By Sergio Figueroa Sanz
Data from the World Bank Development Indicators 2008 reports that almost half of the world’s population lives in less than $2 per day. Think about it for a second… half of the world’s population living on less than $2 a day… According to the 2009 Human Development Report, in Chad, Guinea, and Nigeria, over 80% of the population fit into the definition. In Tanzania, Rwanda and Liberia the percentage is over 90%. Data from the 2007 Human Development Report suggests that over 80% of the world’s population lives in economies where income disparities continue to increase and the poorest 40% of the world’s population account for 5% of global income, while the richest 20% account for over 75% of world income. Poverty is not only a problem of absolute income levels but also of relative nature: the perception of poverty, which is greatly influenced by income inequality, is extremely toxic for social fabrics and economic structures. Indeed, although the definition of what constitutes poverty has been subject to a lot of debate for decades, that inequality makes it worse is not generally challenged. The end of poverty (sorry for the copyrights violation Prof. Sachs) doesn’t seem to be precisely around the corner. Interestingly enough, not everyone views the persistence of poverty is not viewed as something undesirable.
Professors C.K. Prahalad and Stuart L. Hart defined the bottom of the pyramid (BoP) in the late 1990’s as the world population living on less than $2 per day and argued for viewing this segment as an untapped, highly profitable consumer market since it is typically excluded from global goods and services markets. BoP advocates see in the BoP market imperfection, an opportunity for bringing poor consumers access to global market standards at affordable prices and increased availability. The most interesting claim, however, around this business model is that consumption at the BoP has positive spillover effects based on the premise that consumption can and does spur income growth. The reason, the narrative goes, is quite trivial and can be understood as a variant of the Keynesian multiplier of government spending –confusingly enough introduced by Richard Kahn the 1930’s and not John M. Keynes. The idea is simple: a given amount of dollars will be spent in local businesses by the government or a private economic agent, these dollars will generate income for the businesses that will, in turn, increase production and pay wages to their employees; the latter, in turn, will spend their wages in other businesses and the cycle begins again. Note that tax revenues are also generated through this process to the extent that spending is made on the formal economy sector. The result is cycles of spending that increase income, regardless of how spending is made, through a consumption multiplier effect. This is how consumption generates prosperity… So far so good… or is it?
The traditional BoP consumption argument is not conceptually flawed but leaves out considerations of inequality. As argued above, income distribution asymmetries have a particularly pervasive impact over poverty and demand driven BoP development models don’t fully account for this. To illustrate this, let’s consider an example. Consider a hypothetical company called Big A. Big A is a cosmetics company that operates in the United States. This company finds out that poor, young women in some areas in India would be willing to pay for a skin whitening cream if its price dropped by 1/3. Big A develops a low cost version of the cream, which was originally conceived for medical applications and didn’t pass FDA standards. The product begins to be sold to India’s BoP through a big local retailer with wide coverage in the country, making a handsome profit out of sheer sales volume. Big A’s effect on poverty abatement, however, may be much more limited than expected and could even be negative if certain conditions are met. Big A’s incursion into the Indian market constitutes a consumer surplus transfer mechanism from the poor into Big A’s shareholders and employees. A portion of these rents will be spent locally, but since Big A is an American company, another portion will be spent elsewhere in the country and abroad. If the portion spent outside is sufficiently large, the positive consumption multiplier effect assumption will not hold and the income transfer mechanism will result in a reduction of disposable income at India’s BoP. Even if rents are spent in India, because Big A’s representatives in India will likely not reside and spend in BoP communities, the impoverishment effect will simultaneously occur along with a deterioration of income distribution as the extracted consumer surplus is transferred away from the BoP. This means income distribution will also deteriorate. If we incorporate an analysis of the informal economy markets’ role in BoP economic systems and their thinning effect over the multiplier effect, we could come to even less optimistic conclusions. Big A’s model is pretty hard to defend as a promoter of development in such conditions. Still, not all BoP business models are created equal.
Alternatively, consider another hypothetical company called Small Z. Small Z is run by a local in India, in a BoP community. I won’t idealize Small Z and will assume that the product it develops is the exact same as Big A (as opposed to developing a low cost treatment for HIV, for instance). Note that Big A didn’t invest in creating a niche in India through marketing or advertisement so the demand for the whitening cream is not artificial. Big A simply identified preferences and chose to rent from them. Small Z is doing the exact same thing. Does this mean that the difference in ownership makes no difference in terms of the business model’s ability to fight poverty? The answer is “no”. Ownership determines income retention and spending location, which is key for the consumption multiplier effect to kick in and create economic activity cycles. Small Z’s effect on poverty abatement will be, almost unequivocally, positive. Small Z’s model is too a consumer surplus transfer mechanism that will reduce its customer’s disposable income. However, because the rents will be retained locally and spent locally, the multiplier effect will be positive and create business cycles as described by scholars like Prahalad and Hart that truly foster regional development. In this sense, the multiplier effect will be maximized along with the social impact it produces since Small Z’s effect on inequality can be expected to be significantly lower than Big A’s. Such effect will be smaller to the extent that all rents are spent in the BoP community where Small Z operates. Considering the characteristics of the BoP, it’s highly likely that spillover effects will be fully realized locally since spending elsewhere has a high opportunity cost associated for the BoP. In this sense and under this model, extracted consumer surplus from BoP consumers of the whitening cream will be transferred to other hands in the BoP.
The previous example helps draw a distinction between business models of goods and services targeted to the BoP and business models that foster production from within the BoP. The former are demand side only models, where no distinction is made on the ownership of the supplying firms. The later are supply side models where ownership resides in the BoP and that leverage from local demand to create wealth. The lesson is that ownership matters in determining the net effects over poverty abatement of BoP approaches to development. This is why Agora’s Accelerator is so relevant for fostering development in Latin America, given its focus on local ownership of the projects it invests on. For more on the Acelerator, click here.
I hope this reflection helps frame better the way we understand our role as participants of the impact investment community in development practice. Feel free to comment and criticize my take on this issue. I’ll look forward to start a productive discussion.
Originally posted in Agora Partnership's blog
