EFFICIENT DESIGN OF SUBSIDIES

[Government subsidies to education and medical care have become religious beliefs in the modern world. They are widely given, with little thought and plan, and consequently are often very inefficient. In this column in Business Standard of 10 October 2000, I speculate about how they may be designed better.]

Investing in humans

Ashok V Desai

While holidaying in London, I recently got talking to an Indian doctor from Manchester. He was one of the thousands of doctors who left socialist India  and joined Britain’s National Health Service. He was well settled, but was sad about one thing – that patients sometimes abused him.

I put it down to British racism. But then, while I was in America, a child shot dead his teacher. Other children have been less selective; they killed their fellow students, or simply sprayed bullets into a class, killing whoever was available. One teacher told me that he tolerated misbehaviour in class because disciplining a student was too troublesome: the parents might protest, approach his superiors, or file a case.

I have myself wanted sometimes to beat up the linesman who had helped some crook misuse my electric power line, or the Egyptian customs officer who went through every inch of my suitcase because he had nothing else to do, or a man called Chandhok who stole half the things I had stored with him and broke the rest. But I did not. I guess there are customers who beat up sellers and customers who do not; and a supplier tries to attract the better class of customer.

Some businesses are peculiarly susceptible to customer misbehaviour. Obviously, giving credit is a hazardous operation. It has made many a supplier go bankrupt. Some of them adopt suitable strong-arm tactics. After the last car boom in 1996, many who had bought cars on hire purchase stopped paying. It was reported that Citibank employed or commissioned strongmen who had some pretty ungentle ways of recovering the vehicle. Evidently in such circumstances, a businessman would try to choose customers who would give him least trouble.

Now suppose the government offers a free service – say, schools or health care or police. Then it could not choose the customer; everyone who came along would have to be treated, or educated, or protected. Even unsatisfactory customers who beat up their teachers or doctors. No case has been reported of complainants beating up policemen. That is clearly because policemen would beat the pulp out of them. But doctors in NOIDA are taking Karate lessons. No wonder.

But instead of admitting a killer for treatment and then trying hamhandedly to overpower him, it would be better not to take him up at all. Instead of avoiding difficult customers, doctors reduce the chances of meeting them by settling in middle-class areas full of docile middle-class middle-agers.

Where schooling is free, the students as well as teachers are deprived of choice. Children who go to government schools have to attend the one closest to them. It is a principle of modern conservatism that this choice should be restored – for instance, by allowing people to choose which health maintenance organization (HMOs) to join as in the US, or by giving children vouchers which they can use to join any school as in New Zealand.

The results are predictable. HMOs refuse to insure people with prior maladies who pose greater health risks; US Congress has had to pass complicated laws to prevent HMOs from rejecting applicants for policies. Good schools cream off the best students, leaving the stupidest to government schools and making them even worse; so New Zealand has forced good schools to take outside students by lottery.

Are these the correct policy moves? They are solutions typical of politicians – based on minimum analysis, maximum political mileage and hence maximum cost.

In the case of medical insurance, what is being consumed by potential patients is the chance of contracting different illnesses. The probability varies enormously, being from, say, four times a year for a cold to once in a lifetime by a twentieth of the population for a heart attack. It depends on the person’s age and medical history: the chances of arthritis grow in old age, and chances of a diabetic getting hypertension are much higher than average. Hence there must be a premium to insure a person against a particular ailment, which will vary with the person’s age, sex, medical history, lifestyle and environment. An insurance company can thus work out a price list for each person for every ailment. It would be stupid for the government to pay the sum of all the prices for all the people; that is the way to bankrupt the state, and to set the stage for uncontrollable paring of quality of treatment. The thing to do is to give every person a single fixed lifetime subsidy on her health premia, and to let her buy insurance against whichever ailments she wishes at a time of her choice. That way people will be encouraged to live a healthy life so that their subsidy goes further, to treat themselves to save cost, and to use more of the subsidy in old age when they get more debilitating diseases.

Education is more complicated because children are too young and because their family has considerable influence on their aptitude. There are inherent differences in children’s capabilities: some are more intelligent than others. Children’s educability also declines with age: if they do not learn to speak by the age of five, they never will; other skills too are more easily acquired early. Here, the subsidy should go to a child, not to its school. It should vary with the child’s capability: higher subsidies should be given to the more intelligent and the more stupid. But above all, children should be given the choice of more environments: if their families are dysfunctional, they should have the choice of going elsewhere. It may be to stay with relatives, in children’s homes, or in hostels. Institutions should be created for children from families which cannot realize their potential; the children’s subsidy should go to finance the institutions as much as the schools; and the subsidy should be higher for children living away from their families.

DOES CORE COMPETENCE MATTER?

[Mukesh Ambani does not speak much in public; this column in Business Standard of 26 September 2000 was provoked by one of his speeches.]

A rival your size

It was a curious forum to choose: a conclave organized by the Civil Service Officers’ Institute, Department of Administrative Reforms and Public Grievances and the Andhra Pradesh government. And the proposition was one that would have made waves in any management school, but scarcely caused a ripple in that forum. For Mukesh Ambani told this gathering of miscellaneous bureaucrats that he did not believe in core competence. Who is right? C K Prahalad or Mukesh Ambani?

It is said that those who can, do; those who can’t, teach. Mukesh might say that he does it, whereas Prahalad teaches it. And there is no gainsaying that Ambanis do it extremely well: they are by far the most successful entrepreneurs in India. But that would not settle the argument. Prahalad may well argue that on the average, companies that stick to their core competence do better. If he were in a more catty mood, he might say, the story has not ended - just wait till the Ambanis fail.

But the issue cannot be settled by anecdotes or figures. Obviously there are businesses that have done extremely well by sticking to their knitting. But they are not the only ones to have done well; some have done well precisely by going on to something different – or “reinventing the future”, as a management guru would say it. Any business has an advantage in an area in which it has competence. and would be well advised to exploit the advantage to the full. But the value of that advantage depends on how lucrative that market is, and how fast it can be made to grow. If the market itself is declining, core competence is not going to be enough: the company would have to go and become competent at something else if it was to maintain its growth.

That is precisely what Reliance did. Mukesh referred to the migration of the company from its original field of synthetic fibres to oil, and on in the future to telecommunications. In each it had started at the grassroots and built up competence. In this transformation, however, Reliance was helped by two factors. One was mentioned by Mukesh; he said that almost two-fifths of the labour force in Reliance was hired from the public sector. For this, there had to be a public sector – to be more precise, there had to be an Indian public sector. In no other country could Reliance have had this honeycomb full of skilled, little-used and less paid labour available. Nehru made the mistake of building the temples of modern India without the idol of Lakshmi in them; the numerous priests they recruited were lured away by the Lakshmi of the Ambanis. Nor has it been only the Ambanis; public enterprises have been the favoured raiding grounds of many private businesses. The only difference is that the Ambanis have built up an awesome database to track and evaluate the baboos, and have consequently taken away the best.

The other factor is the market: Reliance has largely relied on the protected Indian market, whether in fibres, fabrics, oil or telecommunications. Mukesh talked of being competitive; but being competitive with Modis and Singhanias is somewhat easier than with Du Pont and GE. It is rumoured that the Ambanis put spikes in the wheel fn Du Pont’s efforts to ride into India. It may or may not be true. What is true is that Reliance has chosen its competitors with care, and made sure they were not too difficult to vanquish.

In these circumstances, it is not surprising that Reliance has been able to build up competence in completely unrelated areas. And there is at least one area in which it has not been able to do so. When D V Kapoor left the public sector, Reliance employed him with the obvious intention of making an entry into the power sector. To this end it has bought up shares of BSES. It also bought its way into L&T. L&T has built quite a few power plants, and at one point, contemplated going to power generation itself. But it did not; it is rumoured that the Reliance members of the L&T board vetoed the move.

So does the example of Reliance prove that core competence is irrelevant? Is Mukesh right to assert “We believe in building competence around people and processes to create value”? Or has the success of Reliance been due to special circumstances and has little international relevance?

I think that the managerial model of Reliance would succeed in many countries and circumstances. But it would have faced tougher competition elsewhere. In particular, the governments’ xenophobia gravely truncated the market for businesses. In effect, Indian companies could be sold only to other Indians. They were all pretty short of cash; so takeovers would have required the say-so of the government financial institutions, which were always unwilling to give it. So there was virtually no market for companies in India; that is why Reliance found it easy to vanquish them. If India had opened up to foreign investment, the competitors of Reliance would have been taken over by stronger foreign companies, and Reliance would have had to work harder to achieve the same competitive success.

If it had had to do so, it would not have gone so readily into unrelated grassroots projects, where the risks as well as capital costs are higher. If it had had to face competition from BP or Exxon, it would have thought twice before going into refining without any experience at all.

By the same token, it would have had a larger market for companies to buy from, and would not have needed to go into grassroots projects. And if India had been more open, Reliance would have commanded a larger market, and its managerial competence would have brought it greater returns. In other words, core competence pays off better in larger, more integrated, less protected markets.

MILLIONAIRE GAMBLERS

[In Stanford I lived on Sand Hill Road, the heart of the American venture capital industry, and could watch it from a vantage point; these are my impressions. This column was published in Business Standard of 12 September 2000.]

The spread of equity

Ashok V Desai

Why did the software industry not grow up as an offshoot of the hardware industry? One answer is Microsoft. Bill Gates set it up as a software producer, and has established and defended its primacy against all comers. IBM would have been a software power; Microsoft fended it off. Another reason is that the software industry is in a major part a repairer; it is not a part of hardware for the same reason that car repair workshops are not a part of auto manufacturers. Since the 1960s, businesses have been using software; but the new generations of machines made old software obsolete, and made it necessary to rewrite software. And finally, the sheer labour-intensity of code writing. It has made firms very ephemeral: a firm may do great business today, and may be gone tomorrow if its key personnel fly away. And there have been many opportunities for them to fly: there has been such a labour shortage that people are constantly being stolen.

Thus it happened that the software industry was not funded out of the profits of some other industry, and had to get outside capital. That capital could not have come from banks, because the industry is inherently risky and unstable. It could not be flotations either, because to start with, software firms were unknown, they had no track record, and they could not command the confidence of portfolio investors. There had to be someone to hold their hand while they wrote and sold software. That was the venture capitalist. The software industry is located in Silicon Valley, within 30 miles north and south of Stanford. The venture capital industry is even more concentrated: 60 per cent of America’s venture capital is on Sand Hill Road, a two-mile stretch on the western border of Stanford where I live; and probably another quarter is in San Francisco.

A venture capitalist is not an investor; he is an intermediary. He provides three services. First, he enables the investor to spread risks by investing in a number of risky ventures: he serves as a mutual fund manager. Second, he grills entrepreneurs. He asks them tough questions about what is unique about their ideas and where they are going to find the market. He weeds out the commercial risks. And finally, he assumes sufficient control on the start-ups he finances to ensure that if the entrepreneur shows signs of failing, he can be quickly replaced.

So who then is the investor? Investors who place their money with venture capitalists are very rich people. They are people who do not need their money to live; they are people who can gamble with money. The venture capital industry arose in the US because there are more super-rich gamblers in this country than anywhere else. Some of them go to Las Vegas, some invest in start-ups. The investors, the venture capitalists and the nerds together created the IT industry.

But then came the meltdown earlier this year; market valuations of IT declined sharply, and their prospects ceased to look so glittering. Venture capitalists did not know where to put their money. So they have started looking at other industries with the same eyes they used for the IT industry: they are looking for high risks and high returns.

One of the activities where they are to be found is biotechnology. Here, various molecular materials are made and tested for possible use as medicines, fertilizers, pesticides etc. The more promising ones are given clinical trials. Those that look like commanding a large market are commercialized.

Earlier, the entire process used to be in the hands of pharmaceutical companies. The promising materials were identified by their R&D departments, evaluated by their marketing departments, and finally produced by their production departments. And because the risks were great, drug development was done by the largest pharmaceutical corporations. The drug industry is one of the most concentrated and multinational industries in the world.

This picture changed somewhat in the past 15 years with the emergence of independent biochemical research. As the properties of molecules became better understood, it became possible to apply science to narrow down the range of molecules that might serve particular uses. Identification of promising drugs was no longer a mechanical process of trying them out; clever biologists could get quite far without the paraphernalia of big application research. And then came the genome mapping project; it opened up an entirely new field of possible treatments.

But once they had found a promising drug, they still had to go to a big pharmaceutical company. At that point they generally sold the formula for a fixed sum. The price could be handsome, but the big profits still went to the big companies – not because they took a bigger risk, but because they could invest more.

Now, however, venture capitalists at a loose end for good bets are taking a closer look at biotech companies. And as a result, the latter are able to go further down the road to commercialization. Recently, Andrew Pollack reported on a number of such companies in The New York Times. In the past, a venture capitalist would have given a biotech company $30 million. Now, with money going abegging, he might give it $100 million. And the sums are going up. In March, Celera Genomics raised $1 billion in a secondary issue – more than all biotech companies raised in the whole of 1998.

With that kind of money, biotech companies can run clinical trials themselves, and prove the drugs; then they are in a much stronger bargaining position vis-à-vis pharmaceutical companies. Earlier they might have got a 5 per cent royalty on sales; now they can ask for a 50 per cent share of profits – and be much surer of making profits.

This opens up a golden opportunity for good brains. Let us see if Indian brains are as quick to take it as they were in software.

HAPPINESS INDICATORS

[America is rich; once people get rich, what do they want? What is worth having? I found a number of Americans who had answered this question in their own way. This column was published in Business Standard of 28 August 2000.]

DIY Indexes of Bliss 

Economists take the growth of gross domestic product as a synthetic index of how much better a country is doing. To non-economists this sounds too materialistic. Even some economists think that it does not capture what truly makes people’s lives better. Their dissatisfaction led to the institution of the Human Development Report, and its associated index of quality of life. Apart from per capita GDP, it adds together indicators of health, education, and social welfare. Apart from the UN, a couple of dozen countries report every year on their own quality of life, including Britain, Turkey – and Madhya Pradesh.

Here in America, however, there are people who think other things matter; and it being a free country, everyone makes his own index. Thus Professor Marc Miringoff of Fordham University is known for his social health index. Amongst the 16 indicators he incorporates are child poverty, infant mortality, crime, access to medical care and to affordable housing, alcohol-related fatal traffic accidents, youth suicides, teenage drug-related arrests, low-weight births, unemployment, income inequality and real wages. According to this index, the United States has gone from bad to worse: from 77 in 1973, the index went down to 46 in 1997, although the 1990s showed a modest upturn. The basic reason is that whilst the US is more prosperous today, the prosperity went to those who were well off to begin with. The average income of the top 20 per cent went up by 45 per cent in the 24 years; that of the bottom 20 per cent dropped 2 per cent, and the average wage went down 19 per cent. Behind these figures is a radical structural change in the economy: old smokestack industries have declined in the east, and with them, steady, well paid blue-collar jobs have disappeared, whilst the new industries based on information technology boom on the west coast, bringing untold riches to whiz-kids in their twenties. The poor can neither move so easily nor change their skills to adapt themselves to these continental changes. Thus the proportion of children living in poverty went up from 14 per cent in 1973 to 20 per cent in the 1990s. But some things have improved: violent crime, abortions, AIDS, divorces and suicides have gone down, whilst schoolgoers’ performance and charitable giving have increased.

If Miringoff concerns himself with social health, William J Bennett concerns himself with moral health. Some of his indicators are similar to Miringoff’s: for instance, alcohol-related deaths and drug use. But he also includes crime and births to unmarried women, which are epidemic especially amongst black girls. Some of his indicators are pretty qualitative, like community participation and trust in government. 

Not content with these indexes, a group called Redefining Progress has constructed an index called the Genuine Progress Indicator. It takes the GNP, subtracts from it indicators of regression like legal fees, medical costs, commuting time and expenditure on locks and alarms, and adds in time spent on household work and child care.

These are the better known indexes. But Alexander Stille of The New York Times found some stranger experiments. On Lake Michigan there is an obscure city called Traverse City. A group there surveyed 2000 residents of surrounding counties and asked them what they thought was important. At the top of their list was environment – in particular, the magnificent view of the bay to their north. Then came education and public health. They do not like houses sprawling into the countryside; so the group included the number of septic tanks in its index. It also took in litigation and shoplifting.

One of the oddest indicators is one used in Tucson, Arizona: it is the number of pedestrians on the street. To someone familiar with American cities, it will make immediate sense. Some years ago I spent some time in Washington. At weekends I used to go for walks. In Du Pont Circle one found pedestrians even early on Sunday mornings. But once one went south past White House, their number dwindled. The strangest area was one to the south where poor people lived. There there were presumably far more people behind the doors, but I almost never saw anyone on the streets. Mugging is common in certain areas, and people avoid walking there. If they are seen on the streets, it is an index of how safe they feel.

That would be a pretty irrelevant index in an Indian city, where no one thinks twice before walking out on a street.
What indicators would we take in India? Speaking for myself, I would put atmospheric pollution at the top. It does not simply make our cities ugly and smelly; its harm to health is immense. One of my greatest joys is getting away to the Himalayas; even in dirty cities like Simla one can see stars at night.

Next I would put noise. It is the first thing one notices on one’s return to India: there is so much wanton, unpleasant noise. Most of it is unnecessary. Everywhere else in the world, people drive without blowing their horns; cars do not start sounding alarms at the drop of a hat; weddings are not accompanied by third-rate bands.

Finally, I would put facilities for walking. The vast majority of Indians are pedestrians, but the conditions they face are abysmal. The authorities in Delhi systematically build pavements that are too high; presumably contractors are paid by the volume of dirt that goes into the pavements. There is so much encroachment on the pavements. They are broken and left unrepaired. And there are no beautiful pedestrian areas. In so many old cities of the world, their old centres have been turned into pedestrian areas, cleaned up and beautified; today they attract millions of tourists. Contrast it with what we have done with the core areas of Delhi, Hyderabad and Ahmedabad. We have a great heritage, but we do not deserve it.

CHANGING MODES OF CAPITALISM

[I watched American capitalism going through one more of its transformations as I sat in Stanford; this is how it looked then. This column was published in Business Standard of 31 July 2000.]

Accelerating change

It is conventional wisdom in the United States that economic change has accelerated throughout the 20^th century. Igor Ansoff’s books best reflect this. A hundred years ago, consumer demand was for basic commodities. Consumers were price-sensitive. Price mattered, and businesses succeeded by bringing down costs. Labour was still important, and the way to bring costs down was by making people work hard and keeping wages down. Change was slow, so annual balance sheets and profit-and-loss accounts were good enough to base business planning on. Work methods changed little, so they could be written up in systems manuals. The typical management structure was a hierarchical one, in which a higher administration concentrated decision-making and information and controlled the productive organization.

Then, after World War I, the markets for basic goods became saturated. Instead came cars, refrigerators and cooking ranges. With consumer durables came product differentiation and branding. Marketing gained in importance. With the rise in differentiated competition, future became more uncertain. It was not enough to look at accounts of the past; the past had to be extrapolated. That was how strategic planning emerged. Management structures became more functional; it became customary to distinguish production, procurement, marketing, accounting, personnel R&D and other functions. Basically, the higher reaches of management became more specialized and differentiated. This was the time when big companies emerged, supported by the emergence of the New York and Chicago capital markets.

World War II not only accelerated the growth of the economy, but generated so many innovations that were exploited in the next 25 years. New materials emerged, the relative costs of different materials changed. It was not enough to look ahead; it became necessary to control the future by innovating. Markets began to become multinational. US firms went first to Europe, then to Latin America, and then to East Asia. Production in many locations became the norm. Strategic planning encompassed new functions like location planning and innovation planning. With a rise in the number of locations within the same company, the trend was towards decentralized management. The businesses came to be divided into profit centers. Companies developed internal capital markets, drawing capital from less profitable and older parts and investing it in newer and more profitable businesses. The managements of the big companies became portfolio managers for the shareholders, so to speak.

After the oil crisis, there was a radical change in the financial markets. Starting with the oil producers, big investors arose who were not industrialists; mediating their savings, big banks and financial houses became important. The newly available debt capital led to leveraged buyouts of many companies; board-managed companies with broad shareholdings were taken over by financial entrepreneurs, who sold or closed down less profitable businesses. They made companies issue junk bonds and buy their own equity with the money raised in order to throw out outside shareholders. That was the era of restructuring and reengineering.

In the 1990s, there has been a financial revolution of quite another kind. On the one hand, the supply of risk capital has increased manifold, and to handle it, a new type of intermediary, the venture capitalist, has emerged. The venture capitalist does not finance a business. He finances an idea, an innovation. He spreads his risks by investing in a large number of ideas. He sets short-term profit targets for each; he takes a sufficient share of the equity to replace the entrepreneur if the latter does not deliver on profit targets. The majority of start-up entrepreneurs are routinely replaced. Once an idea is successful, the venture capitalist pours more money into it.

The big difference is that earlier, it was the companies that took the initiative, and the investors had to take their pick. Now the venture capitalist – with his financiers – does the picking. And he is not a long-term investor; he pays by the job, so to speak. This form of financing does not suit big companies at all. And the venture capitalists’ bets were so successful – thanks largely to the rapid rise of information technology – that they sucked away finance.

Hitherto there has been little interaction between this new capital and the old industrial capital. New capital is located in the west – venture capitalists living on Sand Hill Road, where I live, control 70 per cent of the venture capital in the US – while old capital is on the east coast. New capital invests in start-ups; old capital continues to manage old businesses. New capital goes about in slacks and T-shirts, old capital in grey suits.

Not that the old companies have not tried. They have tried to quicken their responses. That meant revamping their accounting and information systems; that is why Indian software companies have been so heavily involved in working for Fortune 500 companies. Most companies have set up web portals. Some have started selling on the web as well. But however hard they tried, they could not make themselves attractive to venture capitalists.

That will start to change soon. The first portent is the crash of the technology stocks in March. It has drastically brought down investors’ growth expectations about the start-ups, and reduced the capital flowing to the latter. Venture capitalists have become far more cautiou

At the same time, old companies are asking themselves how they can participate in the gold rush of information technology. For there is no doubt that web-based marketing is capable of cutting down distribution costs enormously – making big stores and warehouses unnecessary, improving consumer choice, cutting down the time spent by consumers in shopping. That is a threat to distributors, but not to producers. The old-style producers can make the same profits as the new start-ups, if only they can duplicate the processes of the latter which are very different from the traditional ones. Some companies are beginning to see their way to doing this.