The rapid emergence of business models in India’s digital space promises an unprecedented transition. The country’s earlier wave of liberalization in the mid-1990s expanded employment opportunities as well as enhanced private and foreign participation in the business sector, securing India’s position among the world’s fast-growing economies. But India’s current digital economy, still in its early days, offers new prospects for the country: innovation-driven rather than merely consumption-driven growth, the creation of new kinds of blue-collar jobs, and a genuine possibility of joining the ranks of influential game-changers in global politics.

To make good on these offerings, India needs a regulatory approach that helps innovation thrive and allows competition to play out freely, rather than ill-conceived protectionist measures. As protectionist policies are slowly advanced in an increasingly competitive space, the Indian government and other relevant actors must respond to both the specific threat of capital dumping and broader, often xenophobic, calls for protectionism.

Capital Dumping and the Siren Song of Protectionism

E-commerce, broadly defined as the buying and selling of goods and services, and the transmitting of funds or data over electronic platforms, has been growing rapidly. Global retail e-commerce sales, which stood at $1.9 trillion in 2016, are projected to reach nearly $4.1 trillion— 14.6 percent of total retail spending—by 2020. A recent study predicts that India’s e-commerce revenues will grow from $30 billion in 2016 to $120 billion by 2020.

Yet since Amazon commenced operations in 1995, in an environment characterized by stiff competition, e-commerce firms have often received more notice for their market valuations than their actual profits. Success in the digital space seems to depend on the ability to rapidly acquire new customers. Well-funded companies often seek to achieve this by using cash reserves to fund extensive advertising and promotional campaigns, including discounts and cash back offers. Well-funded start-ups are naturally better placed to resort to this kind of spending, sometimes pejoratively termed capital dumping, and so they often are able to capture more customers than less generously funded firms. Over time, this behavior—categorized by competition and antitrust regulations as predatory pricing—hampers the ability of firms with less financial backing to draw more customers. Capital dumping does this by helping predatory companies acquire and retain greater market share by gaining greater exposure and offering consumers very low prices.

As 2016 drew to a close, India’s business world was trading fast and loose accusations of capital dumping. Some prominent Indian start-up founders claimed that venture capitalists and foreign firms were competing unfairly by leveraging their deep pockets to offer heavy and indiscriminate discounts, while other start-up innovators rebuffed this claim. These allegations are largely a mischaracterization, given that many of these start-ups, though founded by Indian citizens, are either incorporated in foreign jurisdictions or heavily funded by foreign capital. The start-ups making these accusations do not have much credibility to accuse foreigners of such practices simply based on instances of capital dumping by companies founded by non-Indian citizens. In fact, many major Indian start-ups have indulged in similar practices.

However, these allegations may be symptomatic of a broader, more worrisome prospect—a protectionist siren song at work in India’s digital economy.

Mobile Apps and Network Effects in the Digital Economy

Like in other countries, India’s present transition to a digital economy takes advantage of two rapidly evolving technological advances: swift mobile Internet penetration and the enhanced capabilities of data analytics. Faster and more ubiquitous Internet access has paved the way for smartphone-enabled, user-friendly consumer apps. And this in turn provides players in India’s app economy with a diverse wealth of data that taps into the innovations of data analytics.

Many start-ups in the digital economy offer products and services for free, or at minimal cost, to end users and vendors. This business model can only succeed when a critical mass of consumers and sellers or service providers rely on a company’s platform. From a user standpoint, the network effects created by such high-volume usage maximize the attractiveness of the product. Network effects exist when the more individuals adopt a good or technology, the greater incentive others have to start using that good too. To illustrate with a real-world example, the more users there are on a ride-sharing platform, such as Uber or Ola Cabs, the greater incentive cab drivers have to offer their services because there are more available customers. When this in turn increases the number of cab drivers, new users then have more reason to join the platform, further raising the value of the network. This principle is formally known as Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of connected users that the system has.

Because tech companies with more users are more valuable, firms in the digital economy need to acquire customers rapidly to keep their valuations high. At the same time, firms cannot afford to stop innovating, because users face relatively low switching costs if they choose to move to a competing network. Consumers face switching costs when they have to incur additional learning or transaction costs if they switch from a product they are already using to a comparable product from a new seller. For example, an organization that has deployed a particular accounting software has invested money and time to negotiate the software license as well as to train its staff to use it. When a competitor approaches that same organization about using a rival software product instead, the organization necessarily has to factor in the switching cost—both money and time—that changing to the new software would require.

In the digital space, because network effects are especially valuable for growth and switching costs are typically minimal, big market players can feel threatened when small ones emerge. After all, learning to use a new mobile app is relatively easy, and users often incur no significant initial charges to join a new network or install a new app. In India, Facebook upstaged the social networking website Orkut; WhatsApp became a ubiquitous messaging platform—overcoming challengers including Google and the then-popular Blackberry Messenger—by offering more innovative, user-friendly solutions than its competitors.

To keep small companies from growing, then, many big firms have started enticing new customers and retaining old ones with predatory pricing schemes involving discounts and other incentives.
Predatory pricing artificially alters demand and supply equilibriums by pushing down prices. A predator’s rivals are compelled to either lower their own prices or risk being sidestepped by consumers. A further incentive for adopting predatory strategies is that players that acquire more users more rapidly typically have a better shot at long-term market dominance. This approach, especially by big industry players, may benefit consumers in the short run. But if left unchecked, it can potentially compromise quality across a given industry, centralize innovation, create unhealthy incentives to expend capital quickly, and give rise to questionable accounting and valuation practices that inflate a company’s real worth.

Lessons from India’s Past Trade and Industrial Policies

This current level of mass-scale, privately led technological innovation is new for India. This has revived old tropes that pit Indian firms against foreign ones, big companies against small ones, and disruptors against incumbents. In such a context, a nation can fall prey to the siren song of protectionism—including broad restrictions on the infusion and use of foreign capital, particularly for price discounting. The attraction of protectionism today is even stronger because of India’s tryst with protectionism in the past. But this same past offers valuable lessons on how flawed that approach was, and how much better things can be when openness is the default guiding norm.

A closer look at the history of India’s trade and industrial policies is key to understanding the protectionist siren song, which stands to potentially alter the future of the country’s emerging digital economy. This includes the protectionist undertones in the first three decades following India’s independence, the negative impact of such policies on economic growth, the country’s consequential policy shift toward economic openness starting in the early 1980s, and the benefits for India’s bellwether information technology (IT) service industry that arose from cross-border interactions and foreign capital infusion.

India’s early industrial policies were a mixture of competing, and often contradictory, visions. India’s strategy for economic development under Jawaharlal Nehru, its first prime minister, placed faith in import substitution—the replacement of imported products with domestically produced ones. This protectionist stance was adopted with an aim to achieve national economic self-reliance and rapid development through domestic heavy industry and temporary economic isolation. Despite some gains, these policies did not come without costs. While India did manage to create indigenous technological capabilities, the country’s overall economic output and total factor productivity growth took a beating, as Nehru’s emphasis on import substitution led to entrenched interest groups and rigid policymaking processes that placed constraints on economic efficiency.

Starting in 1976—first under then prime minister Indira Gandhi’s leadership and then under that of her successor, Rajiv Gandhi—India underwent partial liberalization efforts, including selective freedom from industrial licensing and other attempts to rectify previous isolationist policies. Rajiv Gandhi asserted that in cases where import substitutes were “not cost-effective,” India should opt for “imports, especially of technology.” However, openness to trade was still considered bad politics during this period, leading to the rollback of some key policy measures initiated in the 1980s. Only when a critical balance of payments situation arose in 1991—when India’s foreign exchange reserves plummeted to the value of a mere two weeks of imports—did the country finally, and painstakingly, go further down the path toward an open economy.

As with any big policy reform, there were winners and losers. Against the backdrop of the 1991 reforms, some big domestic players felt threatened by foreign competition. To protect their business interests, eight leading industrialists—now popularized in Indian business lore as the Bombay Club—allegedly handed a note to Manmohan Singh, India’s finance minister at the time, requesting that the government create a level playing field before welcoming multinational corporations (MNCs) to Indian shores. They contended that MNCs benefited from better production efficiencies and larger financial reserves, which would stifle the ability of Indian firms to compete.

The supposed club was not successful in stopping MNC entry into India. However, liberalization in the manufacturing sector continued at a cautious pace, as many products—especially intermediate products and consumer durables—continued to have high tariffs. A careful dismantling of quantitative restrictions, non-tariff barriers, licensing regimes, and tariffs happened only starting in the early 2000s. Even with these reforms, India is still criticized for keeping in place several protectionist policy instruments in key sectors of manufactured products. These innovation mercantilist policies include mandating local production requirements or technology transfers as conditions of market access, as well as restrictions on market access for FDI-enabled ventures.

In contrast to product markets, India’s services sector has been more open and has benefitted accordingly. The services sector—particularly IT services and business process outsourcing—won big in the reforms process. The Indian software industry had started off by providing skilled labor for simple coding jobs, a practice derisively termed body shopping. One study estimated that such on-site services was reduced drastically from 95 percent of the total value of all software service exports in 1990 to 56 percent by 2000, and the figure reportedly decreased further to 19.8 percent by 2013–14. India’s share of aggregate global service exports, however, increased from 0.5 percent in 1990 to 3.2 percent in 2014–15.

In what is considered a move up the value-chain, many Indian IT service companies are now engaged in consulting, product development, social media, data analytics, and cloud computing. Software technology parks built to promote Indian software exports have facilitated the importing of equipment without import licenses or even import duties. Generous treatment of foreign equity and free repatriation of capital investment have also helped these Indian companies scale up rapidly as well as reach a global market. In the words of former chairman of the Indian IT consulting firm Infosys, Nandan Nilekani, “the entry of FIIs [foreign institutional investors] helped . . . they had an understanding of technology.”1

The Indian software industry’s high degree of openness to international trade and investment from the early 1980s onward made the country’s indigenous players capable of quickly adapting to global changes and of dynamically upgrading their technological capabilities and organizational structures to compete with the very best. These key factors for success are perhaps even more relevant when building a vibrant digital economy with cutting-edge software products. The Indian digital economy has a lot to gain from openness and collaboration in a space that is being transformed by artificial intelligence and machine learning, augmented and virtual reality, quantum cryptography, and other technological advances at the intersection of pure research and commercial applications.

Innovation as the Game-Changer

In this technologically complex environment, broad restrictions on firms’ autonomy to price products and offer discounts will only limit much-needed openness, repeating the protectionist mistakes of the past with more perilous consequences. Except for interventions by regulatory authorities when confronted with extreme cases of predatory pricing,2 the best way to combat such pricing strategies is to encourage innovation that drastically improves user experience. Policies promoting innovation and the entry of new players into the digital economy without too many regulatory hassles are best suited to counter efforts to capture market share through predatory pricing, because innovation grows the size of the economy rather than treating it as static.

 The innovation-driven character of the digital economy compels a reassessment of traditional policy responses to predatory pricing. Past responses tended to consist of restraints on scaling up and restrictions on the infusion of foreign capital. The driving assumptions were that the innovative potential of Indian firms was static and could not improve rapidly enough, and that domestic interests would be severely affected if foreign competition was allowed. Yet the digital economy is part of a larger innovation ecosystem that consists of constantly evolving technologies like artificial intelligence and high-speed Internet, agile business approaches to tap into such advances, and an enhanced ability to make innovation-driven business solutions available at a much quicker pace than in other economic sectors. Fostering such an ecosystem requires sending out positive signals that favor more innovation. Restrictions on the use of capital do not bode well for an open, pro-innovation culture.

Whether regulating predatory pricing or more broadly the operational and financial choices made by players in India’s digital economy, protectionist measures miss the forest for the trees. Predatory pricing and other unconstructive uses of capital can certainly act to the detriment of an innovative ecosystem, or at least give advantage to dominant players once market capture is complete. But these undesirable consequences cannot be avoided by restricting how companies raise or spend their capital. Such restrictions equally apply to both incumbents and disruptors, and perhaps would affect disruptors even more. Entrenched players may be able to more easily absorb the impact of regulatory directives that restrain them from below-cost pricing, because they already have large customer bases. New players with a smaller user base but a more innovative product may benefit from below-cost pricing briefly but would not be able to do so if such regulatory restraints were in place.

But adopting regulations that specifically target market leaders and exempt small firms would pose problems too. Confining regulatory restraints to big market players would raise more fundamental objections rooted in fairness and equality. Regulating industry players based on size or market share alone, without any assessment of their conduct, is patently unfair. Moreover, having the state restrict how private actors can spend their cash reserves would potentially violate their ability to conduct business operations freely. Such restraints also may have the unhealthy effect of practically penalizing early movers for their entrepreneurial vision in anticipating business opportunities, impeding their enterprises’ growth.

Shifting the state’s regulatory focus from trade to innovation, on the other hand, rightly directs attention from goods and services to fostering an ecosystem designed to make human capital flourish. As the UC Berkeley economist Enrico Moretti contends, “to remain prosperous, a society needs to keep climbing the innovation ladder.”3 His research demonstrates that for each new high-tech job created in a metropolitan area, in the long run five additional jobs that benefit a diverse set of workers tend to be created in other fields. The multiplier effects of innovation go beyond direct and indirect job creation. Innovation can lead to greater productivity, higher wages, lower prices, and advancements in healthcare. Robert Solow asserts that technological advances—meaning any development that allows for a more efficient use of capital and labor—have a near conclusive effect of boosting an economy’s long-run growth rate.4

Above all, innovation tends to foster an entrepreneurial culture. Whether one is talking about a U.S. company like PayPal or an Indian one like Flipkart, innovative companies in the digital economy have the potential to spawn creative ecosystems, leading to start-up activity by their former employees and others. Such an environment often facilitates creative tinkering by end users as well, which cultivates more follow-on innovation and can even prompt a nation or region to be rebranded as an innovation hub. Recent studies reveal the significance of geographically concentrated innovation clusters, debunking the flat-world theory that one can innovate from any location. Proximity to innovative activity appears crucial in generating more technological progress, while distance from it is deleterious to perfecting and scaling disruptive advancements.

Crucial to such innovation is an open culture built around knowledge sharing and network linkages between diverse actors such as industrialists, customers, investors, universities, and research organizations. Viewed from this system-level perspective, the state’s role is to promote, and at times even create, such innovation ecosystems using policy tools, and then permit open competition to enhance firms’ ability to be innovative with their products and business models.

This stands in stark contrast with policies such as subsidies and tax incentives for research and development (R&D) or public procurement of R&D–intensive products. While such policies have their place, a dynamic approach to promoting innovation is critical to fueling economic growth. Moreover, even when it comes to trade policies, openness is vital in the digital economy. This is best exemplified by an American success story—a product of its open trade policies. A U.S. moratorium on “customs duties on electronic transmissions”—a key pillar of the United States’ bilateral and regional trade commitments—helped the nation establish dominance in e-commerce.5

The case of Israel also highlights the benefits of embracing an open approach to tech innovation rather than protectionism. In recent years, Israel, with a domestic market much smaller than those of China or India, is a testament to the positive externalities generated by innovation. In 2015 alone, foreign and local companies spent a total of $9.2 billion to acquire 104 Israeli tech companies. Far from crafting policy with protectionist overtones, Israel is welcoming to foreign capital and companies. This is borne out by the more than 250 foreign companies that have R&D centers there;6 several non-Israeli start-ups consider Israel their base for innovation. Israel’s rise as a hub for technological innovation is as much a story of progressive state policies and enhanced science and R&D government spending as it is a tale about risk-taking entrepreneurs.

How India Can Further Encourage Innovation

Given the benefits of innovation, Indian government entities such as the Department of Industrial Policy and Promotion and policy think tanks such as NITI Aayog would be well advised to bear in mind several principles when seeking to identify suitable ways to regulate India’s digital economy.

One important principle is to stay clear of closed-door policies that hamper knowledge sharing. The digital economy is part of a broader knowledge-based economy; realizing this is critical to building on current interest from both investors and innovation leaders in developing India as an innovation hub. A vibrant and open innovation policy, rather than trade policies or investment policies centered around protecting domestic players or unduly curbing the flow of investment, is best suited to handle the needs of the digital economy.

Instead, the Indian government and supporting actors should take proactive steps to build a vibrant national innovation system. This requires a massive leap in R&D spending from the officially disclosed 2012 levels of approximately 0.9 percent of GDP to somewhere between 2.5 and 3 percent, as well as a conscious attempt to bridge the gap between universities, industrial firms, and research organizations.7 The Indian government should channel R&D spending through grants to research efforts less likely to be funded by industry players, regardless of the specific sector. In addition, the government should also identify frontier areas—such as artificial intelligence and deep learning, 3-D printing, biotechnology, and human-machine interaction—that can significantly reshape the world, and offer tax breaks and incentives to private players committed to conducting research in these fields in India.

A vital aspect of fostering ingenuity should be actively promoting competition. Innovation-driven competition can alter the structure of an industry, as is currently happening in the Indian digital payments industry amid a proliferation of innovations—which include mobile wallets, new payment gateways, and novel point-of-sale solutions. The Reserve Bank of India has supported this development by driving the creation of complementary technologies, such as the Unified Payment Interface, and allowing technology-enabled financial businesses (or fintech providers) open and interoperable access to these innovations. Policy efforts of this kind—which lower consumer transaction fees and thus challenge the prevailing merchant discount rates and similar transaction fees charged by incumbent entities like credit card providers—enhance the choices available to both merchants and consumers.

The government also ought to tread with caution when regulating disruptive market players. Broad-based guidelines and regulations inadvertently limit firms’ flexibility to tinker, a key aspect of innovation. Designing regulations for predatory pricing and other emerging economic issues must be left to expert bodies such as the Competition Commission of India.

These solutions look simple but political actors can easily fall prey to protectionism. A good example from the digital economy is the opening up of India’s online retail sector to FDI. For years, the Indian government resisted opening up the sector because of lobbying by kirana dukaans—Indian mom and pop stores. Even when good sense finally prevailed and this sector was opened up, several restrictions were put in place on the operational autonomy of online retail companies that depend on FDI. Such restrictions are undesirable examples of protectionism, which compromise gains in efficiency while seeking to protect Indian businesses.

The Indian digital economy offers tremendous potential for growth if appropriate policies are put in place. Nurturing an innovation-friendly space is different from protecting individual players or business models in the digital space, and there is no better time than now for India to keep this in mind.

The author would like to thank Saksham Khosla, Shashank Reddy, and Shruti Sharma for valuable research assistance.

Notes

1 Vinay Sitapati, Half Lion: How PV Narasimha Rao Transformed India (Penguin Books: Gurgaon, 2016), 150.

2 The permissibility of predatory pricing in antitrust/competition law is a complicated issue with a general emphasis placed on whether it can lead to monopolization in the long run. See Douglas Broder, U.S. Antitrust Law and Enforcement: A Practice Introduction (New York: Oxford University Press, 2010), 93–96.

3 Enrico Moretti, The New Geography of Jobs (New York: First Mariner Books, 2013), 129.

4 Please also see Robert M. Solow, “Technical Change and the Aggregate Production Function,” The Review of Economics and Statistics 39, no. 3 (Fall 1957): 312.

5 Anupam Chander, The Electronic Silk Road (New Haven: Yale University Press, 2013), 38–40.

6 Please see Senor and Singer, Start-up Nation. This book chronicles interesting episodes in Israel’s innovation history, including how Intel was saved by its Israel R&D team which led to the chip manufacturer’s organic expansion.

7 Government of India, Ministry of Science and Technology, Press Information Bureau, “Move to Increase R&D Expenditure to Two Percent of GDP,” April 23, 2015, http://pib.nic.in/newsite/PrintRelease.aspx?relid=118574.