The Mad Hatter's Law of Business Models

If I may be a moment of vanity, this is the pithy saying I'd care to have my name attached to - "You can't make a business model out of preventing consumers from having something they want".

There're so many such models around these days. Most of them are dismal failures, others on their way. DRM, Macrovision, the whole of RIAA/MPAA, and the like seem to be destined to be dragged kicking and screaming to business-model-oblivion.

In the good old days, when the scarcity that economic textbooks talked about was 100% real, life was simple. You made your money by making a product (that was scarce, in the economic sense), and made money by selling to people who wanted to buy it at the price you were willing to sell at. Your job was to deliver a product or service to the consumer, and you made money based on how much they were willing to pay.

If you made enough money, others would enter, and the market would begin to resemble a perfectly competetive one. Your price would then decline from what the customer was willing to pay to somewhere above your marginal cost. Not too bad, you still made money. Alternatively, you created artificial scarcity through ownership of the means of production or distribution (I'm talking about you, media companies!), limited competition through whatever means, and kept prices close to willingness-to-pay. You could create an artificial scarcity by owning the medium of communication (records, movies, newspapers) or by imposing protection on content (copyright, IP protection etc.).

It was the digital age that made things different. Marginal costs of software, digital media, and information are now close to zero, as I've blogged about before. Is this the beginning of the post-scarcity abundance economy that Marxists love to presume is inevitable? Perhaps not, but we are definitely seeing the implications of abundance, albeit in a limited domain.

Traditional "own-the-medium" scarcity creators like music or movie companies and newspapers are now in trouble. Rather than adapt, they've chosen to react by throwing money at the problem - buying legislation like the DMCA, pushing DRM down the throats of unwilling consumers and so on.

All this amounts to a reversal of the tradition of business. You're not trying to make money providing goods or services to customers, but by preventing access unless your protection money is paid.

So, expect the outdated scarcity-dependent vendors to continue to try. And expect them to fail.

Expect some interesting half-steps towards dismantling old models - like iTunes. Though currently DRM-ridden, iTunes became succesful because it finally let customers have easy pay-as-you-go access to digital music at a reasonable (compared to alternatives) price. It was incrementally better than competition - it put fewer hurdles in the consumers' path. Apple's DRM is the target of a lot of activism and legislation, and will eventually fall. Even Apple doesn't seem to want to keep DRM alive.

The consumer will find ways to get what he or she wants. He/she will crack DRM. File-sharing will evolve in ways that make DRM or tracking utterly pointless. Blogs have already begun threatening the viability of newspapers and the viability of overpaid reporters who work for them.

Self-publishing on the web and free-access online journals are the next wave, and will probably doom traditional publishing houses.

Recording artists will begin publishing online, and receiving voluntary payments for unrestricted media. They will continue to make money on live shows, with the record company now out of the picture.

In the meantime, it would be a smart move not to try to swim against the tide. Surprisingly, there are a few such models floating around in startup-space. If your business model rests on creating artificial scarcity in a digital world, pause to think. You're probably on the wrong side of history.

You can't make a business model out of preventing consumers from having something they want. They will find a way.

Try finding a way to give them want they want.

From the Good Riddance Department

Renuka Chowdhary - No, we won't miss you
Mani Shankar Aiyar - Yes, there is a God!
Mayawati - time to give up the moh-maya
Laloo - Yeah! potato-less samosas!
Amar Singh - hmmm, really, I wonder.
A R Antulay - How could I forget him!

and last but not the least, Mr. Karat. Don't let the door hit you on the way out!

Not having to see Mr. Karat on TV is worth 500 points on the index
- Samir Arora

Buffalo, Bangalore, and a whole lot of Ballyhoo

US President Obama set off a lot of alarm bells all over the world with his “Buffalo vs. Bangalore” speech, where he promised to revoke tax breaks that “reward our companies for moving jobs off our shores”.

Not that the Hatter doesn’t trust the usual gaggle of journalists that report on these things, but he is of a suspicious bent, often unreasonably so. The lack of specific information on what exactly was a bit jarring to his oversensitive soul, so he went off to find some.

Apparently, the plan hasn't been fully released yet, but reactions to it have been coming in already. We have a little more detail than we did earlier, in the form of some clarifications from the Man himself.

So, should Bangalore be getting their collective dhotis in a knot? Are we in for punitive taxation on outsourcing? Is this the end of Silicon-Halli's cost competitiveness?

The details, sketchy though they may be, were more interesting than the Hatter imagined they would be. Here's what he understood, simplified just a little bit so his head doesn't hurt as much:

The status quo is thus. Imagine a hypothetical US corporation, let's call it Acme Corp. Let's say Acme Corp sells $1000 worth of stuff a year. If Acme makes its stuff in the US, using US labor, its costs are $800 - netting it a $200 profit. Say the tax on that profit is 30%. Acme pays $60 to the guvmint and keeps $140. Not a bad business, eh? That is, until ChinChin Inc from Shanghai starts selling its stuff for $800. Now Acme has to match ChinChin's price, which wipes out its profit.

So, Acme reluctantly moves production overseas to Elbonia, where its costs are $400. Now, it can sell stuff at $800, and make a handsome profit. The lark's on the wing, the snail's on the thorn and the spirit of David Ricardo smiles.

But wait, how much tax does Acme have to pay? Whom does it pay to? The US Guvmint or the Elbonian Guvmint? Or both? Or neither?

The answer, my friends, is stranger than one can imagine. Assume $400 of those sales came from the US and $400 from other parts of the globe - fair enough in these globalized days. US tax laws say Acme pays US tax on its US profits of $200. Also, it pays US tax on its foreign profits of $200, but can claim credits for any foreign taxes it paid on that profit. So far so good.

And it gets better. Thanks to all the lobbying that Acme and its pals have done in the past, the US guvmint doesn't require it to pay taxes on foreign profit of $200 until the money is brought back into the US. If Acme reinvests that money in Elbonia or elsewhere, the tax can be "deferred" - not paid until the money is brought back.

The really clever part is that Acme gets to claim its cost of production in Elbonia as expenses, though it defers paying tax on the profit.

So, Acme's US profit is $200, its foreign profit is $200. In generating the foreign profit of $200, Acme spent $200 in Elbonia, which it can claim as expenses, making its net US taxes zero. Yes, zero. Did I say something about being stranger than one can imagine?

And Acme can create a subsidiary in the Cayman Islands (which doesn't tax income), and pretend its foreign profits came from there, and never pay any tax on foreign income, while all the while claiming foreign costs as expenses. Nifty deal, whoever they paid to lobby for that really earned his money! The US Guvmint ends up subsidizing Acme's investment in Elbonia to the tune of 30%!

So, all the while US multinationals investing in Bangalore or Shanghai or Ukraine, or even Belgium, had been claiming costs there as expenses, while never paying taxes on their foreign profits. The sheer brilliance of this trick has left the Hatter a bit dizzy.

This is what Obama wants to do away with - foreign tax deferral coupled with being able to claim foreign costs as expenses, leading to the US government effectively subsidizing foreign investment of US corporations.

So what if Obama does as he threatens, and defer expense credit on deferred foreign taxes? US MNCs will now have to account for the full cost of investing abroad, and cannot expect an effective subsidy from the US taxpayer. Will this mean they'll invest in the US instead? No!

Why not? Because it remains cheaper to invest outside the US, even though less so without the tax break (read subsidy). Assuming they're rational (to be fair, that's not a word the Hatter would associate with any of his employers thus far), they will continue to invest abroad at the cost of the US, and make the same pre-tax profit. Only, they'll pay more taxes on the profit.

So, no new jobs will be created in Buffalo. Acme will still invest in Elbonia. Tech MNCs will still invest in Bangalore. The US Guvmint just gets to keep more of their profit as tax. And spend it.

Then why talk about creating jobs in Buffalo?

This is where the Man's political genius shines through. Obama has succeeded in framing the debate as a jobs-for-americans debate. That means he gets public support on this while he takes on the lobbying power of US Business, which knows what this is really all about - making them pay their taxes. Keep the job rhetoric loud enough, get enough constituents pressurizing Senators and the lobbying might not work. Brilliant, bordering on evil genius level.

Tip o' the hat to Barack Obama. Well played, sir!

The Streets of ShenZhen

This morning, I was reminded of the streets of ShenZhen.

The roads of ShenZhen are wide (6 lanes plus a divider + 2 service lanes on either side). The thing that caught my attention is that they're green and tree-lined - all along the divider, plus between the road and the service roads. They even look greener than the Bangalore of the early nineties. And most of them were built fairly recently.

Interesting, and something to remember if you're planning to protest any tree-felling. The roads of ShenZhen weren't built without cutting trees. The important part is that more trees were planted in their stead.

Please, please, spend your energy constructively (go plant some trees, or hold authorities responsible for planting trees) rather than obstructing progress.

Remember, the later Namma Metro gets built, the more pollution we all have to breathe. The agencies building the metro cause enough delays by themselves without us adding more.

Concerned Bangaloreans, this means you.

Why didn't economists see it coming?

... the depression, of course. Barry Eichengreen, professor at UC Berkeley takes a look at the problem.

Some quotes:

When it is costly to acquire and assimilate information about how reality diverges from the assumptions underlying popular economic models, it will be tempting to ignore those divergences. When convention within the discipline is to assume efficient markets, there will be psychic costs if one attempts to buck the trend.

and further ...

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

In short, they knew it was coming, but hand an incentive to keep quiet and get with the program. Ironically (or not) economists ended up following the money, rather than the truth about it.

Save the Earth, Rescue the Economy!

Save the environment, rescue the economy. What if you could do both? Nobel prize winning economist Krugman argues for cap-and-trade to reduce emissions while boosting investment.

Krugman won the nobel prize for economics in 2008. His basic argument here is that a gradual emissions limitation program would give private investors a reason to invest even in a contracting economy running under-capacity.

The boom of the nineties was based on the internet, a technology born out of government funding (DARPAnet). Is energy the next boom-creator, and is a gentle government nudge needed?

Interestingly, Krugman does not advocate government subsidies, but a cap-and-trade system. A fixed number of carbon permits are sold and traded in a market - you have to buy a permit if you want to emit carbon.

Basic rent theory would say that the price of permits would settle at the unit cost of carbon emission reduction. In simpler terms, how much would you pay for a permit to emit one unit of carbon? About as much as it costs you to reduce your carbon emission by that amount. This gives you an incentive to invest in technologies that reduce your carbon emission, one that does not involve the taxpayer spending on subsidies.

So far, it's "all goodness", as someone I knew used to say. Will it work in practice?