The Cupidity of the Indian Government

Yesterday’s post about the government’s anti-Midas touch concluded with the question of what explains the sordid performance of practically anything undertaken by the government. I believe that the answer has to do with what is called the objective function of the government.

Loosely defined, an objective function embodies the goal of an economic agent and which the economic agent attempts to optimize in some sense. So for a commercial enterprise, the objective function could be to maximize market share, or it could be to maximize profits. For a consumer, it could be to maximize utility. For a government, it could be to maximize social welfare, or to minimize unemployment, etc. The objective function for a central bank could be to keep inflation below a specified value while maintaining adequate liquidity in the money markets, etc.

The thing about optimization in general is that there are constraints imposed by conflicting interests that define the boundaries of what is possible. In other words, there are choices that have to be made. You can have very little of one thing provided you have a lot of the other. Depending upon how much weight you assign to various constituents of the objective function, the optimization yeilds different results.

I admire the practical wisdom contained in the admonition Good, fast, cheap: choose two. That is an example of a constraint. You can either have good and fast, but it will not be cheap. Or you could choose fast and cheap, but it will not be good. Cheap fast food is not good. Think McDonalds. Food cooked at home is good and cheap but is not fast. Cars: good and fast cars are not cheap. You get the idea.

So now, given a set of constraints, one can optimize one’s objective function and the result pops out.

Back to the government. I believe that the government’s objective is to maximize short-run profits. I will use an example to lend support to that hypothesis. One can in one’s spare time construct hundreds of other examples for one’s edification and amusement (to use a phrase). The example comes from the telecommunications sector.

Which industrial organizational structure maximizes profits? Monopoly. Which maximizes social welfare? A competitive marketplace, in general, subject to some well-understood restrictions such as the absense of externalities, no public goods, etc. What did the government choose for the telecommunications sector? Monopoly. What does a monopoly do maximize its profits? Restrict supply to support high prices and thus realize monopoly rents. What was the outcome of the government monopoly in telecommunications? Years of waiting time to get a telephone connection, shoddy service, prices way above world prices.

It is really very instructive to study the Indian telecommunications sector. How the government milked it for all it was worth when it was the monopoly supplier. Around early 1990s, things began to change slowly. In 1994, a telecom policy was announced. It was flawed to its very core but it was a beginning. The flawed 1994 policy was replaced by an equally flawed 1999 telecom policy. I don’t believe that anyone other than yours truly has read the New Telecom Policy 1999. (In case you have read it, please let me know because I would like to expand the club of people who have read the NTP99.)

Now, your hopes may go up at this point. You start thinking that now at long last the government has become slowly wise and is opening up the sector for private sector investments and now we will have the benefits of a competitive marketplace and now we will enjoy telephone services at prices more aligned with world prices. Your hopes, I am sorry to say, are not justified. For the government did not give up its objective of maximizing profits. It merely decided to extract its monopoly rents in a less direct way. Instead of allowing competition in the market, it decided that it will have competition for the market. That is, will let firms compete against each other to have the license to serve the market. Firms, naturally, would be willing to pay for the license only what they could recover from operating in the marketplace (subject to a reasonable accounting profit). So the government in effect extracted at least a part of monopoly rents from the sector by instituting very high license fees. The firms in turn hope to extract that from the hapless users. Some firms will fail of course in their attempts to do that and this will lead to consolidation. In short, the consumer will be back to paying high prices, firms will have very little left over to expand capacity which would lead to high average costs (telecommunications has low marginal costs) and high prices, and so on.

I think this needs more space and I am running out of space for this column. I will continue this tomorrow.