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:
- 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.
- 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:
- Tier 1: state price for the portion of the produced goods that fall within the state-mandated production quota
- Tier 2: state price for the portion of the produced goods that fall outside the state-mandated production quota
- 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:
- 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.
- The state did not have sufficient warehouse capacity to store all the production outputs. That resulted in significant waste, especially for perishable goods.
- 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.
- The state commercial sector could not meet the farmers’ increasing consumer goods needs.
- 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
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:
- The state owns all land but allows farm families to contract the land use intended for agricultural production.
- The farm families must fulfill state-mandated production quotas and sell at a state-mandated price enforced by the local party cadres.
- Farmers can use the land for other means if they fulfill the quota. Furthermore, they are allowed to sell surplus production.
- 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:
- Thanks to lessons learned from operating under baochan daohu, they pay close attention to operational profitability and consumer dynamics. They are entirely market-oriented.
- 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.
- They are directly responsible for their losses, so they pay attention to the management of the goods.
- They have more flexibility to purchase high-quality goods at lower prices when supply exceeds demand.
- Their operating costs are generally lower than state actors due to lower overheads
- 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:
- 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.
- 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.