Category: economics

Inequality in income and consumption

My hypothesis is that while inequality in terms of income or wealth (measured in rupees/dollars) has been growing, consumption inequality is actually coming down. I hope to do a more detailed analysis using data, but I’ll stick to an anecdote for this this introductory blogpost.

The trigger for this thought came about a year back, at a meeting in one of the organisations I’m associated with. The meeting wasn’t terribly interesting, so I spent time checking out the guy sitting next to me, whose Net Worth I knew is at least a couple of orders of magnitude more than mine.

He was wearing a Louis Philippe shirt, and I have several shirts of that brand. He had a Parker pen, and I use a Parker too. He had a rather fancy watch whose brand I do not recall now, but my Seiko isn’t that bad in comparison. And he had an iPhone, which cost four times as much as the phone I used then (a Moto G), but not out of reach for me.

I can go on but the gist is that while our income and wealth levels were different by an order of magnitude, our consumption wasn’t all that far off. I must admit that I’m also a so-called “1-percenter” in terms of income (recall a study which said that 99th percentile of income in India is Rs. 12 lakh per annum), so I was also part of the power law tail, yet the marginal difference in consumption to income levels was strikingly low.

Since this is an introductory blog post on this topic, I posit that this is a more general trend and applies at many other levels. The thing with inequality is that income (and wealth) is usually distributed according to a Power Law (unless the state is extremely coercive and extractive), so as the economy grows, inequality as measured by measures such as the Gini coefficient is bound to increase (here’s a nice but hard-to-read paper by Nassim Nicholas Taleb on why the Gini coefficient is flawed for fat-tailed distributions such as the power law).

Yet, as the economy grows, more people are pushed beyond a “basic level” of income where they are able to afford “necessities” (and certain kinds of luxuries), so inequality as measured by consumption will actually be lower. The challenge is in measuring such inequality appropriately.

I’ll mention a couple of more anecdotes in support of this. One sector where inequality has fallen is in commute. Some rich old-time Bangaloreans look back in nostalgia at a time when there was no congestion on the streets of Bangalore, and how the city has since deteriorated. Yet, that congestion-free travel was then available only to the extremely wealthy (who could afford private vehicles) or lucky (my father waited for four years to get his first scooter because of limited supply). Public transport infrastructure was abysmal and buses infrequent.

Now, a larger proportion of the population can afford private vehicles and public transport has also improved (though not by much), making life better at the lower end of income/wealth levels. And the rich (who had exclusive access to roads in private cars earlier) are faced with higher congestion.

Another obvious example is the telephone. Very few people had them even twenty years back (we applied for ours in 1989, only to get “allotted” a phone in 1995), and now pretty much everyone has a basic mobile phone now (and with cheaper smart phones, even some relatively poor people own smart phones).

This is a theory worth pursuing. Need to analyse how to collect data and measure inequality, but I think there’s something to this hypothesis. Any thoughts will be welcome!

Why restaurant food delivery is more sustainable than grocery delivery

I’ve ranted a fair bit about both grocery and restaurant delivery on this blog. I’ve criticised the former on grounds that it incurs both inventory and retail transportation costs, and the latter because availability of inventory information is a challenge.

In terms of performance, grocery delivery companies seem to be doing just fine while the restaurant delivery business is getting decimated. Delyver was acquired by BigBasket (a grocery delivery company). JustEat.in was eaten by Foodpanda. Foodpanda, as this Mint story shows, is in deep trouble. TinyOwl had to shut some offices leading to scary scenes. Swiggy is in a way last man standing.

Yet, from a fundamentals perspective, I’m more bullish on the restaurant delivery business than the grocery delivery business, and that has to do with cost structure.

There are two fundamental constraints that drive restaurant capacity – the capacity of the kitchen and the capacity of the seating space. The amount of sales a restaurant can do is the lower of these two capacities. If kitchen capacity is the constraints, there is not much the restaurant can do, apart from perhaps expanding the kitchen or getting rid of some seating space. If seating capacity is the constraint, however, there is easy recourse – delivery.

By delivering food to a customer’s location, the restaurant is swapping cost of providing real estate for the customer to consume the food to the cost of delivery. Apart from the high cost of real estate, seating capacity also results in massive overheads for restaurants, in terms of furniture maintenance, wait staff, cleaning, reservations, etc. Cutting seating space (or even eliminating it altogether, like in places like Veena Stores) can thus save significant overheads for the restaurant.

Thus, a restaurant whose seating capacity determines its overall capacity (and hence sales) will not mind offering a discount on takeaways and deliveries – such sales only affect the company kitchen capacity (currently not a constraint) resulting in lower costs compared to in-house sales. Some of these savings in costs can be used for delivery, while still possibly offering the customer a discount. And restaurant delivery companies such as Swiggy can be used by restaurants to avoid fixed costs on delivery.

Grocery retailers again have a similar pair of constraints – inventory capacity of their shops and counter/checkout capacity for serving customers. If the checkout capacity exceeds inventory capacity, there is not much the shop can do. If the inventory capacity exceeds checkout capacity, attempts should be made to sell without involving the checkout counter.

The problem with services such as Grofers or PepperTap, however, is that their “executives” who pick up the order from the stores need to go through the same checkout process as “normal” customers. In other words, in the current process, the capacity of the retailer is not getting enhanced by means of offering third-party delivery. In other words, there is no direct cost saving for the retailer that can be used to cover for delivery costs. Grocery retail being a lower margin business than restaurants doesn’t help.

One way to get around this is by processing delivery orders in lean times when checkout counters are free, but that prevents “on demand” delivery. Another way is for tighter integration between grocer and shipper (which sidesteps use of scarce checkout counters), but that leads to limited partnerships and shrinks the market.

 

It is interesting that the restaurant delivery market is imploding before the grocery delivery one. Based on economic logic, it should be the other way round!

Getting BRT to work

Dedicated bus lanes are neither a necessary nor a sufficient condition for BRT

After significant success in Ahmedabad and spectacular failure in Delhi, Pune is the latest city in India to embark on a “Bus Rapid Transport” (BRT) project. As the name suggests, the point of a BRT is to provide fast and convenient transport to people on buses that ply on existing roads, with some sections of some roads being reserved for buses.

However, in popular imagination, BRT has become synonymous with bus lanes (a lane of road reserved for buses), and the whole controversy in Delhi (which caused the project to be shelved) was about a lane of an arterial road being reserved for buses. In fact, however, a dedicated bus lane is neither a necessary nor a sufficient condition for implementation of BRT.

The attraction of BRT is that it comes with low infrastructure cost – unlike a train or monorail (or even a tram) line, there is not much investment required in terms of physical infrastructure. The challenge with BRT, however, is that its buses are liable to get stuck in traffic (just like every other vehicle) which might prevent it from living up to its middle name.

For this reason, certain changes are made to traffic patterns so that BRT indeed remains rapid. For example, traffic signals on arterial bus routes might be designed to give priority to the directions where buses travel. You might have bus stops in the middle of the road for people to get on to buses. And you might reserve lanes on roads for buses. Once again note that the last named is not a necessary condition for BRT.

What BRT should deliver is a dense and reliable network of buses. On arterial and other key roads, frequency of buses should be extremely high. Our current model of point-to-point and hub-and-spoke based bus routes need to be given up in favour of a more dense network, where it might be quicker for people to change multiple buses to get to their destination. This also warrants a change in the ticketing system, using a zone-based ticket than the current point-to-point ticket, and moving ticketing offline.

 

The fashion so far in India (with Ahmedabad being a possible exception) is to announce arterial roads as “BRT corridors” and start off the BRT services by reserving lanes on these roads for buses, without bothering about linkages and networks at either end. The problem with this is that the losers of the road space “pay” immediately, but the benefits of BRT are not immediately forthcoming.

A better method of implementation would be to make reservation of bus lanes the last step in BRT. The first should be to increase the density of buses and creation of networks. The problem with this is that it requires investment and the expanded (and densified) network might run far below capacity for a while. Yet, as the network expands (even without dedicated lanes), people will begin to see the benefits and convenience offered, and demand for BRT will increase.

Two things will happen – firstly, the expanded and densified network of buses will start crowding out (literally) private vehicles on the road. Secondly, people will see the relative benefits of taking these buses and these buses will start filling up. As these two effects take place, there will come a point when lanes can be reserved for buses without slowing down any of the rest of the traffic.

What we need, in other words, is “system thinking“, and to look at BRT as a solution to move people to their destination in a more efficient manner. Once policymakers recognise that bus lanes are only a means to this end, we can expect BRT to implemented in a proper fashion.

On Sub-nationalism

Pramit Bhattacharya has a nice piece in MintOnSunday about the positives of sub-nationalism, which fosters provision of public and common goods. He cites academic research to contrast Kerala and Uttar Pradesh, which were similar in the mid-19th century, but now have significantly differing levels of public goods.

The research Bhattacharya cites argues that the linguistic sub-nationalism that was formed in Kerala in the mid 19th century was responsible for the state’s high levels of public goods and development. The absence of such sub-nationalism has resulted in weak institutions and weak development in UP, he says.

He ends the piece saying that sub-nationalism is not always a good thing and can lead to secessionist tendencies. He cites the example of Assam, where sub-nationalism has actually hampered development rather than fostering it.

This discussion reminds me about last year’s “unofficial” referendum in Catalunya about whether to secede from Spain. The vote was unofficial since the Spanish Parliament didn’t authorise it, but there were strong signs of Catalan nationalism when I visited Barcelona last October. The Yellow, Red and Blue flag of Catalan nationalism hung from several windows. There was a clock in one of the main squares counting down to the referendum (which finally didn’t matter).

And while there were several emotional reasons for the demand for secessions, including repression at the hands of the “Castilians”, one of the main reasons was economic – the share of national spending on Catalunya was far less than the proportion of Catalunya’s contribution to the Spanish National Budget. The feeling of “why should we subsidise the rest of the country?” was rampant.

This little story illustrates both the positive and negative aspects of sub-nationalism. The negative is easy to see from the above – strong sub-nationalism leads to a strong “us and them” sentiment towards the rest of the country, and the region begins to resent the rest of the country, especially if the latter gets a larger share of the national pie. And this can lead to secessionist tendencies as is evident in Catalunya.

The positive thing about sub-nationalism, on the other hand, is that it subsumes groupism at smaller levels. A strong sub-nationalist feeling means that people think of themselves as members of that sub-nationalist group, and solidarity to any “lower level” groups weakens.

The problem with high solidarity among small groups is that it may lead to provision of private goods at the expense of public goods. When a place is strongly divided by caste, for example, each caste group wants to maximise the interest of the particular caste, and thus invests in a way that the caste gets a bigger share of the seemingly fixed pie.

When the solidarity is at the level of a state or region, on the other hand, the best way to develop the region or state is to provide for public goods or welfare schemes that span the entire state or region, and this leads to an expansion of the pie and the overall development of the region. In other words, when the “us” is a largish geographical area, it is more likely that investments happen in terms of public goods for the area rather than private goods.

Coming back to the example of Kerala, the strong Malayali subnationalism of the mid 19th century had the effect of pushing down casteism. Consequently, the groupism happened at a level (“Malayalis”) that was larger and more diverse than the caste-level groupism that happened elsewhere (like in UP) where there was no strong sub-nationlist movement. The lack of sub-nationalism in a place like UP has meant that casteist divisions in the region have remained strong, and solidarity at that level doesn’t lead to public goods or development.

Think of the nation as a hierarchy, of sub-nations and sub-sub-nations and so forth. And each person’s loyalty is divided in different extents up and down the person’s “chain”. And among these different layers, it is a zero sum game. Thus, strong loyalties at a particular level are resented both by levels higher and lower, and justifiably so. But the higher the level at which the loyalty remains, the better it is for the provision of public goods and development. Chew on it.

Elasticity and Discounted Pricing

The common trend among startups nowadays is to give away their product for a low price (or no price), and often below what it costs them to make it. The reasoning is that this helps them build traction, and marketshare, quickly. And that once the market has taken to the product, and the product has become a significant part of the customer’s life, prices can be raised and money can be made.

The problem with this approach is the beast known as elasticity. Elasticity means that when you increase your price, quantity demanded falls. Some products are highly elastic – a small increase in price can result in a large drop in quantity. Others are less so. Yet, it is extremely rare to find a product whose elasticity is zero, that is, whose quantity demanded does not vary with price. And even if such products exist, it is extremely unlikely that a product produced by a startup will fall in that category.

A good example of elasticity hitting is the shutting down of this American company called HomeJoy. As this piece in Forbes explains, the chief reason for HomeJoy shutting down is that it couldn’t hold on to its customers when it started charging market rates:

Not only did that kind of discounting make Homejoy lose significant money, it also brought in the wrong kind of customer. Many never booked again because they weren’t willing or able to pay the full price, which ranged from $25 to $35 an hour. Homejoy changed its pricing last year to make recurring cleanings cheaper and encourage repeat business. In response, some customers simply booked at the cheaper price and cancelled future appointments.

Based on the above explanation, it seems like subsidising customers to gain traction is a bad idea, and that a business should not be willing to make losses in the initial days in order to gain market. Yet, that would be like throwing out the baby with the bathwater, for subsidising at the “right level” can help ramp up significantly without elasticity hitting later. The question is what the right level is.

A feature of many businesses, and especially marketplace kind of businesses that startups nowadays are getting into, is economies of scale. This means that as the number of units “sold” increases, the cost per unit falls drastically. In other words, such businesses work well when they have built up sufficient scale, but collapse at lower levels. For such businesses, the thinking goes, it is impossible to bootstrap, and the solution is to subsidise customers until the requisite scale can be built up, at which point in time you can start making money.

The question is regarding the “sweet spot” of subsidy that should be given to the customer in order to build up the business. If you subsidise the customer too much in the initial days, there is the risk of elasticity hitting you at steady state, and things rapidly unravelling. If you subsidise too little, you may never build the scale.

The answer is rather straightforward, and possibly intuitive – start out by charging the price to the customer at which the business will be profitable and sustainable in the steady state. This will imply losses in the initial days, since your unit costs will be significantly higher (due to lack of scale). Yet, as you ramp up and hit steady state, you don’t have the problem of raising the price which might result in elasticity hitting your business.

What if, on the other hand, the subsidy you are giving out is not enough, and you are not willing to build traction? That is answered with the “Queen of Hearts” paradigm. The paradigm says that if the only way you can make your contract is if West holds the Queen of Hearts (talking about contract bridge here), you simply assume that West holds the card and play on. If he held the card, you would win. If not, you would have never won anyway!

Similarly, the only way your business might be long-run-sustainable is if you can generate sufficient traction at your long-run-sustainable price. If you need to drop the price below this in order to gain initial traction, it means that you will have the risk of losing customers when you eventually raise the price to the long-run-sustainable-price, which means that your business is perhaps not long-run-sustainable, and it is best for you to cut your losses and move on.

 

Now think of all the heavily-discounted startups out there and tabulate who are the ones who are charging what you think is a long-run-sustainable price, and who runs the risk of getting hit by elasticity.

Why Grofers is not a sustainable business

When I meet acquaintances for “gencus” nowadays, one of the things we somehow end up talking about is the startup world and inflated valuations of some Indian tech-enabled startups. The favourite whipping boys in any such discussions are food delivery companies such as Swiggy or TinyOwl and grocery delivery startups such as Grofers.

All three aforementioned companies have raised insane amounts of money and are making use of these insane amounts of money to poach employees at inflated valuations. They are also launching significant “above-the-line” advertising campaigns making use of the funds they are flush with. Yet, there is one fundamental concept that indicates that these companies are not likely to go far.

The whole idea of e-commerce is that you trade inventory costs for transportation costs. In “traditional” offline retail, transportation costs are low, since everything is transported in bulk, up until the retail store. In exchange for this, there are significant inventory costs, since inventory needs to be stored in a disaggregated fashion (at each retail outlet) pushing up uncertainty, and thus costs.

E-commerce works on the premise inventory is held in an aggregated fashion thus pushing costs down significantly (especially for “long tail” goods). In exchange, the entire transportation supply chain happens in an expensive “retail” manner. Thus, you save on inventory costs but incur transportation costs.

The problem with businesses such as Grofers is that they incur both costs. First of all, since they rely on picking up goods from retail stores, the high inventory cost is incurred (the hope is that retailers will give Grofers bulk discounts, but that is capped at a fraction of the margin that retailers make). And then, since Grofers transports the item to the customer’s location, retail transportation cost is incurred (whether it is directly paid for by the customer or by Grofers is moot here, since it has the same effect on prices and volumes). Thus, Grofers incurs costs of inefficiencies of both online and offline retail, and is thus a fundamentally unsustainable business.

It can be argued that Grofers offers a degree of convenience that you pay Grofers rather than incurring the cost yourself of getting the goods from the shop. This has two problems, though – firstly, a large number of small and medium retailers in India anyway offer free home delivery (and take orders by phone). Secondly, the cost incurred by Grofers for delivery is a transaction cost and irrespective of who bears it, it results in a reduction of total volume of transactions.

In its last round, Grofers raised $35M. Given the above fundamental inefficiency in its model, it is hard to see the business being worth that much in the long term.

Unions and competition

I completely fail to see why workers’ unions are against competition in the sector. The latest round in this comes from the National Federation for Indian Railwaymen (NFIR), which represents most of the workers in the Indian Railways, which has slammed the Bibek Debroy report on railway restructuring claiming that the report seeks to bring in privatisation into the sector.

Business Standard reports (emphasis mine),

While Debroy has sought to define liberalisation separately from privatisation in the report, he has also said the entry of private players into the system is already provided by extant policy. Trade unions fear any effort at bringing in private players into railway operations would jeopardise the workers’ jobs and negatively impact railways’ financial health

That private players coming in to railway operations could jeopardise jobs simply defies logic. Currently, the sector has a monopoly employer, namely Indian Railways, and this limits the bargaining power of any worker. With the coming of more (private) players, the demand for skilled workmen is only going to increase, and any new players would be much better off recruiting existing employees of the railways who are experienced in this business than recruiting from elsewhere.

So the coming of private players can only be a good thing from the point of view of workers.

 

However, what is good for the workers is not necessarily good for workers’ unions. The NFIR is a powerful union, representing 80% of the Railways’ 1.3 million employees (source: Business Standard report quoted above), or about a million employees. With the coming of private players, this number is surely going to go down (thanks to workers leaving, etc.) and this surely cannot be good news for the unions.

In other words, what is good for workers is not necessarily good for unions, and vice versa. And it is important to take this into account while making policy. In popular discourse, workers’ welfare and workers’ unions’ welfare get conflated, leading to policies that are pro unions but (they have higher bargaining powers) but not necessarily pro workers.

Recognition of this distinction can lead to much superior public policy.

Pipes, Platforms, the Internet and Zero Rating

My friend Sangeet Paul Chaudary, who runs Platform Thinking Labs, likes to describe the world in terms of “pipes” and “platforms”. One of the themes of his work is that we are moving away from a situation of “dumb pipes”, which simply connect things without intelligence, to that of “smart platforms”. Read the entire Wired piece (liked above) to appreciate it fully.

So I was reading this excellent paper on Two-Sided Markets by Jean-Charles Rochet and Jean Tirole (both associated with the Toulouse School of Economics) earlier today, and I found their definition of two-sided markets (the same as platform business) striking. This is something I’d struggled with in the past (I admit to saying things like “every market is two-sided. There’s a buyer and a seller”), especially given the buzzword status accorded to the phrase, but it is unlikely I’ll struggle again. The paper says:

A necessary condition for a market to be two-sided is that the Coase theorem does not apply to the relation between the two sides of the markets: The gain from trade between the two parties generated by the interaction depends only on the total charge levied by the platform, and so in a Coase (1960) world the price structure is neutral.

This is an absolutely brilliant way to define two-sided markets. The paper elaborates:

Definition 1: Consider a platform charging per-interaction charges a^B and a^S to the buyer and seller sides. The market for interactions between the two sides is one-sided if the volume V of transactions realized on the platform depends only on the aggregate price level

a=a^B +a^S

i.e., is insensitive to reallocations of this total price a between the buyer and the seller. If by contrast V varies with a^B while a is kept constant, the market is said to be two-sided.

So for a market to be two-sided, i.e. for it to be intermediated by an “intelligent platform” rather than a “dumb pipe”, the volume of transactions should depend not only on the sum of prices paid by the buyer and seller, but on each price independently.

The “traditional” neutral internet, by this definition, is a platform. The amount of content I consume on Youtube, for example, is a function of my internet plan – the agreement between my internet service provider and me on how much I get charged as a function of what I consume. It doesn’t depend on the total cost of transmitting that content from Youtube to me. In other words, I don’t care what Youtube pays its internet service provider for the content it streams. Transaction costs (large number of small transactions) also mean that it is not practically possible for Youtube to subsidise my use of their service in this model.

Note that if buyers and sellers on a platform can make deals “on the side”, it ceases to be a platform, for now only the total price charged to the two matters (side deals can take care of any “adjustments”). The reason this can’t take place for a Youtube like scenario is that you have a large number of small transactions, accounting for which imposes massive transaction costs.

The example that Rochet and Tirole take while explaining this concept in their paper is very interesting (note that the paper was written in 2004):

…As the variable charge for outgoing traffic increases, websites would like to pass this cost increase through to the users who request content downloads…

..an increase in their cost of Internet traffic could induce websites that post content for the convenience of other users or that are cash-strapped, to not produce or else reduce the amount of content posted on the web, as they are unable to pass the cost increase onto the other side.

Note how nicely this argument mirrors what Indian telecom companies are saying on the Zero Rating issue. That a general increase in cost of internet access for consumers can result in small “poor” consumers to not consume on the internet at all, as they are unable to pass on the cost to the other side!

Fascinating stuff!

On Sony Six telecasting Pacquiao-Mayweather

Summarising the blog post:

1. Having paid for the rights to the fight, the incremental cost of showing the fight to a customer is negligible, making this a great case for “revenue management”.
2. Each television market is independent, and in each the holder of the rights indulges in “monopoly pricing”. The monopoly price for the US is $~100. For India, it is close to zero. 
3. Television is a two sided market, and by offering the content at Zero rupees in India, the rights holders are maximising the sum total of what they can earn from viewers (subscription fees) and what they can earn from advertisers. 

Now for the harikathe:

So the much-awaited bout between Manny Pacquiao and Floyd Mayweather is going to be telecast on Sony Six tomorrow, as per this tweet:

Some people are surprised that this fight is being telecast on a “normal” sports channel in India, considering that elsewhere in the world it is being mostly telecast on pay-per-view channels, with the payment for one connection running close to a hundred dollars. Yet, in India, we will get to see this without shelling out any incremental cost over what we have already shelled out to receive Sony Six (and most people who are interested in the fight are likely to have already subscribed to the channel since it telecasts the ongoing IPL. The difference between {people who want to watch Pacquiao-Mayweather} and {people who want to watch IPL} is infinitesimal and can be ignored).

So why is it that a fight that is being sold at an exorbitant premium in most places in the world, and billed as the most sought after boxing bout in over twenty years, is being shown at a throwaway price (close to zero) in India? The answer is simple – revenue management.

For the holder of the telecast rights of this fight, having paid for global telecast rights, any further costs of telecasting to an additional television set are marginal. In that sense, any marginal revenue that they make from the further sale of these rights goes directly to their bottom line. Hence, this is a classic case for “revenue management”, where they will try to maximise the revenues from the rights they hold.

Given that they hold monopoly rights over telecast of the bout, we can expect them to follow “monopoly pricing” to price their product. Monopoly pricing, as the name says, is how a monopoly would price a product, which is literally true in this case. For every price point, there is a certain demand, and monopoly pricing prices the product at a level that maximises revenue (price x quantity). And considering that television rights are usually at a national (or even sub-national) level, monopoly pricing can mean that there are different prices in different markets.

The US, for example, is a market that has an established model of pay-per-view, and the price they’ve arrived at there (of USD 90 per connection, or whatever) is a function of this history. Based on historical responses to such events, and what people have indicated as their willingness to pay, this rate has been arrived, and from what I notice on social media, it has probably been successful in terms of raising revenues.

In a market like India, however, firstly there is no established pay per view model, and no “channels” for exhibitors to show pay per view content (Tata Sky Showcase might be an exception but it’s too niche). Moreover, boxing is also not that big in India – while Indians (like me) might be interested in big fights like this one, it is not as big for us to actually pay money to watch. In that sense, even if the channels had offered this fight at a low (but non-zero) price, the uptake would have been small.

In other words, for an event like this one, the “monopoly price” that the owner of the content could charge in India would be extremely small, and even at that price, the number of people watching would have been small, leading to small revenues.

But then television is a “two-sided market”. The content is simply a platform to bring together the advertiser and the viewer, and the amount that an advertiser will be willing to pay for an advertisement can be considered to be proportional to the viewership. In India, where the volumes for a non-zero price will be low, the price that the broadcaster can command from the advertiser will also be similarly low, leading to low revenues all along.

Instead, by offering the rights to Sony Six, which will offer the content for “free” for all its currently existing viewers, the owners of the rights are ensuring that a significantly positive section of the population is going to watch the fight. Which in turn means that a significant premium can be extracted from advertisers, which will form strictly positive revenues for Sony Six, a part of which will go to the global rights holders. And these revenues are significantly greater than what the rights holders would have achieved in case the content had not been offered at all in India.

 

Startup equity and the ultimatum game

The Ultimatum Game is a fairly commonly used game to study people’s behaviour, cooperation, social capital, etc. Participants are divided into pairs, and one half of the pair is given a sum of money, say Rs. 100. The objective of this player (let’s call her A) is to divide this money between herself and her partner for the game (whom we shall call B). There are no rules in terms of how A can divide the money, except that both sums need to be non-negative and add up to the total (Rs. 100 here).

After A has decided the division, B has an option to either accept or reject it. If B accepts the division, then both players get the amounts as per the division. If B rejects the division, both players get nothing.

Now, classical economics dictates that as long as B gets any amount that is strictly greater than zero, she should accept it, for she is strictly better off in such a circumstance than if she rejects it (by the amount that A has offered her). Yet, several studies have found that B often rejects the offer. This is to do with a sense of “unfairness”, that A has been unfair to her. Sociologists have found that certain societies are much more likely to accept an “unfair division” than others. And so forth.

The analogy isn’t perfect, but the way co-foundes of a startup split equity can be likened to a kind of an ultimatum game. Let’s say that there are two people with complementary and reasonably unique skills (the latter condition implies that such people are not easily replaceable), who are looking to get together to start a business. Right up front, there is the issue of who gets how much equity in the venture.

The thing with equity divisions between co-founders is that there is usually not much room for negotiation – if you end up negotiating too hard, it creates unnecessary bad blood up front between the founders which can affect the performance of the company, so you would want to get done with the negotiations as soon as possible. It should also be kept in mind that if one of the two parties is unhappy about his ownership, it can affect company performance later on.

So how do the founders decide the equity split in this light? Initially there will be feelers they send to each other on how much they are expecting. After that let us say that one of the founders (call him the proposer) proposes an equity division. Now it is up to the other founder (call him the acceptor) to either accept or reject this division. Considering that too much negotiation is not ideal, and that the proposer’s offer is an indication of his approximate demand, we can assume that there will be no further negotiation. If the acceptor doesn’t accept the division that the proposer has proposed, based on the above (wholly reasonable) conditions we can assume that the deal has fallen through.

So now it is clear how this is like an ultimatum game. We have a total sum of equity (100% – this is the very founding of the company, so we can assume that equity for venture investors, ESOPs, etc. will come later), which the proposer needs to split between himself and the acceptor, and in a way that the acceptor is happy with the offer that he has got. If the acceptor accepts, the company gets formed and the respective parties get their respective equity shares (of course both parties will then have to put in significant work to make that equity share worth something – this is where this “game” differs from the ultimatum game). If the acceptor rejects, however, the company doesn’t get formed (we had assumed that neither founder is perfectly replaceable, so whatever either of them starts is something completely different).

Some pairs of founders simply decide to split equally (the “fairest”) to avoid the deal falling through. The more replaceable a founder or commoditised his skill set is, the less he can be offered (demand-supply). But there are not too many such rules in place. Finally it all boils down to a rather hard behavioural problem!

Thinking about it, can we model pre-nuptial agreements also as ultimatum games? Think about it!