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Thursday, 2 July 2015

Economics: Balancing Corporate Profitability versus National interests

Hello folks,

This blog is an canvas for my interests, it has covered satire, spirituality, politics, amateur psephology attempts and astrology among others. This blog is about economics, about an idea that has been in my head for a long time and am putting it here to stake ownership, in case no one else has thought of it before. So if you have come looking for an astrology post, wait for the next one. Thanks.

The theory goes as follows:

Virtually all efforts in cost cutting at a business entity (BE) level result in a reduced need for man-power. This reduction may be immediate, i.e. people being let go or hidden, i.e. hiring that was planned for the future may be cancelled or curtailed.

Cost cutting may happen through the introduction of new technology, or then through simple 'cost-shifting'. Cost shifting is simply transferring the cost to another jurisdiction where people are willing to work at a lower pay, due to desperation or draconian laws or higher purchasing power of their currency (if jobs are shifted abroad). 

Cost cutting through technology is not as disruptive to employment as mere cost shifting. This is because a adding technology increases the knowledge of society as a whole and creates new employment opportunities. Perhaps a good example is the IT industry. It may be impacted the demand for jobs such as a telephone operator or typists etc, but it created jobs (perhaps more) higher up the corporate ladder. It also created ancillary industry such as colleges for training, application development etc.

Cost shifting on the other hand is merely shifting a production facility to another location only because labour is cheaper at the other location. This does not add to the knowledge of the country from where the facilities are being transferred, though it may curtail some unemployment at the other end.

This displacement of man-power usually happens a the lower rungs in the corporate chain. This cadre may not be easily absorbed into alternative employment due to training or aptitude issues or fewer openings etc.

This displaced man-power (to the extent that cant find jobs) needs the support of the government to survive. These government schemes are funded by tax payments by the very entities from where this manpower was displaced. Typically the unemployment benefits are lower than the employee’s salary when he was employed. It may be 50-80% of the last drawn salary, give or take, or, it may be a fixed sum for sustenance. 

This reduces the person’s purchasing power thus impacting the demand for the product of the very entity from where he was displaced. However, a material demand decline for the product may not happen. This is because if the product was a luxury or even a comfort the displaced worker probably did not represent the key market segment for the company anyway. If the product was a necessity then the demand is relatively in-elastic anyway. So a person may reduce as much as he/she can, and beyond that even borrow to survive.

Thus, the process of cost shifting merely transfers cost from the BE to the government. 

The BE does not mind paying taxes on the increased income as the taxation expense is likely to be smaller than the gains. In fact, if the jobs have been shipped overseas, the company may use various tax planning mechanism (if available) to avoid paying taxes on the additional income to the same extent.

It would then appear that the unemployment benefits given by the government in such an economy is a capitalist move, rather than a socialist one. Consider a country that is suffering high unemployment due to large-scale cost shifting abroad. If there is no mechanism to sustain the unemployed population there is all the likely hood of social unrest. Social unrest, especially a violent one, would put a lot of moral pressure on the government to curtail cost shifting impacting the profitability of the BE that has already done so. 

The situation is singular in the sense that had the BE kept its operations domestic the Gross Domestic Product (GDP - the today's go to metric for measuring growth), would not reflect the lower unemployment rate. However if the same business is transferred abroad, the cost savings would be included in the BE's profit and thus in the GDP as well. So while the GDP may expand due to transfer of jobs abroad, they 'quality' of growth will decline. This may be reflected by a rising share of corporate profits in GDP, coupled with rising unemployment benefit payments.

Another side-effect would be growing income disparity as the employees still employed continue to draw the same (or even higher) salary while the displaced populace is supported at at lower (or even sustenance) rates.

Therefore, a country will benefit from cost reduction only till the benefits the national exchequer receives from the increased corporate profitability and other ancillary benefits is equal to or greater than the national burden it has to bear for supporting the unemployed populace. This would be the indifference point of cost reduction for the country.Beyond this point, the BEs are merely transferring their cost to the country’s coffers.

So the formula for this indifference point would look something like this:

Additional income due to efficiency * tax rate + other related levies + reduction in wastage of national resources + energy/environmental savings >= Workers displaced * non-employment probability^ * unemployment dole per head

^ will exclude workers that that be employed in alternate occupations/ BEs in the short term (say, 1-2 years) and potential new employment avenues that can be created over the longer term (say, 6-8 years). I agree the second metric is difficult to estimate, but believe that an allowance for the same needs to be made. The idea is that only net displacement is important from a macro point of view.

Happy to make additions or modifications to the formula, but it in its current form captures the essence of the concept that I am trying to explain, that there indeed exists a point beyond which cost reduction is more beneficial to the BE than to the national economy.

I will try to explain the above concept through an example:

A country exists which has a population of 100 that is growing steadily. In my case I have assumed average growth rate of a 1% a year. The average family size is 2 and the dependent ratio is 50%. All each person requires per day for all of his needs is a 'widget'. This widget provides him with food, water, entertainment, education, medicines, etc etc. There is only one BE in the country, and that makes widgets and is also the sole employer for the population. Government is minimal and has not full time employees. Inflation is zero and interest rate is zero. Wages are paid in the widgets required for the employee to sustain him/herself and the dependent. Unemployment dole is exactly the same as the salary being paid.

For the first four years, there is full employment, so the GDP will grow in the proportion of widgets required to be produced. From year 5, I have put in a efficiency adjustment, where the widgets produced per employee goes up by 1% each year. This could be due to technology or cost-shifting, that is not relevant at this moment. 

Even as the population expands the employment potential of the population goes down. At the end of year 15, for example, only 53 people were employed, which would have been 59 had it not been for the 1% efficiency improvement. This is a shortfall of 10%. 

The reality of workforce reduction can be more drastic than this. For example, In 1997, One of India’s leading corporate employed ~23,000 staff and sold 1.3 million units of its product. In just 18 years, this corporate is selling 3.3 million units of its product but employs only ~9,000 staff. While this is likely by technology improvement rather than cost-shifting I only use this as an illustration of how big a change is possible.
As the efficiency improvement starts the number of workers required goes down as one can see from the model. This puts people on the market that still need to support their families but are unable to find work (this is a 1 company model, remember?). This necessitates the government to introduce a dole programme even as the GDP soars. As can be seen, in years 6 to 15 the GDP growth rate has doubled.

The share of corporate profit in GDP goes up from 0% in the initial 4 years to 5.77% in year 15, which is matched by a social benefit spend of 5.77% on behalf of the government. Illustrating beautifully how the transfer of costs from the BE to the government is masquerading as profitability.

Is this a perfect model? No. It uses assumptions that insulate it from a few realities such as inflation and interest rates. But if I had introduced inflation and interest rates the situation would look even more skewed than it already is. For then, the BE would invest its surplus in government debt and be paid interests for those costs that is has transferred to the government. And how will the government pay interest, anyway? In this widget world, its only source of income is taxes, which will always be a % of the profit made by the BE. 

A more sober reality check is that not everyone who is let go will remain unemployed. If the cost reduction has come via new technology, there would be allied industries that may provide employment opportunities. Also, my model assumes that no one goes abroad to work. In reality, people do that all the time. In fact, historically people's movement has followed job opportunities. 

I am not a career economist, nor have I studied as one, but I do believe that my model does clearly show the relationship that I wanted it to. i.e. that there exists a point where the profitability of the corporate comes at the cost of the national exchequer. Dealing practically with this relationship is a different issue altogether and maybe I will deal with it at some point in this blog. But for now, the idea of this blog was to lay bare this economic concept and to stake claim to the idea in case no one else has worked on this before.  I will continue to work to improve the idea if any more work is needed.

Kindly do not reproduce the text or picture without explicit written permission from me.

1 comment:

  1. It then begs the question, should the ultimate aim of business be the maximization of profit or the employment of people. This is a tough one as it brings us closer to communism with its ills of lack of freedom, inefficiency, big brother government, no development etc. It has been tried and failed. I think the better way to look at it is, GDP is not the complete measure of the economy's health. There will be a trade-off between the government and private sector on the opposing ideals of full employment versus maximum profit earning capacity. I highlight that my idea is indeed capitalist in essence. If a private enterprise works for its own benefit, then should not the government. However it has to be grounded in fairness. Perhaps a mid way point that can be discussed is that the government cannot legislate full employment, in fact allow companies to have a hire and fire policy. However when efficiency is brought beyond the indifference point I calculate above, then the government may come in through taxes or other levies or rules to ensure that its own interests are not unduly violated. In fact the government can introduce tolerance limits on unemployment levels as well to avoid knee jerk reactions. That will give the private enterprise the signals on how to manage their costs without interference from the government. Additional measures such as mandatory unemployment insurance can be levied on the company that will cost a little bit over a long term but then transfer risks of social security payments from the government to another private enterprise which can then price premiums as per the character of each company.Just a few thoughts. Open for discussion!