Monday, February 25, 2008

Retailers unite against big retailers

Last week there was a state-wide protest organized by the association of small retailers and traders of Kerala. The protest was against the entrance of big retailers like Reliance and Bharti into Kerala. The irony of the situation is that you have small capitalists joining hands together to fight bigger capitalists in a fight seemingly to protect the consumers. First let me take a look at some of the major issues raised by the protesters. A major concern voiced was that the foray of national and multinational corporates into the retail sector is going to cause loss of income, and loss of jobs of people owning and employed in the small and medium retail industry. Another point was that the big retailers would lead to a collapse of the small and medium retail industry, leading to monopolies and ultimately increased prices of everyday commodities. A third issue predicted was that once monopolies were established the farmers, manufacturers and producers would be at the mercy of the retail giants and hence they would be exploited.

Some of the underlying assumptions are a) Retailers and Traders have a right to be retailers and traders and nobody can deny their rights b) The association of retailers and traders are not just fighting for themselves but also for the vast majority of people ie the consumers, c) The existing system as such is very fair to the producers - farmers and manufacturers - in terms of giving them just shares of the retail prices of the products. d) Big retailers are bad e) Multinationals in retail industry are very very bad, f) The retailers and traders form a significant percentage of the population

Before we dissect these assumptions and claims let us take a look at the economics behind this. In any economy people generate revenue by the transfer of goods and services. Correspondingly you have the retail sector and the services sector. The retail sector includes not just the retail shops that sells us the goods we buy, but also the network of systems that exist to maintain these retail stores. Similarly the services sector has the service delivery framework.

From the point of manufacture, or cultivation as the case may be, of items bound for retail trade, to the point of the retailer selling the product to the consumer, there are usually several intermediate processes and people involved in these processes. Some of these would be wholesale purchasers, regional collection centers, transporters, distributors, sub-distributors. There would also normally be several layers of middlemen between these steps.

As the goods move along these chains of people the cost increases at each level until it finally reaches the customer. By the time the product reaches the customer the cost of the product could even have gone up a few hundred percentage points over the original price at which it was bought from the farmer. There would also be other intangible value additions like advertisements, insurances etc along the way which contributes further to the final selling price of the product.

However the real value of the product for the end consumer would not have changed as much as the increase in the cost of the product. Now we could deduce three different things from this. One is that the intermediary steps from the point of production to the final sale are very inefficient in terms of value addition. The second is that if the efficiency of these processes were higher the cost of the product for the consumer would become cheaper. Finally if some of the intermediary steps were avoided and the final price being kept the same a higher price could be paid to the manufacturer or the farmer.

Retailers exist to trade, and trade they do, and their motive is to make profits. The profits that are expected by the retailers would be in proportion to their investment rather than to their livelihood expenses. This rule would apply for all but the small and samll-medium retailers. The right to earn ones livelihood is a universal right, but the means to do that is not a right. A trader has a right to earn his living through his trade. But, the moment the returns are higher than his cost of livelihood his trade will not be covered under the right.

A retailer or a trader sells at a price which will yield him the profits that he is expecting out of his business. The price would also be regulated by the prices of the product at the other retailers also governed by a similar mechanism. A reasonably big percentage of the final price of the product goes towards the overheads in the retailing process discussed above. A percentage would go to the farmer also. This percentage that goes to the farmer and the small percentage that corresponds to the small value addition to the product are the components of the price that is effectively used to maintain productive labor. The rest is used to maintain unproductive labor working in inefficient processes.

A big retail chain in the market would be operating under a different framework. The entire chain of processes from the point of procurement from the original producer to the point of sale to the end consumer would normally be operated directly or supervised directly by the big retailer. This would introduce a massive efficiency increase in the process. Also the advantage of size gives another efficiency increase in terms of the unavoidable overheads. Consequently the big retailer would be able to make two changes - one is to reduce the final selling price for the consumer and the second is to increase the purchase price from the producer.

By giving better prices to the producers big retailers promote productive utilization of labor and by increased efficiency in the retail process the deviation of capital for unproductive labor is minimized. Additionally by reducing the prices for the end customers they are provided with excess capital than if it had been not so. This excess capital could lead to higher purchasing powers and in turn better average quality of living.

Both of the above changes provide the necessary financial incentive for the producer and the consumers to embrace the big retailers. This could result in a collapse of the existing retail framework. Now this is a potential cause for a problem as it could lead to monopolies at the purchase level and at the sale level. If monopolies are established both the above incentives can be taken out or even reversed by the big retailers. However big retailers can not exist everywhere. They will establish outlets only where it would be viable to set up one in terms of the market reach and the purchasing powers of the locality. So there would be big retailers in areas where the population sizes justify the existence of the retail outlets.

The emergence of monopolies in localities where the big retailers exist is a potential risk. This risk however could easily be mitigated by good ant-monopoly laws and regulations. Additionally the monopolies could only emerge even if it does emerge and in cases where it does, local trade establishments can reemerge to bring down the prices. So even in such cases the prices of the products would be cheaper than from an average retailer and the purchasing price given to a farmer would be higher than from an average retailer. If it had not been so the small and medium retail segments could re-emerge to neutralize the situation. So it would be in the interest of the big retailers to maintain the prices at such quasi-monopolistic levels.

Finally it might be good to take a look at the numbers. In an average society the percentage of retailers and traders would be around 10-15% of the population. Even including all the support framework it cannot be more than 15-20% of the population. In the case of big retailers this number would be reduced but would still have to remain significant. This reduction however will have to result in an increase in unemployment. The excess capital saved in the system by a reduction in the costs of retail products and a higher purchasing power for the producers would result in an availability of capital for non-retail use and that would mean the service industry. So this could result in an increased growth of the service industry where the lost jobs in the retail industry could be absorbed easily.

Having said so I still have reservations about multinationals entering local retail industry as it would result in a biased cash flow mechanism in the system in the short term and the Indian economy may not be mature enough to be able to afford that. Also the emergence of Indian big retailers is going to cause a short term aberration in the equilibrium in the system leading to undesirable results like the job loss mentioned above. However in the long run both national and multinational retailers are going to be helpful for the system. Efficiency increases has to be good in itself.

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Thursday, February 14, 2008

Everything is relative including the colors we see

We depend a lot on our perceptions, how we see things, how we hear sounds, how we feel things, how we smell things, how we taste things. More often than not people take these senses for granted and never for once think beyond the senses perceived to the act of perceiving. I recently happened to think a lot about one of these perceptions - sight. These were afterthoughts of a discussion with a person I met during a train journey recently.

When we see something we don't normally think beyond the thing that was seen. We don't think about the physical process that happens when we see the object we are looking at. We don't realize that light waves reflected (or originating) from the object travels through the air and passes through our eyes and falls on our retina. The light that falls on the retina triggers signals on the optic nerve which in turn causes the sensation of sight once these signal reach the brain.

Television engineering was one of my favorite subjects during my undergraduate engineering course. It was very interesting because I was always fascinated about how a television works - how the images are translated to pictures in the television camera and how these pictures are transmitted to the television set where these are converted back to images.

Once the course was over the operation of a television looked simple and plain to me. However I still cannot fathom how human eyes work. Simple questions like the number of pixel elements on the retina and the way the signals are transmitted to the brain. Research has been going on to decode the signals that get transmitted through the optic nerve. I am sure that the person who finally decodes the signals correctly is going to get a Nobel price as the discovery is going to eradicate blindness in humans.

Decoding the physical process of the generation and transmission of signals on the optic nerve is probably going to happen soon; but what about the decoding the process in the brain that gives the perception of sight? What is sight? It is so complex that I cannot even begin to imagine a physical explanation for the perception of sight. This is somewhat similar to the discussion I had on the form of human memory. What happens when the electric signals from the optic nerve reaches the brain?

Now let me come to the point I would like to highlight. How do you define a color? For example how do you define Red? How many primary colors are there? What do you mean by a primary color? What is infrared? What is ultraviolet?

Let me try to answer these questions one by one. A color, for example red, is defined as something we see when an electromagnetic wave of a particular range of wavelength(625–750 nm) falls on our retina. There are three primary colors - Red, Green and Blue. All other colors can be generated as a combination of these three different colors in different proportions and different intensities. Infrared is defined as the range above the wavelength of red. Ultraviolet is defined as the electromagnetic spectrum below the wavelength of violet.

These answers look simple and looks almost like taken out of a Physics text book. There is one thing that we are taking for granted here. An electromagnetic wave does not have a property called a color. There is no such thing as color. It is just a perception that we get when electromagnetic radiation of a given wavelength falls on our retina. If by some quirk of nature, my retina response curve gets reversed and starts generating the same signal that your retina generates corresponding to light of 650nm and 380nm respectively, then I would start seeing red when you see violet.

There is a natural explanation for why we see the colors we see for the range of frequencies as defined by the visible spectrum. These are the frequencies of light that get reflected by the elements and compounds and mixtures that we see in nature around us. In other words, the rest of the spectrum (mostly) gets absorbed by these physical objects.

If we were on a planet that had a different set of elements (that would require a different set of sub-atomic particles and different forces acting on these particles than those that we already know) with a different set of absorption spectra then we would probably have seen the same colors(there is no need to think otherwise) but for different frequencies of the electromagnetic spectrum.

Colors exist only in our brains. Also for a given wavelength of light the colors that each of us sees are unique to ourselves since the physical response of my retina is for almost for sure different from the response of your retina. You will never see the red color that I see and my red color is always going to be my own personal red color.

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Thursday, February 7, 2008

Is there an absolute fair price?

I had written once about my thoughts about fair margins while pricing products. I have been trying to get the concept clearer in my head but have not quite been able to do so till now. A few days back I had a rather productive discussion with a couple of my friends regarding the same issue. Productive because it brought a lot more clarity to my thought process regarding this issue.

When you talk about absolute fair price you are making a fundamental assumption that there is a price that can be called an absolute fair price. The definition of such an absolute fair price would be a price that is independent of the actual buyer or seller. Such a price will be the minimum at which the seller should have to sell and the maximum at which the buyer have to buy and would be fair to both the buyer and the seller.

In a perfect market where there is perfect information and market forces are working perfectly, competition and awareness of the customers will ensure that prices will be fair to both the buyer and the seller. Markets are seldom perfect, perfect information is only a myth and hence the above scenario never occurs in real life (at least it wont happen for all the customers at all the places at all times in the given market).

I am more interested in an answer to the question under imperfect market conditions where there is no perfect information and where customers are not fully knowledgeable about the market. The reason why the answer to this question is interesting is that it will give a solid basis of estimation of prices under any market condition and for any customer.

Before I proceed further, I would like to bring to your attention a few extreme scenarios. Consider a situation where a billionaire is convicted by the court and is going to be hanged. His death penalty will be canceled if he can write a letter to the President asking for amnesty. He does not have a pen. He has access only to a single store and the storekeeper, seeing his situation, sells him a 1 dollar pen for 100 Million dollars. The man gladly pays the amount and buys the pen to write his petition. Here there is no competition, the buyer does not have any choices and the seller sells at a price that the buyer can afford to buy.

Now consider another situation where a man walks into a store to buy a pencil. The storekeeper convinces the man to buy a pen, that is available online for 10 Rupees, for 100 Rupees. Here there is competition, the buyer has choices but he is not aware of his choices and is tricked into buying something at a far higher price than if he had been aware of the other cheaper options.

Pricing, as defined as a function of marketing, is an exercise of profit maximization. Prices are fixed between the total costs incurred by the seller and the maximum affordable price for the buyer. The exact value will depend on the market conditions including competition and consumer awareness. This is how it should work under the Capitalistic model of economy.

Earlier I had come to a conclusion that pricing was to be fixed based on the minimum ROI that is still fair to the capitalist and the growth rate expected of the company. The minimum ROI should be the market rate of Interest for the capital as otherwise the capital invested could have been invested in another venture that would have yielded at least the market rates of interest.

Now the expected growth rate is a tricky question. What should be the expected growth rate? Can't the company grow more if the margins are higher? Yes it has to be conceded that high prices might deter growth but still there is that positive slope till the peak. Should the expected growth rate be equal to the growth rate of the country? But then wouldn't a higher growth rate be better for the country?

I could just be a traditional capitalist and play with the prices according to how the rest of the market behaves. For example I could charge a person higher accordingly as he can afford to pay more or accordingly as he is less aware. I could charge as much as my competitors are charging. I could make a killing in areas where there is no competition.

But the socialist in me is pulling me back from doing that. I cannot give two rates to two different people based on their circumstances or their knowledge. I can not bring myself to give two answers to the same question - "What is the price of this product?". When I had stated my intentions of starting a company, people who knew me told I wouldn't survive as a businessman without engaging in malpractices. I said I will. Neither them nor me ever thought of this kind of predicament that I really have to face.

My take on the issue is that, prices should be determined by the costs involved and not the intended profits to be made and that the fair margin should just be a cost. So if we include a fair margin as a cost we have a solution to the problem. Price of the product equals the cost of the product (See also - True Cost of Things) + the Fair margin. Now if we have an equation or a method to find the fair price then we have a fair pricing strategy. But alas!, both the parameters - ie the true cost and the fair margins - are kind of difficult to find, as we have seen, and my pursuit still continues.

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