Rounded Rectangles

In a recent post that I read in HBR ,it was argued why a patent is not necessary for innovation . This is the exact opposite of what all of us have encountered studying about patents in monopoly . The purpose of a patent is to encourage innovation and new ideas. The premise of introducing a patent/copyright is that people or companies will take conscious efforts to innovate or spend on research and development to come up with new and creative ideas that will be beneficial for the society as a whole that can be in terms of better technology or better utilization of resources. If all firms could just copy the product/service of the other , the other firm will lose its monopoly that is helping it too earn revenues and will be alone facing the research and development. This may happen only in one period and the firm after paying high cost of research and development in one period will not continue to do so in the coming periods  and hence will be discouraged to innovate.

 Now let's look at the mobile industry. The pace of innovation in mobile phone industry is highly dynamic and it is not surprising to see a new model come up every week. Considering the dynamic and evolving nature of the mobile industry , does a 20 or 14  year patent for a mobile make sense. Is it right to consider the mobile phone or a table at par with a cancer life saving drug! So the first question is does the mobile industry need patents with a 20 year life? I think the patent life should be decided using a' case by case 'approach rather than following a 'same size fit all' approach'. As mentioned above this to ensure the patent life is decided keeping in mind the pace of changes/innovations in the industry. 

Secondly , as discussed above  the purpose of the patent is to encourage innovation. Apple has been spending a considerable amount on research and development , it is because of the ability of Apple to come up with simple yet such powerful products and technologies that makes it so successful and  'desirable'  across all  segments. Now the law suit of Apple vs Samsung , where in Apple has accused Samsung of infringement on Apple's patents, has largely been in favor of Apple as the Jury claimed 'Samsung willfully infringed Apple's patents on a wide variety of its phones'. If we were to believe that the Jury's decision is true that Samsung did use Apple's patented designs for products, then why didn't it deter Apple to cut back on its research and development expenditure. Why didn't Apple stop innovating even if its competitor was using its patented products and was coming up with almost similar products(sometimes with cheaper cost). The point here to understand is that the very purpose of the patent is that no person can illegally use a  patented product/technology/service  as it has a legal backing; a patent is supposed to be compiled by all and hence will make sure that companies/individuals innovate and have the right incentives to do so. Now even if the patents were infringed still Apple wasn't deterred to  innovate ,this highlights the competitive nature of the industry. The idea is that the nature of the market is so dynamic given the demands of the voracious consumers looking for new features and models ,that patent or no patent apple or any other mobile company has to innovate itself to survive in the market. 

I am not saying that Who should have won the case and who was right! I argue it is  important to realize  the 'nature' of industry to come up with patent laws. So its not about considering 'rounded rectangle's as ludicrous patents, it is to have a proper law that defines precisely whether a specific product is a patent , a special feature or a service and patents/licenses are given accordingly. The idea should be encourage innovation and benefit the consumer through a plethora of choice, not to grant monopoly to the mobile company for features and interface of the phone.

Agricultural Crop Insurance: How to minimize risks?

In theory, insurance is an efficient risk sharing mechanism,but the same is not always true in case of agriculture crop insurance, because of a costly risk shifting  mechanism . 

 A major role played by insurance programs is the indemnification of            risk-averse individuals who might be adversely affected by natural probabilistic phenomena. By pooling individual risks, insurance leads to Pareto-preferred states. Insurance, by offering the possibility of shifting risks enables individuals to undertake activities  which they would not otherwise undertake.

Agricultural crop insurance market may or  may not lead to Pareto preferred states. Let us first consider the case of identical farmers with perfect information.

 The case of identical farmers exposed to similar types of cases  is  a special case which leads to a risk shifting role of competitive crop insurance markets. In this case a completive equilibrium is established such that the utility of the farmer is maximized subject to the profit function of the insurance companies..If the probability p is known, then, under perfect competition, customers get full insurance at actuarially fair odd so  the outcome is efficient. EF is the fair odd line. The equilibrium policy α* maximizes the farmers utility and the insurance company just breaks even. In equilibrium each farmer buys complete insurance at actuarial odds.

J. Kurian,Ali and Ahsan have asserted that in case of identical farmers, a competitive equibrium is

Agricultural insurance market does not turn out to be like the ‘commodities’ market since it is very difficult  to assess the information of the land type, weather , risk attitude

Why a competitive market does not develop?

Imperfect Information

·      Adverse Selection

This happens if the insurer cannot distinguish the inherent riskiness of different farmers. The individual farmers may have fair knowledge about their own risk position , but the insurance agencies may  not be able to distinguish among such customers. This will eventually lead to only high risk farmers buying insurance and hence the insurance companies will run into losses.

·      Moral Hazard

It is an alteration in input use which deviates from social optimality and which occurs because of incompatible incentives and asymmetric information.Moral hazard problems occur because the insured can take action which affect the probability of losses and cannot be observed by the insurer. It is because the insured choices can affect the distribution of the losses. In crop insurance individuals have no control over the state of nature , but through dependency in the contract , the individual  can affect the amount of indemnity.

Absence of adequate information and high cost of collecting generates imperfect information in agriculture. Given there are two categories of farmers that is high risk farmers with p^h and low risk farmers with probability ^pl.   where  H> L  . Thus in the case of imperfect markets there will be either a pooling  equilibrium or a separating equibrium.The farmers knows and can ascertain his/her risk while the insurance company cannot find this out.

  There would be a  separating and pooling equlibria because of imperfect information in the market. This was given by  Micheal Rothschild & Joseph Stiligtiz

Pooling Equilibrium

A pooling equilibrium is an equilibrium in which a single insurance contract is offered to all customers. Let p’ be the average accident (loss) probability p’=λp^h+( 1-λ )p^l   where λ is the proportion  of high risk farmers.  If α is the pooling equilibrium and consider  profit of insurance firms to be Π(p’,α). Now if  Π(p’,α)  <0   implies  firms are losing money contradicting the condition of a equilibrium, Similarly if   Π(p’,α)   >0  , means there exists a contract which would offer more in both states of nature and this not the equilibrium then. Therefore we get Π(p’,α)  = 0 and α lies on the line  EF ( slope (1-p’/p’).

Competition among insurance firms implies that any equilibrium contract must break even so any pooling equilibrium must lie on the ‘pooling line’

There is a contract  β near α such that the low risk individual prefer to α, but the high risk individuals would prefer α to  β.  Since β is near α, it makes profit when the less risky buy it. The existence of β contradicts the definition of equilibrium

   

                       

 Separating Equilibrium

A separating equilibrium is the one where two separate contracts coexist. This means that the premium rate for the high risk farmers is greater than that for the low risk farmers. If the insurance companies could costlessly separate the high risk  and low risk farmers, farmers  would demand full coverage policies under the separating equlibrium.However practically insurers cannot distinguish perfectly between the risk classes. Hence there would be imperfect information in the market. Therefore the high risk farmers would realize that they can increase their utility taking the low insurance contracts. Given the opportunity to purchase the low insurance contracts they would do so.

              

The problem is that high-risk farmers impose an externality on low-risk people. The low-risk people should have cheap insurance, if only they could separate the two. But if an insurance company offers a contract  which perfectly insures low-risks, then the zero-profit condition of competitive equilibrium means that these contracts make no profit when losses occur with the low probability p. If such a contract exists, then all high-risk farmers would want to buy the low-risk contract. This would drive the insurance companies into losses as the high risk farmers would be buying the low premium rate insurance contracts and the insurance companies would be paying a higher benefit for the loss against a lower premium payment.

If you consider the above diagram EH denotes the high risk farmer’s contract with the slope (1-ph/ ph).Similarly EL denotes the low risk farmers  contract with a slope (1-pl/pl). The contract on EH most preferred by the high risk farmers gives complete insurance ( ). Low risk farmers would of all contracts on EL preferhigh contract β which also provides full insurance. However β offers more consumption than , and high risk farmers would prefer it to . The nature of imperfect information in that insurance companies are unable to distinguish between among the farmers. Profits will be negative ( ,β)will not be an equilibrium.

 An equilibrium contract for low risk farmers must not be more attractive to the high risk types,. This establishes that ( , ) may be an equilibrium . But consider the contract γ, if it is offered both low and high risk farmers would want to purchase it in preference to  or . If it makes profit/losses it will upset the potential equilibrium. EF and EF’line represents the market odds (average probably ) showing the composition of the market. EF’ is for few high risk farmers , in this case the contact γ will earn profits  and EF represents for sufficiently high risk farmers, in this case the contract γ will lose money.  Since ( , )  was the only possible equilibrium, therefore no completive equibriulm exists.

The above shows that absence of competitive markets can be largely explained by market failures due to imperfect information.

The following  explains the public crop insurance model which is cited by S.M Ahsan, AG Ali, Nj Kurian as an effective way of managing risks in agriculture.

Public Crop Insurance Model

According to Kurian, Ahsan and Ali  ,public subsidization is cited as an effective method to overcome the market failures associated with ‘imperfect information’.The insurance policy is such that it guarantees a minimum income M. The farmers is taxed at the rate for the income before applying for indemnity. The reason for including ‘s’ is that otherwise the premium rates would have been very high without such revenues given the value of M.  The value of M is exogenously determined.

In this approach the farmer chooses the optimal amount of the resource devoted to risky cultivation, so as to maximize his utility ,treating the insurance contract as given.The insurance company ,in turn, selects the optimal insurance contract so as to maximize social welfare. The insurance treats the factor utilization under risky farming as determined by the farmer in advance.

This model  asserts that the insurance agency chooses an optimal insurance program to maximize social welfare .Social welfare is assumed to be the total output of the farmer.

The results of this model show that the optimal level of s (tax rate) would be such that the expected marginal product of the resource equals the social value of the marginal revenue of the agency.In the long  rum the farmer receives  what he has put in the form of premium and tax rates ,but the basic purpose is that high premium rates inhibit risk taking. This shows that the farmers will not take high risks  and at the same time are  given a minimum income guarantee,.This will ensure a better farming output as the farmers can undertake ‘farming’ optimally under risky production at the same time have an income guarantee.

In a paper, Mark V Pauly argued that fears of market failure may be lessened by inducing farmers to signal their risk situations. He has suggested that the government could collect and make public the total insurance purchased by individual farmers.

Public provision generates a specific information and if this information is made available to firms, optimal market outcome can occur. Another argument that he raised was to  charge  premium  with quantity. Firms can increase the marginal rate of premium with respect to the quantity purchased by individuals. They will recognize, adjust to the increasing price and thus be inhibited to over insure to some extent.

Private insurance companies then could use this information to classify farmers. One difficulty is that unless all farmers have identical tastes, the above procedure would not yield useful information. Two individuals facing identical risk prospects may purchase different amounts of insurance if one is more risk averse than the other. This means that the definition of risk is different for different people ,therefore this solution will not always work.

Carl H Nelson and Edna T. Lehman argue that the cost of public subsidies may not justify the benefits and thus offer, ‘Other ‘Second Best Solution’. Information collection and application of contract design principles are possible ways of achieving the benefits of insurance at less cost than public subsidies.  The social returns from government expenditure on information collection to improve the structure of insurance contracts is likely to be significantly larger than the social returns from government subsidization of insurance.

The following give various  ‘second best’ solutions to the problem of agricultural crop  insurance

·      Self selection Mechanism

The mechanism offers a set of contracts which satisfy the break-even constraint and would cause farmers to voluntarily reveal their class to the insurer. The basic motive is that the high-risk farmer would voluntarily chooses the contract designed for him and the low-risk farmer would choose the other contract. To implement this concept, the insurer would need to determine the various "types" of farmers. The costs of determining types of farmers and designing contracts and premia accordingly would be lower than the costs of obtaining information and designing contracts for individual farmers. Types of farmers could be defined by the distribution , risk attitudes, and production possibilities. This solutions seems more practical but it depends on the magnitude of the costs required to find ‘classes/types’ of farmers. Thus, private market provision of agricultural insurance is not necessarily impossible. This implies that, without  increasing subsidies, it should be possible to increase participation by offering contracts that are more specialized to an individual's risk characteristics

·      Repeated contracts

The insurance contract covers a series of years under this arrangement. With repeated contracts, a time dimension is added to the insurance problem; both Pareto-optimal resource use and zero profits for the insurer will occur in the limit over time even though the insurer may have positive or negative profits during some particular time periods. The farmer is charged a premium based on initial expectations about the expected value of losses. If the farmer's losses are higher than expected, the premium is revised based on the new loss information and higher premiums are charged for the next year. Rubinstein and Yaari have proven that repeated insurance contracts converge to the Pareto-optimal full information equilibrium.

·      Principles of Contract Design

In applying the economic concepts the following principles are suggested

for the design of an agricultural insurance program or for a revision of the

Inputs and outputs, risk attitudes, and risk distribution functions. The self-selection type should be designed according to types of farmers. Information about realizations of stochastic events, observable input use and imperfect monitors, or inferences concerning un- observable inputs should be used to determine insurance payments. Premium rates should be readjusted over time according to the information obtained about a farmer's actions.The design or revision of an agricultural insurance program should be based on a systematic application of these principles in order to achieve the best possible risk sharing at the lowest cost in terms of resource misallocation and information collection.

According to Nelson and Loehman, the social returns from government expenditure on information collection to improve the structure of insurance contracts is likely to be significantly larger than the social returns from the government subsidization of insurance. However,the above statement is country specific.

The two equlbria that arise when there is a imperfect information in the market were discussed and found that it may not always exist ,therefore according to Rothschild and Stiglitz model that ‘imperfect information’ may not lead to a competitive equilibrium in case of agricultural crop insurance. The  public insurance model showed the government provided subsidies in agriculture can ensure a  better outcome.  Other solutions and  ways to combat the inefficiency of  the market to deliver agricultural crop insurance. were also discussed to combat the problem of imperfect information in agriculture market

Indigo vs KFA: Beyond the rise and the fall

The amazing performance of Indigo Airlines( its the only airline company to make profit since starting operations) since its inception has finally made it possible to be the top leader of the market surpassing JetAirways and now occupies 27 % market share. Under the leadership of Aditya Ghosh ,Indigo has been able to survive the otherwise 'troublesome' aviation sector. This has cleared Vijay Mallaya doubts who had commented on the veracity of Indigo's profitability.

KFA share plummeted from around 20% in July last year  to 3.5 % in August this year. No doubt that Indigo has benefited from the plummeting share of KFA but it is important to realize that this alone isn't the reason for Indigo's success. This opportunity was available to all the airline companies and it is because of its efficient way of functioning that it has been able to expand its market share.

What was  the difference between the business models of the two companies that led to such a contrasting fate for the two companies?Indigo   focused on a slow and steady approach , conducted a thorough analysis of the market to  understand that the average consumer would not be fascinated by red carpets, expensive food and entertainment facilities but rather would be more concerned about the basics of the airline industry are supposed to provide that is   clean aircrafts and punctual flights operations(hence the excessive emphasis 'on time'). I recall that the managing director Aditiya Ghosh had mentioned in an interview that he wanted to show that 'low cost' is not synonymous with  'low quality'. This has precisely been the reason for its success. Indigo understood what the customer essentially wanted from a domestic airline company. Thus it has been able to minimize the wasteful expenditure and focused on ‘no frills’ model followed by US regional airline companies.For example , doing away with 'free food' provided in the flights and instead making the food available on payment as per the choice of the customer.This in turn removes the cost of food in the ticket making it more competitive .Moreover KFA worked on the premise that luxury would sell in the airline industry. What it failed to consider was that fuel costs comprise a very prominent share of variable costs that are subject to changes in international market. In times when the price of fuel would escalate people would often cut down on luxury expenditure ( elasticity for luxury goods is greater than one)

Additionally both the companies followed different strategies to expand  to international operations. While KFA followed an aggressive and haphazard approach ,Indigo  followed a organized approach. This helped Indigo by not increasing costs immediately and gave the airline ample time to expand and stabilize.Malaya’s approach to expand to international operations is best described as aggressive. Impatient to start international operations, he chose to acquire Air Deccan – a low cost provider.This was done to meet the criteria of 5 year domestic operations to fly international routes. In this haste , KFA acquired a low cost airline with a low turnover and huge debts. The most damaging aspect of the merger was that it created a ‘brand conflict’ among the consumers. One of the most important aspects of a merger is to evaluate what would be the impact of the merger on the demand for the current product/service offering. This is exactly where KFA missed the mark and created confusion in the minds of the consumers.

As KFA's market capitalization now stands less than its debts , it now depends how well it can resume its operations back to normal. This will be possible only if the banks would be willing to lend the airline to support its daily operations. Just like an economy fighting recession has to ensure   increase in capital expenditure to drive demand and escalate GDP similarly KFA has to get back to its normal operations to prevent the dilution of its market share ( that is supposed to reach its lowest 3.5%). T

No doubt the aviation industry is not the easiest to survive( even Michael Porter believes so)  but Indigo’s management has proven that the doubts expressed by Mallaya are spurious. It is at the end what the business offers that will decide its fate.

COAL,CAG, and More...

Before 1973, coal production was only undertaken by the state and later on   private and  public sector companies were allocated captive blocks to  mine only for their end use. A lot of zeros have been seen in the CAG reports and raise a lot of questions about what’s really happening in India’s coal sector. As intriguing as it gets, its not a simple problem. Following I provide two key points that came to my mind after reading the reports.

Currently captive coal mines-the  private companies have to give royalty to the government for the coal that they use for the end use. The price of coal is bench marked against the price that CIL chargeswhich is heavily subsidized giving an undue advantage to coal companies. For example if the price of coal that is provided by CIL is Rs 10 which is lower than the price in the international market that is Rs. 13, then in that case the private players are getting coal at a cheaper rate that is subsidized by the government.  Now the basis of calculating losses by the CAG is that it has taken this into account and affirmed that the private players had to pay less in royalty because of the subsidized price provided by CIL. Now the question comes down to should the government provide the price the coal at a cheaper rate to sustain growth.

Similarly, according to the CAG report all Coal should have been auctioned and by not doing this has resulted in a huge loss to the exchequer. What it essentially fails to recognize is that unlike other resources such as telecom allocations, coal has a direct link with the growth of the economy. It is one of the key infrastructural  ingredient to ensure that growth is not comprised. Had the coal been auctioned the price of coal would have become inexorably high which could have had a negative impact on growth through high cost of infrastructure projects. It further suggests that Coal should be auctioned that would lead to an efficient allocation. One of the reasons the government cites as it should not be considered a loss is because The Ministry of Coal has allocated captive mines to bulk users of coal, in public and private sectors. However auctioning of the block to the highest bidder may not be economically viable and adversely affect the ultimate consumer.Hence again the argument is that the government considers coal to be a catalyst in fueling growth and hence wants to keep the price of coal fairly nominal so that it could be used affordably by private players and does not preclude growth.

This process of allocating  captive mines has also not increased production for a variety of reasons. Around 144 captive mines were allotted and in only 45 of them mining is carried out. Mostly this happens  because it takes a great amount of time to get clearances from state government and environment department. Environment clearance alone has stalled production in many of the captive mines. This is where the government needs to bring in reforms and policy changes to ensure that the coal production is not comprised. One measure  is to ensure that there is single window clearance mechanism to ensure that the private companies do not take years in getting license. Apparently the company gets the license for a captive mine from the centre but also has to get a clearance from the State government. This multiple levels of clearances lead to opaqueness in the process of allocation and give rooms for corruption. The efforts of the government should be to make it a transparent process so that coal production is done in the most efficient way possible. Similarly The Environment and The Coal Ministry must work in coordination so that only those coal blocks are auctioned/allotted that will get environmental clearance or have a possibility to get an environment clearance. This eventually brings us to the question whether bidding is the only option left for the government. As mentioned above that the effort of the government should be to not let the price of coal escalate. Allocating coal to the highest bidder will only fill in the coffers of the government but not ensure a cataclysmic effect on growth. Hence it is important to develop a system of allocation in which  coal is allotted to the user who will produce coal in the most effective way and with the least cost. Efficiency in the production of coal should become a key point in making this decision. The approach suggested by P.S Bhattacharya seems quite effective in countering the present challenges. He suggests to allocate mines to those companies which have the highest present discounted value of the future cash flow that is to seek year-wise binding commitment of royalty payments and discount  to arrive at the present value (PV) which should be the bid parameter. Hence the bidder would want to maximize coal production in this which is the essential purpose. Across the board auctions are not an answer to our problems. It will be a retrograde in policy making and a short term measure to restore the government's budget.

FISCAL MESS IN US

this was written back in 2011.Just read it one of the saved file.
US has done well and stands the best among the developed economies while the European economies are struggling  as even the German Engine is showing some signing of recession.

Back then my views when the ratings changed for the US

‘US sneezes and  its  effect is felt all over the world ‘was  witnessed during the world financial crisis in 2008. While India and most other countries are recovering with a scintilla of optimism in US as well, the efforts were dwarfed by the recent debt ceiling by the Congress to avoid a possible default. The ramification  was that US’s credit rating was downgraded the following day by S&P from AAA to AA+ for the first time ever.

    What was the reason for the almost default? America was not able to pay for its high military salaries , medical insurance,social security benefits and unemployment insurances, thus it had to chose the path of extending the debt ceiling,otherwise ‘the impending default’ would have embarrassed the US on the global front. The Wall Street plummeted the following day showing that markets reacted negatively to the surmounting debt. What does  this actually means?  US raises its debt ceiling, which  will be financed  by issuing treasury bills and monetization of fiscal deficit. As the US credit rating is downgraded means that US credit worthiness is low making US bonds riskier. The risk has to be compensated by paying high interest on the bonds as skittish investors try to move to other markets. The interest rate didn’t observe a sharp increase as there aren't many substitute bond markets against the US . China which holds 46% of the US debt can exert pressure on US on policy making as it can withdraw debt leading to high interest rates which in turn would lead to high borrowing costs discouraging private investment and consumption in US.

   The US is in a very precarious position right now, Obama Administration is not able go ahead with abolishment of ‘bust tax cuts’ because the Republicans won’t approve it. Government spending has also been reduced but only to a small extent and it is expected that fiscal deficit will continue to hover around 9% of the GDP. Employment is still as high as 9 % in the US. Also  the retrenchment of government spending  can endanger economy by hindering the Neo Keynesian policies that are required in a ‘depressed economy. Whatever the US is required to follow in this situation will not be approved by the Republicans. They are in not in favor of slashing tax breaks granted to the rich. While this is the time that for the  ultra rich to part with their wealth to ameliorate the economy from this depression, we cannot expect much from them.

So while the US is still not back on its path to recovery with the third quarter experiencing a 1% growth ,India’s growth rate has also remained at 8.2% for the third quarter. The target of 9% growth seems ambitious but not impossible for Indian economy , but with global uncertainties and a volatile  market may inhibit growth by reducing export demands and  FDI.The US would be able to recover only if  Obama Administration is finally able to go ahead with its objectives of fiscal consolidation with appropriate government spending for creation of jobs provided the Republicans would not preclude his efforts.