only so much demand for high-tech research and development as in aerospace, pharma, automotive design, etc. There is a much larger untouched potential for employment in more mundane sectors of the economy.
Not everyone can be trained to do high-tech work. An economy not only needs a wide spread of abilities and skills, any large population has people with a matching wide range of abilities and who have to be trained appropriately. There’s a need for plumbers, mechanics, carpenters, other skilled craftspeople, and as there is a need for scientists, doctors, engineers, and teachers. Just as in the high-tech sectors firms where training is demand driven, in the other sectors as well one can reasonably expect firms will do their respective training provided that these skills are required in the organized sector.
That last clause — skills required in the organized sector — is important. The organized sector of the Indian economy is estimated to employ only around seven percent of the labor force. The overwhelming majority of the labor force in the unorganized sector is most likely not skilled and is probably poorly educated. Consequently their productivity is low. As the organized sector expands to include more activities within its sphere (retailing is a good example), it too will require trained employees. Here one can foresee the private sector once again stepping in to fill the required gap in the education sector.
As the spread of skills required widens, the private sector will widen the areas in which they do their own private training. The expansion of the organized sector, a natural consequence of market forces, will force a change in the human capital resource base.
For me, the implications are simple and strong. First, liberalization of the education system. The private sector is quite capable of providing tertiary education. Tertiary education has very high private returns and therefore the market can be expected to provide it. Here’s how it works in short. Take an engineering degree, for example. The cost of the degree has to be less than the net present value of the future stream of earnings. If it were not so, then it is clearly not privately beneficial (nor socially beneficial) to gain the degree. Therefore if one desires and has the ability to gain an engineering degree, one should be able to pay for it as well, unless there is a credit constraint. If there is a credit constraint, then once again the private sector can step in and provide the loan.
What about secondary education? The middle class (and above) is quite motivated to educate its children, and also has the ability to pay for secondary education. Only the poor need financial assistance for secondary education. This can be publicly funded as the returns to secondary education are significantly social.
And what about primary education? The returns to primary education are mostly social and the return on investment is long term. Therefore, primary education has to be entirely publicly funded for the poor; the non-poor can and do pay for primary education.
If the government withdraws from funding tertiary education entirely, it will have funds for the public funding of primary and secondary education for those who require it. Here I would stress one thing: I am talking about government funding, not government provisioning. Providing the education should still be in the private sector. (See the post “How to make India 100 percent literate in three years” for more on this.)
Second policy implication is that there should be greater range of educational institutions. After secondary school, one should have the option of going to a four-year degree college or to going to a two-year “junior college” (the equivalent of a community college in the US.) The junior colleges can be the equivalent of vocational education institutions. These can teach freshly minted high school graduates or even people who want to update or learn some new skills.
The Market Driven Future
If I were to put on my predict-the-future hat, this is what I believe is going to happen. The private sector, driven by sheer necessity, is more or less on track to enter the tertiary education business. This it is doing in a disguised way, as reported in the Wadhwa paper. It is making the best of a bad situation. It would have been much better if India did have a good tertiary education system. But there are limits to how long this disguised education will go on. I strongly suspect that the private sector will eventually twist the arms of the government and force the liberalization of the education system. It is in their interest to see that the people they hire are as whole as possible–it is better to not have to fix damaged goods, so to speak.
The second change I see is the growth of junior colleges, or as I like to call them, “Advanced Basic College” or ABCs. It would take a person about 2 years after high school to become good at some vocation. The graduates of these ABCs will be younger than the graduates of current 4-year colleges and will be better prepared to enter the workforce. These ABCs will be privately owned and will turn a hefty profit. I also believe that they will use information and communications technologies rather intensively for training.
With the LAFIA Delegation
Last month I spent a week in Delhi and Chennai with a delegation from Australia on a program called “Leading Australia’s Future in Asia-Pacific” or LAFIA. It was comprised of senior government officials from Australia and NZ. LAFIA is a joint program run by the Australian National University and the Australian Public Service Commission which visits a set of countries each year to get an in-depth understanding. This year it was Singapore, India and Thailand. I got the opportunity to present my views of where I thought India was headed (and also got to meet and hear some interesting people across a wide spectrum of activities.)
Discussing India with LAFIA delegates was an intensely learning experience. It helped me figure out how I feel about India and it revealed to me what I knew subconsciously but that I had never articulated. What I figured out is this: that India is going to succeed. And that the success is going to be driven by the people of India — through the private sector. Remember that the private sector is made up of people, just like the public sector. It is the people of India with their entrepreneurial skills and their desire to do well that will end up with India doing well.
What I finally realized was that the government could have been a force for good but it isn’t and we have to live with it. The education sector is government controlled and it is bad. But eventually, at significant cost, that system will be made irrelevant. It will become irrelevant because it cannot be reformed. It cannot be reformed because the government won’t allow reform.
It has been observed by many that China’s growth is top-down, or government driven. India’s growth, to the extent that the government has allowed it to grow, has been enterprise and entrepreneur driven, or in other words people driven.
I suppose it was nationalistic pride in me when I was talking to the Australians that made me come to the defense of India. It was not they were attacking India; on the contrary, Prof MacIntyre of ANU who was leading the group, had observed India over a number of years and had been remarking on the positive trends that he saw. He was clearly optimistic. It was that I felt that I had to somehow give a more positive image of India than what was evident to the delegation — the inefficiency, the senseless bureaucracy, the evident poverty and crowding.
In Conclusion: India will be Free
In my concluding statements I told them that India is not really a lost cause because the people are becoming aware of their potential and that they are struggling to get free from the clutches of the government. The quest for freedom is an exponential process. The nature of exponential processes is such that eventually growth is rapid even though the initial changes are not that perceptible. The people through the private sector, as the main driving force behind the private sector, will overcome the limitations that are currently imposed by the government, and eventually overthrow the government where appropriate and make the government irrelevant in others. This can and will happen with a speed that will astonish.
That India of the Nehru rate of growth — 2 percent a year — is a thing of the past.
I read in Wadhwa’s paper a clear indication of what is to come. The story he told was meant for the Americans. He told them that they don’t have to worry too much about the US losing competitiveness as long as its corporations learn to train their workforce more effectively. The story that I took away from his paper is that what Indian corporations are doing in learning best practices from abroad and training their employees is just the thin edge of the wedge. Soon enough it will transform the Indian education system. India would have achieved freedom finally from a rapacious government.
It’s about time, don’t you think so?