Good Economics for Hard Times

by Abhijit V. Banerjee

  WHAT’S IN A NAME?

  There is something else quite specific about developing countries trying to be the next China that adds to all these challenges.

  The World Trade Organization established an Aid for Trade initiative in 2006, and as of mid-2017, over $300 billion had been disbursed for various programs to help developing countries trade.31 Behind all such initiatives and funding is the belief that trade is a route out of poverty for these countries. A project from Aid to Artisans (ATA), a US-based NGO helping producers of handmade products in developing countries to access international markets, allowed researchers to put that assumption to the test.32

  In October 2009, ATA received funding to implement a new program in Egypt. The program followed a standard procedure. First, ATA looked for a suitable product that appealed to high-income markets and was produced in the country relatively cheaply. The research team helped ATA identify the ideal product: carpets. Handmade rugs are an important source of employment in Egypt, and there is demand for them in the US.

  Second, ATA had to find a location. They chose Fowa, a town located two hours southeast of Alexandria that is home to hundreds of small firms producing a specific type of rug. A typical firm in Fowa is a one-man (never woman!) operation; the owner operates a single loom out of his home or a shed.

  Third, ATA always works through a local intermediary firm with on-the-ground knowledge, which receives the order and finds small-scale producers to manufacture the products. The hope is that ATA will work in the country for some years but then pull out, leaving the intermediary strong enough to keep the project going and growing. A big appeal of the town of Fowa, from this point of view, was the presence of a natural intermediary, Hamis Carpets. Hamis was already marketing many of the carpets produced in the town, although for the most part they were not exported.

  Hamis Carpets and ATA then set out to decide what kind of carpets to make, find the buyers, and generate orders. That took a lot of effort. ATA brought the CEO of Hamis to the United States for a training course, hired an Italian consultant to design rug samples, and showcased Hamis’s products in every gift fair and to every importer they knew. Despite all this, it was only after one and a half years of searching for customers that Hamis Carpets secured its first significant export order, from a German buyer.

  From this point on, business picked up. Between 2012 and 2014, orders arrived rapidly, and five years after the project had started total orders exceeded $150,000. A US NGO with good contacts and financing, a fearless team of very committed and talented young researchers, and a solid firm with a good domestic reputation took five years to get a decent amount of orders, enough to give sufficient work to occupy thirty-five small firms. Without the external push from ATA, it probably would not have been possible for the local intermediary to make this work.

  Why was it so difficult? A large part of the problem seems to be that from the point of view of a foreign buyer (often a large retailer or online store with a brand name), buying from a small carpet manufacturer in Egypt is a gamble. For them quality is critical. Customers expect it; they want flawless carpets. So is timing. If the carpets are not ready for the launch of the new spring collection, the sellers take a big hit. Finally, there is no way to pass the entire risk back to the manufacturer. While it is possible to refuse to pay the manufacturers if quality is low or there is a delay, what the retailer can claw back by returning carpets or refusing to pay is peanuts relative to the reputational loss (think of irate buyers’ web posts about the low quality of products from Wayfair) or the cost of missing the spring collection deadline. In principle, firms can also agree on penal damages (the manufacturer agrees to pay a certain large amount of money for every day of delay, say), but good luck collecting from a small-town Egyptian firm that could vanish overnight. Nor is it feasible for the retailer to check every single carpet to avoid any reputational risk; it would cost way too much in staff time.

  Another possibility might be to offer the products so cheaply that consumers were willing to accept the risk of some defects, knowing they could always send the carpet back. Why stake reputation on delivering a product as close to perfection as possible? Why not lower expectations along with prices?

  It turns out this does not always work, because in many cases the price cannot go low enough for consumers to waste their time with a product they don’t trust. We once purchased a DVD player in Paris. When it came, we realized the flap through which one puts in the DVD was stuck. After about an hour spent trying to make it work, and another hour looking for technical help on the manufacturer’s site, we went online to chat with a nice Amazon employee who offered a full refund. To get the refund we had to drop the DVD player off at a grocery store near us.

  The first time Abhijit went to the grocery store, the shop owner refused to take the player because they had too many Amazon shipments. The second time, the owner made him wait twenty-five minutes before taking the package, because he was getting another consignment of packages at the same time that he needed to log. In the meantime, we bought another DVD player from a different retailer (we were in a rush since we wanted it for our daughter’s birthday). Unfortunately, when it came we realized it would not work with the television in our apartment. We attempted to return it through the product’s website, but since the purchase had not yet been logged as completed, it was not possible until a few days later. At the time of writing, the second DVD player sits, nicely repacked but unreturned, on the table in our entryway. Meanwhile, we gave up on buying a DVD player. Esther’s father lent us one.

  Why this long story about our misadventures with a DVD player? It drives the point home that for the ultimate consumer, time is money, as is reliability, and it’s money we will never recover. It is not like Amazon will pay Abhijit his hourly wage for his two trips to the grocery store or the two hours spent trying to fix the machine.

  Or think about the pretty T-shirt you bought cheap on some website, which infected the entire wash with its brilliant blue color. Who will compensate you for the $100 blouse that now has blue stains across the front? Or for the time it took you to find that blouse by rummaging through every consignment store in the Village?

  This is why Amazon goes to great trouble to maintain its reputation for excellent service. In some cases, for example, they protect the customer’s time by not requiring they return the defective product. For the same reason, Amazon then wants to deal with a producer it can totally trust, ideally a company they have dealt with before, or at least one with a reputation for good products and good service. For both customer and retailer, time is money.

  The structure of global inequality is such that the kind of customers in the West who would buy a handmade carpet or a hand-printed T-shirt (labor-intensive products for whose manufacture poor countries have a comparative advantage) are often so much richer than the makers that any savings from a new entrant offering cheaper prices will be insufficient to compensate the customer for their lost time or the ruin of a favorite blouse.

  Take the example of an Egyptian manufacturer trying to compete with China on T-shirts. Average monthly wages in China are $915, while those in Egypt are about $183.33 Assuming a work-week of forty hours, the hourly wage in China is about $5 an hour, while in Egypt it is $1. So the saving in labor cost to hand print a T-shirt that takes an hour to make (a very, very nice T-shirt) in Egypt rather than in China is at most $4. In fact, it is probably much less since T-shirt makers tend to pay a lot less than the average wage. As buyers, many of us would happily pay the extra $4 for the peace of mind its quality assures. Amazon knows that. Why would it pay to experiment with the unknown guy in Egypt when it has a known and reliable supplier in China?

  In the case of the Egyptian carpets, an intermediary (in fact, two: ATA and Hamis Carpets) was needed because it was impossible for each individual carpet weaver to build a reputation. They were just too small. Hamis at least had the volume needed to establish a track record of identifying good producers and monitor
ing their work effectively, and thereby establishing a reputation for quality. It was also in a position to teach them to improve their quality: the exporting firms improved quality very quickly and were soon much better technically than similar firms that had lost the lottery for being included in the study. But since no one outside Egypt knew Hamis, it is no surprise that hardly anyone initially wanted to deal with it or give it a chance to build a reputation.

  Making matters worse, when Hamis finally got the chance to export, it had the reverse problem to deal with. A foreign buyer might also be tempted to misbehave: to not pay for an order or change their mind on what they wanted. Hamis had to be the trusted intermediary on both sides. For example, one buyer had asked the carpets be given an antique look by bathing them in tea and sprinkling them with acid. Unfortunately, when they received the carpets, they hated the result and blamed the manufacturer.

  In such cases, Hamis was caught between a rock and a hard place. It could try to push back against the buyer, but there was never going to be adequate documentation of all the back-and-forth before the order was filled (“Yes, there was an email, but remember what we said on the phone”). So Hamis would be put into a he said–she said situation where, being a new player and from Egypt to boot, it was unlikely matters would turn out well. On the other hand, the manufacturers in Egypt felt they had done what they were asked to do and would be very upset if they did not get paid. They could not afford not to be. In the end, Hamis often had to absorb the losses.

  We first encountered the pain of establishing a reputation in the nascent Indian software industry in the late 1990s. Software in India initially developed around the southern city of Bangalore, then a sleepy town known for its pleasant climate (and now a sprawling metropolis with impossible traffic). Indian firms specialized in customized products for specific clients. If a company wanted a new accounting software, they could get a standard one customized for them, or they could get one built from scratch by an Indian firm.

  India had several clear advantages in this sector: a supply of graduates from engineering colleges well known for their excellence, good internet access, English as a first language, and a different time zone, which allowed software engineers to work on different shifts from their American clients. The infrastructure needs were minimal: an office, a small team, a few computers. In Bangalore, this was made even easier by the establishment, as early as 1978, of Electronic City, an industrial park reserved for firms in what would later be called the infotech sector, which came with an assured supply of electricity and reliable communication lines.

  All this made it relatively easy for anybody with the right diploma and a willingness to work hard to hang up their shingle and establish themselves as a software firm. But surviving in the industry was not easy.

  In the winter of 1997–1998, we asked the CEOs of over a hundred Indian software firms about their experiences with their most recent two projects. For CEOs of young firms, life was unglamorous and hard. A client would specify what they wanted, the firm would try their best to build it, but the client would often claim it was not exactly what they had requested. The CEOs almost always felt the client had changed their mind, but the client typically took the view that the firm had not understood the requirements. In any case, for the most part disagreeing was futile, since the deal with young firms almost always involved a contract where they got paid a fixed amount irrespective of the amount of work done, and only when the buyer was satisfied.

  We suspect the choice of this type of contract reflected the buyer’s sense that it was taking a risk by contracting with an unknown supplier in faraway India. Consistent with this interpretation, as firms matured and presumably became better known, we saw a switch from fixed-price contracts to cost-plus contracts, where the buyer paid for whatever time and materials it cost the seller to produce the software.34 Our story also explains why the relatively few cases where a young firm got a cost-plus contract tended to be when the firm had already done a project for the client and therefore had established a reputation.

  One of the young CEOs we met was exhausted. He felt he was working night and day on uninteresting projects (and their endless adjustments) just to stay afloat. He had recently taken up a Y2K project, which meant hunting through thousands of lines of code to eliminate dates written in the form “1/1/99” rather than in the form “1/1/1999.” There were dire warnings of the disasters that would ensue if computers started thinking the year was 2099. Companies were rushing to fix their databases.

  The work was predictable—there was relatively little risk of a disastrous cost overrun—but mind numbing. The CEO was considering shutting down and joining a bigger firm. The life of slogging through mindless projects, haggling with clients who did not know what they wanted, and constantly wondering whether he could pay his rent was not what he had signed up for when he launched his dream of software entrepreneurship.

  Young firms lacking a reputation need to start with deep pockets. Although people often refer to Infosys, started in 1981 by seven engineers with $250 borrowed from the first CEO’s wife and now the third-largest software company in India, it is probably not a coincidence that India’s two biggest software firms today are Wipro, owned by a family that had a successful cooking-oil business before branching out into software, and Tata Consultancy Services (TCS), part of the large industrial Tata Group that produces everything from salt to steel. Of course, it took more than money. In these two cases there was also someone with vision and talent. But clearly money helped.

  Having a name also helps. It is no accident that Gucci, originally a high-end leather goods producer, now sells everything from car seats to perfume, and that Ferrari, which started with sports cars, now sells eyeglasses and laptops. Buyers of Gucci perfumes or Ferrari laptops probably don’t expect particularly innovative products from those brand names. They are going, rather, for the assurance Gucci and Ferrari value their good names too much to sell low-quality products, and perhaps the bragging rights that come with buying something clearly expensive.

  THE WORLD OF NAMES

  The value of a brand name is that it wards off competition. That the buyers are so much richer than the producers makes it very important for the seller or the intermediary to focus on quality rather than price. What makes, for any potential new entrant, the challenge of undercutting the incumbent even harder is that the price paid to the supplier tends to be a small part of what a good-quality product is worth to the buyer. Indeed, branding and distribution costs are often much larger than manufacturing costs. For many items, the cost of production is no more than 10–15 percent of the retail cost. This means a more efficient producer can do very little to affect the final price of the product in proportional terms. Cutting his cost of production by 50 percent would only reduce the overall cost of putting the product in the hands of the buyer by at most 7.5 percent.

  That could still be a significant amount of money, but as a large literature has demonstrated, proportional changes are what buyers seem to care about. In a classic experiment, one group was asked whether they would drive twenty minutes to save $5 on a $15 calculator and another group whether they would do the same for a $125 calculator. Twenty minutes is twenty minutes, and $5 is $5, but the answers were very different: “68 percent of the respondents were willing to make an extra trip to save $5 on a $15 calculator; only 29 percent were willing to exert the same effort when the price of the calculator was $125.” The point is that $5 is a third of $15 but only 4 percent of $125, which is why they switch in one case but not the other. Consumers are unlikely to switch sellers to save 7.5 percent.35

  What this means is China’s prices can increase quite a bit without anyone really noticing. Moreover, there is no reason for these prices to significantly increase anytime soon. China is a big country with a lot of very poor people willing to take jobs at current wages, so costs will remain low. Countries like Vietnam and Bangladesh that aspire to be the next China, the supplier of every kind of cheap manufa
cture to the world, might spend a long time waiting in the wings. And it is a bit frightening to imagine just how long that could be for Liberia, Haiti, and the Democratic Republic of the Congo, which would like to inherit the same mantle one day, once Bangladesh and Vietnam are too rich to want it.

  The outsized role of reputation means international trade is not just about good prices, good ideas, low tariffs, and cheap transportation. It is very difficult for a new player to enter and take over a market, because they start without reputation. This along with the stickiness of labor means the easy flow of people and moneys that free trade is meant to leverage, and which the Stolper-Samuelson thesis is based on, does not work nearly as well on the ground.

  THE COMPANY YOU KEEP

  To make matters worse for, say, a new country trying to get into the fray, it is not only your own name that counts. Japanese cars are known to be well built, Italian cars are famous for being stylish, German cars are great to drive. A new Japanese entrant, like Mitsubishi when it first entered the US market in 1982, probably benefitted significantly from the success of older Japanese brands. Conversely, buyers are unlikely to want to try out a car produced in Bangladesh or Burundi, even if it is supposedly made to the most exacting standards, the price is low, and the reviews are good. God knows, they will wonder, what might go wrong in a few years. And they may well be right. It is possible that it would take many years of experience producing for the domestic market to know how to make a good car. That is how Toyota, Nissan, and Honda got started.

  However, suspicion of newcomers can also turn into a self-fulfilling prophecy. If almost no one buys the car, the company will collapse and customer service will cease. Or if everybody expects the Egyptian rugs to fade, then they will sell for very little money and therefore it would not pay for entrepreneurs in Egypt to invest in producing higher quality rugs. It’s a vicious cycle.36