Cheng Hsiao
Shorenstein Reports on Contemporary East Asia
Number 10
October 1996
The 1996-97 Shorenstein Seminars on Contemporary East Asia presented a public lecture on profit sharing in Chinese Town and Village Enterprises by Professor Cheng Hsiao on Thursday, October 24, 1996 at the Institute of East Asian Studies.
Cheng Hsiao is Professor of Economics at University of Southern California and co-editor of the Journal of Econometrics. His presentation examined the advantages of profit-sharing vs. quota systems and other incentive schemes in encouraging successful community enterprises. Using a survey of 200 Chinese Town and Village Enterprises (TVEs) from 1985 to 1990, Professor Hsiao's research also showed that the trend of moving from share profit contract to quota profit contract for the Chinese TVEs in the late 1980's might be an ill advised program.
"When Shares Dominate Residual Claimant Contracts: The Case of Chinese Township and Village Enterprises"
C. Hsiao, J. Nugent, I. Perrigne, and J.C. Qiu
A central feature of the post-Mao reforms in agriculture and industry has been the responsibility system, in which households, townships, and village enterprises have the right to retain whatever surplus remains after having delivered a fixed quota to the state. According to many scholars, this part of the reform program is responsible for the remarkable growth in Chinese agriculture over the last decade and a half. The success of the responsibility system in agriculture led to a similar program in Chinese industries, but with mixed results. According to the industrial responsibility system, managers and workers either share profits with the state or commit to deliver a fixed amount of profit to the state, but have the right to retain whatever profit is left. This policy, Hsiao et al. note, has been introduced only on a partial basis in state-owned firms but has been implemented on a much wider scale in non-state enterprises, particularly in the collective town and village enterprises (TVEs).
Before 1978, managers of TVEs had contracts similar to those of managers in state-owned firms: managers were almost all state-appointed and selected from the ranks of officials with a good deal of experience in local and regional government. They received a fixed salary (on a wage contract basis); profits belonged exclusively to the local government (i.e., the village, township, or county). By 1983, however, TVEs began to implement the agricultural responsibility system. Exactly what sort of contracts managers received at that point is still not 100 percent clear, but the available data suggest that between 1985 and 1990, most TVEs tended to use "residual claims quota contracts," that is, contracts that gave managers a certain fixed percentage of the firm's profit. By 1990, only 10 percent of TVEs compensated their managers using the previous system of providing managers a fixed wage.
According to standard economic theory, such quota contracts should provide managers with greater incentives to boost profits, because their earnings increase as profits rise. Professors Hsiao, Nugent, Perrigne, and Qiu, however, point out that standard economic theory may not work in the Chinese case. A sample of two-hundred Chinese TVEs, showed sharp decline in profits between 1985 and 1989 and then again in 1990. Even accounting for the severe credit constraints in place at the time, the decline in the profit rate (from 14 percent in 1985 to less than 5 percent in 1990) and the increase in the number of firms that experienced losses coincided almost exactly with the trend toward granting managers contracts based on quotas. If such contracts are said to be optimal, why did their widespread introduction in the late 1980s not slow or stop the decline in TVE profitability?
Using a highly sophisticated econometric approach, the authors show that it is not at all certain that quota contracts will necessarily be the best ones to use in the Chinese context. For instance, one shortcoming of quota contracts is that they encourage managers and workers to misuse the firm's assets. If the quota contract is limited to, say, three years, then managers and workers have an incentive to overuse whatever assets they have to achieve short-term profitability; because of the short duration of the contract, they will skimp on maintenance and replacement of old equipment, since the benefits from such steps will be evident only in the long term. In this way, long-run profit is forfeited for short-term gain. Another problem of the quota contract is that it may be difficult to enforce. Because of the shortcomings of the Chinese economy (particularly its capital markets and supply of raw materials), it is virtually impossible for managers to pay the fixed amount of profit in advance. What happens instead is that the quota is deducted from whatever profit there is at the end of the year. If the year happens to end with a loss, the manager can pay only a fraction of his quota. To ensure themselves against such a loss, the owners (i.e., the government) request that managers provide them with a certain collateral in advance. Since these collateral payments are small, they are not effective in motivating managers to raise profits. If losses occur year after year, the only thing the owner can do is fire the manager and take whatever collateral he left. Managers, to prevent such a scenario, then have greater incentive to take high risks in the hope of boosting profits in the short term. The third and probably most significant factor was the tendency to revise the quota upward if an enterprise was perceived as making excessive profits.
What makes quota contracts particularly difficult to use in the Chinese context, the authors emphasize, is that many markets are severely limited, particularly those in critical raw material and intermediate goods. Because of this, firms frequently depend on the ability of local government officials to use their connections to procure critical resources for them. Under the quota contract system, however, local governments have few incentives to provide such assistance; their share of the profits is not directly contingent upon the performance of the TVE. Without their own income tied to the profitability of the firm, they will not do their utmost to assist a TVE to overcome the many bottlenecks in supply, finance, and marketing. Since the nature of the Chinese economy places state officials in a key position with regard to the acquisition of valued resources, it would be useful to consider a type of contract that increases the incentives for local governments to act decisively on behalf of the a TVE. Yet another feature that makes quota contracts difficult to employ in the Chinese case is the tendency of local governments to give their TVE managers a quota they cannot possibly fulfill. Realizing that they cannot possibly fill the quota within the short span of the contract, managers will take more risks than is good for the firm, harming future growth and profitability.
For these reasons, the authors suggest, the trend toward quota contracts may have been ill-advised. Instead, their research suggests that another sort of contract, perhaps one based on profit sharing rather than a fixed quota, might be better. Although it is difficult to assert a causal relationship between the decline of profits and the widespread use of the quota contract given the many other factors involved in making a firm profitable or not, the data on two-hundred TVEs suggest that under Chinese economic conditions, "firms using a shared-profit contact could perform better than those under a quota contract." If profits were shared among managers, workers, and government officials, the latter would have greater incentives to assist TVEs to obtain the necessary materials and overcome financial and marketing difficulties. Such difficulties are often substantial: in 1985, for instance, 37.5 percent of raw materials were obtained from non-market sources, such as county and township governments. To the extent that state officials are themselves an important source of raw material, it would thus behoove TVEs to enter into contracts that give state officials a financial incentive to act as their economic patrons. At the same time, managers would not skimp on maintenance or repairs to make a profit that would satisfy their allocated quota in their contract.
This analysis, the authors point out, does not suggest that TVEs with quota contracts would not receive the help of local governments while those using "shared-profit" contracts would. It suggests that government officials would plausibly have greater incentives to help TVEs if they participated in a contractual form that allowed them to share in the profits. The evidence, even though it is still "circumstantial," shows that shared profit TVEs "seem to enjoy greater effort on the part of local government . . . they obtained larger percentages of the major raw materials from non-market sources in general and local government in particular." This participation by local government might, in turn, result in greater profitability.
Summarized by Neil Diamant.
