Book Excerpt: Abhijit Banerjee & Duflo on India’s Unsung Geniuses

Abhijit Banerjee and Esther Duflo’s book ‘Good Economics for Hard Times’.

(Photo: The Quint)

(This excerpt has been taken with permission from ‘Good Economics for Hard Times’ by Nobel laureates Abhijeet Banerjee and Esther Duflo, published by Juggernaut Publishing.)

Fishing With Cellphones

A central tenet of all the growth theories we have discussed is that resources are smoothly delivered to their most productive use. This is a natural hypothesis as long as markets work perfectly.

The best companies should attract the best workers. The most fertile plots of land should be farmed most intensively, while the least productive will be used for industry.

People who have money to lend should lend to the best entrepreneurs. This assumption is what allows macroeconomists to speak of the stock of “capital” or “human capital” of an economy despite the obvious reality that the economy is not one giant machine: as long as resources flow to their best use, each separate enterprise is like one cog in a smoothly operating machine, which spans the entire economy.

But this is often not true. In a given economy, productive and nonproductive firms coexist, and resources do not always flow to their best use.

Lack of adoption of available technologies is not just a problem for poor households; it seems to also be a problem in industrial settings in developing countries.

In many cases, the best firms in an industry use the latest worldwide technology but other firms do not, even when it seems it would make sense economically.

Often, this is because the scale of their production is too small. For example, until recently the typical clothing manufacturer in India was a tailor who made madeto-measure clothes in his one-man workshop, rather than a firm that mass produces. TFP is low not because the tailors are using the wrong technology, but because tailoring firms are too small to benefit from the best technology. In a sense, the puzzle is why these firms exist.

So the problem with technology in developing countries is not so much that profitable technologies are not available and accessible, but that the economy does not appear to make the best use of available resources. And this is true not only of technologies but also of land, capital, and talents. Some firms have more employees than they need while others are unable to hire.

Some entrepreneurs with great ideas may not be able to finance them, while others who are not particularly good at what they are doing continue operating: this is what macroeconomists call misallocation.

A vivid instance of misallocation comes from the impact of the introduction of cell phones on fishing in the state of Kerala in India. Fishermen in Kerala would go out to fish early in the morning and return to shore mid-morning to sell their catch.

Before the cell phone, they would land at the nearest beach, where their customers would meet them. The market would run until there were no customers left or the fish ran out. Since the catch varied quite a bit from day to day, there were a lot of wasted fish at some beaches, while at the same time there were often disappointed customers at others. This is a stark example of misallocation.

When cell phone connectivity became available, fishermen started to call ahead to decide where to land; they would go where there were lots of customers waiting and not a lot of boats.

As a result, waste essentially vanished, prices stabilized, and both customers and sellers were better off.

This first story spawned a second one. The main tool of trade for a fisherman is his boat, and good boats last much longer than bad boats. The technology of making a fishing boat is always the same, but some craftsmen are much better at it than others.

Before cell phones, fishermen used to purchase their boats from the nearest boat makers. But when they started to travel to different beaches to sell their fish, they often discovered there were better boat makers elsewhere, and they started to ask them to build their new boats.

The result was that the better boat makers got more work and the worst went out of business.

The quality of the average boat improved and in addition, because the better boat makers got more work and therefore got to use their existing boat-making infrastructure more effectively, they could lower the price of the boats.

Misallocation went down: the workers making boats, the equipment, the wood, the nails, and the ropes that went into a boat were all used more effectively.

What is common to these two stories is that a communication barrier led to misallocation. When communication improved, the same resources were better used, resulting in higher TFP, since more was done with the same inputs.

Misallocation is pervasive in developing economies. Take the city of Tirupur in South India, the T-shirt capital of the country, which we have already encountered in chapter 3. There are two kinds of entrepreneurs in Tirupur: those who come from outside to start a T-shirt-making business, and those born and brought up in the area.

The latter are almost uniformly the children of affluent local farming families, the Gounders, looking to do something different with their lives. Those who go there to make T-shirts are generally better at T-shirt making than the locals; many have family connections in the T-shirt business, and perhaps as a result firms run by outsiders make the same number of T-shirts with many fewer machines and their firms grow a lot faster.

But despite being more productive, Abhijit found in a study with Kaivan Munchi, the firms run by the immigrants were smaller in size and had less equipment than the firms run by the locals.

The Gounders poured money into the firms run by their children instead of doing the “efficient” thing: lending money to migrants and passing the interest income so earned to their sons.

As a result, efficient and inefficient firms could persist in the very same town.

When Abhijit asked them why they preferred to sponsor their sons rather than lend money to the more talented outsiders and live off the proceeds, the Gounders explained they could not be sure of getting their money back.

In the absence of a well-functioning financial market, they preferred to give money to their inept sons and get lower but relatively safe returns. It is also probably the case that they felt they had a duty to give their sons not only some hard cash, but also a means to earn a decent living.

Family firms are common all over the world (from small farms to large family groups), and they do not always fully adapt to “economic” incentives. Firms are passed on to sons even when daughters would be better at managing them, all the fertilizer in the family goes to one (male) person’s plot when it would make sense to use a little bit in all the fields.

That is of course true not just of small farms in Burkina Faso or family concerns in India and Thailand, but of the United States as well. Out of 335 CEO successions at family firms a researcher investigated, 122 were “family successions” where the new CEO was a child or a spouse of the current CEO (often a founder or the child of a founder). On the day of the succession, the stock market returns of the companies that appointed an outside CEO went sharply up, while the returns of the companies that appointed an inside CEO did not. The market was rewarding the appointment of an outsider.

And apparently the market was onto something. Firms that appointed family CEOs experienced large declines in performance in the subsequent three years, compared to firms that promoted unrelated CEOs: their return on assets fell by 14 percent.

What all of this tells us is that we cannot take it for granted that resources will flow to their best use. If they do not within a single family, or within a town, we clearly should not expect them to do so across an entire country. Misallocated resources will in turn lower overall productivity. Part of the reason poor countries are poor is they are less good at allocating resources.

The flip side is that it is possible to grow just by allocating the existing resources to more appropriate uses. In the last few years, macroeconomists have spent a lot of effort trying to quantify just how much growth could come from better allocation.

This is hard to do perfectly, but the results have been very encouraging. One very prominent estimate suggests that, in 1990, just the reallocation of factors within narrowly defined industries could have increased Indian TFP by 40 percent to 60 percent and Chinese TFP by 30 percent to 50 percent. If we allowed reallocations across broader categories, the estimates would surely be even larger.

And then there is the misallocation we do not see, the great ideas that never see the light of day.

Given that venture capital is so much more active in scouting out new ideas in the United States than in India, it is plausible that India is also missing more of these unsung geniuses.