Who do you subsidise?

Customers with a lower consumer surplus end up subsidising those with a higher consumer surplus

One basic rule of pricing is that it is impossible for all buyers to have the same consumer surplus (the difference between what a buyer values the item at and what he paid). This is because each buyer values the item differently, and is thus willing to pay a different price for it. People who value the item more end up having a higher consumer surplus than those who value it less (and are still able to afford it).

Dynamic pricing systems (such as what we commonly see for air travel and hotels) try to price such that such a surplus is the same for all consumers, and equal to zero, but they never reach this ideal. While the variation in consumer surplus under such systems is lower, it is impossible for it to come to zero for all, or even a reasonable share of, customers.

So what effectively happens is that customers with a lower consumer surplus end up subsidising those with a higher consumer surplus. If the former customers didn’t exist, for example, the clearing price would’ve been higher, resulting in a lower consumer surplus for those who currently have a higher consumer surplus.

Sometimes the high surplus customer and the low surplus customer need not be different people – it could be the same person at different times. When I’m pressed for time, for example, my willingness to pay for a taxi is really high, and I’m highly likely to gain a significant consumer surplus by taking a standard taxi or ride-hailing marketplace ride then. At a more leisurely time, travelling on a route with plenty of bus service, I’d be willing to pay less, resulting in a lower consumer surplus. It is important to note, however, that my low surplus journey resulted in a further subsidy to my higher surplus journey.

When it comes to markets with network effects (whether direct, such as telecommunications, or indirect, like any two-sided marketplace), this surplus transfer effect is further exacerbated – not only do low-surplus customers subsidise high-surplus customers by keeping clearing price low, but network effects mean that by becoming customers they also add direct value to the high surplus customers.

So when you are pleasantly surprised to find that Uber is priced low, the low price is partly because of other customers who are paying close to their willingness to pay for the service. When you pay an amount close to the value you place on the service, you are in turn subsidising another customer whose willingness to pay is much higher.

This transfer of consumer surplus can be seen as an instance of bundling, but from the seller’s side. Since a seller cannot discriminate effectively among customers (even with dynamic pricing algorithms such as Uber’s surge pricing), the high-surplus customers come bundled with the low-surplus customers. And from the seller’s perspective, this bundling is optimal (see this post by Chris Dixon on why bundling works, and invert it).

So the reason I thought up this post is that there has been some uncertainty about ride-hailing marketplaces in Bangalore recently. First, drivers went on strike alleging that they weren’t being paid fairly by the marketplaces. Then, a regulator decided to take the rulebook too literally and banned pooled rides. As i write this, a bunch of young women I know are having a party, and it’s likely that they’ll need these ride-hailing services for getting home.

Given late night transport options in Bangalore, and the fact that the city sleeps early, their willingness to pay for a safe ride home will be high. If markets work normally, they’re guaranteed a high consumer surplus. And this will be made possible by someone, somewhere else, who stretched their budget to be able to afford an Uber ride.

Think about it!

On abortion and the cost of adoption

This post comes from a *spirited* discussion at a party I attended over the weekend. For reasons you wouldn’t normally expect at such spirited discussions, the topic of conversation moved to abortion, and whether it should be permitted at all.

One person at the party made the point that it should be illegal beyond a certain point in the pregnancy, unless there were strong medical reasons for doing so. It was met with a counterpoint of abortion being the mother’s choice. Which was met with the moral argument about why the costs of killing a born child and an unborn child should be different. The discussion was veering towards one on the question of when life begins.

In my opinion, abortion is a simple case of transaction costs. If you have a baby that is born that you don’t want for whatever reason (maybe you’re going bankrupt, or breaking up, or getting into difficulty), there exists a simple solution for you to get rid of the baby while preserving its life – you can simply give it away for adoption (the liquidity of the adoption market is another topic in itself, and we will not go into it here).

If you don’t want the baby when it is not yet born, though, things aren’t that simple. You need to carry the baby through the rest of the pregnancy and wait for it to be born before you can give it away for adoption (see the movie Juno, for example). And considering the difficulty of pregnancy and childbirth, this can introduce significant costs to the mother. And this is a transaction cost – borne by the mother until the baby is born, and something she bears unwillingly.

I know this can again veer into the discussion of what point it is in the pregnancy that the transaction cost borne by the mother to see out the pregnancy is lower than the cost of killing the unborn child. This is a tricky problem, since there is no good solution for it – there is no reason we should move the limit one day forward or back, and that argument continues.

What helps is that there exists one point of discontinuity in terms of the costs faced by the mother – the time of the baby’s birth. Once the baby is born, the cost to the mother of keeping it drops dramatically, so that represents a kind of “obvious point” around which to frame regulation.

Which means that from the transaction cost point of view, abortion should be legal till the point of the child’s birth!

Weekend spiritual guidance (that led to this discussion): Old Monk with Thums Up

Parking and congestion

It is not too rare to see Indian politicians and policymakers talking about imposing congestion charges on Indian roads in order to control traffic.

The basic idea is pricing based on demand and supply – since supply of road space is constraint, and demand is increasing by the day, the use of roads in certain parts of cities (typically central areas) gets priced. This way, not only does this control the flow of traffic, but also nets revenue for the city.

In Indian cities, thanks to the numerous “cross roads” which can provide arbitrage opportunities, congestion pricing is hard to implement. However, there exists a fairly simple way to price road space and dissuade people from using private transport – charging for parking.

It’s such a simple and intuitive concept that it is a wonder that we need this blogpost (and this) at all. And in some ways, we can think of charging for parking as the “dual” of charging for congestion. Instead of charging for road space through the journey, we charge the ends.

This is of course an imperfect solution – it still doesn’t prevent people from driving through an already congested area with high parking charges, but it is at least a start.

The incremental impact of charging for parking can lead to a reasonable dip in traffic. It will also prevent people from moving around slowly in search of a parking spot (anyone who’s seen congestion on Brigade Road in Bangalore will attest to this). And as anyone who has tried to park a two wheeler in Bangalore will tell you, monitored parking spaces result in significantly better utilisation of parking space.

And then there are benefits to the government. The city government makes money (Takshashila had a paper on this a while back, but I’m not able to find it now) which is not small. The ability to regulate and charge for parking lets people know that the city government is capable of regulating traffic.

What’s more – once basic pricing is introduced, more innovative solutions will be found by the market. We might have apps that lead to pre-booking of parking space at your destination. We might have apps that lead parkers to the nearest empty parking space, thus cutting congestion on roads. We might even have a marketplace for parking space! All of this must be compensated for, of course, and unless parking itself is charged for, such businesses cannot function.

India-Kerala oil swap

India is short crude oil, while Kerala is long the commodity. So it makes sense for the two entities (one of which is a subset of the other) to strike a long-term swap deal.

With oil prices being at a rather low level for the last couple of years (compared to the preceding decade or so), Kerala’s economy is in deep strife, as Mint reported. This is a consequence of a large amount of the Kerala economy being dependent on remittances from its expat workforce (35% of the state’s GDP, according to Mint), most of which is in the Gulf countries. With oil prices down, Gulf economies aren’t doing well, and being foreign workers, the expat Keralites, and consequently Kerala, is bearing the brunt of it.

With economic activity in the state reduced thanks to the withdrawal of legal tender of Rs. 500 and Rs. 1000 notes, the state is in deeper trouble, with doubts even cast on whether the state can pay salaries.

India on the whole, however, has benefited significantly from the fall in oil prices. With India a large net importer of crude oil, the drop in prices has resulted in significant easing of the pressure on the country’s current account deficit. The oil price drop has also helped in inflation dropping over the last couple of years, and since fuel is a transaction cost, has also helped in increasing economic activity.

After the oil prices dropped, experts advised the Union government to lock in the oil prices by signing long term forward agreements, in order to cushion the country’s economy against an oil price shock. The problem with striking this kind of a forward agreement is the need for a counterparty who faces the opposite risk. While investment banks can do such a deal, the margins can be high if a counterparty is not forthcoming.

With India benefiting from low oil prices and Kerala being hurt by them, the two entities should strike a long term oil swap. India can pay Kerala a fixed sum for the duration of the swap. Each month, Kerala will pay India an amount proportional to the extent by which the oil price (measured by indices such as Brent) exceeds a pre-agreed benchmark. In case oil remains below the benchmark, Kerala won’t need to pay India anything – the swap cash flows can be like an option.

This way, both parties will benefit. India will get hurt when prices increase but some of that will get compensated by the payments by Kerala. And while prices remain low, Kerala will get compensated for the loss in remittances by the payout by the government!

Wonder why no one’s thought of this so far!

The velocity of scarce money

Ever since the Union government took Rs. 500 and Rs. 1000 notes out of circulation last week, my consumption patterns have changed. Rather, I still consume the same things but I’ve changed my habits in terms of purchase. Not having the patience to stand in line at a bank or ATM, my inflow of Rs. 100 notes is close to 0. And I’ve been trying to keep my outflow close to that number as well.

So rather than shopping at the local vegetable market, I’ve been buying online on BigBasket, where I can pay using credit card. My grocer always took credit cards, so I continue to buy from him. I take Uber instead of auto rickshaws, and pay for my fuel purchases using credit cards. I’ve told my cook and maid I’ll pay them this month by bank transfer (they have PMJDY accounts).

The point I’m trying to make is that I’m trying to conserve my scarce hard currency, and have changed my purchase patterns to do so. And I’d expect everyone else to do the same, including people who are more into the so-called “cash economy”.

Plenty has been written about how the decision to withdraw notes can be seen as a monetary shock. Read Ajay Shah’s excellent take on it here, though Ajit Ranade argues that in the context of broad money it cannot be classified as a monetary shock. In a cash economy, the short term reduction in the availability of cash can result in sharply lowered economic activity.

In monetary terms, economic activity can be described as the product of the “quantity of money” (there is no one good definition of it) and the “velocity of money” (the rate at which money changes hands by way of enabling economic activity). Lower economic activity can be a result of either low money supply, or due to low velocity of money (see my old piece in Mint on how the 2008 financial crisis was characterised by low velocity of money).

While much has been written about the decrease in quantity of money thanks to money withdrawal, the velocity of money following the withdrawal is also a key variable to take into account. On the one hand, thanks to reasons I described above (scarcity of currency notes), velocity of physical currency is likely to go down. People are going to use it only when absolutely necessary, and not for discretionary purchases.

On the other, the velocity of money in the form of bank deposits is also likely to go down. While those that are experienced in using the banking system might be using the system more for transactions nowadays, a large amount of the currency being deposited is going into accounts of people who are not used to transacting using the banking system. And this money is likely to sit quietly and not contribute to economic activity (unless banks use it to lower lending rates and expand credit), implying a drop in the velocity of money from the banking system.

So both monetary counts taken together, a drop in economic activity in the near future is likely. Hopefully banks will cut lending rates (in the last couple of years, cut in policy rate has hardly been passed on to ordinary customers) in the near future (once they have the bandwidth to do so) to get us out of this drop.

How 2ab explains net neutrality

So Prime Minister Narendra Modi has set off this little storm on Twitter by talking about the relationship between India and Canada being similar to the “$latex 2ab$ term” in the expansion of $latex (a+b)^2 $.

Essentially, Modi was trying to communicate that the whole of the relationship between India and Canada is greater than the sum of parts, and it can be argued that the lack of a “$latex cos \theta$” term there implies that he thinks India and Canada’s interests are perfectly aligned (assuming a vector sum).

But that is for another day, for this post is about net neutrality. So how does 2ab explain net neutrality? The fundamental principle of the utility of the Internet is Metcalfe’s law which states that the value of a telecommunications network is proportional to the square of the number of entities in the network. In other words, if a network has n entities, the value of these n entities being connected is given by the formula $latex k n^2 $. We can choose the unit in which we express utility such that we can set $latex k = 1$, which means that the value of the network is $latex n^2$.

Now, the problem with not having net neutrality is that it can divide the internet into a set of “walled gardens”. If your internet service provider charges you differentially to access different sites, then you are likely to use more of the sites that are cheaper and less of the more expensive sites. Now, if different internet service providers will charge different websites and apps differently, then it is reasonable assume that the sites that customers of different internet services access are going to be different?

Let us take this to an extreme, and to the hypothetical case where there are two internet service providers, and they are not compatible with each other, in that the network that you can access through one of these providers is completely disjoint from the network that you can access through the other provider (this is a thought experiment and an extreme hypothetical case). Effectively, we can think of them as being two “separate internets” (since they don’t “talk to” each other at all).

Now, let us assume that there are $latex a$ users on the first internet, and $latex b$ users on the second (this is bad nomenclature according to mathematical convention, where a and b are not used for integer variables, but there is a specific purpose here, as we can see). What is the total value of the internet(s)?

Based on the formula described earlier in the post, given that these two internets are independent, the total value is $latex a^2 + b^2$. Now, if we were to tear down the walls, and combine the two internets into one, what will be the total value? Now that we have one network of $latex (a+b)$ users, the value of the network is $latex (a+b)^2$ or $latex a^2 + 2 ab + b^2$ . So what is the additional benefit that we can get by imposing net neutrality, which means that we will have one internet? $latex 2 ab$, of course!

In other words, while allowing internet service providers to charge users based on specific services might lead to additional private benefits to both the providers (higher fees) and users (higher quality of service), it results in turning the internet into some kind of a walled garden, where the aggregate value of the internet itself is diminished, as explained above. Hence, while differential pricing (based on service) might be locally optimal (at the level of the individual user or internet service provider), it is suboptimal at the aggregate level, and has significant negative externalities.

#thatswhy we need net neutrality.

Other airlines to bail out Spice Jet?

In a rather bizarre move, the Directorate General of Civil Aviation (DGCA) has directed airlines to not charge “exorbitant fares” for passengers stood up upon cancellation of Spice Jet flights. This is a rather bizarre idea and effectively amounts to asking other airlines to partially bail out Spice Jet.

Essentially when an airline is in trouble, passengers are loathe to book tickets on it, for they know that the chances of their flight getting cancelled is high. A cancelled flight usually means either cancelling the trip itself or rebooking on another airline (sometimes airlines have arrangements with each other for taking on passengers on cancelled flights, but currently no other airline in India will give credit to Spice Jet). Either ways, it is a costly affair for the passengers.

By directing airlines to not charge “exorbitant fares”, and assuming that such a directive will be followed (very likely that this directive is meaningless for this is the busy season and other airlines are likely to be booked out), the total cost of booking a ticket on Spice Jet actually comes down, for the charge a customer will have to incur for re booking on another airline for a cancelled Spice Jet flight is likely to be reduced. And thus passengers will not abandon Spice Jet at the rate at which they normally would. And since other airlines are taking a hit on the spot fares they could potentially charge (in the absence of this directive) they are effectively subsidising and “bailing out” Spice Jet!

The other problem is that in the absence of market mechanisms (which the price cap effectively curb), how will other airlines allocate their remaining capacity among all the passengers who have been stood up by Spice Jet? Some arbitrariness is likely to ensue and passengers are likely to be left more disappointed!

The government had started off by handling the Spice Jet case rather well, as Devika Kher has argued here. However, of late, the wheels of the DGCA seem to have come off in his aspect, and there seems to be a concerted attempt to let Spice Jet stay afloat against the wishes of the market. The Airports Authority of India and oil companies have been asked to extend credit for fifteen days.

It seems Devika spoke too soon!

Uber, Meru and Service Taxes

The use of arbitrary barriers in regulation, like the Rs. 10 lakh limit on Service Taxes is counterproductive and can lead to a non-level playing field. More importantly such barriers encourage small-scale operations which can act against efficiency

A couple of months back, the Service Tax Department slapped a notice on Uber, demanding that the cab aggregation service pay service tax on its revenues. Cab services fall under the service tax net, and recently other cab service providers such as Meru and Mega have started adding a service tax component to their bills.

What queers the pitch in the case of Uber is who pays, and whether they pay at all. Uber claims to be an aggregation platform, bringing together cabbies and passengers, and says that it is the cabbies who are in charge of paying service tax on the revenues they make through the platform. From the Tax Department’s perspective though, going after thousands of cabbies demanding taxes is not very feasible, so they are trying to get Uber to pay the service tax.

More importantly, Service Tax becomes payable only if the annual revenues from the service cross Rs. 10 lakh and it is unlikely that too many of Uber’s cabbies will cross that threshold. So if we were to look at Uber strictly as an aggregator (which it actually is), it is unlikely that any service tax can be collected on its services!

What it also means that this gives platforms like Uber an unfair advantage over companies such as Meru which own their taxis – the latter’s revenue is much more than Rs. 10 lakh per annum and thus service tax has to be paid on the entire revenue! And this means that the playing field when it comes to taxi services is not level – for it is cheaper for an individual running a single taxi to offer service rather than a company offering a fleet.

This is similar to regulations in manufacturing that make it much more expensive (in terms of enhanced labour regulations and disclosures for companies beyond a certain size) for larger companies to operate vis-a-vis smaller ones. Even in the proposed relaxation of labour laws, a number of relaxations are to do with the minimum size of a company for doing the disclosures, and not with the easing of regulations themselves. All that it means is that just the threshold is raised – it becomes easier for companies to grow beyond their current levels of inefficiency, but they will soon hit a new level of inefficiency!

The problem for all this is the arbitrary fixing of slabs. An ostensible reason for fixing the minimum slab for service tax at Rs. 10 lakh is that enforcement for people earning less is going to be difficult. But as can be seen in the Uber case, this can lead to inefficient structures of industrial organisations, by keeping them small, and is hence not prudent. The government would do well to remove such arbitrary numbers from its regulation!

The other thing about service tax is that once your income crosses Rs. 10 lakh, you pay service tax on your entire income rather than the excess over 10 lakh, which is how income tax is structured. This is again inefficient, for someone who is making Rs. 9.8 lakh is now dissuaded from taking new business since it can literally subtract value! Another reason for arbitrary barriers to go.

Batch size at IIMB

A few days back I had written about how the new IIMs with a sanctioned batch size of around 60 and a faculty strength of 20 are unviable and need to scale up quickly. My argument was that one of the big strengths of the older IIMs is its faculty size which leads to a large number of electives, which allows students to shape themselves the way they best feel. In this context it would be interesting to compare these IIMs to one or more of the older IIMs.

I recently received a mail by the IIMB Alumni Association asking me to reach out to batchmates who are not part of the association. This mail had been sent to all IIMB Alumni who are registered with the association, and the purpose was to increase membership and reach of the association (and no, there are no membership fees). And the mail came with a very interesting data set, and one of the fields was the size of each graduating batch at IIMB.

Source: IIMB Alumni Association
Source: IIMB Alumni Association

It can be seen that IIMB also started rather small, with about 50 students graduating in the first batch in 1976. By the end of the decade, the number was close to a 100, which is where it stayed through the 1980s. Around 1990 was when the batch size increased to about 150, and the number stayed within the 150-200 range for another decade and a half (the 2004 batch was bigger than the ones around it, possibly due to the IT slowdown in 2002 when this batch entered IIM).

And then after 2006 (when I graduated), the batch size increased. My batch had three sections as would have the 15 batches prior to that (based on this data; IIM sections normally consist of 60-70 students). In fact, the “quantum” nature of the increase in batch size at IIM can be put down to the concept of sections – so the increase from the 100 to 150 level was a function of addition of a third section, and so on. After 2006, though, the batch size has exploded, and the current batch (2013-15, who I’m teaching) has a strength of almost 400 students (divided into six sections).

A good addition to this dataset would be some data that could show the prominence or measure of success of IIMB Alumni who graduated in each  batch, which can then allow us to examine whether batch size has had anything to do with continued career success of the students. It would be interesting to examine how this additional data can be collected.

Environmentalism and the Discount Rate

Alex Epstein, in his new book “The Moral Case for Fossil Fuels” has a fantastic quote (HT: Bryan Caplan). Epstein writes:

It is only thanks to cheap, plentiful, reliable energy that we live in an environment where the water we drink and the food we eat will not make us sick and where we can cope with the often hostile climate of Mother Nature. Energy is what we need to build sturdy homes, to purify water, to produce huge amounts of fresh food, to generate heat and air-conditioning, to irrigate deserts, to dry malaria-infested swamps, to build hospitals, and to manufacture pharmaceuticals, among many other things. And those of us who enjoy exploring the rest of nature should never forget that energy is what enables us to explore to our heart’s content, which preindustrial people didn’t have the time, wealth, energy, or technology to do.

Or, as Caplan puts it in his annotation,

Epstein’s second key claim is normative: Human well-being is the one fundamentally morally valuable thing.  Unspoiled nature is only great insofar as mankind enjoys it:

This allows us to characterise environmentalism and other conservationist movements through one simple factor – the Discount Rate. Let me explain.

Essentially, let us assume that we are optimising for aggregate human well-being. So we are optimising for the aggregate of the well-being of all humans today, all humans tomorrow, 10 years from now, 100 years from now and so forth. Now, if we try to optimise for short term well-being beyond a point (extracting too much oil, for example, or burning too much fossil fuel or cutting down too many trees), the well-being of future generations gets affected in a negative manner. If we are more conservative (and conservationist) now, future generations will get to enjoy greater well-being.

So, looking at the problem from the assumption that we want to “maximise aggregate human well-being”, the problem boils down to one “simple” tradeoff between well-being of human beings today and well-being of human beings at a later point in time. And it is precisely for answering questions on such inter-temporal tradeoffs that the world of economics and finance introduced the concept of a “discount rate”!

Finance assumes that rational human beings like to consume today compared to tomorrow, but only up to a point – you don’t want to consume so much today that there is nothing left to consume tomorrow. This leads us to indifference curves between today’s and tomorrow’s consumption, and if we add to this the resource constraint, we get the “discount rate” (the actual derivation is beyond the scope of this blog post).

The discount rate essentially gives us a tool to compare consumption today to consumption at a point of time in the future and make a decision on which one is more valuable. The higher the discount rate, the greater importance we give today’s consumption vis-a-vis tomorrow’s. A lower discount rate gives greater weight to tomorrow’s consumption compared to today’s.

So coming back to conservationism, the question finally boils down to “what is our discount rate”, or to track back one step “how do we value today’s well-being vis-a-vis well being at a point of time in the future”. If you assume a high discount rate, that means you give more importance to today’s well-being. A discount rate of zero gives equal importance of well-being today compared to well-being a few generations down the line. The discount rate in this case can even be negative – where you give greater importance to the well-being of humans of a future generation than to current well-being!

So the debate on fossil fuel consumption and carbon emissions and suchlike can be characterised by this one factor – what is our discount rate? And it is a disagreement on this that leads to most debates on this topic. Conservationists usually have a very low (or even negative discount rate), and they tend to play up the risks to well-being of future generation humans. The opposite side works with a much higher discount rate and argues that we should not ignore the well-being of current generations vis-a-vis the future. And the battle rages on.