Caselet 1 The war on drugs is an expensive battle, as a great deal of resources go into catching those who buy or sell illegal drugs on the black

Caselet 1The war on drugs is an expensive battle, as a great deal of resources go into catching those who buy orsell illegal drugs on the black market, prosecuting them in court, and housing them in jail. These costsseem particularly exorbitant when dealing with the drug marijuana, as it is widely used, and is likely nomore harmful than currently legal drugs such as tobacco and alcohol. There’s another cost to the war ondrugs, however, which is the revenue lost by governments who cannot collect taxes on illegal drugs. In arecent study for the Fraser Institute, Canada, Economist Stephen T. Easton attempted to calculate howmuch tax revenue the government of the country could gain by legalizing marijuana. The studyestimates that the average price of 0.5 grams (a unit) of marijuana sold for $8.60 on the street, while itscost of production was only $1.70. In a free market, a $6.90 profit for a unit of marijuana would not lastfor long. Entrepreneurs noticing the great profits to be made in the marijuana market would start theirown grow operations, increasing the supply of marijuana on the street, which would cause the streetprice of the drug to fall to a level much closer to the cost of production. Of course, this doesn’t happenbecause the product is illegal; the prospect of jail time deters many entrepreneurs and the occasionaldrug bust ensures that the supply stays relatively low. We can consider much of this $6.90 per unit ofmarijuana profit a risk‐premium for participating in the underground economy. Unfortunately, this riskpremium is making a lot of criminals, many of whom have ties to organized crime, very wealthy. StephenT. Easton argues that if marijuana was legalized, we could transfer these excess profits caused by therisk premium from these grow operations to the government: If we substitute a tax on marijuanacigarettes equal to the difference between the local production cost and the street price peoplecurrently pay – that is, transfer the revenue from the current producers and marketers (many of whomwork with organized crime) to the government, leaving all other marketing and transportation issuesaside we would have revenue of (say) $7 per [unit]. If you could collect on every cigarette and ignore thetransportation, marketing, and advertising costs, this comes to over $2 billion on Canadian sales andsubstantially more from an export tax, and you forego the costs of enforcement and deploy yourpolicing assets elsewhere. One interesting thing to note from such a scheme is that the street price ofmarijuana stays exactly the same, so the quantity demanded should remain the same as the price isunchanged. However, it’s quite likely that the demand for marijuana would change from legalization.We saw that there was a risk in selling marijuana, but since drug laws often target both the buyer andthe seller, there is also a risk (albeit smaller) to the consumer interested in buying marijuana.Legalization would eliminate this risk, causing the demand to rise. This is a mixed bag from a publicpolicy standpoint: Increased marijuana use can have ill effects on the health of the population but theincreased sales bring in more revenue for the government. However, if legalized, governments cancontrol how much marijuana is consumed by increasing or decreasing the taxes on the product. There isa limit to this, however, as setting taxes too high will cause marijuana growers to sell on the blackmarket to avoid excessive taxation. When considering legalizing marijuana, there are many economic,health, and social issues we must analyze. One economic study will not be the basis of Canada’s publicpolicy decisions, but Easton’s research does conclusively show that there are economic benefits in theExamination Paper Semester I: Managerial EconomicsIIBM Institute of Business Managementlegalization of marijuana. With governments scrambling to find new sources of revenue to pay forimportant social objectives such as health care and education expect to see the idea raised in Parliamentsooner rather than later.Questions1. Plot the demand schedule and draw the demand curve for the data given for Marijuana in thecase above.2. On the basis of the analysis of the case above, what is your opinion about legalizing marijuana inCanada?Caselet 2Companies that attend to productivity and growth simultaneously manage cost reductions verydifferently from companies that focus on cost cutting alone and they drive growth very differently fromcompanies that are obsessed with growth alone. It is the ability to cook sweet and sour that under gridsthe remarkable performance of companies likes Intel, GE, ABB and Canon. In the slow growth electrotechnicalbusiness, ABB has doubled its revenues from $17 billion to $35 billion, largely by exploitingnew opportunities in emerging markets. For example, it has built up a 46,000 employee organisation inthe Asia Pacific region, almost from scratch. But it has also reduced employment in North America andWestern Europe by 54,000 people. It is the hard squeeze in the north and the west that generated theresources to support ABB’s massive investments in the east and the south. Everyone knows about thestaggering ambition of the Ambanis, which has fuelled Reliance’s evolution into the largest privatecompany in India. Reliance has built its spectacular rise on a similar ability to cook sweet and sour. Whatpeople may not be equally familiar with is the relentless focus on cost reduction and productivity growththat pervades the company. Reliance’s employee cost is 4 per cent of revenues, against 15‐20 per centof its competitors. Its sales and distribution cost, at 3 per cent of revenues, is about a third of globalstandards. It has continuously pushed down its cost for energy and utilities to 3 per cent of revenues,largely through 100 per cent captive power generation that costs the company 4.5 cents per kilowatthour;well below Indian utility costs, and about 30 per cent lower than the global average. Similarly, itscapital cost is 25‐30 per cent lower than its international peers due to its legendary speed in plantcommissioning and its relentless focus on reducing the weighted average cost of capital (WACC) that, at13 per cent, is the lowest of any major Indian firm.A Bias for GrowthComparing major Indian companies in key industries with their global competitors shows that Indiancompanies are running a major risk. They suffer from a profound bias for growth. There is nothingwrong with this bias, as Reliance has shown. The problem is most look more like Essar than Reliance.While they love the sweet of growth, they are unwilling to face the sour of productivity improvement.Nowhere is this more amply borne out than in the consumer goods industry where the Indian giantHindustan Lever has consolidated to grow at over 50 per cent while its labour productivity declined byaround 6 per cent per annum in the same period. Its strongest competitor, Nirma, also grew at over 25per cent per annum in revenues but maintained its labour productivity relatively stable. Unfortunately,however, its return on capital employed (ROCE) suffered by over 17 per cent. In contrast, Coca Cola,worldwide, grew at around 7 per cent, improved its labour productivity by 20 per cent and its return oncapital employed by 6.7 per cent. The story is very similar in the information technology sector whereInfosys, NIIT and HCL achieve rates of growth of over 50 per cent which compares favorably with theworld’s best companies that grew at around 30 per cent between 1994‐95. NIIT, for example, stronglybelieves that growth is an impetus in itself. Its focus on growth has helped it double revenues every twoyears. Sustaining profitability in the face of such expansion is an extremely challenging task. For now,this is a challenge Indian InfoTech companies seem to be losing. The ROCE for three Indian majors fell by7 per cent annually over 1994‐96. At the same time IBM Microsoft and SAP managed to improve thisratio by 17 per cent. There are some exceptions, however. The cement industry, which has focused onproductivity rather than on growth, has done very well in this dimension when compared to their globalcounterparts. While Mexico’s Cemex has grown about three times fast as India’s ACC, Indian cementcompanies have consistently delivered better results, not only on absolute profitability ratios, but alsoon absolute profitability growth. They show a growth of 24 per cent in return on capital employed whileinternational players show only 8.4 per cent. Labour productivity, which actually fell for most industriesover 1994‐96, has improved at 2.5 per cent per annum for cement.The engineering industry also matches up to the performance standards of the best in the world.Companies like Cummins India have always pushed for growth as is evidenced by its 27 per cent rate ofgrowth, but not at the cost of present and future profitability. The company shows a healthy excess ofalmost 30 per cent over WACC, displaying great future promise. BHEL, the public sector giant, has seensimilar success and the share price rose by 25 per cent despite an indecisive sensex. The only note ofcaution: Indian engineering companies have not been able to improve labour productivity over time,while international engineering companies like ABB, Siemens and Cummins Engines have achievedabout 13.5 per cent growth in labour productivity, on an average, in the same period. Thepharmaceuticals industry is where the problems seem to be the worst, with growth emphasized at thecost of all other performance. They have been growing at over 22 per cent, while their ROCE fell at 15.9per cent per annum and labour productivity at 7 per cent. Compare this with some of the bestpharmaceutical companies of the world – Glaxo Wellcome, SmithKline Beecham and Pfizer –who haveconsistently achieved growth of 15‐20 per cent, while improving returns on capital employed at about25 per cent and labour productivity at 8 per cent. Ranbaxy is not an exception; the bias for growth at thecost of labour and capital productivity is also manifest in the performance of other Indian Pharmacompanies. What makes this even worse is the Indian companies barely manage to cover their cost ofcapital, while their competitors worldwide such as Glaxo and Pfizer earn an average ROCE of 65 percent. In the Indian textile industry, Arvind Mills was once the shining star. Like Reliance, it had learnt tocook sweet and sour. Between 1994 and 1996, it grew at an average of 30 per cent per annum tobecome the world’s largest denim producer. At the same time, it also operated a tight ship, improvinglabour productivity by 20 per cent. Despite the excellent performance in the past, there are warningsignals for Arvind’s future. The excess over the WACC is only 1.5 per cent, implying it barely manages tosatisfy its investor’s expectations of return and does not really have a surplus to re‐invest in thebusiness. Apparently, investors also think so, for Arvind’s stock price has been falling since Q4 1994despite such excellent results and, at the end of the first quarter of 1998, is less than Rs 70 compared toRs 170 at the end of 1994. Unfortunately, Arvind’s deteriorating financial returns over the last few yearsis also typical of the Indian textile industry. The top three Indian companies actually showed a decline intheir return ratios in contrast to the international majors. Nike, VF Corp and Coats Viyella showed agrowth in their returns on capital employed of 6.2 per cent, while the ROCE of Grasim and Coats Viyella(India) fell by almost 2 per cent per annum. Even in absolute returns on assets or on capital employed,Indian companies fare a lot worse. While Indian textile companies just about cover their WACC, theirinternational rivals earn about 8 per cent in excess of their cost of capital.Questions1. Is Indian companies running a risk by not giving attention to cost cutting?2. Discuss whether Indian Consumer goods industry is growing at the cost of future profitability.3. Discuss capital and labour productivity in engineering context and pharmaceutical industries inIndia.4. Is textile industry in India performing better than its global competitors?







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