of monopoly, monopsony, and externalities by the government. Regulation of Monopoly and Monopsony: Both monopoly and monopsony were perhaps serious problems during the ancient times.5 Kautilya (p 236) stated, ‘Merchants are all thieves, in effect, if not in name; they shall be prevented from oppressing the people (4.1).’ He (p 134) added, ‘It is the frontier officer who promotes trade, whereas traders form cartels in order to raise prices [for the goods they sell] or lower them [for the goods they buy]; they are profiteers making one hundred panas on one pana or one hundred measures on one measure of [grain].’ The Figure 9.1 presents his ideas.
According to Kautilya, traders behaved like a monopsonist in buying goods particularly foodgrains from farmers and selling them like a monopolist to the consumers. That is, paying producers (farmers) a significantly lower price Pp while charging consumers a much higher price Pc. Although Kautilya was aware of the monopolymonopsony rents (Posner’s rectangle FMPcPp ,1975) since he explicitly mentioned profits, He did not mention the use of any resources for capturing those monopoly rents. Similarly, he was not concerned with Harberger’s (1971) triangle FCM, although it might have been quite large. He was primarily concerned with political unrest arising from producers, who were paid a very low price and from consumers, who were charged a very high price. It may be noted that it was not a case of bilateral monopoly since it was the same cartel of traders behaving both as a monopsonist and a monopolist.
It is from time immemorial that both ordinary consumers and kings have expected fair and honest dealings from suppliers of products and services. Kautilya discussed consumer protection at length.6 He (p 250) recommended, ‘cartelisation by artisans and craftsmen with the aim of lowering quality, increasing the profits or obstructing the sale or purchase and by merchants conspiring to hoard with the aim of selling at a higher price (4.2).’ would be dealt with stiff punishments of 1000 panas for such offenses. Such a high penalty indicates the perceived seriousness of the offense. He (p 249-250) recommended punishment for ‘adulteration’, ‘fraud’, ‘false description in selling’, ‘showing one product and selling another’, and ‘stealing precious metal in making new objects’ etc. (4.2). According to him, all such practices were unethical; he equated charging high prices through the formation of cartels to theft.
In the absence of fully developed competitive markets and product warranties, all that the consumers could depend on was the protection accorded by the government. Two points are worth noting. First, Kautilya’s recommendations were almost as specific as the Clayton Act (USA, 1913) in defining the illegal behavior of the monopolies. Secondly, Adam Smith (p 232) had similar concerns when he wrote, ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise price.’
Externalities: An externality obtains when the actions of a decisionmaker have a positive or negative effect on the availability of possible consumption or production choices to others. Kautilya’s suggestion to regulate an externality was not based on the Pigovian distinction between social marginal cost (or benefit), and private marginal cost (or benefit), and imposition of corrective taxes (or subsidies). But he did correctly identify an externality and suggested a fine to prevent it. At that time, one of the major sources of pollution was cow dung or dirt. He (p 373) suggested a fine of 1/8th of a pana for ‘throwing dirt on the road’ 1/4th of a pana for ‘blocking it with mud or water’ (2.36). And he (p 375) recommended a fine for ‘Having a dung hill, a sewage channel or a well too near a neighbour’s house as to cause nuisance’ and also for ‘Causing obstruction and preventing the enjoyment of others’ (3.8).
Nowadays, businesses and governments are concerned with the harmful effects of smoking on health and worker productivity. Kautilya too showed concern about consumption of liquor. He (p 349) recommended, ‘Liquor shall only be drunk in the drinking house, and no one shall move about while drunk. Liquor shall not be stored in large quantities nor taken out of a village. The dangers in allowing large stocks or unrestricted movement are that workers may spoil the work allotted to them, even a dignified person may behave immodestly and assassins may be encouraged to behave rashly (2.25).’
Modern Market Failures: Problem of shirking (called ‘moral hazard’ problem) and the sellers not providing full information to the buyer (trying to sell a lemon) are labeled as information-based market failures. Although Kautilya could not imagine that today, such things would be called information-based market failures and certainly did not develop any theoretical models but he went much farther than the classicists.7 He not only understood many of them but also applied them appropriately to specific situations. Similarly, he did not make any formal distinction between ‘hidden actions’ and ‘hidden information’ but showed awareness of such a distinction and suggested post-modern solutions to deal with them.
Hidden Actions: Kautilya recognized the problem of ‘shirking’. He (p 283) remarked, ‘The king shall have the work of Heads of Departments inspected daily, for men are, by nature, fickle and, like horses, change after being put to work.’ He suggested ‘efficiency wages’ to mitigate this problem (see Chapter 11 for an in-depth analysis). Similarly he (p 317) recommended, ‘They (a herdsman, milker, a churner and a hunter-guard) shall be paid in cash, because if they are paid in milk or butter oil, they will starve the calves to death [by milking the cows dry, leaving nothing for the calves] (2.29).’
Hidden Information: Kautilya showed awareness of the concept of what is nowadays called ‘asymmetric information’ and how to benefit from possession of such private information. For example, according to him, a king knew the quality of his land, which was poor but the buyer of the land did not know anything about its quality. He (p 621) stated, ‘If a settlement of a tract is likely to entail heavy losses or expenditure, a king shall first sell the land, with the intention of re-acquiring it, to one who will fail in the attempt at settlement. Such agreements shall remain verbal (7.11).’ Current Lemon Laws are based on this type of market failure.
Handling Missing Markets: At that time, no system of market insurance existed against losses from fire, floods, diseases, epidemics, and famines. Benefits were provided out of general revenue. Kautilya (p 128) prescribed, ‘It is the duty of the king to protect the people from all calamities (4.3).’
Solving Another Problem of Moral Hazard: In order to guard against any possible ‘moral hazard’ problem, Kautilya (p 373) recommended a fine for ‘not providing fire-fighting equipment’ such as, water pots, a big jar, a trough, a ladder, an axe, a hook, a hooked rake, a skin bag etc. and for ‘not hastening to save his own house on fire (2.36).’
9.3 CONSEQUENCES OF GOVERNMENT FAILURE According to Kautilya, in the beginning government had a very limited role to play as it was confined exclusively to the maintenance of law and order and protection against foreign aggression. However, he greatly expanded its role to meet the challenge created by the new realities of his time. Drekmeier (p 260) writes, ‘By the fifth and fourth centuries BC the ancient tribal institutions had lost their ability to regulate society effectively. New modes of production, new types of social relationships, new salvation theologies were changing the old ways. Kautilya was the theorist who most clearly saw the need for expanded state authority to fill the ever-widening gaps left by the declining authority of tradition. The king needed greater freedom of movement if he was to provide security and the conditions of prosperity.’
Avoiding Failure at the Bureaucratic Level: According to Kautilya, good governance also meant not to allow corruption at the bureaucratic level. He was quite aware of the possibility and the difficulty of detection of corruption at the bureaucratic level. He (p 281) stated, ‘Just as it is impossible to know when a fish moving in water is drinking it, so it is impossible to find out when government servants in charge of undertakings misappropriate money (2.9).’ He (p 283) continued, ‘It is possible to know even the path of birds flying in the sky but n
ot the ways of government servants who hide their (dishonest) income.’
He (p 221) pointed out, ‘There are thirteen types of undesirable persons who amass wealth secretly by causing injury to the population. [These are: corrupt judges and magistrates, heads of villages or departments who extort money from the public, perjurers and procurers of perjury, those who practice witchcraft, black magic or sorcery, poisoners, narcotic dealers, counterfeiters and adulterators of precious metals.] When they are exposed by secret agents, they shall either be exiled or made to pay adequate compensation proportionate to the gravity of the offense (4.4).’ He (p 493-494) asserted, ‘Thus, the king shall first reform the administration, by punishing appropriately those officers who deal in wealth; they, duly corrected, shall use the right punishments to ensure the good conduct of the people of the towns and the countryside (4.9).’
Poor Governance or Government Failure at the Highest Level: According to Kautilya, government failure could occur at the highest level as well as at the bureaucratic level. His statement that a decadent king ‘fails to protect the people from thieves and robs them himself ’ indicates that government failure could occur both due to inaction and inappropriate action, that is, due to poor governance. Additionally,
Figure 9.2: AB= the possibility frontier between GDP and the probability of political stability under monopoly, A1G1=possibility frontier under good governance, A2G2=possibility frontier under poor governance. AC=Possibility frontier if perfect competition is restored through antitrust laws and AG=possibility frontier under government failure in trying to correct market failure.
[according to Kautilya,] if the king were corrupt, the bureaucracy would also be corrupt. Figure 9.2 may be used to express Kautilya’s ideas. Kautilya believed that good governance (which included regulation of monopoly) improved political stability as well as brought prosperity implying that the possibility frontier, AB, under monopoly shifted to possibility frontier A1 G1. On the other hand, according to Kautilya, government failure (due to corruption, indifference, and inefficiency) was a lot more serious.8 Since he believed that the AB possibility frontier most likely would shift to the left, to A2 G2, implying political unrest and a much lower income.
The current debate on market versus government failure is onedimensional and is limited to the distortionary effects only (ie. to marginal changes in GDP). Presumably, the anti-trust laws were passed with the intended goal of rotating the possibility frontier from AB to AC, the possibility frontier under competition.9 However, those who oppose government regulation of monopolies argue that instead of rotating the AB curve to AC, it most likely has been rotated to the possibility frontier AG, which they label as a government failure. Both the proponents and opponents of government regulation, for example, of monopolies, take it for granted that the political stability would not be affected.
9.4 RULES, REGULATIONS AND
ORGANIZATIONAL DESIGN TO REDUCE FRAUD The ruler should avoid appointing persons who are fraudulent, dishonest, cruel, without enthusiasm, incompetent and cowardly
—Kautilya’s Sutras Kautilya believed that prosperity required creation of wealth, both in the private and public sectors. He suggested many economic policies to encourage the creation of wealth in the private sector. Similarly, he advocated minimizing government spending on administration in order to generate the maximum surplus for building the necessary public infrastructure. Additionally, in his scheme, some enterprises, eg. liquor sales and gambling, were to be managed by the government. Each public enterprise was required to generate a maximum amount of profit without crossing the ethical bounds. Therefore, accurate measurement of the economic performance of a public enterprise and elimination of opportunities for misappropriation of public funds by government employees became absolutely critical.
For these reasons, adoption of an appropriate format for bookkeeping and codification and compliance of financial rules could not be left to the discretion of individual enterprises. He attempted to develop solutions to mitigate such problems through uniform bookkeeping rules, for recording data systematically by advocating frequent periodic reporting, and adopting independent audits to reduce the probability of system failure. He suggested incentivebased compensation mechanisms to reduce ‘moral hazard’ problems. As noted below, the Comptroller-Auditor (one official), who was ultimately responsible for all financial matters, must be knowledgeable, efficient and incorruptible.
He realized that the fiscal health of the Treasury depended not only on developing an economically sound fiscal policy that increased the taxable capacity of the economy through economic development, but that depended also on honest and efficient financial management. He was quite concerned about the possibility of fraudulent accounting by government servants. Kautilya listed forty possible ways in which corrupt employees could cheat and believed that it was not easy to detect cheating. His primary goal was to minimize the scope of such possibilities.
Kautilya provided insights into possible inadvertent as well as deliberate accounting errors or irregularities, which decrease revenue in public enterprises. He believed that revenue losses might be caused both by system failure and moral failure. Accordingly, he identified the potential sources of such losses as: (i) inadvertent recording errors, (ii) deliberate deceptive accounting, (iii) collusion among employees to misappropriate revenue, and (iv) loss in productivity due to infighting among employees.
According to him, the major underlying factor for resorting to aggressive and creative accounting (which he called ‘false accounting’) practices, was excessive greed, and he tried to contain it through moral persuasion and legal means. He proposed three kinds of measures to deal with the situation. (a) He believed that employees must be informed of the laws. With that in mind, he modified, extended, and above all codified the existing rules and regulations. Often, accounting rules are vague and thus open to varying interpretations, presenting opportunities to test or extend the limits of acceptable practice. Some enterprises might resort to massaging the numbers to paint a rosy picture of an otherwise barren situation. According to Kautilya, the laws must be very clear, without any ambiguities or loopholes, and should be as comprehensive as possible. (b) He proposed an organizational structure, which reduced the scope for conflict of interests. (c) He suggested long lists of rewards for commendable service and punishments for cheating the government.
Laws Must Have Clarity, Consistency, and Completeness and be in Written Form: Kautilya (p 212) wrote, ‘The rule of kings depends primarily on (written) orders; even peace and war have their roots in them (2.10).’ He believed that effective enforcement (to reduce scope for ‘creative accounting’) of rules and regulations required clarity, absence of loopholes, completeness, and consistency and must be in a written form. He (p 213) envisaged that the Royal Scribe, ‘Has a [thorough] knowledge of all conventions, be quick in composition and have good handwriting. He shall also be able to read [clearly] documents and edicts (2.10.3).’ He recommended that the Royal Scribe be one of the highest paid (48000 panas) employees, to emphasize and ensure that the Royal Edicts had desired characteristics. He (p 215) went so far as to suggest, ‘Cutting off both feet and a hand or 900 panas’ for a ‘Royal Scribe deliberately writing down wrongly a Royal Edict, omission or commission (4.10.14).’
Designing an Organizational Structure to Minimize the Scope for Conflict of Interest: Kautilya was an organizational man.10 He understood the concept of bounded rationality (see Chapter 10 for an in-depth analysis). He realized the necessity of creating a bureaucratic structure to ensure implementation of projects and to provide continuity of operations over the long run. He believed in cognitive division of labour and suggested creation of 28 departments for providing services related to industry and mining (7 departments), agriculture, forestry and livestock (4), trade and transport (7), treasury (2), gambling and entertainment (3), accounting (1), miscellaneous (4) and additional six departments were related to defense services. Interestingly, at least two departments w
ere created to protect the consumers (Chief Superintendent of Precious Metals and Jewellery and the Chief Controller of Private Trading) and one department was created for animal welfare and prevention of cruelty to them.
Kautilya proposed the establishment of two very important offices to monitor and manage the financial health of the state: the positions of a Treasurer and a Chief Comptroller-Auditor. They were very well paid and, in turn, they must be incorruptible and efficient. It is very interesting to note that he divided financial responsibility between the Treasurer and the Comptroller-Auditor. Both were supposed to report directly to the king. The Chief Comptroller-Auditor was responsible for auditing the revenue and expenses of each enterprise and delivering the net balance for each unit to the Treasurer. He was then envisaged to report to the king on how much was delivered. The Treasurer reported to the king how much was received. This cross-checking would, it was believed, reduce, to some extent, the scope for corruption.
But more importantly, creation of two independent positions reduced scope for corruption in another way. Suppose the Auditor was subordinate to the Treasurer and the Treasurer was corrupt and stole from the Treasury. The Auditor might be too afraid to report to the king. Also the Treasurer might ask the Auditor not to audit certain units.
The Treasurer was responsible for managing the assets and the Comptroller-Auditor handled: (i) the construction and maintenance of the Records Office, (ii) maintenance of Records, (iii) compilation of rules, (iv) inspection, (v) audit, and (vi) preparing and presenting financial reports to the king. Thus, Kautilya attempted to encourage specialization, accountability and to limit the scope for conflict of interests.
Kautilya- the True Founder of Economics Page 17
