Category: Economics

The Power of Incentives

It is said that one should not ascribe to malice what can be adequately explained as stupidity. I would go one step further and say that one should not ascribe to malice or stupidity what can be explained by basic self-interest. In other words, the power of incentives. Incentives matter and just like you can explain all sorts of natural phenomena by understanding the law of gravitation, you can explain all sorts of diverse economic puzzles by asking what are the incentives.

Consider this. BBC News on Sept 3rd 2004 carried an item: Solar plan for Indian computers. Some excerpts:

Authorities in the Indian state of Uttar Pradesh have drawn up a pilot project to use solar power to run computers in village schools…

Many have to use kerosene lamps for light and most government-run primary schools have no power at all.

It is hoped the plan will help schools cope with the rural power crisis.

Last year, the Uttar Pradesh Education for All Project Board bought about 1,000 computers for selected primary schools in all 70 districts.

The schools were selected in villages which had no power lines, and teachers were given special training for computer-aided education.

Consider the typical village school in UP: totally strapped for resources, teacher absent most of the year, perhaps not even a blackboard, students unable to afford books and most likely malnourished. Why, one asks incredulously, would anyone be spending money on computers when there are more important needs that are crying out for resources?

The report goes on to say:

A further 1,000 computers are to be purchased this year for village schools, but most of these will not work because there is no power available.

The mind boggles at the waste of resources which a poor state can ill-afford. Funds for rural public education are severely limited and yet they are wasting it buying computers that will serve no apparent purpose. These funds could have been used more effectively in paying teachers living wages, buying supplies such as books and blackboards, perhaps food for the starving students. Why?

Here is my explanation. Some time ago, I had pondered the question of why telephones, radio, and TVs don’t make the conference circuit. The vendors of PCs have an incentive to push their wares and they are a powerful lobby. Couple that with the avarice and corruption of the “authorities” mentioned in the BBC report, and you have the answer. When tens of millions of rupees are spent in bulk purchases of computers, there are kickbacks. The authorities make their pile, never mind that the computers end up being expensive non-functional display items in the villages without power.

But wait, it gets better. No power for computers? No problem: use expensive solar power to power them. And you will find the vendors of solar power panels eagerly getting into the game of rural development. They make hay while the sun shines.

It is disgusting, all things considered. Last Friday I made the mistake of driving about 10 kms on Mumbai roads. It took an hour and a half. We were stuck at a T-junction for about 20 minutes because of a deadlock. Vehicles had moved into the intersection and there was no way any vehicle could move. I had described a similar situation earlier in a post entitled Seduced by ICT:

Recently I came across a news item which said that they are looking at solving Mumbai’s traffic problems by making Mumbai roads “electronic intelligent roads.” I don’t have the slightest doubt that it would involve huge outlays to the tune of millions of dollars and lots of people will make lots of money up and down the line providing expertise and hardware and software for this hi-tech venture. I am also convinced that it will not make the slightest effect on the congested Mumbai roads because it is not the roads that need the intelligence but the people designing the roads that need to be intelligent.

Close to where I live in Kandivali, a suburb in North Mumbai, there is an intersection that is almost always caught in a grid-lock. The intersection is like an “H” with bi-direction flow of traffic along all the sections and it has one traffic signal at one of the points where the horizontal section meets the vertical sections. Traffic gets log-jammed around 300 meters of this intersection and it takes about a half hour to cross this bit every evening. Hundreds of autorickshaws, buses, cars, trucks, two-wheelers, and whatnots spew exhaust fumes and honk continually and people suffer. It is astonishing that the traffic people have not figured out that the simplest thing to do would be to paint some part of this intersection with the “KEEP CLEAR — DO NOT BLOCK” sections and put a couple of traffic cops to teach the people to keep off these sections. It would be a simple effective system which would cost very little compared to the enormous price that everyone pays throughout the day due to the congestion.

Instead, the Mumbai municipal corporation is investigating ways of using electronics. Why not better road markings and so on? Because there is not much money involved in a simpler but more effective system. Simpler may be better but there is not much profit in it. A blackboard, a teacher, and a dozen slates and some chalk may be simpler and better for adult education, but there is not as much profit as in putting PCs with literacy programs to teach adults how to read in rural areas.

That is all there is to it. Expensive solutions are proposed because those in control of the spending benefit. This is a universal phenomena, not restricted to poor overpopulated corruption ridden third-world people. Doctors in the US freely sometimes recommend unnecessary heart-bypass surgeries instead of recommending life-style changes. They make more money performing by-passes and don’t make any money if the patient changes his life-style.

The power of incentives is awesome. Look carefully at the roots of persistent poverty and you will see that someone makes money and therefore it is in the interests of the person to perpetuate that poverty. This is not even limited to the economic sphere alone, of course. Mother Teresa’s goal was religious glory and her incentive was therefore perpetuation of overpopulation because people are the fodder that the church feeds on. Is there a way out? I think there is. Stay tuned.

The Economics of Software

“The time has come,” the Walrus said,
“To talk of many things:
Of shoe–and ships–and sealing wax–
Of cabbages–and kings–
And why the sea is boiling hot–
And whether pigs have wings.”

An item titled the economics of software caught my eye on Rajesh Jain’s blog. Rajesh quotes from an article by Bryan Cantrill which begins with:

Software is like nothing else in the history of human endeavor unlike everything else we have ever built, software costs nothing to manufacture, and it never wears out. Yet these magical properties are arguably overshadowed by the ugly truth that software remains incredibly expensive to build. This gives rise to some strange economic properties: software’s fixed costs are high (very high — too high), but its variable costs are zero…

Clearly, Mr Cantrill is out of his depths when it comes to basic economics, and consequently his analysis of the economics of software is fundamentally flawed. Ignorance of basic economics is bad enough when one takes on the task of explaining the economics of software but what is worse is that he is mistaken about some facts as well. For instance, he asks rhetorically, “… doesn’t it strike you as odd that your operating system is essentially free, but your database is still costing you forty grand per CPU?”

Which planet are you on?

One wonders if he has heard of that obscure little company called Microsoft which makes a decent living out of selling operating systems. As far as I can tell, they don’t give them away for free. And I suppose that he has not heard of MySQL which is database software and for which you have to pay a lot less than forty grand — zero, to be precise.

Sorry, Mr Cantrill, but it will take us too long to fix all the bugs in your analysis. So I will just write the analysis from scratch. Here is a short introduction to the economics of what is called “information goods” to which class computer software belongs.

Of goods and services and information

To start at the top, there are things called goods and there are things called services. Services are things such as haircuts, transportation, heart surgeries, operas, and psychoanalysis. Goods are stuff such as cd players, cars, toasters, shirts, and books. Most goods are ‘hard’ in that they are kickable. Then there are goods that are not kickable. An idea or a thought or a receipe is not kickable because it is not made up of matter. Note however that to convey, store, transmit, and use the idea or receipe, it has to be incorporated into some physical medium which is kickable. But the information good itself is not a material entity unlike a car or a desk.

The distinction between the information good itself and the material object used to store, retrieve, transmit and use it is vitally important. The idea or the receipe is ‘software’ while the stone tablet or book or the cd in which it is found is the ‘hardware’. The cost and economics of hardware follow the usual economics of kickable goods. So it may be good to review those basics quickly before we look at the economics of software.

Costs — fixed, marginal, and average

To produce stuff (hardware), you need labor, capital, and other stuff. Let’s say we need to make a car. We need to buy some humongous machines, make parts, put them together and we get a car after some time and cost. Even before we get one car out of the shop, we have to spend money — put the factory up and pay people to design the car, etc. Those are fixed costs. For every car we produce after we have paid the fixed costs, it costs some money. That is the variable cost. The more the number of cars, the higher the variable costs because you need more parts. The difference in the total cost of producing n+1 cars and n cars is called the marginal cost of producing that n+1th car. Finally, the total cost (sum of the fixed and variable costs) divided by the number of cars gives us the average cost.

Supply and demand

Usually, the marginal cost decreases as the number of units produced increases, and at some point it starts rising for reasons that need not detain us now. The upward sloping supply curve is actually the rising part of the marginal cost curve and it represents the fact that as you produce more and more of some good, it costs more to produce the next unit than to produce the current unit. This is true for most kickable goods but not so in all cases and definitely not so for software as we shall see.

Then there is a demand curve which is usually downward sloping (on a price-quantity graph where the y-axis is used for the price and the x-axis is used for quantity). This is so because of a number of reasons. For a consumer, each additional unit of a good delivers diminishing additional utility. This diminishing marginal utility or benefit implies diminishing willingness to pay. So the demand curve is a marginal utility curve or a marginal benefit curve.

Markets

If you draw the marginal benefit curve (aka demand curve) and the marginal cost curve (aka supply curve) on the same price-quantity space, they may intersect and if they do that point of intersection is called the equilibrium which represents a market-clearing price and quantity. The equilibrium condition is that the marginal cost equals the marginal benefit. Markets determine this equilibrium and under idealized conditions (which do not obtain in the real world but are realized approximately in many instances), this is welfare maximizing.

Which brings us to a very important point that is relevant to our goal of understanding the economics of software. We have to know something about competitive markets and how they maximize welfare and under which conditions. Markets are competitive if a bunch of conditions are met which include, among others, (1) zero fixed costs (implying no scale economies), (2) no externalities, (3) perfect information, (4) no public goods, and so on. In a competitive market, the price determined is welfare maximizing and the price is equal to the marginal cost of production. Whether real world markets achieve efficiency, that is, whether they arrive at this welfare maximizing price or not, depends on whether the conditions for competitive markets are met or not.

Marginal Cost Pricing

One last thing we need to keep in mind before we continue on. For economic efficiency (in other words, for maximizing social welfare), price has to equal marginal cost. That is, the additional cost of producing the marginal unit (that is, the next unit) has to equal the marginal benefit from the consumption of that unit. So if the marginal cost of production is zero, the economically efficient price is zero. But here is the catch. You could have zero marginal cost of production but have a very high fixed cost. In which case, you still have a positive average cost. Granted, this average cost decreases as the total number of units produced grows. But pricing the good at marginal cost will leave you unable to recover the fixed cost. You could of course price the good at that average cost but then it will not be maximally efficient — it will lead to dead weight losses. Alternatively, you could have the government or your rich uncle subsidize the fixed cost component and price your good at the marginal cost of zero.

Economics of Software

Now let us move to software. First order of business, what is software as used in this analysis. I define software as anything that is an organized collection of information. Examples of software: receipes, stories, driving direction, computer programs, population statistics, exam results, poems, instructions on how to achieve enlightenment, a movie script, and such. Let us lump these in the generic group called information goods (IG). Every IG requires some amount of intellectual effort and unlike the production of hard goods (HG), the cost of production is totally front-loaded and the cost of producing additional copies of an IG is zero. In other words, the cost of producing one IG is the same as the cost of producing a billion copies of the IG.

Distribution Costs

Note however that merely producing something is not enough; you have to distribute the stuff before you can use it. The cost of distribution is an important and significant component of the total cost of IG. This is distinct from the case for HGs. To take an example, producing a car costs say $100 million, producing each additional unit costs (marginal cost) say $20,000, and the cost of distribution for each car through a dealer network is $1,000. The distribution cost is therefore only 5% of the marginal cost of production.

Now consider IGs. Take the case of an operating system or a database system. It costs umpteen hundred million dollars to produce the first unit, if you are a Microsoft, but it costs next to nothing if you are an open source collaborative project. So the range of fixed costs of production extends from very high to practically zero. Marginal costs in any case for IGs is always zero. Then comes the distribution costs. If you were to distribute your software on punched paper tape or cards, you have to hire a fleet of 18-wheeler tractor trailers to deliver one copy of Microsoft Windows XP to one customer and it will cost you $19,500. If you were to use a set of floppy discs and mail it to the customer, it will need a shoebox-full of floppies and your distribution costs will be $40 per customer. Not as bad as the fleet of tractor trailers, but still not as good as using a few cds and cutting your distribution costs to $4. And it gets really sweet when you can just have your customer download it from your site for about $0.04 total cost to you. (But the sweetest thing of all is when you can charge your customer $300 for the download.)

Summary

To sum up the discussion so far, depending upon the size and complexity of what a software program does, you have to employ a bunch of programmers and have some computers for them to do their stuff on. That is the fixed cost of producing the software program. That fixed is high in the case of operating systems and huge database programs if you have to pay programmers fat salaries. If you got a whole bunch of people to collaborate and produce software for free, then you have low fixed costs. The latter is what mostly happened in the case of Linux while the former is what happens in a commercial shop like Microsoft.

Once you have produced the software program with whatever fixed costs — high, low, or intermediate — you then make a certain number of copies. Depending on the cost of the medium you use to distribute the software, your variable costs (and therefore the marginal costs of distribution) is determined. If you use punched cards or paper, marginal cost of distribution is high; if you use cds, it is low; it is lowest so far if you send it over electronically by wires or wirelessly. Because electronic distribution of software is so cheap over the internet, you can say that the marginal cost of production as well as distribution comes pretty close to zero.

Is software really different?

Information goods are essentially different from material goods. That is so because of two reasons. First, the nature of information goods itself. And second, the cost of production of IGs. IGs have public goods characteristics, they have externalities, and have high fixed costs. All these are deviations from the conditions required for competitive markets. Thus markets will not deliver the social welfare maximizing outcome. All sorts of distortions will result such as the presense of monopolies. Monopolies, like everyone and his brother, maximize profits and since they have market power, they can charge whatever suits their fancy. So they can price an operating system at $300 a pop which is way above the marginal cost of production (exactly $0) and the marginal cost of distribution (nearly $0).

So is the economics of software essentially different from the economics of other goods? Not really. There are differences in their associated costs (fixed, marginal, average) and the ways in which they deviate from the conditions required for a competitive market. But the fact remains that there is nothing surprising about the way the market for software behaves if one were to understand the nature of software and the nature of markets. Like shoes and ships and sealing wax, they follow predictable pathways in the marketplace. Pigs don’t have wings and the sea is never boiling hot.

In the concluding bit of this piece, I will explore some of the issues that follow from this preliminary analysis. Later, alligator.

High Population Considered Necessary but not Sufficient for Poverty

A lot of water has passed under the bridge since my last blog entry. “Where in the world,” some asked, “is Atanu and why is he not writing stuff anymore?” For better or for worse, I am back from a brief round-the-world trip. Among the exotic far off places of the world, I was in Helsinki, Paris, London, Boston MA, New York NY, the San Francisco Bay area, Los Angeles, San Diego, and Seoul Korea. I flew Air France (which I call ‘Air Chance’), Delta (don’t ever make the mistake of flying Delta), and Korean Air. Met lots of interesting people and heard lots of great stories. One of these days I will write about them. But for now, it is back to the usual business.
Continue reading “High Population Considered Necessary but not Sufficient for Poverty”

It is transaction costs all the way – Part 2

In my last post I claimed that the fundamental role of ICT is reduction of transaction costs. What, you may ask, is transaction costs? The answer is this: pretty much everything is transaction costs, with a little bit of physical stuff thrown in.

In California, you can buy a loaf of bread for about $2. The basic materials that go into the making of the bread — wheat, primarily — is about $0.07. Then there is some energy required for baking it and transporting it. Add a dime for that. The total material cost is therefore about 17 cents. The difference between the cost of the inputs and the price of the product is the value added. In our case, it is $1.83. That is, about 92% of the price of the bread is value added.

How do you allocate the value added in this case? Most of it has to be assigned to services — from the marketing of the bread, to the stocking of it in the store shelf. The cost incurred in bringing a loaf of bread to the market (less the cost of the material, the fuel and labor involved in the baking and transportation) is transaction costs.

Of course, costs seen from a different angle are revenues and incomes. And part of revenues are profits (if prices exceed costs.) The generalization of these costs are transaction costs.

Transaction costs are ubiquitous. Consider what happens in any organization, say a car manufacturing firm. Cars are produced by people using machines to transform steel and other stuff. If you add up the costs — labor, material, and machines — the car would not cost all that much. But when you add the fact that there are other people employed by the car firm who have nothing to do with the manufacturing of cars, you realize that they represent transaction costs. For instance, you have managers, and accountants, and secretaries, and human resources divisions, … the list goes on. They all represent transaction costs. And the greater the transaction costs, the higher the cost of production. Why do firms exist? Because they reduce transaction costs.

Ultimately, one can explain pretty much all organizations as an attempt to systematically reduce transaction costs. Economies of scale, scope, and agglomeration themselves arise from the reduction of transaction costs.

Information and communications technologies reduce transaction costs. Here is a simple demonstration of that. The next time you make a phone call, ask yourself what it would have cost you if you could not have made that call.

For instance, I called the store to find out if they had indeed installed the AC in my apartment. (They had not.) If I could not have made the call, I would have had to spend at least two hours and a lot of money to travel to the store to find out that information.

I will continue to ramble on the transaction costs theory of the universe in the next few posts. As they say on the radio, stay tuned.

It is transaction costs all the way – Part 1

It is worth pondering this question: What exactly is the role of ICT in any economy?

This week, I would like to address myself to that question in detail. The answer can be succinctly stated as: It reduces transaction costs. It will take a pretty long time to explore that answer. But first a few personal experiences to set the stage would be appropriate.

Today I called up a local store which sells “white goods” (major appliances such as washing machines, etc.) I wanted to order an air-conditioner. Could I order the AC over the phone, I asked when the phone was finally answered by someone. I was told that I had to come down personally and bring cash. Will they accept a debit card? No. Will they deliver today? They can’t tell me that until I had paid and only then will they check to see if the department that does the delivery has the capacity to deliver today.

I drove to the bank to withdraw the cash. At the bank, the line for withdrawing cash was immensely long. I could not use the ATM because the amount I needed was above the ATM cash withdrawal limit. It took me a half hour before I had the cash in hand.

Next step: drive to the store. The closest branch was in Shivaji Nagar. I told the driver the address and we proceeded to drive the four or five kilometers to the store. It was on ‘L.J.’ road. The traffic was bad, as usual. The driver did not know where L.J. road was. We asked for directions from various taxi drivers. We traveled with hope thinking that this time the directions were right. In about 45 minutes, we had reached the store. It was closed because that branch of the store is normally closed on Mondays. I could not have found this out without going to the store. This was in Mumbai, the commercial capital of India.

I had spent about 2 hours in trying to buy something that in a different setting (for instance in California) it would have taken me all of 5 minutes and that too from the comfort of my home: I would have checked the prices of ACs on the web and ordered it online and paid for it with my credit card. Instead, after about 2 hours of frustration, I was still without what I wanted.

This little episode is indicative of a depressingly large set of similar experiences. The features of this set almost always include having to spend an inordinate amount of time searching. The search cost of locating a place is non-trivial. Street addresses don’t exist. You could be looking for a place with an address with reads “122/1/B Lajpat Nagar II”. You reach 121/1/B. And then you discover that 122 is not adjacent to 121 but is somewhere else altogether. Sequential numbers are not physically close. The house numbers are in the order in which the plots were registered, for instance. Once I spent about an hour hunting around for a place in Lajpat Nagar in Delhi. I am sure that I was not the first — nor I was the last person — to waste time and energy (gasoline) trying to locate an address there.

Another feature common to all the episodes includes transportation. On Saturday last, I was invited for dinner at a house that was about 5 kilometers (3 miles) from the Andheri local train station. I took a bus from the station. It took about 50 minutes for the bus to cover the 5 kilometers. Traffic moves about 8 kms an hour in the city of Mumbai, and at the breakneck speed of 18 kms an hour average on the nation’s highways.

Traffic is not the only thing that is slow. The movement of payments is an important function in any economy. I had to pay my brother Rs 25,000. I mailed him a check to Nasik without asking him first. He called to say that it will take about 3 weeks for that check to clear and so it would be good if I could send him cash or do a wire-transfer.

Cash is inconvenient to handle and carrying large sums is stressful. For furniture shopping, the only acceptable form of payment appears to be cash. Part of the reason is of course tax avoidance. But the slowness with which checks clear could have something to do with it as well.

There are a few things that one can do at a macroeconomic level to push the economy towards its potential such as fixing the monetary and fiscal policy. But they are limited instruments. Fundamentally, what really puts the brakes on the machinery of the economy is a very large number of very small grains of sand which are individually ignored but together form a very potent force. These grains of sand arise from what can only be said to be the overall culture of the economy.

It is an unfortunate fact that the Indian economic culture is dismal and unless that changes, India’s economy cannot reach its potential. Becoming aware of the problem is fundamental to the solution, of course.

In the next piece, we will explore what ICT can do to remove the sand from the Indian machinery.

[Continue reading part 2 of “It is transaction costs all the way“.]

It’s the Small Stuff, Stupid

An ironic bit of popular wisdom goes

  1. Don’t sweat the small stuff.
  2. It’s all small stuff.

In the context of economic development, I totally agree with the latter bit, but strongly disagree with the former bit. If we don’t sweat the small stuff, we don’t have much hope of managing the big stuff since the big stuff is exactly what arises from an aggregation of all those small bits of stuff.
Continue reading “It’s the Small Stuff, Stupid”

Abolishing Natural Laws

Like a bad penny, articles on BPO and its backlash keeps turning up again and again. The best I have seen so far was a New York Times article by Hal Varian of UC Berkeley called What Goes Abroad Usually Comes Back, With Benefits. (Thanks to Reuben for the link.)
Continue reading “Abolishing Natural Laws”

A Set of Hard Problems — Part 2

An attitude to life which seeks fulfillment in the single-minded pursuit of wealth –in short, materialism– does not fit into this world, because it contains within itself no limiting principle, while the environment in which it is placed is strictly limited.
E. F. Schumacher in Small is Beautiful

THE ETHICS OF POLICY

Economist Thomas Schelling defined the ethics of policy ‘as what we try to bring to bear on those issues in which we do not have a personal stake.’ It can be convincingly argued that there are no issues in which we do not have a personal stake. Every action in an interdependent global system has far-reaching consequences. My desire for cheap hamburgers could translate however indirectly to rainforest destruction.

One has to grapple with the notion of social obligations and what we owe to the poor and the disadvantaged who have legitimate claim to the resources that are required for a decent human existence.

Continue reading “A Set of Hard Problems — Part 2”

We are Made of Stuff

… We are such stuff
As dreams are made on; and our little life
Is rounded with a sleep.

    Shakespeare’s The Tempest

Writing in the Dec 28th, 2003 edition of The Week, President Kalam says, “In the 21st century, knowledge is the primary production resource instead of capital or labour.”

I have been unable to fully comprehend that insight, fundamentally because it does not make any sense. Sounds profound but makes no sense. What is a ‘primary production resource‘? Did Kalam imply that once upon a time capital and labor were primary production resources but knowledge wasn’t? What changed so that labor and capital got displaced and now knowledge holds that position?
Continue reading “We are Made of Stuff”

BPO and Kuznet’s Curves

These days one of the dangers of reading newspapers is that one is faced with yet another article on business process outsourcing (BPO) and how there is a backlash from specific sectors in the developed countries. It makes for breathless copy and many of these articles are mere regurgitation of rehashed articles on the same subject. What is the broader context in which to locate all this talk of BPO?

Let’s step back a bit and look at an economy from a macro viewpoint. Economies are usually subdivided into three sectors: agricultural, manufacturing, and services. At the earliest stages of an economy’s development, agriculture is the dominant sector. It is low productivity initially and therefore low wages prevail. Since most of the population is engaged in low wage agriculture, income inequality is low.

Then manufacturing starts to grow, which is high productivity relative to agriculture. Manufacturing wages are therefore high relative to agricultural wages. Income inequality grows in the economy. The mechanism for this income inequality was first explained by Kuznets in 1955 in his paper Economic growth and income inequality. Here is an introduction to the paper from a World Bank site:

The process of industrialization engenders increasing income inequality as the labor force shifts from low-income agriculture to the high income sectors. On more advanced levels of development inequality starts decreasing and industrialized countries are again characterized by low inequality due to the smaller weight of agriculture in production (and income generation).

In other words, there is an “inverted-U” relationship between income inequality and per capita income. At the two extremes of very low and very high per capita incomes, income inequality is low; at intermediate per capita incomes, income inequality peaks.

There is a fractal nature to this “inverted-U” phenomenon in that this relationship holds at different scales of organization. It is definitely true for the rural and urban regions of an economy. The income inequality exists not just at level of an economy, it exists at the global level as well. Early on in the history of the world economy, various parts of the globe had similar income levels, since all were pretty much in subsistence agriculture. Then, as some regions industrialized before others, income inequality grew. In some future time, all regions will become industrialized and once again income inequality will fall. So also, urban regions of a country will initially have higher incomes relative to rural regions. But in time, rural areas will become urbanized and income inequality will fall.

In the long run, income inequality will eventually decrease to zero. But, as John Maynard Keynes observed, in the long run we are all dead. What I understand from that is that the ‘long run’ is really very uninteresting. Interesting things happen in the short- and medium-run time frames. And that’s where we are today — in the intermediate stages where income inequality is high in the global arena.

I will not go into the reason for the differential emergence of industrialization in some regions of the globe. For now, I will take that as a given and thus also take as given the income inequality. It is interesting to ask what accounts for the maintenance of that inequality. Primarily it is the cost of population migration from low income regions to high income regions. By ‘cost’ we mean barriers both natural such as distance, and man-made such as laws against migration. The natural barriers can be lumped together as ‘transportation costs.’ With technological advances, transportation costs come down. However, man-made barriers continue to exist and therefore labor migration is still not possible.

However, since transportation costs have come down, it makes possible what I would call virtual labor migration which is achieved through trade between the various regions. Virtual migration takes place because labor is embodied in the goods that are traded. A Chinese laborer virtually migrates when the goods produced in China are sold in the US. This virtual migration of labor is a factor that puts pressure on wages so as to equalize them across the two regions. To use a mechanical analogy, if the income levels in the two regions were seen as two containers with different levels of liquid in them, then the lowering of transportation costs can be seen as a pipe connecting the two containers: the pipe allows equalization of the fluid levels.

The trade in goods is just a way for labor in the manufacturing and agricultural sectors of low income countries to be available to high income countries. What about the services sector? Services are categorised as tradeable and non-tradeables. In the latter category is included services such as haircuts and house-cleaning and transportation: the production and consumption of which is local. For these, transportation costs are so high that they can almost never be ‘traded’: the cost of haircut in NY is $20 but the cost of a trip to Mumbai is $1000 where a haircut is only $1. Unless transportation costs (and times) come down to $5 (and half hour), haircuts will continue to retain their price differentials.

For those services whose transportation costs have dramatically reduced, trade becomes possible. With the advances in information and communications technologies (ICT), certain services have become tradeable and thus the phenomenon of business process outsourcing. Income inequality between regions is what drives the BPO phenomenon and one can no more wish away the BPO phenomenon than wish away the income inequality underlying it.

Just like the trade in goods, trade in services will tend to equilibrate wage levels across the trading regions. Programmers in the US are paid multiples of wages earned by Indian programmers. With fewer H1-B visas and lower costs of transporting bits, instead of physical movement of Indian programmers to the US, you will have Indian programmers doing work for US firms off-site for lower wages. With perfect substitutability between American and Indian programming skills, the wages will tend to “equalize” after adjusting for average wage levels in the two countries. This adjustment will always keep Indian programming wages lower than American wages and therefore at least in the medium run, programming will continue to get done in India, just as manufacturing will be done in China.

Time to conclude this one. BPO is a consequence of income inequality just as much as off-shore manufacturing is. Both are here to stay until the other end of the Kuznet’s curve is reached.