Autonomy and Incentives in Chinese State Enterprises ⑧ Theodore Groves; Yongmiao Hong; John McMillan; Barry Naughton The Quarterly Journal of Economics, Vol. 109, No. 1 (Feb., 1994), 183-209. Stable URL: http: //links. jstor. org/sici?sici=0033-5533%2819940229109%3A1%3C183%3AAAIICS3E2.0.CO%3B2-S The Quarterly Journal of Economics is currently published by The MIT Press. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http: //www.jstor.org/about/terms. html. jstor's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. P Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http: //www.jstor. org/journals/mitpress.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is an independent not-for-profit organization dedicated to creating and preserving digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org. http://www.jstor.org/ Fri May2123:03:592004
AUTONOMY AND INCENTTVES IN CHINESE STATE ENTERPRISES* THEODORE GROVES YONGMIAO HONG JOHN MCMILLAN BARRY NAUGHTON When the responsibility for output decisions was shifted firm, and when firm e allowed to retain more of their profits, managers of Chinese state-owned enterprises strengthened workers'incentives. The managers paid more in bonuses and hired more workers on fixed-term contracts. The new incentives were effective: productivity increased with increases in bonus payments and in contract workers. The increase in autonomy raised workers'incomes(but not managers'incomes)and investment in the enterprise, but tended not to raise emittances to the state I CHINAs INDUSTRIAL REFORMS In deciding the best way to reform a planned economy, one of the crucial questions is about the prospects for improvements in state-owned firms' notoriously low productivity. Can changes in policy induce state firms to perform better? We shall offer evidence that in one reforming economy, China, state-owned firms'produc tivity has been significantly improved by the introduction of some lementary incentives Beginning in 1978 and continuing throughout the China reformed its industrial sector. Enterprises that had d been largely controlled by the state were given some market or market like incentives(though by the end of the decade, twelve years into the reforms, they were still a long way from looking like capitalist firms). State-owned enterprises were allowed to keep some fraction of their profits, where before all profits had to be remitted to the state Enterprises began to sell some of their outputs and buy some of their inputs in free markets, rather than selling and procuring everything at state-controlled prices. Managers were given mone- tary rewards explicitly based on their firm s performance, and the right to decide what to produce, how much to produce and how to produce it was shifted from the state to the enterprise [Byrd 1991 Naughton 1994 "We thank ulia Lawrence Katz and three ref comments, and the Fo 1994 by the President and Fellows of Harvard College and the Massachusetts Institute of The Quarterly Journal of Economics, February 1994
184 QUARTERLY JOURNAL OF ECONOMICS Workers' lack of motivation has been a major problem in Chinese enterprises. That productivity could be improved by strengthening the workers' incentives is suggested by anecdotal accounts of inactivity in pre-reform Chinese factories--of workers idling away the day after fulfilling some minimal quota. One of the reforms tried in China was the shifting of responsibility for output decisions from the level of the state to the level of the firm. another as to increase the fraction of its profits that the firm could retain The hypothesis to be developed and tested here is that a firms manager should respond to these increases in autonomy by strengthening the workers'performance incentives, and as result, the firm should become more productive Reforms can be ineffective Managers may fail to respond to the opportunities created by their expanded autonomy. Partial efforts at reform may be contradictory either with themselves with the remnants of the planning system. It is often argued that artial reforms are useless. " I am relatively pessimistic about the effectiveness of reforms that rely on shifting decision making and financial responsibility to the enterprise level until there is a fundamental reform of the price system, 'says Johnson [1988, pp S241-$242], for example: " Planned control by the center of inputs d output may well be a superior nth best solution to decentral- ized decision making with an inappropriate price structure. We sk whether China's partial reforms--shifting decision responsibili- ties to managers while leaving the firms state- owned-has resulted in perceptible improvements in enterprise productivity Our empirical analysis will ask whether, when the responsibil ity for deciding output levels was shifted from the state to the firm and when the firm's marginal profit-retention rate was increased agers of Chinese state-owned enterprises responded by strengthening the discipline imposed on workers(by increasing the proportion of the workers'income paid in the form of bonuses y increasing the fraction of workers whom, being on fixed-term contracts, it was in principle possible to fire). We shall then ask hether the new incentives were effective. Did productivity in crease significantly with the stronger incentives? The next set of questions will be about who benefited from the reforms. Did the increased autonomy result in higher incomes for workers or managers?Was autonomy followed by more investment by the enterprises? Did autonomy result in smaller subsidies or larger Chinese industrial productivity growth accelerated markedly
AUTONOMY IN CHINESE STATE ENTERPRISES in the reform period of the 1980s. Before the reforms, industrial productivity had been almost stagnant. Total factor productivity grew at an annual rate of only 0. 4 percent between 1957 and 1978 (according to Chen, Hongchang, Wang, Zheng, Yuxin, Jefferson and Rawski [1988]), but this changed after the reforms began Between 1978 and 1985 industrial productivity grew at an annual rate of 4.8 percent [Chen et al. ] and it continued to grow strongly after 1985. For the firms in our sample, between 1980 and 1989 total factor productivity rose at an average annual rate of 4.5 Not all of this improvement in productivity is attributable to the particular reforms we investigate here. A large number of reforms were introduced in gradual and piecemeal forms. Changes in behavior were the result of the total impact of these incremental reforms. An important source of gains is the extra discipline resulting from the increased product-market competition that these firms have faced, both from other state firms and from new nonstate firms [McMillan and Naughton 1992]. Gains also came from better methods of selecting managers and from linking managers' pay and career prospects to their firms'performance [Groves, Hong, McMillan, and Naughton 1993a]. The reforms we analyze here are only part, but an important part, of a broad I. THE COSTS OF HIERARCHY In order to learn about costs so as to decide on appropriate output quantities, and in order to learn how to organize production o as to minimize costs the ultimate decision-maker (the central planner in a planned economy, or the firm s manager in a decentralized economy) must rely in part on information that comes from below. Information about how high costs are whether workers could be reassigned to increase productivity, whether ng held, what improvements tion techniques could feasibly be introduced how well newly introduced techniques are working, and so on must be gathere from workers and foremen. Information inevitably becomes dis- es from other data sets show similar increases le of twenty state enterprises, that productiv 978-1982
186 QUARTERLY JOURNAL OF ECONOMICS torted as it moves up through the organization, Bargaining costs are created as people try to use any information they have to influence the decisions that will be based on that information(as Milgrom and Roberts [1988, 1990] noted in their theory of influence costs ). Costs of hierarchy arise from the fact that information becomes distorted within the firm as it is transmitted from production floor to management, and in the case of firms subject to central planning, the information is further distorted in the communications between the firm and state agencies, as has been noted by observers of Chinese enterprises. "The basic prob- lem is that the narrow channels connecting subordinates to superiors become clogged with pseudo-information, which is often intentionally distorted. While the system continues to report thousands of bits,of data, the actual information content is quite limited"[Naughton 1991]. " In their dealings with industrial bureaus and government agencies, managers engage in continual face-to-face bargaining over the setting of mandatory production lans., and in procuring low priced supplies, subsidized credit and tax breaks. The bargaining, invariably including a measure of deception, and sometimes the cultivation of official favor, has several goals"[Walder 1987, p. 36 People' s proclivity to exploit any information they have affects the incentive system offered within a firm. In the McAfee -McMillan [1991] model of the interaction of hierarchy and incentives, informational asymmetries and the rents they create result in workers being given incomplete performance incentives. The incen tives imposed on production workers will be more stringent according to this analysis, the shorter the hierarchical distance between the production floor and the ultimate decision-maker. The logic of this result is that informational distortions increase cumulatively as information moves up a hierarchy, as each person through whose hands the information passes uses the information to gain some bargaining advantage The shorter the hierarchy therefore, the less concerned the top decision-maker need be about giving incentives for information transmission, so the more the decision-maker can focus on providing performance incentives The mere fact that the right to make output decisions is shifted from the state to the enterprise ought by itself to result in stronger worker incentives and consequently improved productivity. 2In he McAfee- McMillan [1991] model w the watk er'i htp xt depsenTheothaoages
AUTONOMY IN CHINESE STATE ENTERPRISES what follows, we use data on reform-era Chinese state enterprises to test this proposition Managerial decision-making autonomy would be meaningles however, if the enterprise were required to remit all its profits to le center. Conversely, the larger the fraction of its profits the enterprise is allowed to retain, the stronger the manager's incen ternal incentives of increases in the enterprise s marginal profit- re differences in managers and bureacrats'objectives provide an additional reason why the grant of output autonomy will be followed by a strengthening of workers'incentives. The industrial bureau may want to maintain excessive employment at the expense of productive efficiency [Boycko, Shleifer, and Vishny 1993].The shifting of decision- making rights to the manager will result in production being organized more efficiently, provided that the manager is at the same time given a stake in the firms profits (which increases in the marginal profit-retention rate and other managerial reforms did achieve--see Groves, Hong, McMillan, and Naughton [1993a]) Bonuses, having been denounced in China as politically unac ceptable in 1966, were revived in 1978 [Walder 1987, pp. 23-24 But giving managers the right to offer bonuses to workers did not ensure that they were immediately used: bonus payments did not suddenly increase but rather rose steadily through the 1980s It is personally costly for a manager to institute an incentive-payment scheme, in that it creates contention between workers and manage ment, as well as among different groups of workers. Rewarding performance usually means increasing disparities among different workers' remuneration. Disputes arise over how to assess perfor- e contract for the worker, and the planner for the manager. H (as myerson cigre s hared. The wert ad therefore ret tt theinfoffe ng e n nager has acquired the worker information rhgotmates with the manager,the Tirole [1986] showed ). By the time the plar 物m ction
QUARTERLY JOURNAL OF ECONOMICS mance, how much to reward seniority, whether it is fair to create income inequalities, and so on. In the wage adjustments that occurred in 1977-1978 and 1979-1980. for instance the"evalua tions often became conflict-ridden, dragging on month after month affecting morale, and creating dissatisfaction among those not chosen to receive raises"[Walder, p. 27]. Thus, managers may be reluctant to introduce incentive schemes, even if they are being ncouraged to do so by the state The managers must be given sor positive inducement to bear the costs involved in introducing yorker incentives. In addition, the rules that govern bonuses may affect the ability of managers to institute effective incentive- payment schemes. When bonuses were first revived, the total amount that could be paid in bonuses was fixed at a specified percentage of the wage bill, typically 10 percent. With total incentive payments limited, and growing only as rapidly as the basic wage workers correctly treated bonus distribution as a ero-sum game and resisted differentiation. In 1984 the limit on onuses was replaced by a progressive bonus tax paid by the enterprise. With this change, workers may have begun to perceive bonus distribution as a positive-sum game, reducing the costs incurred by management in instituting effective incentive-payment schemes. during the course of the 1980s, increased authority and autonomy granted to managers may have increased the effective- ness with which bonuses were used to elicit work effort granting the manager autonomy changes the managers incentives over the design of the workers'incentive system ccording to the MeAfee-McMillan [1991] model. Making it the manager's role to decide output, rather than merely to pass information up to the center, changes the managers personal calculus. When decisions are made at the center, they are made using information supplied by the manager. It is in the manager's interest to exploit whatever bargaining power is to be obtained from his information. Thus, the information on which the center bases its decision is distorted. When the buck stops at the manager, more efficient decisions are made because there are now fewer transmission ch manager would be expected to introduce performance payments to induce more effort from workers As well as immediate monetary rewards, workers can be given rt incentives by facing the prospect of losing their job. An additional consequence of output autonomy, therefore, is that managers will expand their ability to fire workers. Most workers in
AUTONOMY IN CHINESE STATE ENTERPRISES 189 Chinese state enterprises have permanent jobs, but an increasing number have been hired on fixed-term contracts. It is easier for a manager to refuse to renew a worker' s contract at the end of his term than it is to fire a permanent worker. According to aggregate data, a contract worker in 1989 was six times as likely to have a contract terminated as a permanent worker was to quit or to be fired [State Statistical Bureau 1990a, pp 204, 218 The introduction of an incentive-payment mechanism does not by itself guarantee that a factory' s productivity will rise. It might be that in practice bonuses are paid out equally, regardless of individual productivity, so that they have no incentive effect.Often it is difficult to define adequate output measures, and basing ayment on the wrong measures of performance can be counterpro ductive. Workers might collude against management, subverting attempts to reward good performers by imposing social sanctions on anyone who works too hard. Similarly, although workers on contracts in principle can be laid off at the end of their term so that they have some incentive to exert effort, in practice it may be that their contracts are always renewed, and thus they are effectively the same as permanent workers. Thus, it is necessary to look at the data to see whether the strengthening of worker incentives was real or just apparent and whether the new incentives actually succeeded in improving productivity II. TRENDS IN AUTONOMY, INCENTIVES, AND PRODUCTIVITY The data we use come from surveys conducted by the Institute of Economics, Chinese Academy of Social Science(CASS),in consultation with the authors of this from the University of Michigan and Oxford University. Annual data for 1980-1989 for 769 enterprises in four provinces(Sichuan Jiangsu, Jilin, and Shanxi)give details of the firms'internal incentives, the firms cost and revenue accounts, and the nature of lationship between the firms and the state. The questi naires were sent out by the provincial System Reform Commis- sions (which are responsible for assessing and implementing reform measures)to 800 enterprises, and 769 valid questionnaires were returned. The System Reform Commission does not directly supervise enterprise activity, but it is an official government body with which the enterprise has regular interactions, which may account for the esponse rate. The questionnaire had two parts. The first part, directed specifically to the factory manager
190 QUARTERLY JOURNAL OF ECONOMICS sked 70 questions, mostly qualitative, relating to the firm Incentive s system and its relation to governmental supervisors.The second part, designed to be answered by the enterprise accountant asked 321 quantitative questions covering almost every aspect of enterprise activity during the years 1980 through 1989 All the firms sampled are state-owned, and large firms are overrepresented in comparison to state-owned firms in general The sample therefore covers the core of the traditional state-run economy, the set of enterprises for which it is generally held that progress in reforms has been modest, compared with the small- scale, nonstate sector. The sample appears reasonably representa- tive of state-run industry as a whole in dimensions other than enterprise size. Output per employee in 1980, the first year of the sample, was 11, 329 yuan, 6 percent below the national average. B 1989 output per employee had increased to 18, 891 yuan (in constant 1980 prices) and was now 3 percent above the national average. Between 1980 and 1989 real output per employee in creased 67 percent in the CAss sample slightly better than the 52 percent increase recorded for state-run industry as a whole Beginning in 1979, the Chinese government began granting expanded autonomy provisions to selected enterprises nationwide Initially, enterprises were granted rights to retain a share of profits and to sell some output outside state delivery quotas. Additional autonomy provisions were extended throughout the 1980s. Most state-owned firms in China are controlled by provincial and municipal governments, and expansion of autonomy occurred unsystematically. The factory managers answering the question- naire were asked when they achieved autonomy to plan activity in six areas: value of output, physical quantity of output, product mix production technology, production scheduling (quarterly or monthly), and exports. With the exceptions of production schedul ing, which came earlier, and exports, which came later, the answer to the questionnaire show that the other four types of autonomy were tightly clustered, usually being achieved simultaneously. In the regressions reported below, we take explanatory variables the date of achieving autonomy to plan output value Autonomy is a multidimensional construction, but autonomy is a crucial element, particularly in the Chinese cor The grant of output autonomy implies that the enterprise's production activity is clearly separated from the obligation to turn over a certain amount of output to state delivery channels With
AUTONOMY IN CHINESE STATE ENTERPRISES 191 production autonomy, the state delivery plan is a compulsory contract, rather than the basis for surveillance and control of firm activity by government superiors. In other respects, the firms achieved a measure of "autonomy"very early in the reform process. By the early 1980s nearly all firms were retaining a share of profits and had the authority to sell some portion of their output outside the plan. We hypothesize that, in such an environment, the grant of output autonomy was a crucial component required for a qualitative increase in overall autonomy, since it allowed firms to integrate incentives, sales, and production.(Conversely, most firms by the end of the 1980s still did not have clear rights to fire ermanent workers .) There is considerable diversity across the firms in the CASS chey were granted output autonomy The number of firms in the sample receiving output autonomy in each year is shown in Figure I In each year between 1980 and 1989 some firms were granted output autonomy but it occurred most commonly between 1984 and 1988. While a few of the firms had output autonomy before 1980, some had not received it by the end Firms with output autonomy still operate with a number of obligations to bureaucratic superiors. Firms must deliver output at 100 60 SNN 6978 982984 1990 FIGURE I Output Autonomy
