A New Way to Think about Fighting Poverty

(This article originally appeared in Ross Thought In Action and has been republished with permission.)

Michigan Ross Professors outline a cost-based evaluation to optimize how private money is used for social ventures.

Private money that goes to poverty fighting ventures often does so under a number of catchphrases — patient capital, impact investing, social enterprise, social capital, and others.

But those terms help muddle how these ventures actually work and ultimately hinder poverty alleviation, say Michigan Ross Professors Paul Clyde and Aneel Karnani. It’s an understanding they’d like to clear up, because the prospects of reducing poverty have never been better, thanks in part to private-sector interest.

Their latest research is a way for investors and donors to better understand whether it has to sacrifice some profits in a social venture and, if so, to what extent. They argue this clarity is needed because delivering products and services to the world’s poor often involves a subsidy.

But where that subsidy lies is a key question.

“Most people understand that social entrepreneurship, or whatever term you use, involves some sort of subsidy,” says Karnani, professor of strategy. “But what’s not clear is the extent of it, or what would be the most effective way to subsidize. We take an approach that combines the logic of economics and accounting. Let’s not just throw around phrases.”

Their paper, “Improving Private Sector Impact on Poverty Alleviation: A Cost-Based Taxonomy,” was published in the California Management Review. (Subscription link.)

Ideally, private companies would be able to reduce poverty without sacrificing profits or offering a subsidy. A famous example is mobile phones, where technological advances and innovative business models helped bring those devices to the world’s poor.

But Karnani and Clyde argue this is an exception. Other purely for-profit ventures serving the world’s poor have had trouble reaching scale.

“We’re not taking a position on what donors and investors should or shouldn’t do,” says Clyde, Tom Lantos Professor of Business Administration and president of the William Davidson Institute. “But let’s lay some groundwork to describe what’s really going on. All these buzzwords tend to shove things under the rug, which can lead people to make suboptimal decisions.”

Clyde and Karnani outline four main subsidies common to ventures serving the poor, and the benefits of drawbacks of each:

• Subsidize equity costs. This is when an investor to a social enterprise expects a lower return than with other market ventures. “This isn’t often seen as a cost or a subsidy, but it really is,” says Clyde. “You can put $1 million anywhere. If you put it into a social venture and just get the investment back instead of putting it in the stock market for a bigger return, you’ve made a contribution. It’s an opportunity cost.” Though there have been successes with this approach, it doesn’t lead to lower prices on its own. Even a zero percent return doesn’t allow for low enough prices on products and services in most cases, they say.
• Subsidize assets. Some ventures can cover their operating costs once they have a physical location. A philanthropist or organization can donate a location or cash to build one. Usually a cash transfer is more efficient, but even that has drawbacks. Having a physical asset, such as a fully subsidized building, reduces the incentive to economize. One way to remedy that is to subsidize only the the initial investment. That way many efficiency incentives remain. “The idea is to distort the market as little as possible,” Karnani says.
• Subsidize annual fixed costs. This is a higher level of subsidy than an asset subsidy, and could reduce efficiency incentives long-term. But some organizations have found a way to limit that risk. Sustainable Healthcare Foundation, for example, has donations that cover annual fixed and asset costs, but not variable costs. That scenario retains some benefits of the market.
• Subsidize customers. Sometimes poor customers cannot cover even the variable cost of a product. Providing products that cover basic needs may be considered a human right, regardless of ability to pay. Obviously a market distortion, but in some cases society is better off providing the product or service to the poor at very little or no cost.

“Our goal is to help investors and donors clarify the cost structure,” says Karnani. “It applies to donors, investors, policy makers, everyone who talks about social entrepreneurship, which itself is kind of a vague phrase. It’s useful for anyone trying to solve this serious problem. Let’s just be clear about the extent of subsidy.”