1Patterns of Success in the Indian Software Industryby Rishi DaveSenior Honors Thesiscompleted under the direction ofProfessor Frank Wolak
2AbstractThe software industry in India has been growing at phenomenal rates over the lastten years. Currently a 17.15 billion rupee ($560 million) industry, it has experiencedcompound annual growth rates of over 40-50%. Based on interviews of Indiangovernment officials and over 35 CEOs and managers of Indian software firms andeconometric analysis of over 190 firms in the industry, this paper provides simpleframeworks to understand the start, growth and evolution of this industry. It focuses onthe behavior and incentives of both the potential clients of the software industry and theIndian firms. By understanding this behavior, we can understand why some Indiansoftware firms grew and gained large degrees of market power while others did not.These frameworks will then provide a context for analyzing actual firm and customerbehavior in the software industry.Traditional comparative advantage models only provide superficial explanations forunderstanding the growth of the Indian software industry. We must evaluate the industrybeyond the basic assertion that western firms wished to take advantage of the wagedifferential existing between Indian software firms and western software firms. Thisdoes not sufficiently explain the imperfectly competitive nature of the industry and the riseof some Indian firms and stagnation of others. In order to understand this behavior, onemust look at the transaction costs involved in using an Indian software company ratherthan a local, domestic one. Potential clients incur an additional search cost in trying to finda company that satisfies their needs and Indian firms must find methods to reduce thissearch effort. This paper examines specifically how Indian firms have managed to do thisthrough market signaling. Then, econometric analysis will provide an examination of therelative impact of these methods on individual firm growth.This study has important implications for understanding the growth of technologyindustries in developing countries. It provides an understanding of what these firms witha global view can do to grow in the international marketplace. Understanding this allowsgovernments to design effective policies to help firm level growth which then translatesinto overall industry growth.
3AcknowledgmentsI would like to first of all thank my advisor for this thesis, Professor Frank Wolakfor spending many hours at all times of the day and weekends explaining how economiststhink and construct solutions to difficult research problems. I would like to thank him formaking the creation of this thesis the most intense and rewarding experience of myacademic career.As well, I would like to thank Laura Selznik and the staff of the UndergraduateResearch Opportunities office for providing the funding for the field research andinterviews in India.I would also like to thank the members of the Stanford Computer Industry Project,Professor William Miller, Professor Timothy Bresnahan, Avron Barr, and Shirley Tesslerfor taking in an undergraduate and providing support, advice, resources to complete thisproject.I would also like to thank Professor Timothy Bresnahan and Professor PaulMilgrom for their excellent teaching of two of the best undergraduate courses at Stanford,Imperfect Competition and The Modern Firm in Theory and Practice. These coursesprovided a valuable basis for the development of this research.I would like to thank all the people listed in appendix A, who took time out of theirbusy schedules to allow me to interview them as part of this research.Finally, I would like to thank my parents who I know, no matter what anyonesays, will like this paper.
4What kind of industries develop in third world countries? Westerners often see visions ofthe poor, unskilled third-world laborer working for meager wages in work such as textileweaving or simple machine assembly. Workers toil for long hours and take jobs awayfrom westerners because of the lower labor cost brought on by the high population drivingdown the equilibrium wage. Because of this, one would expect developing countries toexport low technology, labor intensive products. This makes sense within the economictheory of comparative advantage. Countries export the goods and services in industries inwhich they are relatively better at producing. Developing countries with theiroverpopulation of unskilled labor should be relatively better at sectors that require theselaborers and as a result, they export goods and services in these industries (Caves,Frankel, and Jones 1996). Since the work requires unskilled labor and little technologyinvestment, the industry structure is usually extremely competitive in nature and a largenumber of small firms earn minimal profits. The ease of entry and exit causes thecompeting away of most profits and the lack of dominance of any one firm. Developingcountries have more or less followed this comparative advantage trade model over most ofhistory. For example, India primarily exports ready-made garments, gems, and leathergoods. All these goods require production factors in which India is relatively wellendowed.However, if a developing country has a large number of skilled labor in fields suchas science and engineering, can this model be applied in the same manner? If so,westerners will see a profit opportunity in using this large population since theirequilibrium wage is lower. High technology industries provide the best possibleallocation of this skilled labor since these industries require engineering talent. Thispresence of skilled labor explains the recent rise of high technology industries in certaindeveloping countries. When western firms see a profit opportunity in using the low-costtechnical talent, they find a method to use this talent. From the viewpoint of the
5developing country, people can profit by exporting the services of this talent to othercountries.Therefore, a straightforward application of this model may seem to explain therecent rise of the Indian software industry. Simply put, the Indian government hasdevoted many resources to university technical education which produced a large amountof technical talent. This drove down the equilibrium wage in India, and foreign companiestook advantage of this differential to increase profits. Although this may explain theindustry on a superficial level, it does not help us understand deeper questions regardingthe evolution of the industry. We still need to examine how the current industry structureevolved and why some companies grew and gained large degrees of market power whileothers did not. To understand these questions, one must explicitly reexamine thefundamental assumptions of these models. These traditional economic models assumezero transaction costs when trading internationally. However, transaction costs seem toplay a large role in the success of firms in the industry. These costs involve asymmetricinformation between the foreign customers and the Indian firms. Asymmetric informationoccurs because foreign firms do not have complete knowledge of the Indian firms andtheir abilities. Therefore, they incur additional costs in "searching" for the right companyfor their needs when trying to take advantage of the wage differential. Economists oftentake these costs to be zero or assume them to be negligible. However, this paper willargue that they actually play a crucial role in understanding the Indian software industry.If these costs are too high, it may not be worthwhile for foreign companies to use anIndian company for their software work. Then, a mutually beneficial transaction will failto occur (North 1989).According to traditional comparative advantage models, western firms wouldimport this Indian talent individually. Early in the development of the industry thispractice known as "bodyshopping" prevailed but now has decreased due to increasingregulation by western countries and India (Hass 1992). Other problems also occur in
6importing this talent from the standpoint of the western firm which increases the cost ofdoing this. Trying to find the people in India who have the relevant skills and knowledgethat the western companies need incurs additional costs. As well, companies may alsosuffer the risk that the person will not fit in with the nature of their work and culture. Inaddition, the western company may find it difficult to assemble a team of engineers fromIndia who have a diverse set of skills. Once the engineers come from India to the westerncountry, employers may not find it feasible to pay them differentially from everyone else.The creation of Indian software firms provides the solution to these problems.Western firms can shift these transaction costs to the Indian firms and they takeresponsibility for managing and assembling the software talent. This also maintains thewage differential existing between the two countries. To formalize this idea of the creationof firms to lower transaction costs, Milgrom and Roberts (1992) show that a firm canminimize both the coordination and motivation costs of the transactions between the twocountries. A firm minimizes coordination costs by better organizing the talents of theskilled workforce and using them in a more efficient manner than if they worked asindividuals. A firm also decreases motivation costs that arise from the informationasymmetry existing between the workforce in the developing countries and the westernclients. This information asymmetry arises because the companies in developed countriesmay not have all the information that they need to determine whether the people in thedeveloping country will satisfy their needs. Even with firms, the western clients have toincur search costs to find the Indian company that satisfies their needs but finding firmsinvolves lower transaction costs then finding individuals. Part of this reduction occursbecause Indian firms provide signals of their abilities to the overseas customer so that theywill feel comfortable using the company. If they did not, foreign companies may fear theuncertainty of knowledge about Indian software firms and may not use them especially inhigh technology projects that may be crucial to the eventual functioning of theirorganization. The nature and impact of these costs differ between organizations according
7to the type of sectors that the firms work in and the nature of the transactions. However,when looking at the Indian software industry with its customers in developed countries,this paper will argue that high motivation costs from information asymmetry exist andsuccessful firms in these types of industries must organize themselves to minimize thesetypes of transaction costs as much as possible in order to grow and gain larger degrees ofmarket power.In the first section of the paper, I will provide the relevant background on theindustry. Then, a theoretical model of the behavior of potential Indian software clientswill be developed and applied to actual client behavior. Then, once we understand howthe potential clients behave, I will theoretically model the Indian firm response and apply itto actual Indian firm behavior. Econometric techniques using actual data on over 190software firms in the industry will then examine the magnitudes and interaction of thedifferent factors developed in the models. The final section summarizes the findings andextends the implications of the model to other industries and developing countries. I thenwill suggest the public policy implications of the findings and speculate on the future ofthe industry.The Indian Software Industry OverviewIndia has build itself on traditions of mathematics and science. Today, it has theworlds largest technical workforce with over 3 million engineers, scientists, and othertechnologists and the second largest English speaking technical workforce. This largenumber of technical talent drives down the equilibrium wage in this sector. Less thanthree-fourths of this skilled workforce have technical or scientific jobs due to the lowerwage and fixed number of jobs available (Zorpette 1994). This occurs because atechnically trained person views this wage as the opportunity cost for going to work inanother sector. A lower wage lowers this opportunity cost causing the skilled workforceto move into other sectors. With Indian programmers available for less than $12 to $15per hour, Indian firms complete software projects for less than half the cost of in the
8United States (Krepchin 1993). Therefore, by the theory of comparative advantagediscussed above, the software industry should grow since foreigners see this lower wageas a free profit opportunity and exploit it. This creates a greater numbers of jobs in theindustry and the skilled workforce reallocates itself back into this sector.For 1994, the industry had sales of rupees 17.15 billion ($560 million) where tenyears back it had less than rupees 300 million ($10 million), and it only employs around120,000 people. The compound annual growth rate for the industry has been 38.6% withthe export industry growing at 46.6 %. The map in figure 1 shows the location of themajor software activity. 61 % of the exports are to the United States, 17% are to Europe,5% are to West Asia, 4% are to Japan, and 5% are to Southeast Asia (Mehta 1995). Thisindicates that countries did exactly what the theory of comparative advantage predicts andtook advantage of Indias high endowment of skilled professionals.The government set up several software technology parks in 1990 in locationsshown in the map in figure 1. These parks make entry into the international softwareindustry simple and only allow 100% export oriented units. Companies in these parks canimport goods duty free and for the first five years without corporate taxes. The parks havecentralized computing facilities and members get complete access to high speed datacommunication links and the internet. The leaders of the park provide the singlegovernmental contact for all procedures such as licenses, import certificates, etc. allowingIndian firms to avoid the bureaucracy of the central government. In export processingzones, the government allows duty free imports, income tax holidays, and simplifiedprocedures (The Indian Software Industry : Discover It ). The units maintain themselvesindependently from the profits they earn from the companies that use them. According toN. Gopalaswami, the joint secretary of the Department of Electronics, five STPs makeextremely high profits, four make slightly less, one is breaking even and two arestruggling.
9Figure 1 : The location of major software activity in India Source : Udell 1993Figure 2 shows the types of activities in the industry. The activities allow foreigncompanies to utilize fully the skilled talent available to them in India. Large scale turnkeyprojects for sectors such as telecomm, gem exploration, and mining dominate thedomestic software market while professional services top the export market. Theseprofessional services include customization of foreign packages and professionalconsultancy. Products and packages are not necessarily shrink wrapped packages butinclude general purpose products used for certain sectors (Mehta 1995). Much of thepackage work includes the creation of large scale vertical applications in areas such as
10banking, manufacturing, insurance and other financial services (Malhotra Aug. 16-311995). Consultancy includes integrating information technology into companies andinstitutions. Within the top 72% of software activities, 60% are done on site while 38%are done offshore in India.Domestic Software Export SoftwareActivity RupeesMillion% of total RupeesMillion% of totalTurnkey 3096 45% - -Professional Services - - 5040 50%Products & Packages 2416 35% 1030 10%Consultancy 422 6% 2275 23%Training 586 8% - -Data Processing 320 4% 805 8%Others 110 2% 870 9%TOTAL 6950 100% 10200 100%Figure 2 : Activities of the Indian software industry Source : Mehta 1995Many companies also serve as domestic distributors or "agents" for foreigncompanies. Companies like Microsoft or Oracle use these companies as points of entryinto the Indian software market. The distributors in India may further help integrate thisforeign software into Indian systems. Therefore, Indian companies acquire muchknowledge and quick profits by acting as these kinds of agents. Both lower end andhigher end markets use professional and consultancy services. The international marketrequires the higher end work with the latest techniques and methodologies. Smallercompanies usually dominate the lower end work that does not require the latest tools.Besides purely Indian companies, many joint ventures exist as shown in figure 3.Joint ventures allow a transfer of methods and capital from one company to another. Thewestern companies use their overseas partners as marketing channels and a source ofskilled labor for their overseas operations. As shown in figure 4, large foreign companiesalso set up wholly owned subsidiaries in India for the same purpose . Large holdinggroups of companies that carry a well-known brand name also contain many of thesoftware companies. For example, Tata Unisys and Tata Consultancy Services bothassociate with the well-known Tata group of companies.
11Indian Company PartnerCiticorp Overseas Software CiticorpHCL-HP Hewlett-PackardITC Lotus DevelopmentMahindra British Telecomm British TelecommunicationsMastek IngresOnward ComputerTechnologiesNovellPertech Computers Dell ComputerRolta India IntergraphTata Information Systems IBMTata Unisys UnisysWipro Infotech Sun MicrosystemsFigure 3 : Major Indian joint ventures Source : Udell 1993Indian Subsidiary Foreign OwnerDigital Equipment (India)Ltd.Digital Equipment Corp,USAModi Olivetti Ing. C. Olivetti & C., ItalyOracle Software (India) Ltd. Oracle Corp, USAHewlett Packard (India) Ltd. Hewlett Packard, USASiemans InformationsSystems Ltd.Siemans Nixdorf, GermanyFigure 4 : Major Indian subsidiariesSource : Malhotra Aug. 16-31 1995330 companies currently work in the business of software exports. In 1993-94,100 companies exported more than rupees 10 million in sales. This number was only 5 in1991. In 1993-94, 15 companies exported more than rupees 150 million. Only 3companies exported this amount in 1990. The top 20 Indian software exporters are shownin figure 5. The top 8 firms in the export market account for 35% of the industryrevenues. The top 20 companies obtain 70% of the industry export revenue (Mehta1995). The industry remains less competitive than comparable industries that requireunskilled labor and many of the top companies gain significant profits. Therefore, somecompanies gain a large amount of market power while others do not. An interesting trendalso seen in the industry is the move towards less market dominance by the top companiesand a more competitive structure.
12Company Exports(Rupeesmillion)1 Tata Consultancy Services 20002 Tata Unisys Ltd. 7503 HCL Hewlett Packard Ltd. 4054 Digital Equipment (India) Ltd. 384.15 ICIM Ltd. 322.56 Wipro Systems Ltd. 301.57 Silverline Industries Ltd. 3008 Pentafor Software & Exports Ltd. 2839 Patni Computer Services 282.510 Infosys Technologies Ltd. 274.911 Citicorp Overseas Software 247.312 Information ManagementResources243.713 Siemans Information SystemsLtd.199.614 Square-D Software Ltd. 194.315 Wipro Infotech Ltd. 155.316 Citicorp InformationTechnologies Industries Ltd.144.617 Tata Information Systems Ltd. 140.918 Mahindra British Telecom Ltd. 138.619 Texas Instruments (I) Ltd. 138.420 PSI Data Systems Ltd. 137.3Figure 5: The top 20 software exporters Source : Mehta 1995Models of Customer and Firm Behavior in the Indian Software IndustryIn developing a method to understand how transaction costs due to asymmetricinformation effect the Indian software industry structure and evolution, I will examine thebehavior and incentives of both parties in the transaction. First, I will examine thepotential foreign customers of the industry and see how they make their decisions. Then, Iwill use this information to examine how Indian firms have behaved to become successfulin satisfying these needs. Simple graphical models will provide a method to betterunderstand the decisions made by both sides.Behavior of Potential Indian Software Clients : A Theoretical ModelCompanies looking for software services realize that India has a large number oftechnically talented people available at a lower cost. As mentioned in the introduction,companies wish to use this talent to undergo their software projects at a lower cost.
13Western companies gain by the lower prices while technically talented people reallocateback into the sectors which suit their talents. This occurs because they receive higherwages due to the increase in demand for their services.Potential clients, however, remain unclear on the abilities of the Indian talent to docredible, quality projects within a well-defined time frame. In other words, informationasymmetry exists between the providers of the software services in India and the potentialcustomers in western countries. They do not know whether the talent in India has theability to provide the type of services or products in the manner and specifications that theyneed. This becomes especially crucial in large-scale software projects where the clientsorganization and profitability depends on the proper implementation and management ofsystems. At the initial growth of the industry, a viable domestic market did not even existwhich further raised the concern of potential overseas clients. In light of these concerns,how do the foreign companies gain the information on companies in India and find onethat may closely satisfy their needs and concerns?They have to search for them. Although western companies know of the cheapertechnical talent available to them overseas, they incur an additional search cost in lookingfor the firms that have the abilities to satisfy their specific needs. If this search cost is toohigh, clients may not find using the Indian talent feasible and a mutually beneficialtransaction will fail to occur. The transaction becomes profitable only if the benefit ofusing the Indian talent outweighs the cost of searching.Now lets try to model how the western firms behave when trying to select anIndian company. This model will include ideas of traditional comparative advantagemodels with the new concept of transaction costs involved in searching for the right Indiancompany. Consider a western firm searching for an Indian partner to complete a softwareproject. Subtracting the cost of using an Indian company from the benefit gives the gainthat the western firms obtain from using an Indian company
14Gw, I = Bw, I − Cw, I (1)where Gw, I = Gain to the western company in using Indian firmBw, I = Benefit to the western company in using Indian firmCw, I = Cost to the western company in using Indian firmNow, what is the benefit of using an Indian company? As mentioned at the beginning ofthe paper using traditional comparative advantage models, companies use Indian firms ifthe cost of a software project is cheaper in India then in the local domestic country asshown in equation (2).Bw, I = Cp, w − Cp, I(s) (2)whered(Cp, I)ds< 0Cp, I(s) < Cp, wCp, w = Cost of a software project done by western firmsCp, I(s) = Cost of a software project done by Indian firms = Search effort by western firms to attain required qualityThe cost of doing a project in India is a function of the search effort because the clientsearches for the lowest cost company and the more effort the client spends the lowerproject cost company he or she is likely to find. Therefore,Cp, I(s) is a decreasingfunction of s.Now what is the cost, Cw, I , of using an Indian company? As mentioned earlier,the western firm must spend effort searching for the right Indian firm that satisfies itsneeds and this effort incurs a search cost. Therefore,Cw, I = SC(s) (3)whered[SC(s)]ds> 0SC = search costThe search cost is an increasing function of search effort so that as a firm spends moreeffort searching, the search cost increases. Now plugging this into the equation (1).Gw, I = Cp, w − Cp, I(s)( )− SC(s) (4)
15Now, this function is maximized by taking the derivative of the above expression withrespect to search effort and setting this derivative equal to zero.dds[ Cp, w − Cp, I(s)( ) − SC(s)] = 0 (5)We get the following equation that maximizes the gaind(Cp, I(s))ds= −d(SC(s))ds(6)To ensure the existence of a maximum, we must assumed2(Cp, I(s))ds2 <−d2(SC(s))ds2Intuitively, this equation maximizes the gain of clients and indicates that they willcontinue to use effort in searching for a quality company until the search cost of spendingthe next marginal unit of effort equals the reduction in the cost of a project in Indiaobtained from using the next marginal unit of effort. This equilibrium level of searcheffort will be denoted as s*. Beyond s*, potential clients will no longer find it beneficialto devote these resources because the search cost of the next level of effort is greater thanthe cost reduction of spending effort finding the next, lower cost firm. Therefore, theywill chose the Indian company which best fits their needs within this search period. Thismodel provides a way of understanding how much effort the western client will spend insearching for an Indian company. However, it does not assume that the client will pickthe last, lowest cost firm. The client will chose from the firms that it encountered in theequilibrium level of search effort that also best fits its needs and provides the highestquality work. If it fails to find an Indian firm with the proper mix of skills within thissearch effort, it will go back to using its local, western companies. Some firms may evenfind searching for an Indian company economically unfeasible. This result where theequilibrium level of search, s*, equals zero is called a corner solution. This occurs whend(Gw,I (s))ds< 0
16Now that we understand this theoretical model of how potential clients behave, we canconfirm this by looking at how actual clients in the Indian software industry makedecisions.Actual Behavior of Potential Indian Software ClientsA 1992 World Bank funded study surveyed potential western clients on the criteriathey use in chosing software companies. Since the World Bank conducted the survey in1992, some issues such as communication infrastructure or security may not be as relevanttoday. However, this study does helps us to understand exactly the type of asymmetricinformation that exists in using Indian companies.The survey asked different groups of people to rate a set of decision criteria from 1to 5 (5 being highest). Figures 6-8 show the vendor rating when selecting softwaresubcontractors in their domestic market, the foreign market, and Indian market.0 1 2 3 4 5Work LocationTrack RecordTech ExpertiseStds SupportSecurityQualityPost-Impl. SupportManagementMachine AvailImmediate AvailabilityCostFigure 6 : Vendor criteria for selecting Source : Maxi/Micro Inc.,local, domestic software International Data Corporationcontractors and IDC (India) 1992
170 1 2 3 4 5Work LocationTrack RecordTech ExpertiseStds SupportSecurityQualityPost-Impl. SupportManagementMachine AvailImmediateAvailabilityCostFigure 7 : Vendor criteria for selecting Source : Maxi/Micro Inc.,foreign software contractors International Data Corporationand IDC (India) 19920 1 2 3 4 5Tech CompetanceStds SupportSecurityResponsivnessQualityProj ManageProductivityPost Impl, SuppOverall ImageDocumentationCostFigure 8 : Vendor criteria for selecting Source : Maxi/Micro Inc.,Indian software contractors International Data Corporationand IDC (India) 1992The survey results show some strong conclusions. When selecting foreign orIndian subcontractors, vendors rated cost as the second most important criteria, while forthe domestic subcontractors cost was not a major issue relative to other concerns. Thisprovides evidence for the move towards Indian software companies because of the costdifference as shown in the previous model. As well, quality ranks most important in allthree segments. Asymmetric information arises because vendors have more knowledge ofthe quality of their domestic companies than they do of the foreign companies. Therefore,they have to search for information on the quality of Indian companies.
18A similar survey was done for users. Figures 9-11 show the results for the usersurvey.0 1 2 3 4 5Work LocationTrack RecordTech ExpertiseStds supportSecurityQualityPost-Impl SupportManagementMachine AvailImmediate AvailablityCostFigure 9 : User criteria for selecting Source : Maxi/Micro Inc.,local, domestic software International Data Corporationcontractors and IDC (India) 19920 1 2 3 4 5Work LocationTrack RecordTech ExpertiseStds supportSecurityQualityPost-Impl SupportManagementMachine AvailImmediate AvailablityCostFigure 10 : User criteria for selecting Source : Maxi/Micro Inc.,foreign software contractors International Data Corporationand IDC (India) 1992A similar result appears for users with quality and cost as their top criteria. Again, whenwestern users want to use foreign and specifically Indian talent, cost is a larger factor thenwhen using domestic companies. We can also see that potential foreign users requireinformation on the quality, project management skills, and technical competence of theIndian software companies.
190 1 2 3 4 5Tech CompetanceSide SupportSecurityResponsivenessqualityProject ManagementProductivityPost-Impl SupportOverall ImageDocumentationCostFigure 11: User criteria for selecting Source : Maxi/Micro Inc.,Indian software contractors International Data Corporationand IDC (India) 1992A survey of vendors not doing business in India shows this asymmetricinformation in a stronger way. In this survey, the vendors gave a rating of what theirrequirements were in using Indian software talent and what their current perceptions were.The difference between the two ratings will be called the "GAP".GAP = (rating from 1-5 of what users or vendors require when using Indian firms) -(rating from 1-5 of users or vendors perceive when using Indian firms)The results are shown in figure 12. The notable large GAPs occur in the ease of doingbusiness, post implementation support, project management, and quality. Thecommunication infrastructure and security are no longer significant issues in the Indianindustry due to the rise of software technology parks and stronger piracy regulations.Now we can see exactly why foreign vendors do not use Indian companies. We see thisby looking at the results of the surveys of users and vendors in figures 12 and 13 whochose not to do business with Indian firms but rather use the local companies. For bothfigures, project management, quality, ease of business, and technical competence all havea GAP of greater than 1.
200 1 2Tech CompetanceStds. SupportSecurityResponsivenessQualityProj manageProductivityPost-Impl SupportOverall ImageEase of BusinessDocumentationCostComm InfrastructureFigure 12 : GAP for vendors not doing business Source : Maxi/Micro Inc.,in India. International Data Corporationand IDC (India) 19920 1 2Tech CompetanceStds SupportSecurityResponsivenessQualityProject ManagementProductivityPost Impl. SupporOverall ImageEase of BusinessDocumentationCostComm InfrastructureFigure 13 : GAP for users not doing business Source : Maxi/Micro Inc.,in India. International Data Corporationand IDC (India) 1992These differences in requirements and perceptions reflect the lack of completeinformation that vendors have in using Indian talent. They also reflect the high searchefforts that the vendors must spend in finding companies which fulfill their requirements.Putting this in the framework of the model developed earlier, these companies may nothave been able to find the right Indian company to satisfy their needs within theequilibrium search effort, s*, that they spent in trying to find them. Therefore, a GAPexisted between their requirements and their perceptions from the search efforts that theyhave done and they moved back to their domestic companies.
21Now that we understand the behavior of potential clients on both a theoretical andpractical level, we can turn towards the behavior of Indian firms in response to this.Again, I will examine this response on both a theoretical level and then a more practicalone.Behavior of Indian Firms : A Theoretical ModelUnderstanding this model of how potential clients behave can help explain theincentives for Indian companies. Successful Indian companies must increase the chancethat the searching client finds their company and selects it. Increasing the chance of being"found", means that a western company must find the Indian client within an s* amount ofsearch effort. If not, the client will never find the Indian company because he or she willnot find it economically feasible to devote any more effort beyond s*.Therefore, the Indian company has the incentive to lower the amount of effort thata western client must devote to searching for it. However, for an Indian company to dothis, it must devote its own resources to increasing its awareness in the market and mustalso convince the western company of its abilities once it is found. Therefore an Indiancompany would like to:1) Make it possible for the foreign company to find them at the minimal amount of searcheffort.2) Signal and convince the foreign companies of their abilities once the company findsthem.The effectiveness of these signals depends on if the foreign companies can use them toseparate high quality and highly skilled companies that match their needs from ones that donot. This separation occurs because less qualified companies do not find it economicallyfeasible to use the signals while qualified companies do. High quality firms that signaltheir abilities to foreign companies will tend to grow since they can effectively show theirpotential clients that they have the ability to do good work.To better understand this behavior, we can graphically model the reaction of theIndian companies given the behavior of the potential foreign customers developed earlier.
22In other words, we can see how companies can optimally react to the earlier model on thebehavior of potential foreign customers.Pindyck and Rubinfields (1989) model on job market signaling provides a simplebasis for examining the reaction of Indian companies. In the job market model, employersdo not have total information on the people they interview for jobs. However, peoplewithin the job market can signal their abilities by going to college. Since only the topquality people will find it worth the cost to go to college, it provides an effective signal ofabilities. By signaling their abilities, people reduce the amount of search effort that anemployer must spend in finding the right person for the job. This occurs because theirabilities are summed up in a single, measurable, and simple factor, college education.Employers know that the years of college education can effectively separate out productivepeople from nonproductive ones and, therefore, rely on it as a effective signal.In a similar manner, Indian companies must provide useful and credible signals oftheir abilities. These signals must reduce the search effort of the foreign companies in asimilar simple manner and clients should be able to rely on them as effective measures of afirm’s quality. Later in the paper, I will discuss the actual signals used by Indian softwarecompanies and examine the effectiveness of these signals in my empirical work using firmlevel data. Right now, I will motivate this behavior with a graphical model. I will useequation (1) but from the standpoint of the Indian firm as shown in equation (7).GI, w = BI, w − CI, w (7)where GI, w = Gain to the Indian firm in getting western clientBI, w = Benefit to the Indian firm in getting western clientCI, w = Cost to the Indian firm in getting western clientNow the benefit is the revenue received for undergoing a project with the western client.BI, w = RI, w (8)whereRI, w = Revenue received by Indian firm from western client
23Now recall that an Indian company must signal its abilities because of theasymmetric information that exists between the western clients and the Indian company.Examining both the cost and revenue side of equation (7) will help us to find theequlibrium level of signaling.Suppose that we represent the amount of a particular observable signal that anIndian company could use as y. Therefore in equation (7) the cost of obtaining a westerncompany is a function of a particular signal that an Indian company must do. If wepartition the Indian companies into two groups, we can better evaluate this cost. Group Icontains poor companies which do not satisfy the needs of the foreign companies wellwhile group II contains highly skilled companies that do. An important thing to rememberin developing this model is that membership in Group I or Group II is exogenous to themodel meaning that companies can not switch from one group to another. Group I faces ahigher cost in devoting resources to a particular observable signal. Companies in group Iwill not have the quality of resources to signal their abilities as would a group II company.For example, some quality companies signal their abilities by collaborating with a foreigncompany. Potential western clients hope that the partner provides the skills andmethodologies to make the company a credible one. Poorer companies may find it moredifficult to find a collaboration or may not find one at all since the collaborator will onlybecome a partner if it is profitable to do so. Poorer companies also have a lowerprobability of being chosen and, therefore, may have to devote more resources thannecessary to "fool" the customer with false signals. As well, they incur an addition costdue to the risk of entering the market with less of a quality company since they may not bechosen even if they are found. Realizing this, we can now examine the cost side ofequation (7) for both types of firms. For group I people, the cost of devoting moreresources to signal, y, is
24CI,wI(y) = ay (9)and for Group IICI,wII(y) = by (10)a = constantb = constanta > bWe can now look at the revenue side of equation (8). A western company mustrely on certain signals before it will chose an Indian firm that satisfies its needs. Thesignal must be simple such as years of college in job market signaling, and musteffectively separate the poor firms from the quality ones. Now lets assume that westerncompanies find that after a level of signal y1, they can be relatively certain that they havefound a good quality company that satisfies their needs. Therefore, they decide to use theIndian company that effectively provides this level of signal and the company gains thelevel of revenue r*. Remember that the western firm selects companies that it finds withthis level of signaling within the equilibrium search effort, s*. This increase in earnings isthe benefit of signaling and is shown in equation (11).Bw ,I = RI, w(y) =0 y < y1r * y ≥ y1(11)Plugging equations (9), (10), and (11) into equation (7) we get for group I.GI, w = RI, w − ay (12)and for group IIGI, w = RI, w − by (13)whereRI, w(y) = equation (11)Both group I firms and group II firms wish to maximize equations (12) and (13)respectively. Although we can do this by taking the derivative of the equations withrespect to y and setting it equal to zero, it may be easier to see the solution graphically as infigure 14 due to the step nature of the benefit function.
25C =ayC =byIIICost /BenefitofSignaly1Amount of SignalingR(y)Figure 14 : Optimal level of signal, y1Looking at figure 14, we maximize gain for group II firms at y1 since thedifference between the benefit and cost is greatest at this level of signaling. Group I firmssuffer negative gains at all signaling levels so they do not find it feasible to signal.Therefore, this signal effectively separates poor firms from quality ones and the westerncompany has selected the appropriate signal to find the right firm. If signaling is relativelyless costly, both types of firms will find it feasible to signal at y1 making the signalineffective in separating high quality firms from poorer quality ones as shown in figure15.We can now turn towards how the actual firms in the Indian software industryfollow the models developed in this section. The rest of this paper will be practical innature but will always refer back to our theoretical understanding developed so far. I willfirst examine how firms in the Indian software industry successfully signal their abilitiessuch that the client finds and selects the firm within s* level of effort. Then, empiricalanalysis on over 190 firms will help determine the relative impact and relationship of thesedifferent signals and how they effect firm growth.
26C =ayC =byIIICost /BenefitofSignaly1Amount of SignalingR(y)Figure 15 : Signaling by group I and group II firms when signaling is less costlyHow Indian Firms Lower Clients Search Effort by SignalingIndian software firms must devote their own resources to signaling their abilitiesso that the potential western client finds them within the equilibrium level of search effort.A firm could easily do this by providing homogeneous products or, in other words,providing the same good or service repeatedly. If a firm can show that it has undergonethe same type of consultancy work or project many times before, potential clients may notdoubt their ability to do it again. In fact, early in their development many successfulcompanies became identified with one or two particular areas and then expanded into otherareas as they grew. Wipro Systems specialized in systems work for the communicationsector and became experts in UNIX. The company quickly became identified with thesetwo areas and grew rapidly. The idea of product homogeneity even further explains therise in software products and package exports. Firms implement and slightly customizethe same products for the same type of application repeatedly. Once the company hasimplemented the packages many times before, it has no problem convincing a potentialcustomer that it can do it again. Manhattan Associates in Bangalore has an installed base
27of over 140 customers in the United States for its distribution, retailing, and warehousemanagement software.Relationships with leading foreign companies provide a powerful signal of theabilities of Indian companies. This occurs because the international company will have aknown name that the potential overseas clients recognize. Figure 16 shows these types ofrelationships.Type of Relationshipwith Foreign CompanyAmount of Ownershipby Foreign PartnerSubsidiary fullJoint Venture partialAgency Operations noneFigure 16 : Types of international relationshipsAligning with a western company in a joint venture allows Indian companies tosignal that they have gained knowledge from their partner. Overseas companies becomecomfortable in dealing with these Indian firms since they often recognize the partnersname and abilities as shown in figure 3. Members of the Indian software industry findjoint ventures advantageous since they both allow them to acquire the knowledge of theirpartner and signal their abilities easily to an overseas client. Overseas companies havethe incentive to undergo these joint ventures with Indian firms since they may find thattheir market share may be declining in their high priced services, and profits are increasingwith the Indian companies. In addition, the Indian companies often end up doing much ofthe work for their overseas partner. Therefore, it gives the foreign software companies aopportunity to take advantage of the cheaper labor costs in India in the same manner thatthe potential western companies do. They benefit from both sides of the transaction sincethey act as the software service provider and the customer.Vijay Thadani, CEO of NIIT, noted that the company relied heavily oncollaborations for gaining knowledge and signaling their abilities in the marketplace.Currently partnered with over 24 overseas companies, the company grew from itsinception in 1981 to an over rupees 123 crore company today. Increasing collaborations
28was the primary focus of NIIT early in its growth. They used a specific model ofinteraction with their collaborations where both sides benefited by learning from theiralliance, refining their methodologies, mastering them, and giving back to partnersthrough software work and training.When clients need a large amount of important systems work on a continual basis(like a worldwide bank), they may devote extensive resources to finding the right Indiancompany and may still not find one within s*. However, they find ways to exploit thiscost difference by setting up branches in India known as "wholly owned" subsidiaries.By setting up a subsidiary, western firms reduce the asymmetric information costs becausethey have complete control over the running of the organization. Many of these whollyowned subsidiaries exist in India where the Indian branch does work solely for the parentcompany. Figure 4 shows some examples of these organizations. The empirical work ofRamachandran (1993) found that subsidiaries of companies in India do indeed receive thegreatest amount of resources over any other type of ownership. This provides evidencethat these foreign companies try to maintain control over these subsidiaries to undergoprojects using their standards and methodologies.Joint ventures and wholly owned subsidiaries show a type of signaling wherewell-known companies have some type of ownership of the Indian technical talent.However, another type of international relationship arises where foreign companies haveno ownership. This occurs when Indian companies do agency operations. Agencyoperations are when an Indian firm becomes a distributor of a well-known, overseassoftware company such as Oracle or Microsoft. They may even undergo projects thatinvolve implementing the western software that they distribute. The foreign companiesoften train the Indian firms on the products as well as the methods of implementationallowing them to quickly acquire knowledge from the foreign companies and apply it toother types of work. Potential customers in foreign countries recognize this and feel moreconfident in using these companies especially if the companies have successfully
29implemented the software in the domestic market before. As well, knowledge of particularproducts makes it easier for the foreign client to see exactly the type of skills that thecompany has acquired. Therefore, the client can more readily evaluate if the Indiancompanys skills match their needs.So far, we have seen how international relationships may provide a means tosignal to overseas companies. However, some Indian companies have relationships withlarger, more well-known Indian companies such as a widely recognized Indian holdinggroup. However, this signal may not be as strong since the foreign client will not have asmuch knowledge about them as an international partner. Therefore, to evaluate theeffectiveness of these signals, we must turn to empirical data to see whether foreigncompanies see these as credible signals and have knowledge of the Indian partner. Manycompanies remain part of these larger groups and execute software projects for othermembers of the holding group. They use this to show that they have done successfulprojects and have acquired skills help them venture into other markets. Many softwarecompanies also arise as offshoots of hardware companies that need softwareimplementation along with their hardware work. These companies effectively"piggyback" off hardware sales and gain considerable expertise that can signal theirabilities to overseas customers.The creation of overseas branches provides one of the most effective ways thatIndian companies have to decrease the amount of resources that foreign companies have tospend in searching. By developing branches in every region they target, companiesmarket directly to the companies and provide a local point of contact to the foreigncompany. As well, foreign companies can easily find information about the companythrough local branches and can receive local support for the work that the Indiancompanies do. Marketing through these offices must be specific and aggressive. Manyless successful companies rely too much on "word of mouth" marketing or previouscontacts. However, the simple development of branches does not ensure the abilities of
30the companies unless it has already established some type of reputation or signals itsabilities to the overseas customer through methods previously described. Branches simplyprovide a vehicle for the flow of information from India to the overseas customers.Current Industry StructureHow does this theory explain the current structure of the Indian software industry?The top 8 firms in the export market account for 35% of the industry revenues. The top20 companies obtain 70% of the industry export revenue. The remaining hundreds ofsmall to midsize companies obtain only 30% of the total revenue (Mehta 1995). The largercompanies do higher end customization and reengineering using the most currenttechniques, methodologies, and technologies mostly for the international market while thesmaller companies tend to do lower end customization and reengineering that requiresimple computerization and information technology needs. Companies generally gainmarket share in the industry by effectively signaling their abilities to the overseas customerand convincing the potential client of their abilities.The largest companies were often the first ones to start international work early inthe growth of the industry. They were "pioneering brands" as noted by Schmalensee(1982) where they establish themselves early as quality companies with a reputation forgood work. Schmalensee showed that through this method companies can differentiatethemselves in a manner different from simply advertising. In Schmalensees model,companies enter sequentially into the market and the potential customers feel initiallyunsure about the quality of the firms work. When the overseas client become convincedthat these first companies can execute the work by seeing them do it successfully, they usethem as a benchmark to rationally judge subsequent entrants. This gives later entrants adisadvantage because the overseas customer must invest search effort in learning about thenew companys quality and abilities while they already know about the establishedincumbent in the industry. In this framework, the later Indian software companies will nottry to totally emulate the current pioneering companies. Rather, they will differentiate
31themselves from the current leaders so a sizable amount of foreign companies find thempioneering and not following. Therefore, to penetrate the market, new entrants must doeither one of two things. They can either provide a higher quality product or lower theresources that the foreign companies spend on learning about quality through signaling.As noted by B V Vankatesh, Executive Director of the three year old BFL software, thebiggest competition in the international market is not multinationals, but homegrowncompanies like Tata Consultancy Services, Wipro, and Infosys since they haveestablished themselves well in the market.The concentration of the industry provides evidence that significant entry barriersexist in international work. The top ten companies work in an oligopoly structure wheresignificant barriers come from either being pioneering firms or having already signaled tothe bulk of the potential overseas market. However, the hundreds of smaller companieswork in more of a competitive nature with easy entry and exit and lower prices. The largercompanies have made large investments to disseminate information about themselves andto signal new clients. This includes the formation of branches and numerous jointventures, large training facilities, and constant knowledge of the latest technology. Forexample, figure 17 shows some statistics for the largest and oldest companies in the Indiansoftware business.Company 1995SoftwareRevenue(Rs.Crore)Number ofEmployeesYearsOpenNumberofcollabora-tionsNumber ofagencyoperationsNumberofbranchesTata ConsultancyServices35228 4400 27 0 6 43Tata UnisysLimited10846 1598 17 3 6 30Wipro Infotech 9393.92 1789 14 2 0 28Figure 17 : Signaling by "pioneering" firms. Source : Malhotra Aug 1-15, 1995Companies in the more competitive sector do have an incentive to invest inproviding information to the customer since it allows them to gain market power despitethis relatively competitive structure. Investing in methods to disseminate information
32makes it more difficult for later companies to gain power. Therefore, they can keep theserents and prevent competitors from accessing them. When a firm invests in marketsignaling, clients can either use the firm in which they already have knowledge or invest infinding information about an unknown firm. Customers usually find it profitable to staywith the known firm.Companies may not find other types of investment as profitable such asinvestment in technology or new methodologies. Once a firm in the competitive sectorstarts using a new technology, all the firms start using it causing the competing away ofpotential profits. Therefore, companies wishing to transition away from this competitivesector have incentive to invest in methods that signal their quality methodologies and theirabilities to overseas clients rather then in methods that simply advance their techniques.However, they must invest in new technology to at minimum keep up with thecompetitive nature of the industry.In order to improve information dissemination and gain market power, firms mayrequire large investments. Rationally, this should not be a problem since it is an immediateprofit opportunity. Venture capital companies "search the streets" of cities like Bangaloreand Bombay to find unknown companies that have the potential to grow and manycompanies make money through agency operations and collaborations. These all providesignals of quality and sources of capital for investment. In addition, many spin-offs oflarger holding companies and engineering firms have gained investment capital throughthese associations.Empirical Examination of Indian Software FirmsExamining data on actual firms in the industry and modeling their behavior canprovide a quantifiable means for understanding how different aspects of the theory in theearlier section impact firm behavior. As mentioned before, firms must spend a certainamount of search effort in trying to find an Indian company that does quality work and cansatisfy their needs. They find it feasible to do this only until the marginal search cost
33equals the decrease in the project cost from searching. If a company does not find theproper Indian firm within the equilibrium level of searching, it will use domestic softwarefirms. Therefore, a quality Indian firm has the incentive to signal its abilities to thewestern firms so that the firm finds them within the equilibrium search effort, s*. Indianfirms signal at a level where the revenue received from signaling exceeds the signaling costas much as possible.When companies select signaling levels that do this, they grow since their revenuesexceed their costs and they gain profits. Recall that western companies rely on thesesignals because only higher quality firms will find it beneficial to use them as shown infigure 14. This section examines different signaling devices that Indian firms have usedand their contributions to the firm growth in this manner. If both poor and high qualitycompanies find it economically feasible to use a particular signal, the western companywill not use it and the signal will not contribute to Indian firm growth.Keeping this theory in mind, I will develop an empirical model and apply it toover 190 firms in the industry to evaluate the magnitude of the impact of these signals onfirm growth rates. This way, we can evaluate which signals western firms rely on andwhich ones are not as effective. In this section, I will first discuss the nature and sourceof my data set. Then, I will discuss the variables that I examine in my model. Finally, theempirical model and its results and implications will be presented.The DataOne of the largest Indian computing publications, Dataquest published byCybermedia (India) Ltd. (not to be confused with Dataquest Inc., a company of Dun &Bradstreet, USA) prints a special, annual two volume issue that provides comprehensiveanalysis and data on the Indian software industry. This paper uses annual firm datacompiled for the years 1991-1995 by Dataquest. The data set includes an analysis of 193firms over this period. The composition of the firms in the set is shown in figure 18.
34Subcatagory # of firmsAge of Company<10 Years Old 148>10 Years Old 45Size of Company<100 Employees 154>100 Employees 39MarketsInternational or International +Domestic94Domestic Only 99Figure 18: Characteristics of firms in the data setDescription of VariablesThis section describes the variables on the Indian firms that were analyzed in the empiricalmodel.Dependent VariableGROWTHThis variable represents the continuously compounded one-year growth rate in firmrevenue from to to t1 where to represents the base year and t1 represents the followingyear. The growth rate is calculated by the equationGROWTH = ln (Revenue (t1) - Revenue(to)) (14)The entire data set consists of the one year transitions in revenue growth from 1991-92,1992-93, 1993-94, and 1994-95 for the selected firms. In other words, each firm couldhave up to 4 observations in the data set representing each of the one-year transitions inrevenue over the specified time period.Independent VariablesThe independent variables were taken in the base year of the one year transition in revenuegrowth. Therefore, the model examines how initial conditions effect the one year growthrates for each of the years examined.YEARSThis variable represents the number of years that the firm has been in business from itsstartup to 1995.
35INTERINTER is the percentage of the firms revenue that is obtained through international work.EMPLOYEMPLOY represents the number of employees in the company.BRANCHThis represents the number of branches that the firm has either overseas or domestically.SQBRANCHThis is the square of the BRANCH variable.COLLABThe COLLAB variable represents the number of overseas collaborations that the companyhas.SQCOLLThis is the square of the COLLAB variable.GROUPGROUP is a dummy variable that is "1" when the firm is a member of a well-knowndomestic holding company or set of companies and "0" otherwise. For example, themost popular group of companies, Tata, contains Tata Unisys and Tata Consultancyservices. Each of these companies would have a dummy variable of “1”.HWGROUPThis is another dummy variable which takes the value of "1" if the company mainly doeswork in hardware but has a software portion and "0" otherwise.AGENCYA company that has agency operations provides domestic distribution and service ofoverseas products for well-known companies such as Oracle or Microsoft. This variablerepresents the number of overseas companies that the Indian firm is an agent for.
36The ModelThe goal of developing this model is to show how well the industry actuallyfollows the theory previously discussed. Recall that foreign companies wish to takeadvantage of the less expensive engineering talent available in India but have to spendresources to search for the right company to satisfy their needs. This occurs because oftransaction costs due to asymmetric information existing in the market where the foreignclients may not have knowledge of which companies to use and which ones can do qualitywork. Good Indian companies, therefore, have the incentive to lower the search cost forthe foreign client so that the client "finds" them. This accounts for the imperfectlycompetitive nature of the Indian software industry where some companies who caneffectively signal their abilities to the foreign companies grow and gain market powerwhile others do not. In this section, I will develop a model to show the impact andinterplay of these different signals and how they account for their growth. Often, thesimplest models can provide the most powerful and intuitive results and this is the type ofmodel I will develop here.An important thing to remember is that the dependent variable, GROWTH,represents the one year growth rate. Therefore this empirical model looks at how thesedifferent methods of lowering the potential clients search costs by signaling effect itsgrowth rate. A rate accounts for the size effects that occur when using revenue levels.In general, a company’s growth rate will tend to slow down as it becomes larger. Thisoccurs because the older company has fully signaled to a large portion of their potentialclients and thus experience lower growth rates. I attempted to take these types of effectsinto account in the model.Before examining the signals directly, I first attempted to see whether the numberof years that a firm has been in the industry increases the growth rate. In other words, dothe potential clients chose the Indian firm based on the length of time they have been in thebusiness or size. Therefore, the YEARS variable was included in the model.
37The model presented earlier shows that only good, quality firms will haveincentive to devote resources to signaling to the potential customer. Therefore, we cansee if the amount of international work has an effect on the growth rate. Since only good,quality companies find it worthwhile to signal, companies that obtain a larger portion oftheir revenue through international work may tend to grow faster by taking advantage ofthe rapidly growing international market.Branches located near target customers provide an effective way to lower searchcosts for the client. They also provide a simple way to disseminate information on thecompanys abilities and methodologies. However, one would expect that branches mayhave a different effect on growth rates when the Indian firm creates the first branch versesthe thirtieth branch. When they develop the first branch, they signal to a large, newmarket. However, as time progresses and the company gains a reputation, the brancheswill have less of an effect in growth. Therefore, the model contains the branch variable ina nonlinear way by having a branch and (branch)2 specification.A similar theory applies for the collaboration variable. The effect of the firstcollaboration may differ from that of later collaborations. Therefore, the model alsocontains this variable in a nonlinear manner. Recall that a collaboration with an overseascustomer provides a powerful signal to the potential overseas client. It shows that theIndian company has learned the methodologies and techniques from the overseas partner.Therefore, the potential client may feel more comfortable using a company with anoverseas collaboration.Agency operations where an Indian company distributes a foreign productdomestically also provides a signal to the potential overseas client. Often, the Indiancompany must modify the product for different types of domestic customers and mustreceive direct training from the foreign company to do this. Therefore, when the Indiancompany moves into the international market, its potential client may feel more confidentof its abilities since it has had direct knowledge of the product. The strength of the signal
38comes from the knowledge that the foreign client has on exactly the type of skills that thecompany has acquired since the products that the Indian firm sells domestically are oftenpopular worldwide. Therefore, we would expect a different effect than collaborations andbranches with the agency variable. As the company starts selling more productsdomestically, it shows that it has acquired more directly measurable skills on moreproducts causing the effect on growth to be similar for the first agency operation as thethird. Therefore, the model contains the agency variable linearly.The final empirical model is specified in the following manner :GROWTH= + 1YEARS + 2 INTER+ 3EMPLOY + 4 BRANCH+ 5SQBRANCH + 6COLLAB + 7SQCOLLAB + 8GROUP+ 9 HWGROUP+ 10AGENCY + et(15)ResultsThe regression results are shown in figure 19. In general, the results confirm theimportance of signaling to lower the effort that the client must spend in searching for theIndian company and shows how these signaling techniques cause some companies togrow and gain market share while others do not. We can also now understand themagnitude of the impact of each of these variables on a company’s ability to grow.Specifically, the YEARS variable appears to be estimated precisely and isnegative. This confirms two aspects of the theory described earlier concerning the twotypes of firms :1) Lower quality firms (Group I firms described above) do not find it worthwhile tosignal in the international market or try to signal but do not do so effectively. They sufferin growth over time and fail to gain market share in the industry. This is described in thetheory based on the Pindyck and Rubinfield (1989) model on labor market signaling.2) Firms who have grown to a significant level have fully signaled to a large bulk of thepotential international market and tend to have slower rates of growth over time andsometimes suffer negative growth. These include the "pioneering" firms described by
39Schmalensee that entered the industry early on and have already established a reputationfor good work. These will tend to grow at slower rates as they spend more years in theindustry. The effect of number 2 above is further confirmed by the EMPLOY variablewhich shows that the size of the company essentially has no effect on its growth rate.The precision of the BRANCH variable indicates that companies tend to growwhen they create more overseas branches because they signal their abilities easily bybranching in the markets that they directly target. Notice that the square term is slightlynegative indicating that after a certain point, the effect of branches tapers off. This usuallyoccurs with "pioneering" firms that have become large and have already signaled to a bulkof their potential market. For this particular model this effect occurs at about 38 brancheswhich is very close to the number of branches established by the largest and oldest firmsin the business as shown in figure 17.The SQCOLLAB variable also appears to have a nonlinear relationship with thegrowth rate. Although the level of COLLAB has no effect, the SQCOLLAB shows thatcollaborations have an increasing effect on growth rate. In other words, the firstcollaboration increases the growth rate differently then the fourth or fifth. This makessense within theory since collaborations provide powerful signals that the company haslearned the software development methodologies from their overseas partner. However,this indicator does not take into account the type of company that the Indian firm hascollaborated with but only looks at the number of collaborations. A collaboration with alarger, well-known company may have more of an effect than a smaller overseas partner.This may account for the lower level of precision of the t -stat in the regression. Aninvestigation of the linear COLLAB variable provided no precise or meaningful results.In a similar manner, the AGENCY variable shows that distributing a foreignproduct provides a signal of the abilities of the company. However, again, this indicatoronly takes into account the number of companies that the Indian firm distributes for not thetype of company. This may account for the lower level of precision of this variable as
40well. For both the SQCOLLAB and the AGENCY variables, a general conclusion can bemade that the increase in these relationships with foreign companies provides a goodsignal of abilities and increases a companys growth rate.Dependent Variable GROWTHIntercept 0.45065(6.48899)YEARS -0.013083(-2.40507)INTER 0.012447(2.63897)EMPLOY -3.44E-05(-0.464344)BRANCH 0.031265(2.62923)SQBRANCH -4.01E-04(-2.91764)COLLAB -0.066882(-0.649062)SQCOLL 0.028157(1.22002)GROUP -0.124923(-1.35754)HWGROUP -0.170359(-1.77964)AGENCY 0.027041(1.26799)No. of observations 358R2 .044(t-stats are indicated in parenthesis under the coefficients)Figure 19 : Estimation of empirical model parametersThe effect of a firm having a relationship with other, more well-known, Indiancompanies rather than an international one provides an interesting result in this model.The variables up until now such as COLLAB, SQCOLLAB, and AGENCY reflectrelationships with overseas, western companies. However, the GROUP and the
41HWGROUP dummy variables show software companies with relationships with otherIndian companies. These relationships tend to have a negative to no effect on the growthof Indian software firms making these ineffective signals to obtain potential overseas ordomestic clients. Lets look at this from the framework that was developed earlier. Apotential overseas client has to spend resources in searching for an Indian company.Signaling aims to lower the amount of resources that the foreign company has to spend infinding an Indian company that suits its needs. Recall that an effective signal must besimple to do and a useful indicator of abilities such as the number of years of collegeeducation in the market for jobs. If an Indian company has a relationship with a foreigncompany that is well-known around the world such as Microsoft or Silicon Graphics, apotential client has immediate knowledge of their abilities and skills. However, if anIndian company has a relationship with another Indian company, the potential westernclient still may not have knowledge of their abilities since they may not know what thecollaboration does or how good the collaborator is. In order to find this out, the clientmust search even more which incurs additional cost and takes away the simplicity andeffectiveness of the signal.As well, these signals may not be effective in separating poorer Indian firms fromhigh quality ones as shown in figure 15 and both types of firms may find it economicallyfeasible to use them. Indian firms may find domestic partnerships easier and moreinexpensive to undergo so both high and low quality firms may use them. Therefore, theydo not provide a useful indicator of ability and the client does not find them beneficialsignals.This has occurred for many of the companies with the exception of the Tata groupof companies such as Tata Consultancy Services and Tata Unisys who have grown atphenomenal rates. They have grown because of their ability to collaborate with overseascompanies and set up branches early in the company history. As well, these were the“pioneering firms” that Schmalensee discusses in his paper. This advantage is no better
42shown than by Dr. Nirmal Jain, Senior Vice President of Tata Consultancy Services(TCS) who answered when asked why TCS grew at such a high rate, “We were therefirst.” They had the advantage of establishing themselves first in the industry early on andestablished a reputation for quality by quickly collaborating and branching. TataConsultancy Services was established over 27 years ago and Tata Unisys entered theindustry 18 years ago in collaboration with Unisys Corporation in the United States.So why would companies bother joining hardware groups or larger holdingcompanies if it seems to hurt their growth in the industry? The highly successful WiproSystems Limited, the sixth largest company in the export market shows an example of thiscase for the HWGROUP variable. The software work was done as a part of implementingthe communication hardware that they developed. The prime focus of the work washardware, not software and the software was done only so far as it was needed toimplement the hardware. Therefore, the growth or decline of the software portion ofWipro depended on the type of hardware that they developed. This explains a portion ofthe negative growth in the HWGROUP variable. The GROWTH variable for theHWGROUP companies reflects the growth of the software portion of their work nothardware and software combined. The companies who are members of larger groups ofcompanies also tend to have similar characteristics. The holding groups may set up thecompanies to do software work for other group members. Therefore, the growth in theirsoftware revenue may depend heavily on the type of work that other members of theirgroups need. Again, they may not focus on their software revenues but on growth of theirother companies using software implementation and development.Structural Stability of the ModelAn important thing to examine is if this empirical model developed above remainsstable among different subsets of the data. In other words, does this model apply both tosmall and large companies? Do the coefficients in the model differ between older
43companies and younger ones? or is the model applicable to all types of firms? The Chowtest provides a way to test this (Gujarati 1995).What I want to see is if the empirical model undergoes a structural change betweendifferent subsets of the data. In other words, I am trying to see if the parameters of themodel such as α or the βs change between these subsets. If they change, a separate modelmust be estimated for the particular subset of the data. If not, the entire sample can beestimated with one single model. The Chow test simply uses the F test with the residualsum of squares from the individual, subset regressions and the combined regression. Thedata are first separated into two subsets of data containing n1 and n2 observations whichare hypothesized to be structurally different. The residual sum of squares for thecombined regression, S1 is found. Then each subset is used to estimate the model andthe residual sum of squares, S2 and S3 are found for each subset. These two are thenadded together and become S4. S5 is then found by subtracting S4 from S1. The F testfor the Chow test is thenF =S5 kS4 (n1 + n2 − 2k)(16)If the F value exceeds the critical value of F, the null hypothesis that the parameters are thesame is rejected. In other words, we reject the hypothesis of structural stability.The data was put into logical subsets that might not be structurally stable and the resultsare shown in figure 20.Subset 1 firms >10 yearsoldfirms >100employeesfirms doinginternationalworkSubset 2 firms<10 yearsoldfirms<100employeesfirms working indomestic onlyFChow test 1.002 0.4142 .9732Fcritical 2.4 2.4 2.4df numerator 11 11 11df denominator 336 336 336Result fail to reject fail to reject fail to rejectFigure 20: Results of Chow Test
44In all subsets, we fail to reject the null hypothesis that the model differs. Therefore, theempirical model remains structurally stable for all types of firms across the dataset and wecan apply it to any firm in the industry. This is a powerful result of the model indicatingthat it may have explanatory power for all types of firms.Implications of StudyReturning to the first question of this paper, what kind of industries develop inthird world countries? This paper focuses on the rapid growth of firms in Indias softwareindustry. Can we cross apply this experience to other countries? The software industriesin developing countries need two things before applying any of this analysis. First of all,there must exist skilled software professionals that can do software work according to theneeds of an international client (or can learn to do so). Secondly, some type wagedifferential must exist between the programmers in the developing country and theirwestern counterparts. In this paper, it was taken as given that skilled professionals existedin the market and firm growth depended on lowering the asymmetric information betweenexisting firms and their potential clients.International relationships play a large role in the development of this industrybecause they both provide signals to potential western clients and allow the Indiancompany to learn from their partner. However, western software companies will onlycollaborate if they find it profitable to do so. This occurs when they can use the Indiancompanies to make money not only in the international market but also in the domesticmarket through agency operations. Again, this profitability relies on the assumption that asufficient amount of skilled programmers already exist because if they did not, therewould be no reason for the foreign software company to believe that the Indian companywill make any money. These international relationships also provide a large amount offunding to increase the signaling in the international market by methods such as creatingoverseas branches and specialties in particular sectors or technologies.
45The notion of agency operations implies that some type of viable domestic marketmust exist. As noted earlier, NIIT relied heavily on foreign partners for their growth inthe industry. Companies joined them because they promised to help the companies selltheir products or services in the domestic market. A domestic industry is also crucialbecause entrepreneurs can begin in the domestic market and then venture internationally.Five business school students with only classroom knowledge of computer programmingstarted Mastek. They ventured into the international market only after workingdomestically for five years. (Desai, 1994).Now even if these parameters such as skilled and inexpensive software talent and apotential domestic market are in place, how can the government help increase the growthsoftware industry? Remember that Indian companies will grow because they signal in away that allows clients to find them within a low level of search effort. Therefore, thegovernment can simply help the Indian companies signal their abilities easily. In India,the government has successfully undergone large scale marketing efforts in other countriesthrough brochures and conventions. They also provide easy means for smaller companiesto disseminate information through the creation of the Software Technology Parks. Theseparks provide a method for smaller companies to signal internationally by providing basiccommunication links and supplies to enter the industry easily. The Export ProcessingZones have lowered the cost of importing hardware and provided tax breaks forcompanies engaged in 100% export work. This further reduces the cost that foreigncompanies incur in collaborating with Indian firms. The recent liberalization of theeconomy also allows international companies to enter the industry easily. As well, theIndian government has helped many companies signal quality by providing simplifiedprocedures for ISO 9000 certification.Future of the IndustryAs the industry progresses, more firms will have the ability to signal and foreignfirms will become more comfortable using Indian software firms. The number of firms
46that have either fully signaled to a bulk of their potential market or have proven theirabilities through previous work will increase. Many Indian firms will also have longstanding relationships with a number of western firms. All these factors considerablylower the search effort that clients have to spend in finding an Indian company to matchtheir needs.Because of the increase in reputation due to a history of effective signaling andlowering of transaction costs, western firms, banks, and venture capitalists have beentrying to fund new Indian software start-ups which helps the start-ups invest ininternational signaling efforts. This type of funding by well-known venture capitalists andinvestment banks may also be a new signal that acts in a similar way to collaborations. Ifthe western bank or venture capitalist has been successful in starting up companies in thepast and then funds an Indian start-up, western firms may feel more comfortable using thenew company. This is another example of the model discussed earlier. Only qualitycompanies will find it economically feasible to signal internationally through these meanssince venture capitalists fund only high quality start-ups.The domestic software industry which historically lagged the international one hasbeen fast at catching up with growth rates of 40-50% over the last few years (Mehta1995). The domestic level of hardware including multi-user systems, servers, and single-user systems has increased over 64% between 1994 and 1995 (Malhotra Aug. 1-15,1995). As western companies clamor to gain market share in this rising Indian market,Indian firms continue to undergo successful collaborations and agency operations. Aswell, the rise of the domestic market allows smaller companies to enter and gain significantexpertise and specialization by starting locally.The largest firms who have been in the industry for a long time and have alreadysignaled to a bulk of their market still have the potential to grow if they use theirexperience to move into higher end work such as software packages. The growth of thedomestic market helps this movement since the firms can sell their packages at home
47before venturing internationally. Dr. Nirmal Jain, Senior Vice President of TataConsultancy Services, the largest software company in India, related that TCS has thepotential to move into this market since it has learned much from the failure and problemsof earlier packages. It has recently been successfully selling its financial accountingpackage, EX in the domestic market.The current growth in the Indian software industry has been so great that theincreasing demand for Indian programmers has been driving up their wage and increasingthe cost of Indian software projects. Does this mean that the Indian software industry maylose its competitive edge? Although this wage differential has provided a basis for the startand rise of the industry up until now as I described in this paper, the long standingrelationships, gain in reputation, and quality of work which has increased during thisevolution may outweigh the closing wage gap. As described in earlier models, the closingwage gap leads to a lower search effort by western firms but up until now, Indian firmshave been able to establish strong signals and long standing reputations that have madethese searches successful. Although these models provided a good explanation of the startand growth of the industry, perhaps future models should include other factors for usingIndian companies in addition to wage differentials.
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