Institutions and the Organization

of Rural Production and the

Reforms

Lectures 6 and 7
A framework is needed for studying developing countries
(for individuals that live in certain types of environments with certain
types of preferences):

There is a special environment in rural areas of developing countries:

a.) the environment in developing countries are unlike those in

traditional economics ... we have consider the specific
characteristic of developing:
they are full of risks / information is costly …
agrarian economies which are spatially disperse, making
enforcement difficult, slowturn around and a place in which
people are poor and face high risks;
b.) unlike traditional economies where there are good markets, in
developing economies, like that in rural China, markets are
often absent. Therefore things like labor markets and insurance
markets do not exist.
We assume that individuals in the economy have a certain set of
preferences:

a.) wants to achieve high income and consumption …

while enjoying as much leisure as possible
b.) wants to even out income and consumption over time, to
avoid risk and disaster, and to make provisions for
dealing with the consequences of unavoidable risks.
c.) must face these simultaneously since insurance markets
do not necessarily all exist ...
In this part of the lecture we want to set up a conceptual
framework that is able to explain the institutions that affect
behavior of individuals in developing countries … we want to
understand institutions for several reasons … in order to:

1.) understand how people organize production …

2.) explain patterns of ownership …
3.) examine the way in which people relate to each
other: e.g.: village leaders/villager … township
leader/factory manager … etc.

Basic assumption: Institutions – production relations /

ownership / person-to-person relationships – are jointly
determined by preferences and the environment within people
live and work
Preferences, Environment and Behavior in Rural China
Environment:
Riskand
Risk andInformation
costly Preferences
Behavioral Determinants
poor information

A1 A2 A3 A4 A5 A6

Risk Costly Selfish Consump. Effort Risk

Information (+) (-) Averse

C1
Assymetric Information

C2
Incentive Problems
(Moral Hazard and Adverse Selection)

C4 Demand for Insurance

 Nature of the Environment in Rural China and Effect on Organization of Production

A7 A8 A9 A10 A11
Spatial Transport Seasonality Risks Yield
Dispersion Cost -- yield (weather) Risk
High -- timing Covariance
-- market
-- life cycle

Travel
C time intensive:
high Travel
information costs
Time Intensive

A10
Synchronous
Timing
A11
High Cost C1 C2 A2 or A11
Of Information
Acquisition No Banks in
Rural Areas

Because difficult/impossible to monitor: a.) C10

Leads to no labor markets in agriculture / b.) Absence of
poor efficiency of collective farming  Crop Insurance
dominance of family farming
 Using the Framework to Understand
China’s Rural Organization and
Economic Performance

Lecture 7

• Why Collectivization of Agriculture failed

• Why Rural Reforms (Household

Responsibility System) worked so well
 Rest of Lecture 6
• Lets use our “material and behavioral framework” … to explain the institutions that we
observe around us …

• Why is there polyandry in Tibet (and polegamy in West Africa … )

and Utah

• Why didn’t parents allow kids to marry for love?

– Why do cute riverside village girls always get married to strong mountain boys?
– Dowry: Do girls in China get ‘shortchanged’ by not being included in the inheritance process
(fenjia)?
– Why do girls in South China command a high bride price; and girls in North China need a
hefty dowry?
– How does one explain the “strange” marriage forms in China … like child brides / delayed
marriage …

• Why do those in England practice primogeniture and those in China practice multi-
geniture?

• How would a loving Mom and Dad ever send their child to a Sweat Shop? … or a
House of Prostitution?

• Why did Chinese parents bind their children feet?

• And more …
 New Schedule
• Last week – Lecture 6 (given during Tuesday and
Thursday  on developed a framework for:
“Understanding the material and behavioral determinants
of institutions in developing countries / China”) … we
used this framework to explain many of the institutions
that we observe in history … and today …
• Skip Lecture 9 (Gradualism – as a Reform Strategy …)
• New Schedule for this week … we will continue to use
the framework … to understand the choices and
outcomes that have driven the reforms in China …
– Lecture 7 (Today—Tuesday 2/5)
• Motivate Gradualism …
• Why collectivization did not work
– Lecture 8 (Thursday 2/7)
• The Rise and Fall of TVEs … a story of the ultimate victory of
privatization
• Quiz … next Tuesday (2/12)
Gradualism … A Strategy that was
only a Strategy after the fact

• Motivation: “booming economies in the

rest of the world … stagnation at home
PLUS: need for openness with the West,
in order to counterbalance Soviet threat

• Methodology: “crossing the stream by

feeling the rocks”
 Realization of Gradualism – part I
• Start with the unplanned part of the economy (Agriculture
—this is what we will talk about today)
– Do not allow reforms to occur in industry … in China’s cities during
1978-84, it is mostly “business as usual”

• Decontrol the production and sales of secondary

commodities (fruits / vegetables / eggs / tofu) … Keep
control of key commodities (grain / cotton / tobacco)

• Open the Door … but only the back door … and keep the
rest of the doors to that room locked
– 4 Special Economic Zones
– Where? In the south (remember the geography lecture … isolated
from the rest of China)
– Only let State agencies become engaged in import and export

• Communist Party is in complete control …

 Gradualism—Part II
Main strategy … inch out from areas that were successful … allow markets to
play a small role in periphery of many sectors …

• Within agriculture:
– More commodities (meats / soybeans)
– Partially allow sales of grains (after the quota is completed
– Allow free markets (once state’s share is completed)

• From agriculture to the rest of the rural economy … and beyond

– Township and Village Enterprise Reform (on Thurs.) … run by leaders/ party
members
– Begin to let some reform of non-key commodity enterprises in urban areas …
allow rural traders with food to enter urban areas (migration restrictions relaxed)

• Open the door a bit wider:

– From 4 SEZ’s to 14 Open Coastal Cities
– Allow private firms to trade in non-central commodities (especially exports …
e.g., textiles / toys / tools)

• Communist Party is in complete control

 Gradualism—Part III
Victim (beneficiary) of their own success

• Small traders in agriculture more successful than state traders 

state traders in some areas outcompete state traders in others …
[lots of food everywhere] … make state traders redundant … more
private traders enter … state traders lobby for reform … entire state
sector is not needed …
– Though keep control of grain until late 1990s … and tobacco until now
…
• TVEs / industry … same story (Thurs) …
– Put pressure on urban industries … they lobby for reform … decontrol
… reform … privatization … [though keep control of oil and media and
steel and communications and …]

• Trade / FDI …
– In come 100000s of traders … out-compete state trades … soon any
one can get license … [except in key sectors: like energy / minerals /
airplanes]
 Using the Framework to Understand
China’s Rural Organization and
Economic Performance

Lecture 7

• Why Collectivization of Agriculture failed

• Why Rural Reforms (Household
Responsibility System) worked so well

Again: this is an illustration of two things:

a.) why material and behavioral factors determined which
institutions was best
b.) gradualism, step 1
 Just a foreshadowing of the
consequences of the tradeoffs

• Yields/Production (1952-1978): >2% per

year …
– Good … but, population was rising at 2+% per
year

• Productivity (TFP): ZERO

• Income/capita: ZERO
 Mao’s promise: Improve Rural
Livelihoods (and Modernize)
• Give farmers land (from Mao’s point of view
this was paying them off for their support
during the Revolution … and a way to raise
their assets and incomes)

• But, Mao believed that traditional agriculture

was backward, and lacked economies of
scale … this led to experimentation with
collectivization
 Increased efficiency from collectivization

Food

Source of efficiency
gains:
for a given amount of
labor, if farmers share
tools and collaborate in
certain tasks, such as
transplanting and
harvesting, can get more
output for same amount
of labor and/or land ….
or get same amount of
Labor or Land
 But there is a cost to collectivization …

• Have to look at the decline in efficiency from

collectivization …

• Then compare tradeoffs: gains from

economies of scale VS. costs from lower
incentives …

• How does collectivization affect incentives

 Non-economic concerns for
collectivization
• [another view: it did not matter … gains to Mao
were beyond economics …

• as claimed in the “Mao Years,” collectivization

was also a way to help “plan and control” the
rural economy … a way to simplify planning the
unplanned economy … and increase ability of
the State to extract resources and support
China’s number one goal of modernization, even
at the expense of rural welfare]
 Farming and returns – by household itself

Food Output -- kgs

5400
5300
5100

4800

4400

3800

3000

1 2 3 4 5 6 7 8

Weeks of Labor
 Economics of Farming as a Household
Each manweek is worth 300 RMB to the household (could produce that much in garden in private plot
… or that is how much leisure is valued)

Profits from Farming as a Household

Labor Output Marginal Price for Marginal Marginal
week (kgs) product output increase in cost (Y)
(kg) value (Y)
Point of profit
1 3000 3000 Y1/kg Y3000 Y300 maximization:
marginal
2 3800 800 Y1/kg Y800 Y300 revenue equals
to marginal cost
3 4400 600 Y1/kg Y600 Y300 … therefore,
when household
4 4800 400 Y1/kg Y400 Y300 farming by itself,
they will put in 5
5 5100 300 Y1/kg Y300 Y300 weeks of labor
and produce
6 5300 200 Y1/kg Y200 Y300
5100 kgs of
Y1/kg Y100 Y300 grain and earn:
7 5400 100 3600 yuan
8 5400 0 Y1/kg Y0 Y300
 Farming and returns – by 2-member collective
At end of season, split returns (½ and ½) with your partner
Food Output -- kgs

Returns to
other
1/2 household

2700
2650 2550
2400
2200
Returns to
1900 OWN
1500 1/2 household

1 2 3 4 5 6 7 8

Weeks of Labor
Economics of Farming as a Collective: Note reduction in effort (from 5
weeks of work to 3 weeks … because only get part of return!
Each manweek is worth 300 RMB to the household (could produce that much in garden in private plot
… or that is how much leisure is valued)
Farming as a 2
Profits from Farming as a Household person collective
Labor Output Marginal Price for Marginal Marginal Marginal Marginal
weeks (kgs) product output increase in cost (Y) product increase
(kg) value (Y) (kg) in value
(Y)

Y1/kg Y3000 Y300 Y1500

1 3000 3000 1500
Y1/kg Y800 Y300 Y400
2 3800 800 400
Y1/kg Y600 Y300 Y300
3 4400 600 300
Y1/kg Y400 Y300 Y200
4 4800 400 200
Y1/kg Y300 Y300 Y150
5 5100 300 150
Y1/kg Y200 Y300 Y100
6 5300 200 100
Y1/kg Y100 Y300 Y50
7 5400 100 50
Y1/kg Y0 Y300 Y0
8 5400 0 0
Incentive problems with collectives
• Because they get only part of the return, they will
naturally reduce their effort …

• But, remember, there is a collective manager (the

commune leader) … and a party secretary …
– They will monitor effort
– They will use normative incentives (fly flags; play
music; shout slogans; recite Mao’s Red Book)

[Will this solve the effort problem and induce

farmers to put out more effort?
Think of farmer preferences and environment]
 Farming and returns – by household itself

Food Output -- kgs

5400
5300
5100

4800

4400

3800

3000

1 2 3 4 5 6 7 8

Weeks of Labor
 Farming and returns – by 2-member collective
At end of season, split returns (½ and ½) with your partner
Food Output -- kgs

Returns to
other
1/2 household

2700
2650 2550
2400
2200
Returns to
1900 OWN
1500 1/2 household

1 2 3 4 5 6 7 8

Weeks of Labor
Incentive problems with collectives
• Because they get only part of the return, they will
naturally reduce their effort …

• But, remember, there is a collective manager (the

commune leader) … and a party secretary …
– They will monitor effort
– They will use normative incentives (fly flags; play
music; shout slogans; recite Mao’s Red Book)

[Will this solve the effort problem and induce

farmers to put out more effort?
Think of farmer preferences and environment]
Preferences, Environment and Behavior in Rural China
Environment:
Riskand
Risk andInformation
costly Preferences
Behavioral Determinants
poor information

A1 A2 A3 A4 A5 A6

Risk Costly Selfish Consump. Effort Risk

Information (+) (-) Averse

C1
Assymetric Information

C2
Incentive Problems
(Moral Hazard and Adverse Selection)

C4 Demand for Insurance

 Nature of the Environment in Rural China and Effect on Organization of Production

A7 A8 A9 A10 A11
Spatial Transport Seasonality Risks Yield
Dispersion Cost -- yield (weather) Risk
High -- timing Covariance
-- market
-- life cycle

Travel
C time intensive:
high Travel
information costs
Time Intensive

A10
Synchronous
Timing
A11
High Cost C1 C2 A2 or A11
Of Information
Acquisition No Banks in
Rural Areas

Because difficult/impossible to monitor: a.) C10

Leads to no labor markets in agriculture / b.) Absence of
poor efficiency of collective farming  Crop Insurance
dominance of family farming
 Failure of Collectives and Inability
to Benefit from Economies of Scale
• Therefore:
– Poor incentives
– Inability to monitor
Leads to reduced efficiency … people work
less and inefficiently

• And then need to compare: reduction from

incentives VS. gains from economies of
scale
 Net change in efficiency from collectivization:

+ gains from economies of scale

Food
– losses from incentives
Gains from economies of scale

Reduction in
Net loss from efficiency
collectivization from poor
monitoring

Reduction in
effort from
poor
incentives

Labor or Land
 Impetus to Reform
• Deng Xiaoping’s First and Greatest Contribution
to China: Rural Reforms
• Started with Household Responsibility System
(HRS)
• Began in 1978 … as an illegal experiment in
Anhui (farmers were starving; production was
almost nothing; leaders gave up; collectives
collapsed; naturally started to farm as
households again)
• When leaders visited (unofficially), they saw the
results were remarkable …
 Implementation of HRS
Percent of villages adopting HRS
• Village allocates plots of 100
land to the farmers 90
• Farmers have to pay 80
taxes and deliver quota 70
(part of their crop at 60
below market prices)
50
• Farmers get to make 40
cultivation decisions
30
(control rights)
20
• Households gets to keep
10
ALL residual output …
0
they earn 100% of profits 1978 1980 1982 1984
NOTE: land still “belongs” to
collective … restrictions on rental Rapid adoption of HRS
… and sometimes on uses
 Gains from HRS:
+ although loss economies of scale

Food – great gains from incentives

Increase in New point of output from HRS

Net increase from efficiency
decollectivization because
farmers self-
monitor

Increase in effort
since hh gets full
return for effort
(incentive effect)

Labor or Land
 Result of
Outputs andHRS:
Inputs of Soybeans
in China, 1979
Corn Production, 1979-95
to 1995
200 Output
growth: +7%
150 from 1980 to
1985
100

50 Input
Growth: < 0
0
1979 1981 1983 1985 1987 1989 1991 1993 1995

Ouput Index Input Index

 TFP for Wheat in China, Maize
1979-95
200
Wheat
170

Rice
140

110
17 year period: 3.5 - 4%
annually
80
Recent 10 years: 2% annually
50
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997

Growth of Wheat, Rice and Maize Productivity in China,

1979 to 1997 (shifting UP of the production function)
 Per capita income in rural
Average:330%; Bottom 10%:180%; Top
10%:407%
7500 7500

6500 Average 6500

Botton 10% Top 10%

5500 5500

4500 4500

3500 3500

2500 2500

1500 1500

500 500

-500 -500
1980 1985 1990 1995 2001 1980 1985 1990 1995 2001
 Other reforms
• Raised prices (administratively)
• Lift trading restrictions (locally)
• Allowed selling sidelines in local markets and in
the cities
• Allowed crop choice / sideline activities
• TVEs … and off farm work (Thursay)
• Fiscal reform (hardened budget constraints, and
gave local leaders incentive to raise revenues …
you get to keep and spend what you raise)
 Gradualism!
• Did not allow interprovincial trading (1985 or so)
• Did not allow migration to cities without permission (late
1980s)
• Did not allow private enterprises (late 1980s)
• Still rationed food in the cities at low price (until 1992)
• Did not get rid of quotas … or government’s role in
marketing (2000)
• Did not allow private sector to import/export grain (WTO
in 2001)
• Right to Rent Land without Permission (2004)
• STILL TODAY:
– Do not allow permanent move to cities
– Purchase / sell land (still belongs to village)