Category: Economics

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.

India’s Biggest Blessing

This one is in the context of an entry on HP’s Thin Client at Rajesh Jain’s weblog. In response to a bunch of comments on that entry, Rajesh wrote to me:

I think we will need to create the large domestic markets for the affordable computing solutions.

I totally agree. And I am thankful for one positive factor in India’s favor.

The most significant positive factor in India’s favor is its size. It is what we economists call a “large economy”. Large economies have the luxury of changing parameters which define the market itself. In comparison to that, “small” economies have to take those parameters as given (or ‘exogenous’) or external to them or outside their control. In a way, you can consider a large economy to be have some sort of ‘monopoly power’. Monopolies have the power to change one parameter (price) at will which firms in competitive (or oligopolistic) markets don’t have — the latter are ‘price takers’ in that they cannot dictate prices and take whatever price they can get.

So India is large enough to be able to change ‘world prices’. Suppose you were to create a widget which is suited to Indian conditions. Assume that the cost of production of these widgets exhibit economies of scale — that is, fixed costs are extremely high and marginal costs are very low, and hence average costs continue to decline as the volume produced increases. In such a case, given India’s enormous population, the number of widgets required would be high, and thus the average cost will be appropriately low, and therefore the market clearing price for widgets will be low and quantities will be high.

Now replace ‘widgets’ in the above with whatever — “COMPUTING SOLUTION” for instance. Get the hardware that is appropriate for the Indian market developed and get the software developed for the same. Concentrate on the needs of India alone to begin with. Note that hardware and software meet the criteria of high fixed cost and low marginal cost. Marry the hardware and software to create the computing solution, price it just above average cost, and voila! YOU HAVE LIFT-OFF!!

Do we need to create the large domestic market? If by creating you mean bringing the solution to the market, then yes. However, all the ingredients exist. We just have to judiciously put them in them together using the right recipe. I suspect that we are more than up to that job.

The CAT and Transaction Costs

It is important to remind ourselves from time to time what poverty is all about. Poverty has something to do with production. Not exactly the most esoteric bit of knowledge but often it gets forgotten in the shuffle. To produce you need to have what we call factors of production which are usually broadly classified into land, labor, and capital.
Continue reading “The CAT and Transaction Costs”

ICT and Development (Part 2)

Rambling on about transaction costs from the last post.

Transaction costs are all over the place. When I travel to talk with someone, the cost of the travel in terms of time and money is the transaction cost of the talk. I could use the phone to have a talk. That reduces the transaction cost of having the talk. Telephones are a lower cost substitute for transportation in this case. This is one way that information and communications technologies reduce transaction costs. It is cheaper to move electrons than to move molecules.
Continue reading “ICT and Development (Part 2)”

It is transaction costs all the way

In my last post (Transaction Costs — Part 1) 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.
Continue reading “It is transaction costs all the way”

Transaction Costs — (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.
Continue reading “Transaction Costs — (Part 1)”

Outsourcing and Comparative Advantage

Are you as tired of reading the next article on the out-sourcing of white-collar jobs from the US to India as I am? If not, here is one by Katharine Mieszkowski in Salon.com called “Gone in the blink of an eye”.

A couple of UC Berkeley economists, Ashok Bardhan and Cynthia Kroll, estimate that 14 million white-collar jobs are at risk of being outsourced, or about 11 percent of the total, by 2015.
Continue reading “Outsourcing and Comparative Advantage”

Use it instead of merely exporting IT.

ICT and Development

ICT presents an opportunity for developing countries to make more efficient use of the available resources. However, ICT is neither necessary nor sufficient for economic development. The advanced industrialized countries were underdeveloped (by today’s standards) once upon a time and their transition from subsistence to a modern exchange economy did not involve modern ICT.

In contrast to the experience of the advanced industrialized countries, the developing countries find ICT available to them at a much earlier stage of their development. These economies don’t have highly optimized economies and the use of ICT has the potential to help them transit from a subsistence to an exchange economy relatively rapidly. For this to happen, ICT must be targeted for domestic use, and not just seen as an avenue for foreign exchange earnings.

ICT is arguably strategically important for economic growth of all less developed countries (LDCs). However, government policies tend to emphasize only the export-led growth potential of ICT. India’s success in the IT-export sector is often used as an example to be emulated by countries similarly placed along the development spectrum. It is important to recognize that while IT export-led growth is an attractive goal, it is not as relevant for sustainable economic growth for rural India. However, a policy that stresses the use of ICT within the country could lead to the development of a domestic IT industry that can serve as an engine of growth by its direct contribution to job creation and GDP growth in rural India, in addition to its contributions to the urban economy. (Needless to say, other appropriate technology can also have a multiplier effect on resources available.)

Production versus Use

The production of IT related products and services targeted for export markets is generally done in high-technology enclaves. The benefits of the production and the use of IT is therefore limited to the small number of producers in the LDC while the majority of the benefits accrue to the users of the IT products and services in the importing developed countries. The products address the needs of the importing countries and they gain significantly from the use of IT produced at low cost in the LDCs.

Increasing the Income Divide

While the IT-export sector may be earning foreign exchange through IT production, there is no benefit from the use of IT products and services to the country as a whole. The vast majority of the people are completely unaffected and do not obtain any gains from the use of IT; only the producers of the IT products increase their human capital. Consequently, the income inequality within the country itself grows which has adverse macroeconomic consequences.

ICT for Sustainable Economic Growth

For economic development to be sustainable, it has to be broad-based. IT-export led growth alone cannot result in broad-based growth because the knowledge-goods produced by the country are targeted not to a domestic market but to an export market.

Economic growth models emphasize the importance of capital – both human and physical – state of the technology and the dependence of growth on the size of the market. We view IT in this context as an enabler of delivery of services. Domestic demand for IT products and services will spur the domestic production of IT and knowledge-goods. There are important forward and backward linkages in the domestic consumption of IT products and services that go beyond the benefits attained by IT exports alone. For instance, the use of IT in the education and health sectors will provide a large user base which will not only have access to new technology but also participate in the information economy.

Evidence of the effect of ICT on Economic Growth

Is there any hard evidence that ICT has an effect on growth? Most of us believe that the ICT does have a positive effect on growth. In a recent book, Matti Pohjola reports that The Working Group of the United Nations Commission on Science and Technology for Development recommends that each country establish a national ICT strategy aiming at maximizing the benefits of ICTs and minimizing their risks. He concludes that

“… in recent years IT has had a strong influence on economic growth in industrial countries and at least in those newly industrialized countries (that is, Korea and Singapore) studied in this volume. Admittedly, however, developing countries seem to have neither invested in IT nor benefited from such investments to the same extent as industrial countries. There is concern that information is becoming a factor, like income and wealth, by which countries are classified as rich and poor. To prevent this from happening, developing countries need to formulate national IT strategies to promote the use of these new technologies.”

It can be argued that more than the production of IT goods and services, the use of IT goods and services is more critical for economic growth. The question whether ICT contributes to growth or not is akin to the question whether transportation contributes to growth. Both are instrumental and provided that they are used appropriately, growth enhancing. Investment in ICT for developing countries is not anymore an option than investing in a transportation network is an option. It is absolutely necessary, although it is far from sufficient to ensure growth.

The two most important functions for ICT are these. First, improving the functioning of markets. What to produce, how to produce, what to sell, how to sell, where to sell — all these are critical questions that directly affect growth. Clearly ICT is indispensable for this function. The second function is in the area of production and delivery of educational content. When the majority of the population is illiterate, the resources needed for educating them (and not just making them literate) is formidable. ICT provides the only hope of leveraging limited resources to address this problem.

The proximate causes of poverty can be seen as two gaps: the ideas gap and the objects gap. The objects gap is the lack of physical resources – too little land, too little capital stock, etc – that contributes to persistent poverty. The ideas gap is the lack of know-how about how to make the best use of the resources one has. It is the ideas gap that ICT can most effectively bridge.

The Case for India

India has had a reasonable amount of success in the export of ICT products and services. But until IT is used, it is hard to predict what exactly the impact will be. However, it is a reasonable expectation that IT cannot but have a beneficial effect by its use.

Domestic ICT use must be given the attention it deserves because only through broad-based ICT use can the benefits of modern technology be made available to all and bridge the income divide. Domestic use will have important linkages to the supply of human capital required for the export of ICT products and services.

For a large country such as India, domestic demand for ICT products and services can provide the necessary base for sustaining the industry and to shield it from external shocks. Therefore, India must create the institutions that encourage the use of ICT domestically.

The Power of Ideas

As an economist trained in the neo-classical tradition, I am constantly on the lookout for market failures. Externalities are a reliable source of market failures and when I come across a positive externality, I get a warm and fuzzy feeling. Consider a story that exhibits the benefits of positive externalities.
Continue reading “The Power of Ideas”