Paternalism and the Mirage

Professor Karnani’s primary critique of Prahalad’s The Fortune at the Bottom of the Pyramid, is that it focuses multinationals on the extreme poor as consumers. Instead Karnani offers that “…we should emphasize buying from the poor. By far the best way to alleviate poverty is to raise the income of the poor.”

This is not a new idea, nor is it at odds with the idea of marketing innovative products toward the poor. Karnani’s arguments against the poor as consumers often boil down to naked paternalism:

“Holding the poor consumer’s income constant, the only way he can purchase the newly available product is to divert expenditure from some other product. If he is a ‘rational’ consumer, this will increase his welfare. However, as a practical matter, this is unlikely to result in a significant change in his poverty situation. Additionally, if for some reason, the poor consumer is irrational in his resource allocation choice, the BOP initiative might even result in reducing his welfare.”

“The poor surely have a right to buy televisions; the issue is whether it is in their self interest to buy televisions.”

So if there is a risk that poor consumers might make irrational buying decisions, who should help guide them? The United Nations? The dictator of that poor country? A local tribal leader? Religious clerics? In an ideal market, consumer choice is best left to… the consumer.

Professor Karnani emphasizes that the government should be focused on consumer protection. But we have to remember that consumer protection laws in the West have taken a century to build. Should developing nations that can’t even deliver basic sanitation, infrastructure and public health shift their focus to developing consumer protection laws? Consumer protection is a worthy goal, but it is ultimately citizens who must hold their own governments accountable when the forces in the free market are perceived as harmful to their society or environment.

Karnanai also takes issue with Prahalad’s example of a skin whitening cream that was marketed to women in India by international giant Unilever. Karnani blames it for it entrenching women’s disempowerment, writing that:

“The BOP proposition is not satisfied with just giving the company the right to sell skin lightening cream. It goes further and commends the company for empowering women and helping eradicate poverty. This is an intellectually and morally problematic position.”

He also notes that Unilver’s marketing campaign was failure:

“The All India Democratic Women’s Association campaigned against this and another advertisement as being racist, discriminatory, and an affront to women’s dignity.

“Ravi Shankar Prasad, minister of Information and Broadcasting, said ‘Fair & Lovely cannot be supported because the advertising is demeaning to women and women’s movement’. Unilever has since discontinued these two advertisements in India.”

Karanani advocates that we preemptively limit consumer choice because the poor might make economic decisions that seem irrational from a Western perspective.  But it was by giving consumers a choice in India that they considered the role of women in Indian society, and market forces ultimately drove Unilever to pull the ads. Would Karnani consider poor customers to have been rational economic actors in that case?
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Paternalism Meets Micro-Credit

Karnani also finds harm in Prahalad’s example of Casas Bahia. This Brazilian superstore facilitates the purchase of high-quality appliances by offering credit to poor consumers who have unpredictable income streams.

Karnani argues that:

“The BOP proposition again falls prey to a fallacy: providing credit does not change the affordability of a product. The finance term for Casas Bahia ranges from four months to one year, with an average of six months. All that the financing scheme does is provide instant gratification at a price. For the privilege of this instant gratification, he pays an interest rate of over 4% per month. People with ‘low and unpredictable income’ would be well advised to save and pay in cash; this will enable them to do a better job of comparison shopping too. It is not surprising that many of Casas Bahia’s customers do not understand well how to unbundle the purchase price and the interest cost and instead focus on the monthly installment payment.”

Using credit in a developing nation is rarely about instant gratification. Village groups in West Africa without access to micro-credit schemes organized themselves and made small loans to group members for the monthly interest rate of about 10%. These loans helped fund medicine for sick children or seeds for cash crops. Poverty tends to produce desperately pragmatic people. Would Mr. Karnani advocate saving money throughout the rainy season only to buy seeds for a cash crop to be planted the next year? Doesn’t it depend on the rate of return? And who is best able to judge when to extend credit?

If a poor Brazilian consumer buys an appliance on credit, isn’t it possible that this person might become more productive as a result? Washing machines liberate people from having to spend the day washing by hand. Gas stoves are more efficient that searching for firewood.

You don’t have to question whether someone will make the right rational economic choices just because they are poor. I agree that government regulation is needed, but we should not discourage the private sector from extending credit just because poor consumers might buy something they don’t need. If someone defaults on the loan at Casas Bahia, I’m guessing they won’t be issued more credit.
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Corruption - Total instances found: 0

Unfortunately this heading applies to a search for the word “corruption” in the PDF of Professor Karnani’s paper, not to the situation the facing the world’s poor. Transparency International recognizes that this is one of the gravest problems facing the poor. Corruption hurts the poor both as consumers (by distorting prices) and producers (by discouraging investment). Neither Karnani and Prahalad offer much insight into how to remedy this.

In fact, Karnani hardly even acknowledges the difficulty hurdle that corruption presents in establishing well-functioning institutions needed to turn the poor into producers. In attacking Prahalad, he seems to lose sight of the fact that billions of the world’s poor live in countries with failed governments.

“By emphatically focusing on the private sector, the BOP proposition detracts from the imperative to correct the failure of the government to fulfill its traditional and accepted functions such as public safety, basic education, public health, and infra-structure.”

Karnani and BOP advocates both want to see improvements in governance. Both want to improve the conditions facing the poor. It’s only a question of how to reach that noble goal. Making a market at the BOP gives multinationals a stake in the improvement. Surely sophisticated market analysts at the world’s corporations would recognize that a well-educated, healthy population of consumers purchases more goods?

We could, of course, step back and try to figure out what is going wrong in the failed states of the world. We just need to fix the infrastructure, education, eliminate AIDS, and end epidemic corruption. This is not a novel idea. The World Bank, UN and countless other academics, advisors and NGOs have been trying to achieve this for decades. As soon as we have that all figured out, will Karanani let companies sell approved goods to the poor?

Karnani concludes that:

Private companies should try to pursue marketing to the poor. However, the profit opportunities are modest at best and we suggest a cautious approach. Large companies that require scale economies should be even more hesitant.

Why ward off large companies? Free market innovation is an invaluable tool. Companies should try to earn a profit in developing nations. Many will fail as thousands of companies before have failed in rich nations. Just don’t wave off the LifeStraws and PlayPumps of the world while we wait for developing nations to create consumer protection laws up to our standard.

Karnani is correct to focus on establishing institutions that will help the poor earn more income. But while we wait, why not try the BOP approach?

Yesterday I wrote about the shortcomings of Prahalad’s book, The Fortune at the Bottom of the Pyramid. We left with the question of whether there was even a market to discuss. Several factors make it difficult to estimate disposable income at the bottom of the pyramid (BOP). Even if it is not a fortune, there is likely much more than a nickel a day of disposable income amongst the world’s 4 billion poor.

Most people in extreme poverty live in rural areas and derive much of their diet from subsistence farming. This means that relatively little of their income is spent of food. In family or tribe-oriented societies, there is also an income smoothing effect. Kinship networks, for example, mean that if one person in a family has a high-paying position in the government, many in the family will benefit. In addition, income such as flows from non-governmental aid, international transfers from foreign nationals living abroad, and the grey economy may be under-reported in GNP figures.

In response to Karnani’s paper, the WRI’s NextBillion.net noted that:

BOP households collectively spend money, lots of it, on a wide variety of goods and services, and are clearly willing to pay for services such as connectivity, clean water, financial services, energy, health care, and education for their children, as well as food, housing, and consumer goods. The BOP is already an economic actor, not just a passive, dependent group, and its collective actions define a market.

So there let’s assume that there is indeed a market of billions at the bottom of the pyramid. Should companies try to reach it? Karnani cautions that viewing the BOP as a vast market of micro-consumers is “potentially a dangerous delusion.” Let’s look more closely at his argument.
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Distribution and Economies of Scale

Concerned about the apparent gullibility of multinational corporations (MNCs), Karnani warns that:

“Not only is the BOP market quite small, it is unlikely to be very profitable, especially for a large company. The costs of serving the markets at the bottom of the pyramid are very high…. This increases distribution and marketing costs and makes it difficult to exploit economies of scale. Weak infrastructure (transportation, communication, media, and legal) further increases cost of doing business.”

Two words: Coke and Guinness. Both have very deep penetration in West Africa. Granted these are not going to improve the health and well-being of the BOP (though Guinness bottles do read, “Guinness is Good for You“). Somehow these MNCs have overcome the challenge of distributing and marketing their products across a large geographic area.

Regardless of infrastructure and marketing costs, the market will help align buyers and sellers if the price is right for each.
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Reducing Prices at the Bottom of the Pyramid

Prahalad’s thesis hinges on the idea that attracting more competition to the BOP will drive down product prices, thus freeing up their disposable income for other purchases. This is basically how Wal-Mart has made low-income Americans feel richer even as real income has stagnated over the last decade. But Karnani takes issue with Prahalad’s assertion that the private sector can deliver high quality goods to the world’s desperately poor at competitive prices:

“There are only three ways to reduce prices: 1) reduce profits, 2) reduce costs without reducing quality, and 3) reduce costs by reducing quality…. the only realistic way to reduce price is to reduce cost. The BOP proposition is adamant that we should not reduce quality in this process.

“Unless all the current producers are grossly inefficient, the only way to reduce cost… without reducing quality will always require a significant improvement in technology. Good examples of this are found in the areas of computers, telecommunications and various electronic products. It is difficult to find examples of such dramatic cost reduction in other product categories. It is not surprising that the BOP proposition repeatedly uses these same examples. We should also note that the ultimate impact on the real income of the poor due to these major price reductions is quite low because the poor spend only a small part of their income on such electronic products. The poor spend over 80% of their income on food, clothing and fuel – products that have not benefited from such dramatic technological changes in a long time.”

Let’s evaluate that last statement and have a look at how technology might help deliver improved food, clothing, fuel, and public health.

Food: There are constant improvements in pest-resistant crops, hybrid seeds, or high volume animal husbandry. Many famers in Africa still till individual family farms by hand. Certainly technology could help them improve efficiency which would lead to lower prices.

And technology improvements in computers and telecommunications do not exist in a vacuum. There are numerous positive spillover effects that affect the BOP as producers. The Washington Post recently reported that cell phones in Congo have enabled farmers and fishermen to “…use text messaging to check market prices, eliminating middlemen and increasing profits — and preventing long trips to the market on days it is canceled.” So a technology unrelated to agriculture has helped farmers saved on input prices (transport to the market on days when it’s canceled) and output prices.

Clothes: Apparel prices have tumbled over the past decade. Much of this is due to reduced quotas on Chinese apparel imports in the U.S. and Europe. Thus, the assertion that “the only way to reduce cost… without reducing quality will always require a significant improvement in technology” is inaccurate. Clothing prices have dropped as a result of trade policy, not an improvement in technology. This does have a trickle-down effect for the world’s poor.

Fuel: Fuel has indeed become more expensive. Women have to scavenge farther for firewood. Oil prices lead Nigerians into the deadly practice of siphoning off crude oil from pipelines running through their villages. But technology can improve access to energy sources. Military applications such as SkyBuilt mobile solar power could find a market at the BOP helping medical centers or providing a short term power source for harvesting and processing crops.

Public Health: As patents expire on novel drugs, cheaper generic drugs will enter these markets. Playpump is an innovative approach to water delivery. LifeStraw promises to exploit economies of scale in order to drive down prices for its personal water filtration device.

Technology: Last week, the Wall Street Journal ran a front-page story about an American entrepreneur, Greg Wyler, who was building an Internet infrastructure in Rwanda. The focus of Terracom is to first focus on market access, then profits. Mr. Wyler might disagree with Karanani’s ideas about providing a quality product at reasonable prices for the poor. He is quoted as saying, “We’re on a mission here to see what happens when we drive prices down and quality up.”

And lest you think that Rwanda is an obvious market for an outside investor, have a look at the graph at the right.

As WRI writes in response to Karnani’s critique:

The pertinent development question is whether the BOP is well served by the present (often informal) markets, and whether there are unmet needs that could be better served by more competitive markets and broader participation by the legitimate private sector.

I believe that private sector innovation help can drive prices lower, maintain or increase quality, and help deliver goods that result in better livelihoods for those at the bottom of the pyramid. But what if multinationals start marketing products that the poor don’t need? Are BOP consumers rational economic actors? Or is Karnani correct when he says that, “The problem is that the poor often make choices that are not in their own self interest.”

More on that soon…

Yesterday Foreign Policy and the Center for Global Development released their 4th annual Commitment to Development Index (CDI). This index attempts to quantify how well rich countries “help poor countries build prosperity, good government, and security.” The index measures seven policy areas: aid (per capita and quality), trade, investment, migration, environment, security, and technology.

Many countries’ own policies stand in direct contradiction to one another showing, perhaps, that internal politics are primary, and policies affecting the poorest countries on earth are secondary. Andrew Natsios, the former head of the U.S. Agency for International Development (USAID), pointed out some of these contradictions before resigning in January, 2006. As Foreign Policy notes:

“Natsios criticized a law that requires the U.S. government to buy food from U.S. farmers, ship it on American boats, and deliver it to famine-stricken regions via U.S.-based organizations. The U.S. government must deliver food aid this way even when it depresses local food prices, pushing more farmers into poverty, and even when it could buy food from farmers just outside a famine zone for much less. Some nongovernmental organizations that get a large fraction of their funding from the program defended the status quo, arguing that dropping the ‘made in America’ requirement would undermine the program’s support among American farmers and shippers. Congress quickly axed Natsios’s proposal for reform. That the U.S. government must pay off American interests to feed the starving is a sad commentary on how low the commitment to development may still be.”

In an unrelated but equally interesting measure, Transparency International has for several years been publishing the Corruption Perceptions Index (CPI) in order to draw attention to the role of corruption in stifling economic development. When we look at corruption in rich countries, there appears to be a parallel between increased corruption and decreased effectiveness at helping poor countries. To be fair, the 21 rich countries ranked in the Corruptions Perceptions Index are squeaky-clean relative to the countries they are trying to help (with the exceptions of Italy and Greece).

Is there a link? Perhaps pandering at home - the constant political pressure from competing interests - creates economic inefficiencies that hurt poor countries. These policies could come in the form of unfair trade policies (e.g. Switzerland’s $987.58 per-cow subsidy) or environmental indifference (the United States’ ultra-low gas taxes).

Then again, it’s also easy to be small. The 5 countries “most committed to development” have an average population of 7.9 million whereas the bottom five have an average population 53.7 million. Similar ratios hold for corruption: the most transparent rich countries have smaller average populations.

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Sources: Statastic research; Foreign Policy; Center for Global Development; Wikipedia

Today’s announcement that British Petroleum would be taking crude oil production offline to make urgent repairs drove up oil prices to $77 a barrel. So what about those renewable resources we keep hearing about? We want to break the oil addiction!

Ethanol is indeed sparking renewed interest and a flurry of investment in the U.S. Most of the 3.9 billion gallons of ethanol came from corn and was used in the states where it was grown. Impressive until you realize that Brazil produces 4.8 billion gallons of sugarcane-based ethanol, providing about 40% of their annual gasoline needs.

We have been producing ethanol-based fuels in the United States for decades. Most of the Midwestern states (see charts below) that benefit from $4 billion in corn subsidies have an available 10% mix of ethanol in their gasoline. And with low corn commodity prices, high gas prices and a lack of ethanol refining in the Midwest, it has created the perfect investment storm.

Profit from Archer Daniels Midlands’ (ADM) corn bioproducts increased from $259 million to $446 million this year, and they have aggressive expansion plans. According to today’s Barron’s:

“In the past year, the difference between ethanol [prices] and corn prices has soared from less than 50 cents to about $3.10 a gallon…. That’s lifted the annual return on capital for some ethanol plants toward 50% and set off a stampede of new investment in ethanol refining.”

So it will come as no surprise that the ethanol industry has a strong lobby to protect itself. It’s a twisted relationship. The federal government’s price supports and subsidies regularly create overproduction of corn. This drives corn prices lower suppressing world prices (something the developing nation’s rightly bemoan).

Some of this surplus is used for ethanol. Why? Refineries - and consumers - are incentivized by a $.51 per gallon tax credit for 10% ethanol-based gasoline. Ethanol producers also enjoy significant trade protection in the form of a 2.5% ad valorem tariff and import duty of 54¢ per gallon of ethanol.

In August, 2006, Amani Elobeid and Simla Tokgoz from Iowa State University published a paper that analyzed the economic effects of removing these protections:

“The study finds that the removal of trade distortions induces an increase in the world price of ethanol and a decrease in the U.S. domestic ethanol price, which results in a decline in U.S. ethanol production and an increase in consumption. Consequently, U.S. net ethanol imports increase significantly….”

The Iowa State paper shows that if we were to remove trade barriers and the tax credit, we would see a 14.46% price drop in ethanol for consumers. Ethanol currently makes up 10% of our gasoline in a limited number of markets in California and the Midwest. Lifting trade barriers would allow Brazilian ethanol to more easily reach ports on the East Coast.

Yet we continue to protect ethanol refineries. ADM Chief Executive Patricia Woertz told Barron’s that “ethanol demand could triple. ‘It looks like it has room to grow to 14 billion or 15 billion [gallons per year],’ she said, ‘which is a full 10% blend in the gasoline pool in the United States.’”

Barron’s analysis of the ethanol market was about as sheltered as the heavily-protected ethanol refining industry: “Unfortunately, before ethanol refiners can reach that goal [14 billion or 15 billion gallons per year], they might reach the limits of the country’s corn supply. America’s entire corn crop would satisfy just 12% of gasoline consumption, leaving no corn to feed livestock and humans.”

No corn to feed our delicious cows? Once we remove ADM’s trade protections and give the Brazilians a new market for their ethanol, we should have plenty of corn to feed those future Big Macs. It will help our farmers counteract the predicted 1.7% drop in domestic corn prices, and it might help lift some desperate Brazilians out of poverty.

Didn’t most of us learn competitive advantage in econ 101? This may be a good time for Congress to brush up.

Sources: Statastic research; Environmental Working Group - Farm Subsidy Database

Trade model based on scenario 2 in the following paper: “Removal of U.S. Ethanol Domestic and Trade Distortions: Impact on U.S. and Brazilian Ethanol Markets,” Amani Elobeid and Simla Tokgoz, Working Paper 06-WP 427, August 2006, Center for Agricultural and Rural Development, Iowa State University

Agricultural subsidies criticized in the Washington Post… but not very well

The Washington Post is running a series of articles that expose some of the true costs of agricultural price supports in the United States. Agricultural subsidies are indeed very bad. These subsidies hurt developing nations by artificially depressing global agricultural commodity prices for the crops that developing nations are desperately trying to export. Proponents who claim that such price supports help smooth price fluctuations ignore unintended consequences, and political rhetoric about “saving the family farm” is empty… as are most of the family farms.

Although the Washington Post’s first two reports are well researched, their data is often misleading, incomplete or anecdotal. An example comes from today’s article about the failure of our current system of price supports, also known as Loan Deficiency Payments (LDPs):

One who played it right last year was Michael T. Sullivan, who produces a million bushels of corn annually with his three sons in Franklin, Minn. He thrived even during the depressed post-Katrina market.

Well before the storm, Sullivan said, the family had arranged to sell three-quarters of its crop to a local grain elevator for about $2 a bushel. The practice, called “forward contracting,” is increasingly common and helps insulate farmers from the market’s routine ups and downs.

On top of their contracted price, the Sullivans got the subsidy: $292,054 for that same corn, according to payment records.

Sullivan considers the LDP a godsend, given the uncertainties of farming. “Without it, Main Street Minnesota would have no money to keep the economy rolling,” he said.

Great, lots of numbers in there. A million bushels. $2 per bushel. And the hardest hitting of all: $292,054 in subsidies. Wow, that’s a lot of subsidies American taxpayers are shelling out.

Problem #1: The numbers cited are production and income based. How much did the family actually net in 2005? $292,054 sure seems like a lot of money in government subsidies, but relative to what? It looks like the Sullivans would have earned about $2 million had they 1 million acres at the market price of $2 per bushel.

Readers would be more sympathetic to the Sullivans if the inputs to produce those 1 million bushels cost them $2.25 million, netting them only $42,054 in income, and only being cash positive because of those government price supports. But what if their costs were only $200,000? Then the Sullivans would millionaires, netting $2.09 million in 2005.

Problem #2: How does the Sullivan family’s subsidy compare to the average subsidy for a corn farmer in Minnesota? How about compared to the U.S.? Is this the average corn production for a farm in Minnesota? A million bushels sounds like a lot to me. But is it? I mean, I probably only eat 200 or 300 bushels a year. (Statastico really likes corn.) Of course this doesn’t matter, because of problem #1: we don’t know anything about their income.

Next, the Washington Post produced a colorful map that makes Iowa look like price support central for corn. Sure, most counties receive more $10 million is price supports for corn. But how much corn does Iowa produce? Well if you’ve seen Field of Dreams or Children of the Corn, you won’t be surprised that Iowa produces 18.8% of all U.S. corn. So the map is colorful, but it tells a deceptively simple story.

If you want harder hitting numbers, head to Iowa State University. Chad E. Hart reports that according to USDA projections, almost half of the market value of Iowa’s 2005 corn crop was made up of government payments. Now we can start to understand why those nations struggling to boost agricultural export walked out of WTO trade talks.

I’ll leave you with some data based in part on what the Washington Post Business section reported on Friday. If you take a look at how much the following countries pay in government support to farmers in 2005, you’ll see that every European paid $293.20 in agriculture support. Americans paid al total of $43 billion, or $145.40 per person. In contrast, the per capita GDP in Sub-Saharan Africa was only $575 in 2002. Statastico does not advocate transferring those agricultural subsidies to development. These subsidies should, however, be reduced to zero over time. Give Africa and other poor farmers around the world a chance to export, an incentive to develop, and above all, a level playing field.