(From The Archives) Aap Party Hain Ya Broker? Mission Creep in PLIs

Why Brokers shouldn't get a bad name. We had anticipated how Production Linked Incentives (PLIs) will turn out.

Programming Note: We are on a short ‘writing’ break. Normal service will resume from Oct 24. Meanwhile, here are two essays from our archives.

Aap Party Hain Ya Broker?


That line from Dibakar Banerjee’s sleeper hit Khosla Ka Ghosla (2006) sums up our attitude to middlemen. Indians have an instinctive distrust of business or ‘corporate’. But that’s small chhutta compared to our almost visceral antipathy to broker. We use dalal as a pejorative in polite conversations — it is someone who gets in the way of an honest transaction between two willing parties and takes a ‘cut’.

From the trader at the APMC mandis to the life insurance agent selling you a policy that you don’t need, the middleman is the easy policy target whose elimination is seen as necessary. Nobody can see what they produce or the labour they put in, yet they seem to corner most of the profits.

India might be an extreme case but elsewhere in the world too, the intermediary isn’t the most welcome of sights. For every business that has middlemen bringing the buyers and sellers together, there are scores of entrepreneurs building platforms to make them irrelevant. The billion-dollar start-up idea to disrupt any industry is to take out the intermediaries, drive the costs down, reduce ‘friction’ and offer customers a wider array of choices for free.

There are two questions that interest us here:

  1. Why did we have intermediaries in the first place if they add to friction, make a cut by buying low and selling high and, in general, viewed unfavourably by everyone?

  2. Is real disintermediation possible in any marketplace?

The Economic Case For Brokers

The usual arguments made for an intermediary are quite intuitive. There is the market-making role, to begin with. Take flowers for example.

There are customers looking to buy flowers but who don’t know flower-growing farmers. Even if they knew a few, those farmers might not be growing the variety of flowers the buyers need. In the same vein, the farmers won’t know their likely buyers beyond their immediate vicinity. The transaction costs of finding out each other for every individual farmer or buyer is just too high. The brokers step in to create a market. They understand the demand of the customers located in a specific area, search for farmers who grow those types of flowers, take the risk of buying them, then transport them to a market close to the buyers and provide an assortment of flowers as choices to the customers. There are various costs the broker incurs in this process – search, transportation, storage and risk capital. The broker makes the market ‘liquid’ – the transactions follow from there. Without these costs, there’s no market. Without a market, there’s no trade between the farmers and customers. No trade satisfying needs of two parties is a net negative for the society.

There’s more to this though. Once the broker repeats the transaction over time and attracts other brokers who compete for the same buyers and sellers, we have two additional benefits for the ecosystem. One, every broker looking to increase his business works to optimise the transaction costs which then translates to lower price for the customer. This dynamism of price discovery ensures there is a continuing relevance of the broker. Two, over a period of time, the broker is able to differentiate between the output of various farmers, rate them on quality and provide additional service of ‘certifying’ the product. This deepens the market with customers willing to choose their desired quality of product and paying a price for it.

However, even this example doesn’t quite capture the fundamental role of a broker in a society. Why? Because the above example is a win-win kind. Everyone benefits at the end of it. But what about instances where the size of the pie is fixed?

That brings me to R.A. Radford’s seminal paper, The Economic Organisation of a P.O.W. Campwritten in 1945. This 11-page paper is a deep sociological study of life in a prison camp and from it emerges a truth that’s simple and profound.

The camp had over 2000 prisoners who received food parcels from the Red Cross. The parcels were exactly the same for everyone containing tinned milk, jam, butter, biscuits, beef, chocolate, sugar, etc., and cigarettes. The POWs in the camp were from various ethnicities and religions. It isn’t difficult to see what happened next. The prisoners had different preferences for the goods within the parcel. The non-smoker had no use of the cigarettes, many didn’t want the milk and the Sikhs didn’t want the beef. Soon trading started.

As Radford writes:

“At once exchanges, already established, multiplied in volume. Starting with simple direct barter, such as a non-smoker giving a smoker friend his cigarette issue in exchange for a chocolate ration, more complex exchanges soon became an accepted custom.

Stories circulated of a padre who started off round the camp with a tin of cheese and five cigarettes and returned to his bed with a complete parcel in addition to his original cheese and cigarettes; the market was not yet perfect.”

There are two fundamental truths here. First, the gift economy doesn’t stay that for too long. People like to trade. Second, a broker (like the padre mentioned) can go around enabling exchange among prisoners because he’s seen to be trustworthy and could end up with more than what he started. This is a very powerful point. Everyone who traded with the padre did so on their own volition. All transactions were voluntary. They traded because they thought they were better off with that transaction. Yet after all the trades were done, the broker (padre) made a tidy profit of a complete extra parcel. This was a classic case where the size of the pie was fixed. The total parcels remained the same. The padre merely rearranged them on the basis of individual preferences. The prisoners ended up with less than what they had yet everyone felt they benefitted.

Differential preferences and different perceptions of value drive trade among people and anyone facilitating that will make a profit even in a ‘zero-sum’ scenario. This was a remarkable insight.

Also, over time as the prices were ‘discovered’, preferences became more varied and barters got more complex, a full-fledged exchange developed in the camp:

“…there was a lively trade in all commodities and their relative values were well known, and expressed not in terms of one another - one didn't quote bully (beef) in terms of sugar - but in terms of cigarettes. The cigarette became the standard of value. In the permanent camp people started by wandering through the bungalows calling their offers - "cheese for seven" (cigarettes) and the hours after parcel issue were Bedlam.

The inconveniences of this system soon led to its replacement by an Exchange and Mart notice board in every bungalow, where under the headings "name," "room number," "wanted" and "offered" sales and wants were advertised. When a deal went through, it was crossed off the board. The public and semi permanent records of transactions led to cigarette prices being well known and thus tending to equality throughout the camp, although there were always opportunities for an astute trader to make a profit from arbitrage. With this development everyone, including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency, though, of course, barter was never extinguished.”

This isn’t easy to comprehend. Nothing was being produced by anyone in the camp. Yet a market developed and some middlemen made profits. As Radford writes:

“It is thus to be seen that a market came into existence without labor or production. …the articles of trade - food, clothing and cigarettes - as free gifts - land or manna. Despite this, and despite a roughly equal distribution of resources, a market came into spontaneous operation, and prices were fixed by the operation of supply and demand. It is difficult to reconcile this fact with the labour theory of value.”

Despite all of this, the middleman still got a bad rap:

“More interesting was opinion on middlemen and prices. Taken as a whole, opinion was hostile to the middleman. His function, and his hard work in bringing buyer and seller together, were ignored; profits were not regarded as a reward for labor, but as the result of sharp practices. Despite the fact that his very existence was proof to the contrary, the middleman was held to be redundant in view of the existence of an official Shop and the Exchange and Mart. Appreciation only came his way when he was willing to advance the price of a sugar ration, or to buy goods spot and carry them against a future sale. In these cases the element of risk was obvious to all, and the convenience of the service was felt to merit some reward.”

There is no getting away from this. The broker adds value, even in zero-sum scenarios, while being simultaneously despised. This is hard-wired into us. In some cultural contexts, like in India, this is deeply entrenched.

What makes it worse in India is the idea that state can play the role of the broker and eliminate the profits made by them for the betterment of the market. Multiple problems stem from this. One, the state is a monopoly. It doesn’t have the incentive like that of an individual broker to lower transaction costs and keep price dynamic. Over time the cost of this lethargy is borne by both the buyers and sellers. The agents of the state who wield the power of the broker without the attendant risks turn into rent-seekers. The buyers and the sellers are at the mercy of the broker who sets the terms of the trade.

Lastly, the market gets distorted. The price loses its value as a signal. Side deals are struck. Licenses are scarce and get auctioned in informal markets. Black markets emerge. And the liquidity is held to ransom by a few people. This is exactly what happened in India when the government played the role of intermediaries controlling the APMC mandis. The government didn’t eliminate middlemen. Quite the opposite, it metamorphosised middlemen into odious, profiteering rent-seekers. A free market of brokers with regulations that prevented cartelisation would have served the farmers and customers better.

Is Real Disintermediation Possible?

That brings us to the question of disintermediation. The internet has reduced the search and information costs down to zero. This gives the impression that real disintermediation is possible like that done by Uber, AirBnB or TripAdvisor. But there are three flaws in this argument:

  1. Many of these platforms have turned into intermediaries themselves with almost monopoly powers in certain markets. Come to think of it even Google and Facebook are intermediaries who turn in enormous profits every year in their roles as market-makers. The one disintermediating an industry eventually becomes an intermediary.

  2. These platforms disintermediated by offering more choices directly to the customers. Over time the choices available on them multiplied to an extent that it paralysed the users. Anyone looking to choose a restaurant in an unfamiliar city knows of this problem. Soon enough you will need an intermediary to sort through the many highly rated restaurants all around.

  3. There are intermediaries whose role is exact opposite of what traditional brokers do. They keep parties apart to enable a transaction. Investment bankers and sports agents are examples of this. The intermediary keeps things on balance and doesn’t let a deal fall through by keeping the parties from directly interacting with another. As search and information costs fall, this role of keeping parties away from one another continues to remain relevant.

So long as there is trade and there are differential preferences, the broker won’t go out of business. The poor image they suffer is on account of a deeply held Marxian belief that visible labour is the real thing of genuine value and anyone trading only in information or whose labour is invisible is a mere opportunist. This gets compounded when the state intervenes to intermediate themselves or allows for cartelisation of brokers.

A free market where broker competes on equal terms to drive transaction costs down, provide choices and keep the market liquid benefits all. Intermediaries came into play to reduce friction in transactions. Eliminating them won’t make things frictionless.

India Policy Watch #1: Production-Linked Incentives

Insights on burning policy issues in India

— Pranay Kotasthane

Production-Linked Incentives (PLI) — that’s the name the government’s recent, most-favourite industrial policy instrument goes by. It seems elegant on paper: the government will reward companies for incremental sales of manufactured goods with a subsidy. More the sales (either domestic or exports), more the subsidy amount.

The intent seems sound too: encourage companies to up their manufacturing game.

First introduced for the electronics sector earlier in the year, PLIs worth ₹2 lakh crore for ten disparate sectors over the next five years were announced by the Union Cabinet earlier this month. These sectors are automobiles and auto components, pharmaceutical drugs, advanced chemistry cells (ACC), capital goods, technology products, textile products, white goods, food products, telecom and specialty steel.

Let’s assume that the size of the incentive is big enough to change companies’ investment decisions at the margin (that’s a big if). What are the consequences likely to be in that case? Can we anticipate some unintended consequences beforehand?

Let’s parse this policy through the framework discussed in edition #48. Three unintended effects are possible:

  1. “Reasonable regulation drifts toward overregulation, especially if the costs of overregulation are not perceptible to those who bear them.”

    The PLI scheme for the electronics sector has specific eligibility criteria both on incremental investment and incremental sales a company needs to commit over the next five years. This is supposed to be cross-checked by a Project Management Agency (PMA), a government-body formed under the Ministry of Electronics and Information Technology (MeitY).

    The PMA will further submit its recommendations to an Empowered Committee (EC) composed of CEO NITI Aayog, Secretary Economic Affairs, Secretary Expenditure, Secretary MeitY, Secretary Revenue, Secretary DPIIT and DGFT which will make the final decision. The EC is also empowered to revise anything — subsidy rate, eligibility criteria, and target segments.

    In short, more bureaucracy and predictably unpredictable delays. The speed of incremental investments might get decided by the speed of government decision-making. EC’s powers to make any changes to this policy in the future is also filled with possibilities of regulation becoming overregulation.

    There’s one more gap. In order to increase innovation, the PLI scheme will not consider incremental investments towards land and buildings towards the eligibility criteria. Only investment towards plant, machinery, equipment, research, and development is allowed. This might incentivise companies to fudge their land dealings and for government officers verifying the real quantum of incremental investments to cut deals for themselves.

  2. “Moral hazard increases.” The ten sectors chosen by the government might see a crowding-in of investment at the cost of all other sectors. Are these ten industries strategic for India while others aren’t? I don’t quite know the basis of this selection.

    Next, every policy move has an associated opportunity cost. It’s a bane of Indian policymaking that policy decisions are rationalised solely by looking at projected benefits; by ignoring opportunity costs. In the context of PLIs, the government needs to pay up ₹2 lakh crore over the next five years to a few companies in these ten sectors. The government will most likely rake in this revenue in the form of taxes. Using the Kelkar/Shah Marginal Cost of Public Funds (MCPF) estimate for India of 3, the total cost to India from this subsidy would be of the order of ₹6 lakh crore. The scheme would make sense if the benefits are projected to be higher than this number. Whether an analysis of these costs has been taken into account, we don’t know.

  3. “Rent-seekers distort the program to serve their own interests”. Companies that benefit will seek to modify the eligibility criteria to suppress competition thus leading to more market concentration. They might even try to extend the sunset clause of this scheme in order to keep benefiting from the discount.

These unintended consequences might substantially diminish the benefits that the PLI schemes are aiming at.

What are the alternatives?

Read this statement by the chairman of the India Cellular and Electronics Association (ICEA):

“The disability stack runs deep in the economy. For example, the taxes on fuel. Second, electricity is not subsumed under GST (goods and services tax). So how do you become competitive?

This is the key point. Perhaps PLIs are a much-needed band-aid solution for a wounded economy but it cannot transform manufacturing in India. Doing that would require consistent and simpler tax, policy, business, and trade environments. Improvements on these grounds will benefit all sectors and investments will follow sectors which show higher productivity. In other words, we’re still waiting for a reforms 2.0 agenda.

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Reading and listening recommendations on public policy matters

  1. [Article] Tim Harford’s Undercover Economist piece on the Radford paper in the FT: Rules of trading in a POW camp.

  2. [Article] Economists Ila Patnaik and Radhika Pandey on Production-Linked Incentives (PLI) scheme.