China’s First Market-Oriented Ecosystem

In this blog post, I summarize the emergence of a market-oriented ecosystem in rural China following Baochan Daohu in the late 1970s, as detailed in the 1996 book “How Farmers Changed China” by Zhou Kate. While the book discusses the topic of market creation, I intentionally use the term “market-oriented ecosystem” to bridge with Ulrich’s Market-Oriented Ecosystem in a follow-up blog post.

I encourage you to read my previous blog post, A Brief History of Baochan Daohu, to understand its significance.

In summary, following the CPC’s victory in the Chinese civil war, the party took control over land and agricultural production by placing it in the hands of local cadres (party loyalists). Unlike the farmers, who had managed food production thousands of years prior, local cadres were unfamiliar with managing land for food production. The cadre’s technical incompetence, combined with the disincentivized farmers, planted the seeds for food production output below expectations.

Farmers held the local cadres responsible for the millions of deaths during the Great Leap famine. Slowly, the farmers tried to regain control over the land and food production process to ensure subsistence at the very least. Mao’s death in 1976 enabled farmers to pursue family autonomy further, and efforts ultimately led to the Deng Xiaoping government formally recognizing and encouraging Baochan Daohu.

Baochan Daohu Generates Surpluses

At its core, Baochan Daohu is about generating surpluses from production activities. Just like for any business, a well-functioning operating model generates surpluses. The surpluses have two effects:

  1. When your operating model generates surpluses, your basic needs are covered. That is certainly the case when you have a high surplus, but also when you have a low surplus.
  2. When your operating model generates consistent surpluses, you can “trade” and “reinvest” them.

The implication of the first effect is significant for the farmer. When farmers regained control over the food production processes, they also controlled their own food production. The farmers felt incentivized to generate food surpluses that cover their family’s basic needs and, preferably, a little extra just in case.

The implication of the second effect is essential for the emergence of markets. All that you don’t consume, you can exchange for things you don’t produce, like food products or money. It also encourages specialization and diversification to make surplus produce more attractive or of higher value. That facilitates searching for better production processes, including biological and technological innovation. 

“When the basic production quota was fixed, and farmers were allowed to keep or to sell the rest of the harvest, farmer’s incentives soared, leading to the greatest sustained increase in productivity per worker and hectare in Chinese history”

How the Farmers Changed China, p77

Dealing with the State Procurement System under Tonggou Tongxiao (统购统销)

I explained the system of Tonggou Tongxiao (统购统销) in a previous blog post.

After the approval of baochan daohu, the farmers quickly started dealing with the state apparatus directly rather than dealing with the local party representatives. The state would issue a production quota at a fixed price to the farmer. Then the farmer would sell this directly to the state procurement station.

Farmers were mandated to ensure sufficient production to meet the quota and sell at the fixed state-mandated price. Farmers could sell to the state at a higher state-fixed price or market prices for goods produced more than the production quota. For goods produced where there wasn’t a production quota, farmers could also choose where to sell.

From the market perspective, the new arrangement institutionalized three distinct price levels:

  1. Tier 1: state price for the portion of the produced goods that fall within the state-mandated production quota
  2. Tier 2: state price for the portion of the produced goods that fall outside the state-mandated production quota
  3. Tier 3: market price for the portion of the produced goods that fall outside the state-mandated production quota

The new market dynamics quickly caught up with the state. The state found it increasingly more challenging to procure highly valued goods for which the state price was lower than the market price. In addition, farmers flooded the state procurement stations with low-value goods like grain and cotton, for which the market price was lower than the state price. That didn’t necessarily cost the state cash, as they refused to buy or issued IOUs. However, it did create a surplus problem rather than the scarcity problem from before.

Take the example of grain.

The state offered two prices: one price for the quota production and a higher price for the above-quota production. This incentivized farmers to produce more than the agreed-upon quota. The farmers could sell the above-quota output to the state or on the market. Due to the surge in production, the market price for above-quota grain would fall below the state price for above-quota grain. Thus, farmers would try to sell the above-quota grain to the state at a higher-than-market price.

From a business point of view, the product mix of below- and above-quota production determines the average selling price (ASP). To achieve a higher ASP, the farmers would heavily invest in rapidly and intensely increasing the output to sell nearly all the products at above-quota prices to the state. Ultimately, the state had to lower the purchasing prices for certain goods to disincentivize overproduction. The state sometimes even implemented a fengding or selling cap.

峰頂 (fēng dǐng) = peak

On the surface, this may look like a significant wealth transfer from the state to the farmers since the state would pay, on average, more for every ton of grain produced. However, the state balanced the wealth gain by the farmers with state-controlled price increases for the raw material inputs such as fertilizers. So, while farmers could sell grain at a higher price, their production costs also increased.

The State’s Perspective Under Tonggou Tongxiao (统购统销)

From the state’s perspective, one could argue it had the perception of being in control because the state could set production quotas, below- and above-quota pricing, and reserve the right of purchase refusal or utilize non-cash payments. However, the state apparatus was much less flexible in dealing with ever-changing market conditions. Thus, creating marketing problems. For example:

  1. The state did not have sufficient staff to deal with the increased production output, thus creating dissatisfaction with the farmers who had to wait for days to sell their produce.
  2. The state did not have sufficient warehouse capacity to store all the production outputs. That resulted in significant waste, especially for perishable goods.
  3. While the state offered price flexibility to the rural farmers for purchasing the output goods (above-quota purchasing prices), they did not have the same flexibility for selling the input goods to the urban industrial sector. So, the more the state purchased at above-quota prices, the less it made by selling at subsidized prices to the urban industrial sector.
  4. The state commercial sector could not meet the farmers’ increasing consumer goods needs.
  5. While the state increasingly purchased grain at above-quota prices, it continued selling it to the urban population at subsidized below-market prices. That caused a budgetary crisis where the more they bought, the more they lost.

It is important to remember the mechanism with which the state subsidized the urban population: hukou and danwei. I discussed these topics in my previous blog post. In short: Hukou links a person to a place of residence, and Danwei links a person to a place of work. Urbanites would receive coupons and subsidies through both Hukou and Danwei registrations.

More open markets could reduce the pressure on the state budget by allowing state actors to purchase at market prices if those fell below the above-quota or below-quota prices. However, free markets don’t align with the government’s ideology. That said, the government’s desire to reduce its debt eventually led to more tolerance for markets.

Either way, as they did in the past, the farmers tested the boundaries of what’s allowed and started opening up their own markets. They had every incentive to do so. After all, if you’re trying to sell perishable goods to the state and the state cannot keep up with the purchase, you either find a way to sell elsewhere or your goods rot.

In 1985 the government sought to alleviate the financial burdens by ending the procurement system and replacing it with Paigou.

派购 (pài gòu) = unified purchase

Paigou (派购)

Under Paigou, the state contracted with individual farm families to set a sales quota. That allowed the state to always purchase at a low price and regain control over production and marketing. Naturally, it reduced the incentives for farmers to sell to the state.

So, the state instituted Sanguagou. Under this scheme, the state provided 30% of the agricultural inputs at subsidized prices. However, that was not enough of an incentive, not in the least because the state provided the Sanguagou coupons through the sometimes corrupt cadres.

三掛勾 (sān guà gōu) = the three hooks

The state did achieve to lower grain production. As a result of the supply reduction, it increased its market value, and thus market prices rose above the state purchasing prices. That allowed the state to lower its total expenditure on grain. However, since the market price exceeded the state price, it also made the farmers desire ever more selling to the market instead of the state.

The most effective way to escape the grip of Paigou was the development of the rural industry, the service sector, and commercial trade activities.

Business Model Disruptive Innovation in Market Economy

So, here’s the status quo in 1984:

  1. The state owns all land but allows farm families to contract the land use intended for agricultural production.
  2. The farm families must fulfill state-mandated production quotas and sell at a state-mandated price enforced by the local party cadres.
  3. Farmers can use the land for other means if they fulfill the quota. Furthermore, they are allowed to sell surplus production.
  4. The state purchases the farmers’ agricultural goods at a low, fixed price, then sells them to the subsidized urban population. The state also sells subsidized agricultural inputs to the farmers to help maintain a low agricultural production cost.

For the farmers looking out for their families, the most attractive place to sell their goods is at the market, as the market price is generally higher than the state price. Thus, the land used to produce commercial crops increased much faster than the land used for state-procured crops.

The attractiveness of selling on the open market incentivized farmers to look for new ways to be successful. One of those ways is through the garden economy or tingyuan jingji, which could include any of the following: two gardens (vegetables and fruit), two pens (fowl and livestock), one fish pond, and one small factory. In one 1986 survey cited in the book, 85% of farm households argued cash income as their principal reason for raising pigs.

庭院经济 (tíngyuàn jīngjì) = garden economy

While farmers flooded the market with their produce, many traders emerged. These traders visited the market solely to buy goods to then resell. They tried to leverage the price arbitrage that existed between regions. The state initially forbade the practice of trade, though, as the author points out in the book, one could argue that the practice is already out of hand when prohibition is needed. The state didn’t legalize long-distance trade until 1983

Either way, the market dynamics quickly spread from local trade between the rural population to trade between rural merchants and the urban population. That gave rise to a class of trade-specialized farmers: the rural merchants. Perhaps unexpectedly, Chinese farmers were the first class to own private cars, trucks, and tractors.

Rural merchants became formidable competitors of the urban state sales organizations for six reasons:

  1. Thanks to lessons learned from operating under baochan daohu, they pay close attention to operational profitability and consumer dynamics. They are entirely market-oriented.
  2. They are more knowledgeable than their urban counterparts about the product, particularly agricultural and perishable goods. This product know-how translates into better sales tactics.
  3. They are directly responsible for their losses, so they pay attention to the management of the goods.
  4. They have more flexibility to purchase high-quality goods at lower prices when supply exceeds demand.
  5. Their operating costs are generally lower than state actors due to lower overheads
  6. They are intrinsically motivated to work hard and build better and more comfortable lives for themselves and their families

In business terms, we could say that the farmers provided a better sales experience with better products at a lower cost. That’s a business model disruptive innovation strategy.

From Business to Market-Oriented Ecosystem

The rise of rural merchants and increased economic activity promoted rural specialization and diversification. Furthermore, it also created a market for rural services and industrial goods in addition to rural agricultural goods.

Included in the rural services are transportation, construction, and marketing services. Transportation services enabled farmers to deliver their products to ever more-remote customers. Construction services allow farmers to build new facilities tied to their business operations, for example, warehouses and small factories. Marketing services enabled farmers to trade at markets more effectively.

The farmers initially traded at the Jishi or market town in the countryside. However, over a decade, the jishi evolved from a place of local trade to a place where farmers and urbanites went to buy goods. Slowly, the jishi took over from state-planned markets as the primary source where people, farmers and urbanites alike, would go to purchase their food.

集市 (jí shì) = market

In 1983, sales at jishi represented 14% of all retail sales. In 1989, 70% of the goods sold in the cities were at jishi.

The success of the jishi was also favorable to the state for two reasons:

  1. The state-controlled grocery stores offered subsidized food. The more urbanites purchased their food at the jishi, the less they required subsidized good. So, the less the state had to subsidize.
  2. The state collected taxes on sales done at the jishi

The local jishi eventually expanded to a variety of different types of markets. Those include roadside markets near the cities, specialty markets which focus on specific products, and wholesale markets where you could go and buy nearly everything.

In addition to the sale of goods, farmers also pioneered in private restaurants and inn-keeping. This primarily served the needs of the rural merchants who needed a place to sleep and eat will traveling around to different markets. A key side-effect of the farmer-driven development of services industry that I want to quickly mention is that the more general availability of food decreased the power of the state-issued food ration coupons in the cities.

A Brief History of Baochan Daohu

In this blog post, I summarize the history of Baochan Daohu, the household responsibility system, as detailed in the 1996 book “How Farmers Changed China” by Zhou Kate. In a follow-up blog post, I will also cover the emergence and evolution of markets as described in the same book.

The book’s central thesis is that rural farmers and not the party elite were the main driving force behind’s China’s rise from the ashes of the civil war mid-20th century to a world-leading economic power. While I’m not the right person to judge the accuracy of the thesis, I want to share some of the insights from the book about grassroots Chinese entrepreneurship within the environment of early communist rule.

Before Communism

Before the communist victory in the Chinese Civil War, most Chinese people were self-sufficient for their daily needs. Chinese families ran independent family farms that provided daily food and sometimes surpluses which were traded in the village. They generally avoided centralized structures for organizing everyday life. This open class system was around for thousands of years.

Tonggou Tongxiao (统购统销)

Following the victory in the civil war,  the Communist Party of China (CPC) took control of the country. It began to organize food production through agricultural and land reforms (1950-1953), which removed the family from the nexus of local organization and decision-making.

The CPC installed loyal cadres as party representatives to run the villages. The cadres executed agricultural reforms to create a more equal land distribution and increase food production. The reforms included the formation of farming cooperatives (communes and later production teams), which brought together small farmers to share resources and increase efficiency. This replaced the family unit as the organizer of food production.

Most importantly, while the state allocated land for farmers’ use, it denied them ownership and control. Before the farmers could even start enjoying the fruits of the land reform, their autonomy was further reduced by the introduction of Tonggou Tongxiao, or the Public Grain Procurement System.

统购统销 (tǒnggòu tǒngxiāo) = unified purchase and sale

Under the Tongou Tongxiao, the government required farmers to sell their grain at a fixed price to the state. No private merchants were allowed to deal with grain. This ensured the state had enough grain to feed the urban population and the army. The government also used the proceeds from selling surplus grain on international markets to fund industrialization and other development projects.

Through a business model lens, one could say the state forced input prices to stay low while selling industrial goods at a high price (jiandaocha). The surplus value (800 million yuan between 1953 and 1978) extracted from the market was used for industrial development.

剪刀差 (jiǎndāochā) = price scissors

The local farmers communicated with the party via the local cadres. Thus the local cadres had enormous power over the local population. They were sometimes referred to as tuhuangdi (土皇帝, tǔhuángdì) or local emperors.

When faced with the difficult situation of lack of control of your destiny and the feeling of oppression by the local party cadres, why not simply move for better opportunities?

In the mid-1950s, many farmers left their villages to find city work. Since cities were unprepared to deal with such an influx of migrants and the state needed the farmers to produce the grain for food, the state issued four documents to stop the flow of rural-urban migration. This system is known as Hukou.

户口 (hùkǒu) = household registration system

Hukou & Danwei (户口 & 单位)

The Hukou system, also known as the Household Registration System, is a system of household registration to register and identify individuals based on their residence.

Under the Hukou system, every individual is registered in a specific location, either rural or urban, depending on their family’s registered location. This registration determines their access to public services such as education, healthcare, social welfare, and housing.

The Hukou system divides the population into two categories: rural and urban. Rural residents are often excluded from many of the benefits of urbanization, such as access to better-paying jobs, social welfare, and education. They are often subject to discrimination in urban areas. Effectively, it made the Chinese village become a closed society.

With an urban hukou, one received Liangpiao (food rationing coupons). People without this coupon, such as rural migrants, couldn’t buy food in the city. Without an urban hukou, one couldn’t get housing in the city. Rural migrants had to get a letter of introduction from their commune cadres to stay in a hotel.

粮票 (liáng piào) = ration card

Urbanites also had a Danwei or registration for the urban work unit. The danwei linked a person to a place of work in the city. Under the danwei system, workers were not only employed by their workplace but were also provided with social welfare benefits such as housing, medical care, and education by their workplace. In addition, workers were expected to participate in political activities and study sessions organized by their danwei.

单位 (dānwèi) = work unit

The Danwei provided job security or, as it was often referred to: Tiefanwan (铁饭碗, tiěfànwǎn) or an iron rice bowl.

The polarity of the Chinese society, with, on the one hand, the cadre-bound farmers who were obliged to produce grain for the state and, on the other hand, the subsidized urbanites who received plenty of support from the state, was fertile ground for the eventual changes.

Baochan Daohu (包产到户)

Baochan Daohu is the practice of turning grain production over to the household. While many credit Deng Xiaoping with the introduction of the practice, in the book Kate Zhou argues that this transition involved an unplanned struggle between the farmers and the state that started decades before the official party policy.

包产到户 (bāochǎn dào hù) = household responsibility system

The book breaks down four phases of baochan daohu.

  • Phase 1: 1956-1957
  • Phase 2: 1961-1962
  • Phase 3: 1967
  • Phase 4: 1977-now

To recap the status quo: the agricultural reforms placed land under collective ownership, transferring it from the household to the local party cadre. The party cadre was responsible for managing food production and meeting the central government’s quotas. Families became members of the production team, brigade, and commune. Food distribution was according to the work points earned, ultimately dependent on the cadre’s decision-making.

Phase 1: 1956-1957

Following collectivization, farmers pressed for greater autonomy, including the freedom to engage in sideline production and marketing.

The term baochan daohu first appeared in Zhejiang Daily on January 27, 1957. It contained four elements:

  • Baochan daodui: output quotas for the production teams
  • Zeren daohu: each household responsible for the production quota
  • Dinge daoqiu: the output of land was fixed, and anyone responsible for the land would decide how many work points a worker could receive
  • Tongyi jingying: production and distributive decisions were made by the team leaders

This approach spread rapidly in parts of the Zhejiang province. It became known as the la niu tui she movement. However, the political response by Mao to this idea was quick and was framed as a capitalistic idea of a “nouveau riche” farmer. Eventually, the political movement led to an expansion of the collective system in 1958 and gave rise to the People’s Commune

Phase 2: 1961-1962

The Great Leap famine fundamentally changed the relationship between the state and the farmers as the farmers held the local cadres responsible for the famine. This opened the door for a renewed policy towards the rural people and a push for agricultural reforms. In various locations, local cadres experimented with different approaches. Two examples:

  • Sanbao yijiang (三包一奖, sān bāo yī jiǎng) ,or 3 contracts plus reward, was a system where the production team contracted with the production brigade to produce a certain quantity of grain at a certain cost with a certain labor force. Any surplus was retained as a reward.
  • Zeren tian (责任田, zérèn tián), or responsibility land system, was a system where commune members received work points according to the output of the land, and there was unified distribution within the collective.

An important note is that these systems did not provide rural people with freedoms beyond the scope of field management. Crucial decisions about farming were still handled at the brigade level.

The local successes were communicated to the central leadership and were initially met with support. A 1960 emergency directive from the central government called on production teams to have sanbao yijiang. It permitted farmers to have limited private land (5%) to produce sideline products. Deng Xiaoping supported the zeren tian system ~ “no matter whether the cat is black or yellow, the cat is good as long as it can catch mice.”

In July 1962, Mao launched an attack against zeren tian at a party conference. He launched the Socialist Education Movement (1962-1965), stripped provincial leaders supporting zeren tian of power, and forced farmers back to collective farming.

Phase 3: 1967

Farmers took advantage of the chaos of the Cultural Revolution (1966-1967) to press for the expansion of the household and the market. This took the form of civil disobedience and even armed struggle. However, not much is known about the extent of the protests. Many of the demonstrations were organized by a local central figure, allowing the party and local cadres to counter-act with precision.

The organized attempt to force collective farming during the Cultural Revolution was successful.

Phase 4: 1977 – Now

Following the Cultural Revolution, farmers’ resistance to collective farming took a silent but daily form. As the state pressed back against a farmer’s desire for independent agriculture, the movement went underground and on the defensive. Despite the many central government initiatives to increase the growth of grain production through the introduction of modern technology, grain production growth grew at low single digits. It did not keep up with population growth.

Mao’s death in 1976 gave farmers a new opportunity to pursue family autonomy. Unlike the previous attempts, the farmers did not try to organize or make demands from the central governments. Instead, they succeeded by making individual deals with local cadres and giving them more than they expected.

The idea is to incentivize the local cadres to allow family farming. The cadres would receive a significant percentage of the production surplus in return for more autonomy. This bargaining strategy worked best in poor areas where local cadres didn’t live in good conditions.

The combination of the corruptibility of local cadres and unorganized farmer’s individual deals allowed to break the collective dike. While the movement was not organized, baochan daohu spread through informal networks across villages. An important role is played by women whose marriages voiced their preferences.

This form of baochan daohu was different from the three previous versions:

  1. Farmers didn’t ask for land ownership. They didn’t riot. They didn’t fight the local cadres
  2. Farmers didn’t organize. They made individual deals with cadres.

This is a SULNAM: Spontaneous, Unorganized, Leaderless, Non-ideological, Apolitical Movement.

After baochan daohu, the family head again became the dangjiaren (master of his own house).

当家人 (dāngjiārén) = head of family

The response from local and provincial governments was supportive of baochan daohu. However, the support took different forms. Often the governments would initiate reforms that mimic the effect of baochan daohu without formally adopting shared practices.

The response from the central government was not supportive. At the Third Plenum of the 11th Party Congress in 1978, the state specified that baochan daohu was illegal. Note that Deng Xiaoping was deeply involved in drafting the resolution.

It was not until 1981, when Chen Yizi (陈一咨), a research fellow and government adviser, submitted a report about the impact of baochan daohu to the reform leaders, that the central government would consider supporting the practice. The report, titled “The Dawn for the Rural Area, the Hope for China – Report of a Survey on the Implementing of ‘Baochan Daohu’ in the Rural Area in Anhui Province,” provided evidence that baochan baohu improved productivity and the living conditions for all. After reading this report, on May 31, 1981, Deng Xiaoping discussed the “baochan daohu miracle” with a few senior leaders.

Deng and his reform leaders facilitated the spread of baochan daohu in 1983, following the evidence of increased productivity. In January 1983, the central government formally recognized baochan daohu and encouraged its development in rural China.