In the context of the debate on formalisation of the economy, I have written that the transition will remain constrained by the demand for formal products and services. Formalisation adds a layer of cost that increases the price. The higher price, in turn, reduces the demand. There’s only so much demand for Rs 100 haircuts!
On similar lines, Indian companies will be constrained by the smaller than expected size of its consumer market and the price-sensitive nature of the vast majority of consumers. This is a binding constraint on the dynamism and growth of Indian companies. It’s useful to keep in mind this analytical framework as we analyse the Indian economic prospects.
Businesses require margins to invest in R&D and grow. Some companies like Apple and the Big Tech firms have business models that allow them to appropriate large margins. But in most cases, businesses leverage market differentiation to also offer premium goods or services at higher price along with their regular offerings. These premium products come with the high margins required to generate the surpluses the firm needs to invest in R&D and overall expansion. In other words, the premium market segment ends up cross-subsidising the other segments and driving the companies dynamism and expansion.
But small size of the Indian high consumption market segment comes in the way of businesses being able to generate anywhere near the level of surpluses required to support large R&D investments and aggressive business expansion. This logic applies with great force to all the major markets in India. The Airlines market is characterised by the near complete dominance of no-frills airlines and the tiny share of premium class travel. In sectors like automobiles, consumer durables, electronic equipment, clothing, footwear, hospitality services, and so on, the premium goods or services of the brand/company are a tiny share of the overall demand.
This constraint binds even more in sectors at the cutting-edge of innovation, where R&D investments are essential. In markets like electric vehicles and EV batteries, this constraint means that Indian firms do not enjoy the surpluses required to pursue innovation at the industrial scale required to make a meaningful impact.
The Indian software firms are a good example of how this constraint can entrap a whole industry in a low-level equilibrium. In their case, the constraint was perhaps self-imposed. Very early itself these firms chose the market for lower value added services, thereby competing on very thin margins. This also meant that they never generated large surpluses like the Big Tech firms to invest in R&D and move up the value chain. Despite this constraint, it should also count as the singular failure of Indian software industry that none of the early movers had the vision to step out and pursue higher value added services and product development.
The manufacturers and firms in the East Asian economies overcame this structural constraint of low domestic demand in a developing country by being able to produce and export to the global market. The absence of any industrial policy that promoted export-led growth like in North East Asia, coupled with the poor global competitiveness of Indian manufacturers, meant that these companies remained stuck in making lower quality products for India instead of making high quality products in India for the world.
In this context, the trajectory followed by the Indian software industry whose growth too was export-driven is instructive. Unlike the North East Asian manufacturing behemoths who gradually moved up the manufacturing global chain, despite their head-start from the eighties, India’s software industry frittered away a massive opportunity by not making efforts to move up the value chain. Instead of grabbing the several business opportunities presented by areas like technology consulting services, software products, cloud computing, robotics, Internet of Things, Artificial Intelligence etc, they have remained stuck in the paisa vasool model of lower value labour services.
The experience of the Indian software industry is an illustration that market forces by itself does not necessarily ensure corporate dynamism. Did the North East Asian economies do something by way of industrial policy to encourage its firms to move up the manufacturing value chain? Or is movement up the value chain in services sectors like software not amenable to industrial policy like with manufacturing? Or are there some innate characteristic that those firms had which the Indian software firms lack? Or did the absence of a domestic market, where the North East Asian firms experimented and refined their products before exporting them, handicap the Indian software firms?
In earlier posts, I had pointed to entrepreneurship deficit, lack of business dynamism, chronic deficiency of good quality skilled manpower, and low base of risk capital as constraints on India’s economic growth. I have also written about the weaknesses of the Indian private sector and the problems associated with the insufficiently broad-based nature of the country’s economic growth. In this post, we’ve seen that the narrow base of the consumption class may be a major constraint on business dynamism and expansion.
In the next post, I’ll examine a few features of the Indian economic growth that holds promise as possible drivers of future economic growth.
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