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