The economics of Bangalore

Coase’s insights on transaction costs help us understand why Bangalore became an outsourcing boomtown

Cities have patron saints and deities, not patron economists. But every now and then we come across cases of urban success that are deeply linked with how a particular economist viewed the world.

Haseeb A. Drabu, now the chairman of Jammu & Kashmir Bank and once a fellow journalist, wrote an article comparing Mumbai and New Delhi a few years ago. He concluded that piece with a memorable line: “Delhi is Keynesian while Bombay is Schumpeterian.” One city gets its importance from being the heart of government, while the other thrives on entrepreneurial energy.

I would like to extend the thought experiment. Bangalore is Coasian.
Ronald Coase won the Nobel Prize in economics in 1991. As a young economist in the 1930s, Coase tried to solve a puzzle that had escaped others. The traditional economics of the time assumed that the market coordinated all economic activity. Replacing it with a plan was inefficient.

Coase has studied business administration before he turned to economics, so he could not ignore the fact that a lot of economic coordination was done outside the market, in firms. There must be a reason why these firms exist. At the same time, the Soviet dream of running the entire economy like one big factory, as Lenin had put it, was not successful either. So the question was: why are some things done better in the market and some within a firm?

Coase asked himself: why did firms exist at all? All around him, he saw how company managements, outside the open market, coordinated the use of capital and labour. They had corporate plans to do so, many of which worked quite well. Why?

Coase’s answer was strikingly original. He wrote in a groundbreaking article almost exactly 60 years ago that firms exist because there are costs involved in market transactions. When these costs are too high, it makes sense to coordinate certain activities within the boundaries of a firm. “Whether a transaction would be organized within a firm or whether it would be carried out on the market depended on a comparison of the costs of organizing such a transaction within a firm with the costs of a market transaction that would accomplish the same result,” Coase said in a speech that he gave in 1994.

In a very crude sense, a company employs workers on a long-term basis because the costs involved in finding skilled workers every morning would be too high to make the attempt efficient. If by some wave of the magic wand or stunning innovation, it would be possible for a company to locate just the sort of talent it needs for the day, then we would all be freelancers. There are several other transactions besides employing labour every day that are better done outside the purview of the market. Transaction costs became the centrepiece of Coase’s economics.

“So what does all this have to do with Bangalore and its success as a global outsourcing hub?” you might ask. Bangalore’s astonishing boom over the past 15 years can best be explained by using Coase’s insights into the nature of the firm. Bangalore had most of the ingredients on its later success in previous decades—including a skilled workforce that could be employed at a fraction of the wages paid for similar work in Europe and the US. Yet the outsourcing wave did not gain power till the mid 1990s.

Coase’s insights on transaction costs help us understand why Bangalore eventually became an outsourcing boomtown. As firms in the rich countries grew in size and became large and tangled conglomerates, the cost of carrying out certain activities within these firms went up. It made economic sense for them to focus on their “core” activities. Meanwhile, the drop in international telecom costs helped slash transaction costs in the outside market.

Internal transaction costs went up while market transaction costs fell after the mid-1990s. That was the economic cue for outsourcing to take off, as companies found it cheaper to get certain things done outside rather than from within the boundaries of the firm. This is straight out of Coase.

A lot of attention is paid to the famous rule-of-the-thumb laws in the world of technology. Take Moore’s Law, which says that the power of microprocessors would double every year without a similar increase in costs; or Grosch’s law, which states that computing power grows as a square function of its costs.

It would be good if Coase’s simple rule that stuff gets outsourced when external transaction costs dip below internal transaction costs, gets wider recognition as the core rule explaining Bangalore’s rise as a tech hotspot.

It is now 60 years since Coase wrote about the nature of the firm, a paper that led to the rise of an entire discipline known as transaction cost economics. The young techies who gather in Bangalore’s buzzing pubs should perhaps raise a glass of cold beer to salute the man whose work so neatly explains why their city is such a success today.