BROADCASTS.com

Published: Oct. 28, 2020, 8:49 a.m.

b'

This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?

Welcome to the mid-week edition in which we write essays on a public policy theme. The usual public policy review comes out on weekends.

PS: If you enjoy listening instead of reading, we have this edition available as an audio narration on all podcasting platforms courtesy the good folks at Ad-Auris. If you have any feedback, please send it to us.

- RSJ

Aap party hain, ya broker?

That line from Dibakar Banerjee\\u2019s sleeper hit Khosla Ka Ghosla (2006) sums up our attitude to middlemen. Indians have an instinctive distrust of business or \\u2018corporate\\u2019. But that\\u2019s small chhutta compared to our almost visceral antipathy to broker. We use dalal as a pejorative in polite conversations \\u2014 it is someone who gets in the way of an honest transaction between two willing parties and takes a \\u2018cut\\u2019.

From the trader at the APMC mandis to the life insurance agent selling you a policy that you don\\u2019t need, the middleman is the easy policy target whose elimination is seen as necessary. Nobody can see what they produce or the labour they put in, yet they seem to corner most of the profits.

India might be an extreme case but elsewhere in the world too, the intermediary isn\\u2019t the most welcome of sights. For every business that has middlemen bringing the buyers and sellers together, there are scores of entrepreneurs building platforms to make them irrelevant. The billion-dollar start-up idea to disrupt any industry is to take out the intermediaries, drive the costs down, reduce \\u2018friction\\u2019 and offer customers a wider array of choices for free.

There are two questions that interest us here:

* Why did we have intermediaries in the first place if they add to friction, make a cut by buying low and selling high and, in general, viewed unfavourably by everyone?

* Is real disintermediation possible in any marketplace?

The Economic Case For Brokers

The usual arguments made for an intermediary are quite intuitive. There is the market-making role, to begin with. Take flowers for example.

There are customers looking to buy flowers but who don\\u2019t know flower-growing farmers. Even if they knew a few, those farmers might not be growing the variety of flowers the buyers need. In the same vein, the farmers won\\u2019t know their likely buyers beyond their immediate vicinity. The transaction costs of finding out each other for every individual farmer or buyer is just too high. The brokers step in to create a market. They understand the demand of the customers located in a specific area, search for farmers who grow those types of flowers, take the risk of buying them, then transport them to a market close to the buyers and provide an assortment of flowers as choices to the customers. There are various costs the broker incurs in this process \\u2013 search, transportation, storage and risk capital. The broker makes the market \\u2018liquid\\u2019 \\u2013 the transactions follow from there. Without these costs, there\\u2019s no market. Without a market, there\\u2019s no trade between the farmers and customers. No trade satisfying needs of two parties is a net negative for the society.

There\\u2019s more to this though. Once the broker repeats the transaction over time and attracts other brokers who compete for the same buyers and sellers, we have two additional benefits for the ecosystem. One, every broker looking to increase his business works to optimise the transaction costs which then translates to lower price for the customer. This dynamism of price discovery ensures there is a continuing relevance of the broker. Two, over a period of time, the broker is able to differentiate between the output of various farmers, rate them on quality and provide additional service of \\u2018certifying\\u2019 the product. This deepens the market with customers willing to choose their desired quality of product and paying a price for it.

However, even this example doesn\\u2019t quite capture the fundamental role of a broker in a society. Why? Because the above example is a win-win kind. Everyone benefits at the end of it. But what about instances where the size of the pie is fixed?

That brings me to R.A. Radford\\u2019s seminal paper, The Economic Organisation of a P.O.W. Camp written in 1945. This 11-page paper is a deep sociological study of life in a prison camp and from it emerges a truth that\\u2019s simple and profound.

The camp had over 2000 prisoners who received food parcels from the Red Cross. The parcels were exactly the same for everyone containing tinned milk, jam, butter, biscuits, beef, chocolate, sugar, etc., and cigarettes. The POWs in the camp were from various ethnicities and religions. It isn\\u2019t difficult to see what happened next. The prisoners had different preferences for the goods within the parcel. The non-smoker had no use of the cigarettes, many didn\\u2019t want the milk and the Sikhs didn\\u2019t want the beef. Soon trading started.

As Radford writes:

\\u201cAt once exchanges, already established, multiplied in volume. Starting with simple direct barter, such as a non-smoker giving a smoker friend his cigarette issue in exchange for a chocolate ration, more complex exchanges soon became an accepted custom.

Stories circulated of a padre who started off round the camp with a tin of cheese and five cigarettes and returned to his bed with a complete parcel in addition to his original cheese and cigarettes; the market was not yet perfect.\\u201d

There are two fundamental truths here. First, the gift economy doesn\\u2019t stay that for too long. People like to trade. Second, a broker (like the padre mentioned) can go around enabling exchange among prisoners because he\\u2019s seen to be trustworthy and could end up with more than what he started. This is a very powerful point. Everyone who traded with the padre did so on their own volition. All transactions were voluntary. They traded because they thought they were better off with that transaction. Yet after all the trades were done, the broker (padre) made a tidy profit of a complete extra parcel. This was a classic case where the size of the pie was fixed. The total parcels remained the same. The padre merely rearranged them on the basis of individual preferences. The prisoners ended up with less than what they had yet everyone felt they benefitted.

Differential preferences and different perceptions of value drive trade among people and anyone facilitating that will make a profit even in a \\u2018zero-sum\\u2019 scenario. This was a remarkable insight.

Also, over time as the prices were \\u2018discovered\\u2019, preferences became more varied and barters got more complex, a full-fledged exchange developed in the camp:

\\u201c\\u2026there was a lively trade in all commodities and their relative values were well known, and expressed not in terms of one another - one didn\'t quote bully (beef) in terms of sugar - but in terms of cigarettes. The cigarette became the standard of value. In the permanent camp people started by wandering through the bungalows calling their offers - "cheese for seven" (cigarettes) and the hours after parcel issue were Bedlam.

The inconveniences of this system soon led to its replacement by an Exchange and Mart notice board in every bungalow, where under the headings "name," "room number," "wanted" and "offered" sales and wants were advertised. When a deal went through, it was crossed off the board. The public and semi permanent records of transactions led to cigarette prices being well known and thus tending to equality throughout the camp, although there were always opportunities for an astute trader to make a profit from arbitrage. With this development everyone, including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency, though, of course, barter was never extinguished.\\u201d

This isn\\u2019t easy to comprehend. Nothing was being produced by anyone in the camp. Yet a market developed and some middlemen made profits. As Radford writes:

\\u201cIt is thus to be seen that a market came into existence without labor or production. \\u2026the articles of trade - food, clothing and cigarettes - as free gifts - land or manna. Despite this, and despite a roughly equal distribution of resources, a market came into spontaneous operation, and prices were fixed by the operation of supply and demand. It is difficult to reconcile this fact with the labour theory of value.\\u201d

Despite all of this, the middleman still got a bad rap:

\\u201cMore interesting was opinion on middlemen and prices. Taken as a whole, opinion was hostile to the middleman. His function, and his hard work in bringing buyer and seller together, were ignored; profits were not regarded as a reward for labor, but as the result of sharp practices. Despite the fact that his very existence was proof to the contrary, the middleman was held to be redundant in view of the existence of an official Shop and the Exchange and Mart. Appreciation only came his way when he was willing to advance the price of a sugar ration, or to buy goods spot and carry them against a future sale. In these cases the element of risk was obvious to all, and the convenience of the service was felt to merit some reward.\\u201d

There is no getting away from this. The broker adds value, even in zero-sum scenarios, while being simultaneously despised. This is hard-wired into us. In some cultural contexts, like in India, this is deeply entrenched.

What makes it worse in India is the idea that state can play the role of the broker and eliminate the profits made by them for the betterment of the market. Multiple problems stem from this. One, the state is a monopoly. It doesn\\u2019t have the incentive like that of an individual broker to lower transaction costs and keep price dynamic. Over time the cost of this lethargy is borne by both the buyers and sellers. The agents of the state who wield the power of the broker without the attendant risks turn into rent-seekers. The buyers and the sellers are at the mercy of the broker who sets the terms of the trade.

Lastly, the market gets distorted. The price loses its value as a signal. Side deals are struck. Licenses are scarce and get auctioned in informal markets. Black markets emerge. And the liquidity is held to ransom by a few people. This is exactly what happened in India when the government played the role of intermediaries controlling the APMC mandis. The government didn\\u2019t eliminate middlemen. Quite the opposite, it metamorphosised middlemen into odious, profiteering rent-seekers. A free market of brokers with regulations that prevented cartelisation would have served the farmers and customers better.

Is Real Disintermediation Possible?

That brings us to the question of disintermediation. The internet has reduced the search and information costs down to zero. This gives the impression that real disintermediation is possible like that done by Uber, AirBnB or TripAdvisor. But there are three flaws in this argument:

* Many of these platforms have turned into intermediaries themselves with almost monopoly powers in certain markets. Come to think of it even Google and Facebook are intermediaries who turn in enormous profits every year in their roles as market-makers. The one disintermediating an industry eventually becomes an intermediary.

* These platforms disintermediated by offering more choices directly to the customers. Over time the choices available on them multiplied to an extent that it paralysed the users. Anyone looking to choose a restaurant in an unfamiliar city knows of this problem. Soon enough you will need an intermediary to sort through the many highly rated restaurants all around.

* There are intermediaries whose role is exact opposite of what traditional brokers do. They keep parties apart to enable a transaction. Investment bankers and sports agents are examples of this. The intermediary keeps things on balance and doesn\\u2019t let a deal fall through by keeping the parties from directly interacting with another. As search and information costs fall, this role of keeping parties away from one another continues to remain relevant.

So long as there is trade and there are differential preferences, the broker won\\u2019t go out of business. The poor image they suffer is on account of a deeply held Marxian belief that visible labour is the real thing of genuine value and anyone trading only in information or whose labour is invisible is a mere opportunist. This gets compounded when the state intervenes to intermediate themselves or allows for cartelisation of brokers.

A free market where broker competes on equal terms to drive transaction costs down, provide choices and keep the market liquid benefits all. Intermediaries came into play to reduce friction in transactions. Eliminating them won\\u2019t make things frictionless.

HomeWork

Reading and listening recommendations on public policy matters

* [Article] Tim Harford\\u2019s Undercover Economist piece on the Radford paper in the FT: Rules of trading in a POW camp.

* [Article] \\u201cIt\\u2019s chiefly rent-seekers who oppose our farm reforms\\u201d: Shruti Rajagopalan writing for the Mint on how governments legislate to create rents for middlemen that distort the market.

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit publicpolicy.substack.com'