Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 18 - Microfinance in South India

Chapter 1. Frameworks: SWOT Analysis, Porter’s Forces and Vertical Integration [00:00:00]

Professor Douglas W. Rae: Today’s case, SELCO SEWA, is a wonderful transition to Collier’s Bottom Billion and a — I want to start with some frameworks and I’m going to do these briefly. I’ll post them this evening so you can look back at them. I want to introduce — these are very standard MBA-ish, shorthand frameworks for thinking about cases. You heard, I think most of this, but I should rub it in a bit. One is called SWOT, and this one has really no analytical content to it, it’s just a way of organizing your thoughts on a topic, strengths, weaknesses, opportunities, threat. In the temporal dimension typically the strengths and weaknesses are things which are immediately present in your situation, and the opportunities and threats are things you might have happen to you or might cause to occur. A lot of back of the envelope thinking about business cases is organized in this shorthand. You might make yourself a grid like, this and let the column heading be SWOT, and then let the row headings be whatever you choose, but one candidate is the Porter forces, which we’ve seen before. How fierce is the direct competition in your business from other people doing more or less exactly what you do and trying to do it better than you? What’s the threat that others not now doing it will enter the business and increase competition? How likely is it that people will find substitutes for your whole industry, that your industry will be undermined by an adjacent industry? I could tell — I was able to determine which letter it was. Can you hold that up and tell us what it’s about?

Student: [Inaudible] crimes of sexual violence that are inflicted upon civilians as a result of the mineral conflict, such as copper and coltan, which were frequently found in our own devices such as iPods, cell phones, and cameras so just trying to draw attention to the crisis.

Professor Douglas W. Rae: Terrific. It’s certainly an eye-catching accessory as you walk in. The threat of substitution then the power of your suppliers in the SELCO case, think about where you’re buying the basic components of these generation and lighting systems. If there’s only a limited number of sources, or perhaps even just one source, then they’re in a position to squeeze you on price, and that’s an important strategic consideration. Buyers; if buyers have a lot of leverage, or as in the SELCO case, not a lot of money, then buyers become a central point of strategic focus. You could, if you wanted, and I often do this, you could combine SWOT across the top with supply — with Porter in the rows so that if you take potential entrants, threat of entry, your strengths might be that there’s no money to be made in this field, so not many people are going to want to do it, or it might be that there are huge switching costs so that once people have bought your equipment, it is very difficult for them to switch to other people’s equipment.

The weakness might be that you’re making money, and that the Financial Times just ran a large article about how lucrative your business is, which is likely to attract the attention of others. Opportunities; perhaps — how is barriers to entry an opportunity? Perhaps you can build pricing advantages — if you increase the scale of your operation your unit costs may get low enough that whenever a new entrant comes, you can crush him with low prices. Threat; similarly, somebody else may jump in and get the higher scale of production much lower unit costs and crush you.

You can walk all the way through the twenty cells there, but it — frameworks like this are meant to be useful and when they’re useful they — you use them, and if there’s a particular cell here that doesn’t make any sense, you just put an X through it and go on. Another concept that we’ve used briefly and it gets to be important in cases like SELCO is vertical integration, which I’ve drawn horizontally, as almost everyone else does. The rough idea here is that on the left is the supply of raw materials, and then making of the product; its assembly, its distribution and sale all the way out here. The sale end is called the forward part of integration, so forward integration. The raw materials and intermediate products is called backward integration, and so defying all logic, backward plus forward makes vertical. Don’t ask me how that came about.

Behind that process, which we think of in very physical terms, is an intellectual and managerial layer, which starts not with raw materials but with a business plan, and a product design, and the assembly of a management team, and the creation of channels for distributing the product. Again, left to right, and if you think about the SELCO case — where’s their main focus on this arrow at SELCO? What are they mostly paying attention too? Back left, you got to shout if you don’t have a microphone.

Student: They — most of their staff is focused on distribution and sales within India.

Professor Douglas W. Rae: Okay, absolutely, so the forward integration of SELCO is its most obviously unusual feature. They’re reaching into very difficult markets to do the sales and very awkward places to do the service, which has to go with the sales. If you look now at — another way of looking at the backward to forward story, it’s — I reproduced what was already there but then I’ve added service out there. It turns out that taking responsibility for durable goods that you sell, there’s not much long term responsibility for toothbrushes or toothpicks, but there is a lot of service responsibility for any form of machinery, especially when people are going to organize their lives around the machinery. The classic insight on — classic example on this is on McCormick farm machinery in the 1800s. The brilliant thing they did, which none of their competitors did, was to manufacture only during the winter season and use the same people that were running the manufacturing plant to be servicing agents for the farmers during the growing season so that the advantage of buying their stuff had everything to do with service. Now think about the laptop in front of you, take yours, is service an issue?

Student: Service, like getting the service?

Professor Douglas W. Rae: Well does it just run forever and keep you happy?

Student: It sometimes has problems.

Professor Douglas W. Rae: Okay and what do you do?

Student: I’ve sent it off to the Mac Store.

Professor Douglas W. Rae: Okay, or you call them up and talk to a so-called genius? What a thought, the “genius bar,” and Mac’s competitive advantage is partly the elegance of the equipment, but a lot of it is that their servicing is way better than anybody else’s. Who’s got a kind of computer that service is hard to find for? You’re all perfectly happy with the support you get for your computers? Well that’s wonderful; improbable, but wonderful. Okay, so you get with SELCO a huge emphasis on the service end of the business.

Chapter 2. Case Analysis: SELCO [00:10:37]

Okay now let’s turn to the case itself. There’s an A part and a B part, the B part is really kind of more like a teaching note than an actual case. The focus is on a certain rural part of India and on sales to people who are either in business on a very small scale, entrepreneurs of some kind, or householders in an area that is off the electric grid. It’s an interesting fact about India that the electric grid is highly problematic and incomplete, and the first mass development of wind turbines was actually begun in India by a textiles manufacturer who got tired of all the down time in his reliance on grid electric power, and started developing turbines for his own use, and then had the insight that turbines were a more profitable business then textiles for him and switched altogether. It’s now headquartered in Denmark and it’s a huge company. The alternatives to what these guys are doing, the ones mentioned in the case are the grid, Pico Hydro, and its very hard for me to envision how you do distributed generation with water. Well anybody got a thought about this? You live next to a running stream and you build a little water wheel — it’s got to be something a little glitzier than that — and wind turbine on a micro scale. Now what are the inherent disadvantages of the distributed generation strategy that SELCO is engaged in? If you were looking at it from a business point of view what would be factors that would strike you as scary? Yes.

Student: Every time they entered a new market they had to convince the financial institution to finance their products to the market that they were catering too, so it was almost a barrier of entry for them, because the kind of people they wanted to sell their products too did not have the resources and it was also a new concept that they were introducing, because financing was never done with respect to energy before in the country.

Professor Douglas W. Rae: Okay so one problem that is inherent in the market segment they choose to serve is that you’ve got a twin door-to-door finance at the micro level, with door-to-door sale of the generating equipment and the lighting equipment, so that’s one difficulty. Are there are any others?

Student: Some days there’s no sun, and then obviously a solar system isn’t going to work.

Professor Douglas W. Rae: There are — and there are some seasons in which that happens repeatedly, though in the part of India they’re doing it, it’s a pretty sunny place. But — okay so that’s a genuine drawback, other thoughts?

Student: Essentially they’re competing with the government. If the government chose to expand the grid in the region they’re doing business, that would put their business plan at a decided disadvantage.

Professor Douglas W. Rae: Okay there’s a lot said there, all in one elegant sentence. The biggest piece of it, as I heard it, was the threat that the grid might expand into a given area. Why would people, once the grid came — switch from SELCO’s equipment to grid equipment?

Student: Probably cost, it’s more efficient to generate electricity in a power plant than in your own house.

Professor Douglas W. Rae: Okay and is there a general concept here?

Student: Economies of scale.

Professor Douglas W. Rae: Economies of scale, right? The whole point of centralized generation is huge economies of scale so that if you — if the grid is run reasonably efficiently it will time after time trump distributed generation. Why would we do this business? What’s the point? Is this something that a brilliant young reptile from The Harvard Business School is going to jump in to make his fortune? Sasha what do you think?

Student: No.

Professor Douglas W. Rae: No, and why not?

Student: I think there are too many risks.

Professor Douglas W. Rae: Too many risks, and how big an upside is there?

Student: I’m not sure how you would quantify the upside, but I’m not convinced that it’s huge enough to take advantage of.

Professor Douglas W. Rae: Okay. Does anybody remember the financing story for this? What subsidies are required? Let’s watch a little bit of film and get further along with the actual story.

Chapter 3. Video: The History and Founding of SELCO [00:17:45]

[video 17:45-23:00]

Okay the — if you had to summarize what was just said there in twenty words or less, what would it be? Sasha?

Student: I think ultimately they don’t want to be a bottom line company, that their mission is not purely financial.

Professor Douglas W. Rae: Okay, now help people who don’t talk bottom line counts to understand what you just said.

Student: Some of you talk about a double or a triple bottom line and then you have people who are looking at social returns and environmental returns in addition to purely financial returns.

Professor Douglas W. Rae: Okay so — that’s terrific. So heretofore we have talked as if companies had one bottom line and their net results were correctly reflected in a profit and loss statement. What Sasha is suggesting is that a firm like SELCO or a bank like SEWA thinks about more than one bottom line, and they want to say that some net losses in the financial bottom line may be balanced and overcompensated by gains in environmental territory or in social services. This is capitalism hybridized with non-profit service sector institutions; SELCO and SEWA are neither of them, institutions which would have been designed if you thought about just one bottom line. The merit in them has to be captured in social, and to some extent, environmental terms. Now what’s the market’s message to village India about the availability of light and electric current for purposes like running small machinery or heating water? What’s the market say? Yes, this is the case where there’s exactly, as economists say, an equilibrium outcome. What’s — somebody got a hand up over there, there we are.

Student: I mean for the darkness area there’s simply insufficient demand to justify expanding the infrastructure drastically across much of rural India.

Professor Douglas W. Rae: Okay all right, so that’s good. Adam Smith distinguishes between total demand and what he called effective demand. Total demand is how many people put up their hands if you say would you like electricity. Effective demand is people who would do that and back it up with money, and effective demand is very low. Now not only is it low but overcoming it with a grid structure is inherently difficult, because while there are some customers capable of paying market rate for grid electricity, the vast majority of customers in many of these regions are below that income level and could not afford any of the above. In addition to that, their poverty is reinforced by the absence of energy supplies. If you don’t have the energy supplies to do small-scale production, or to illuminate a market during evening hours, or any of a hundred other such things, the low level of commerce is kept low by the absence of efficient energy supplies. The justification for an enterprise like this has everything to do with finding a way around the market equilibrium at zero, which prevails in some of these places.

There’s another feature in the film clip. What’s the attitude toward customers? How does their attitude compare with — well let’s establish the high end of the scale. How does Yale do it providing a choice of courses for you to take? Ridiculously well, right? A third of Yale courses have fewer than ten students; think that over. Imagine that you’re brought a cost accountant in here to look at Yale College, 20% of my brothers and sisters on the faculty would be looking for a job, and the enormous wealth of the institution is what makes this possible, and it’s a wonderful thing. Now if you were — now go back to, what’s your least favorite company that you deal with routinely? Most of you have an unfavorite company? I see a good nod right back in the sixth row, third seat in.

Student: My least favorite company ever is Connecticut Limo.

Professor Douglas W. Rae: Okay Connecticut Limo, dare I ask?

Student: They don’t give customers what they promise, they’re always late, they’re too expensive, and they’re mean.

Professor Douglas W. Rae: Mean! Okay, anybody else got an unfavorite? Over here —

Student: McDonald’s.

Professor Douglas W. Rae: McDonald’s; what’s your grudge against them?

Student: I have many. First how they market to children, and how unhealthy their food is in general.

Professor Douglas W. Rae: Okay. How many of you have eaten at McDonald’s sometime in the last two weeks? That’s a really interesting datum; we’re at about 3%. I’ll bet you are the lowest McDonald’s demographic in the country. Okay, but your objection to McDonald’s isn’t — is it that they don’t offer a wide enough range of customizations?

Student: Partly.

Professor Douglas W. Rae: Okay I mean if I were them I would say to you, come on what’s the beef, we offer you twenty sandwiches, five breakfasts, is it one flavor or more — or two of ice cream? Two of ice cream, that’s quite a lot. Your beef is of another nature isn’t it?

Student: That they popularize unhealthy food.

Professor Douglas W. Rae: Okay so you — if you were king, would you put them out of business?

Student: Yeah.

Professor Douglas W. Rae: Okay. I have a good friend and prominent faculty colleague named Kelly Brownell, is Kelly Brownell visible to all of you, some of you? Brownell is the leading advocate of the fat tax. He himself is a big guy actually, but he wants to tax restaurant fat so that there would be an excise tax on the Big Mac of three or four bucks because it is just one huge clump of cholesterol. We’re off topic here, the least favorite — my least favorites are several airlines and providers of internet service, and providers of television signal. It’s because they’re rigid, their business strategy involves a rigid interface with customers, and the Delta shuttle between here and Washington — brutal, just brutal the way they do it. That — and there’s a reason for that. It’s not just because they’re bad people, they’re not even bad people, it’s because there are huge economies in not listening to the details of what people want.

Do you want a ticket on the shuttle or do you not want a ticket on the shuttle? It will leave at 8:17, full stop, end of conversation, and it isn’t even actually a conversation, it is an interplay with a website, and the website is often kludgey, uninformative and so on. But in a cost benefit ratio from their point of view it works really well. When you look at SELCO, the first — my first impulse would be to say, simplify, don’t customize, and get one product that you can generate at much lower cost and stay with it. Remember how, in the dialogue in the film clip, and in the case he talks about one size fits all doesn’t work. What he means is that people who can barely afford this equipment are inclined to take it only if you match it very well with their preferences. Now is that — somebody defend SELCO please. They’re highly defendable.

Student: I mean I guess this goes back to the bottom line we talked about, and whereas SELCO and SEWA, it’s not just a for profit bottom line; they really want to help people, and that comes up a lot in the case, wherein they thought that what the name of the manager of SELCO is that he really wanted to help these people. Unless he tries to at least, to some extent, customize his products he won’t be able to help as many people as he would like too.

Professor Douglas W. Rae: Okay that’s good, hand the microphone on here.

Student: It’s also sort of about growing the market, because if you provide a customized solution to, say, a street vendor, and that vendor is able to light his storefront, make more money, and maybe in the future when he’s adding another side to his storefront he’ll come back to you and buy the full package.

Professor Douglas W. Rae: Okay, so there is a sort of multiplier effect when on the commercial side of this you customize it correctly. Now the major issue in the background here is — what’s the size of this market worldwide? Ballpark?

Student: One billion about.

Professor Douglas W. Rae: Somewhere around a billion, so there are a hell of a lot of customers out there, and if that’s so, scalability as it’s called, becomes a pressing question for a firm like SELCO. Scalability would mean that you could drive your costs low enough and develop your distribution system strongly enough that you can reach vastly more. They are — when the case is written, they’re still well under 10,000 households, and at well under 10,000 households this is an experiment, a noble experiment, but merely that. It is a demonstration project.

Now a background fact about them which isn’t in the case is this: I had lunch today with a Yale College alum who worked last year for an India company that manufactures equipment like this, GWP, and GWP assigned her the task of finding a sales relationship with SELCO, so she spent a year working with SELCO trying to sell them a high quality, but completely standardized system that was designed to achieve scale economies. Her experience was entirely frustrating, because SELCO ultimately wasn’t interested in achieving scale. They were interested in serving the immediate customer base in front of them. Okay what does that mean? I think it means that SELCO is a service company and is destined to remain a very small one.

Chapter 4. Case B Analysis: SELCO [00:37:36]

Now in the case there’s — in the B case there is some discussion about their not for profit financing. Anybody remember the amount of financing they have? No reason you should $462,000, which isn’t a monumental sum but it’s a pretty hefty sum if you’re talking about a few thousand customers. The rhetoric in the B case is no, no we’re going to get to 300,000 customers and the unit cost will be $1 and change per customers of the subsidy will be that small. Well I actually don’t think they’re going to get there. I don’t think it can be done with this level of customization. Okay, so now the task is each of you is a management consultant, and you’re brought in by the board of the funder for SELCO, and you’ve got to figure out how to take the baby out of the bathwater, get rid of the bathwater and come up with something scalable. How would you go about that? Anybody got a thought? Would we fire management or not? Over — yes —

Student: First I would try to get them to stop being dependent on one geographic area. It seems like they really concentrated between Bangalore and I think it was Ahmadabad, and like clearly there are a lot of poor regions in India, and once they get out of those — that specific region, I’m pretty sure they will be forced to look at it a bit differently.

Professor Douglas W. Rae: Okay so let me see if I understood that. You want them to move into higher income groups?

Student: No, I want them to go to another poor region.

Professor Douglas W. Rae: Okay you want them to go to another poor neighborhood and do what?

Student: Clearly by seeing that there are — like since there are so many different cultures within India, and so many different needs, that they continue this model of customization they will see they will ultimately fail, and they need to start moving into something else.

Professor Douglas W. Rae: Okay. I’m going to pretend to be another person — a person on the board. “Look, we’ve already figured out these guys are running straight into a dead end. I’m inpatient, all you’re going to do is demonstrate failure again. Find me a better solution.” Now anybody think they’ve got one? Yes, far back.

Student: I just figure out a couple of SELCO’s products, a couple of their best products that numerically meet the needs of the most number of people, and then I would expand by pushing those products and of course in the process you would lose out on customization and individual solutions, but if your goal is to provide illumination to the maximum number of people just kind of focus on what you’re good at and skip that —

Professor Douglas W. Rae: Focus on a few products, sounds like a good idea. Now what about people who are — remember there’s talk in the case about a pyramid. There’s even a picture of a pyramid and we’re talking about serving people near the bottom of the pyramid economically. Is there a way that you might think about serving people at the bottom of pyramid by also serving people a layer or two above them in the pyramid? Yes.

Student: If you can charge the people a little bit higher up the pyramid more than the systems, they can subsidize the people below.

Professor Douglas W. Rae: Okay, so if you can take a — you probably have to have the product differentiated a little bit to produce a higher margin product which is very similar to your straight product, and build a distribution channel in — so that the same distributors can cover the higher margin product and also the low margin product for the people at the bottom of the pyramid, and achieve some scale economies so that you begin to make the pump run on its own. The video clip we just watched, they talk about how when they let distributors do what they wanted, the distributors ended up drifting into higher income strata, and that’s not very surprising because the margins can be much higher. In the bottom channel, unless you get the thing very standardized, the margins have to be negative because people just can’t afford it, so high customization at the very bottom looks like a highly problematic strategy, inspiring as it may be.

Is there — are there other lines of production unrelated to electricity that strike you as interestingly analogous to this? For example, let’s say the nub of this idea is distributed production. Instead of centralized grid production we’re doing distributed electric production of electricity, just as we have distributed computing on all these laptops. Are there other highly distributed strategies that might be of service in bottom billion countries? Okay, talk — say more —

Student: You could distribute mobile phones instead of building a land line.

Professor Douglas W. Rae: Okay has anybody thought of that yet?

Student: I’m sure, yeah.

Professor Douglas W. Rae: Big time, right? I mean the story here is land lines become — completely saturate the market and then cell phones are a layer on top of that. In all the countries we’ll be talking about with The Bottom Billion, cell phones just leap over land lines, right, and are technologically superior to land lines from almost every point of in a very low income setting. That’s a good suggestion. Any others occur to anyone? Jennifer?

Student: Water purification.

Professor Douglas W. Rae: Okay water purification and the technology there is — how do you do it?

Student: Well instead of running pipes to transport clean water to remote places you could just build their own filters or dig their own wells.

Professor Douglas W. Rae: Okay you could build your own filters, dig your own wells might or might not work, depending on the water tables depth and quality, but yes it’s a very good point and right at the end of the semester we’ll see a case in Bolivia — Cochabamba, Bolivia where we try to fix a water supply system using straight capitalist technique and get into a lot of trouble. We get into a lot of trouble for the — basically because the pricing model for the capitalist to make money leads to too high a price for people who are right at the bottom of Bolivia’s pyramid, which is not very different from India’s pyramid, except it’s got a lot less growth in it. That’s — anybody else got one?

Student: Fighting malaria, for example, you could focus on like big projects who alter the landscape, like draining swamps versus just giving people, giving mosquito nets in their own homes.

Professor Douglas W. Rae: Okay, and the Gates’ agree with you, and are throwing billions at them. In general, there’s this whole family of models for multiple bottom line businesses, and some not so multiple bottom line, some straight out for profit businesses. Where having decentralized production as in SELCO’s equipment, is a terrifically valuable asset. Now for Monday the main metric that is used in the world for progress, and what defines the bottom billion as bottom billion, is GDP per capita. In my part of Monday’s class, which I’m about to record, I’m going to pick at — I’m going to start with the proposition maximize GDP per capita and make the country better. Paul Collier more or less advocates that in The Bottom Billion. I’m sympathetic to that view but I’ll set up some critical screens to pass it through and explain those, and you’ll see that video at the beginning of class on Monday and then after my little video there is a Ted talk by Paul Collier explaining what he thinks his book has to offer.

[end of transcript]

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