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IGDR 4,2

Human capital, migration and rural entrepreneurship in China

Jialu Liu
Allegheny College, Meadville, Pennsylvania, USA
Abstract
Purpose Many countries have experienced, or are experiencing, urbanization. One such example is China. Even though the large-scale rural-urban migration seems chaotic on the surface, there are certain underlying forces driving individual decisions. The purpose of this paper is to provide some understanding of the relationship between human capital, migration, and occupational choices. Design/methodology/approach The paper starts with an overlapping generations model. Human capital plays various roles across different occupations it does not affect the income of farmers, it affects income of workers linearly, and it has increasing returns in rural non-farm business. The paper then derives income proles for individuals with heterogeneous human capital, and nds the human capital thresholds of occupations. The paper calibrates the model to China, and simulates the model to answer two questions: how does an improving human capital distribution affect rural wages, quantities of migrants and return migrants? How does a fast-growing urban wage rate affect rural wages, quantities of migrants and return migrants? Findings First, depending on the initial human capital level, policies aiming to enhance human capital may have different impacts on migration. If the initial human capital level is low, these policies will yield more permanent migrants; on the contrary, if the initial human capital is at a relatively high level, then a shrinking permanent migrant class with a growing entrepreneur class can be expected. This results in an inverted U-shaped relation between the initial human capital level and the size of the permanent migrant class. Second, even though the non-farm business of return migrants helps raise rural wages, the income inequality between rural and urban areas is not eliminated and migration is persistent. Third, borrowing constraints limit the size of rural non-farm businesses and slow down the development of rural industry. The fourth and nal point is that, migration costs discourage labor mobility and reduce the quantities of both permanent migrants and entrepreneurs. Originality/value This is an original paper on this subject. Keywords China, Rural areas, Urban areas, Internal migration, Human capital, Entrepreneurship, Borrowing constraints Paper type Research paper

100

1. Introduction This paper analyses rural-urban migration and rural non-farm entrepreneurship in China. The migration from rural to urban area is induced by the prospect of higher income; meanwhile, a relatively high return to human capital in rural non-farm business entices some talented migrants to return to the countryside and start as entrepreneurs. The (outward) migration to the cities and eventual (inward) return-migration back to rural areas is one instrument that circumvents credit constraints in rural China.
Indian Growth and Development Review Vol. 4 No. 2, 2011 pp. 100-122 q Emerald Group Publishing Limited 1753-8254 DOI 10.1108/17538251111172023

JEL Classication J24, J62, O15, O18, L26 The author is grateful to Professor Gerhard Glomm and Professor Michael Kaganovich for insightful comments and suggestions; and appreciates comments from all participants of the Ninth Missouri Economic Conference, and the 85th WEAI Annual Conference. The author is responsible for any remaining errors.

A thorough understanding of Chinas policies and background is necessary for the study of the migration phenomenon. Chinas transition from a central planning economy to a market economy began at the end of 1978, when a series of economic reforms were launched. The program of economic reforms has several important implications for rural areas. First, the restrictions on rural-urban labor mobility were relaxed and migration to urban areas became possible for most rural agents. From the 1950s to the late 1970s, rural-urban migration was prohibited by the household registration system, or the hukou system. The hukou system not only strictly regulated internal migration, but also effectively prevented rural residents from accessing public services that their urban counterparts received. The hukou system essentially blocked upward social mobility for almost all rural citizens during this period. In the early 1980s, rural agricultural productivity improved tremendously, which resulted in a large surplus of rural labor. In order to accommodate this labor supply pressure, the Chinese government called for a hukou system reform to promote the rural-urban labor mobility. Beginning in 1984, rural born individuals could obtain resident status in towns if they had employment and housing and could provide their own food rations (Chan and Zhang, 1999). Consequently, the urbanization in China leaped from 17 percent in 1978 to 24.52 percent in 1986 and to 42.99 percent in 2005 (Table I). The number of migrant workers increased from less than two million in the early 1980s to 229.78 million in 2009 (Research Team in the State Council of China, 2006; NBSC, 2010). Second, economic reforms initiated and deepened the development of rural non-farm sectors. Prior to the reforms, development policies in rural China focused on farm production. Rural non-farm sectors were almost non-existent and only began to develop after the early 1980s (Mukherjee and Zhang, 2007). According to NBSC (2005), employment in rural non-farm sectors expanded from 9.163 million in 1980 to 190.993 million in 2004, and the share of rural non-farm sectors in total rural employment increased from 2.98 percent in 1980 to 38.43 percent in 2004. Even though rural non-farm sectors witnessed fast growth, rural nancial markets failed to exhibit a comparable pace of development. Since 1980, there have been several government attempts to liberalize the nancial system in rural China; however, the results have not met with expectations. Financial markets in rural areas largely differ from those in urban areas. While the latter have modernized and even actively participated in global competition, the former remain stagnant. Cheng and Zhong (2004) and Guo and Xiangping (2009) show that the rural credit markets are fragmented: formal credit programs are highly centralized; cheap credits are earmarked to certain agricultural investment; and private lending is strictly regulated and usually illegal. Deposits in rural China have been increasing over the past two decades; however, loans in those areas have not shown similar growth. Figure 1 shows that from 1985 to 2004,
1978 Population Urban Rural Total Million 159 803 963 % 17 83 100 Million 502 782 1,285 2002 % 39 61 100 Million 343 2 21 322 Change % 129.41 2 26.50

Rural entrepreneurship in China 101

Source: NBSC (2003); data in this table exclude the population of Hong Kong SAR; Macao SAR and Taiwan

Table I. Rural and urban population in China from 1978 to 2002

IGDR 4,2

Loan to Deposit Ratio in China 2 1.8 1.6

102

1.4 1.2 1 0.8 0.6 0.4 0.2 L/D ACLD/OLs

Figure 1. Loan to deposit ratio in rural China

Data: Almanac of China's Finance and Banking (1986-2005); Guo (2009)

the ratio of outstanding rural loans to outstanding deposits (L/D) and the ratio of annual cumulative rural loan disbursement to outstanding of loans (ACLD/OLs) both declined, indicating that loanable funds have been either channeled outside of rural markets or left idle (Jia and Guo, 2007). Successful entrepreneurship calls for complete nancial markets. Owing to borrowing constraints, most rural entrepreneurial projects rely heavily on their own savings or borrowing from relatives and friends. Growing migration and return migration have contributed to the development of rural non-farm sector by providing nancial capital to rural areas. According to China Rural Development Research Center, one-third of migrants began returning to their rural homes in late 1990s. Murphy (2002) shows that, out of all the new projects in the surveyed counties with annual product values of one million yuan (0.12 million dollars), 63 percent were created by return migrants. It is not a coincidence that return migrants are more likely to invest and venture into entrepreneurship. Migrants have at least two advantages over non-migrants in starting their own business. First, migrants have better education than non-migrants in general. Table II presents the summary statistics of non-migrants, migrants, and return migrants in a survey conducted by the Ministry of Agriculture in 1999. It is very clear that the human capital of permanent migrants and return migrants is higher than that of non-migrants. Second, thanks to higher income in cities, migrants are able to save more than non-migrants. When ofcial bank loans are unobtainable, the self-owned funds become extremely crucial for rural agents to start businesses. Three strands of literature are directly relevant for this paper. The rst strand explores reasons for migration and return migration. The celebrated Harris and Todaro model (1970) predicts that, rural to urban migration will continue as long as the expected urban wage exceeds rural marginal productivity. Rural migrants are driven by expected higher urban income, even though ex post urban wages could actually be lower sometimes. Glomm (1992) attributes migration out of the countryside and into the city to higher rate of growth in the city. Liang et al. (2002) explain

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

All No. of interviewees Interviewees (%) Male (%) Married (%) Age (years) Schooling (years) Illiterate (%) Primary school (%) Junior high (%) Senior high (%) Technical school or higher (%) 2,137 100 52.0 83.3 39.6 6.0 12.4 38.9 41.3 6.9 0.6

Non-migrants Continuing migrants Return migrants 1,673 78.3 47.8 89.5 42.0 5.5 14.9 42.9 35.1 6.6 0.4 289 13.4 63.3 48.6 27.9 7.7 3.8 18.5 68.5 7.6 1.0 175 8.3 73.6 80.9 35.6 7.1 2.2 33.7 54.9 8.6 1.1

Rural entrepreneurship in China 103

Source: Survey, Ministry of Agriculture (1999)

Table II. Return migrants, non-migrants, and migrants in China, 1999

migration by the level of rural industrialization, using a 1990 China population census. Lucas (2004) views migration as a transfer of labor from a traditional, land-intensive technology to a human capital-intensive technology with an unending potential for growth. The desire of accumulating skills in cities is emphasized as the key motivation for migration. To understand the phenomenon of return migration, Dustmann (2007) argues that the return of migrants is driven by the preference of consumption in hometown. Zhao (2002) claims that both education and age increase ones likelihood of returning; besides, people who are married and especially geographically separated from their spouses are more likely to return. Dustmann (2003) introduces parental concerns for their children that may affect migrants tendency of return. A second strand of literature reaches to explain occupational choices. Lucas (1978) postulates a distribution of people by managerial talent to understand the division of persons into entrepreneurs and workers. The empirical studies in Evans and Jovanovic (1989) suggest both human capital and physical capital are necessary for starting a business. Borrowing constraints can potentially block the rising talent with insufcient funds. Banerjee and Newman (1993) illustrate the importance of initial wealth distribution in affecting the individuals ability in becoming entrepreneurs over wage workers. Lloyd-Ellis and Bernhardt (2000) consider both inherited wealth and entrepreneurial efciency as factors that separate entrepreneurs and employees. Rapoport (2002) provides a simple model of occupational choice where liquidity constraints determine access to both entrepreneurship and migration. A third strand of literature considers the mechanism through which migration helps hometown non-farm business and investment. Adams (1991) identies various effects of migration income on the investment behavior of migrants. Lopez and Selligson (1991) show that migration income promotes small business investment in El Salvador. Ilahi (1999), using cross-sectional data from Pakistan, nds that return migrants exhibit a higher tendency of choosing self-employment over wage employment. Dustmann and Kirchkamp (2002) examine Turkish immigrants to Germany who returned to Turkey in 1984 and nd that half of the returning immigrants became active as entrepreneurs, utilizing their savings acquired abroad as business start-up capital. McCormick and Wahba (2001) illustrate how return migration shaped the nature of non-farm enterprises in Egypt. Mesnard (2004) evaluates the impacts of liquidity constraints

IGDR 4,2

104

on self-employment of return migrants. Only a handful research pays attention to similar issues in China. Murphy (2002) supports the importance of return migrants in hometown non-farm business: one-fth of non-farm enterprises in surveyed rural areas were owned by former or current migrant workers. Zhao (2002) emphasizes local investment and shows that return migrants invest signicantly more than non-migrants. An empirical study by Liu (2010a) shows that rural agents with more savings from migration are more likely to start businesses. Two gaps in the literature thus emerge. First, outward and inward migrations are studied separately, which downplays the fact that both activities are indispensable parts of lifetime decisions. Second, even though plenty of research has been conducted in this eld for many other developing countries, only a few studies have paid attention to migration, return migration, and rural entrepreneurship in China, and none has provided a theoretical framework on these issues. Aiming to ll the gaps in the literature, this paper examines the interactions among out-migration, return migration, and rural entrepreneurship in China. In a two-period overlapping generations model, combinations of migration and occupational choices when young and old categorize rural residents into four groups. Facing borrowing constraints, rural individuals are unable to start a business when young. Nonetheless, migration to cities offers an opportunity to accumulate enough capital to enter entrepreneurship when old. An agent who chooses not to migrate when young remains in the rural area when old. An agent who migrates in the early stage of life can either stay in the city or return home later on. In this way, return migrants essentially channel credits from cities to their rural hometown. This framework accommodates the analysis on how and to what extent return migrants contribute to employment and economic growth in the countryside. After solving the model analytically, we calibrate it to China. Several ndings emerge: rst of all, depending on the initial human capital level, policies aiming to advance rural human capital may have different impacts on the volume of permanent migrants. If the initial human capital level is low, such policies will lead to more permanent migrants; on the contrary, if the initial human capital is at a relatively high level, then we can expect a shrinking permanent migrant class. Therefore, the fraction of permanent migrants exhibits an inverted U-shaped relation with respect to the median human capital in rural areas. Second, even though the non-farm business of return migrants helps raise rural wages, the income inequality between rural and urban areas is not eliminated and migration is persistent. Third, the rural wage rises when human capital improves, as a result of the decreasing supply and increasing demand of rural labor. Lastly, the migration cost hinders labor mobility. Rural agents cease migration or only migrate temporarily when migration cost surges. Costly migration accompanies fewer entrepreneurs and impairs rural wage. The paper is organized as follows: Section 2 introduces the model; Section 3 denes the equilibrium; Section 4 calibrates the model to China, discusses the simulation results and implications, and relates to migration issues in other economies; and we conclude in Section 5. 2. The model Consider the rural areas of an economy in a one-good world. Rural agents live for two periods. In the rst period of life, they can either work in the farm sector, in the rural

non-farm sector, or migrate to a city and work there. At the beginning of the second period, they have accumulated some savings. These savings can either be deposited in a bank to earn interest, or be invested in a rural non-farm business to earn a prot. Goods are used for either consumption or investment. Following Galor and Zeria (1993), an individual derives utility from consumption in the second period of life: u logc 1 Goods are produced by three technologies: rural farm technology, rural non-farm technology, and urban manufacturing technology. Production in the rural farm sector is described by:
2h h F f Lf A f L1 Zf ; f

Rural entrepreneurship in China 105

h [ 0; 1;

where Af is the total factor productivity (TFP) in the rural farm sector, Lf is the labor input, and Zf is the available farm land. Production in the rural non-farm sector is described by:
b F e ke ; l e ; h Ae hka e le ;

a b [ 0; 1;

where Ae is the TFP in rural non-farm sector, ke is the physical capital input, le is the labor input, and h refers to the entrepreneurs human capital. Lower-case letters, ke, le, h, are used to emphasize that equation (3) is the production function of one non-farm enterprise. There exist many non-farm enterprises, differentiated by the entrepreneurs human capital. The role of entrepreneurial skills in operating businesses has been widely explored in the literature. Lucas (1978), Jovanovic (1982) and Evans and Jovanovic (1989) all have shown that more talented entrepreneurs have a higher level of production and marginal product of capital. Following the literature, the sum of a and b is assumed to be between zero and one so that the entrepreneurs human capital has increasing returns. Lastly, the production in the urban sector is described by:
12 g F u K u ; H u Au K g uH u ;

g [ 0; 1;

where Au is the TFP in the urban manufacturing sector. Ku and Hu are aggregate capital and efcient labor inputs, respectively. 1. Solving rural farm productions problem Land is owned by the state and the people. Since individuals are prohibited from purchasing and selling land by law in China, a land market does not exist. The farm production uses labor and land as inputs. The prot maximization problem for the farm sector is: 2h h max Af L1 Z f 2 wr Lf given {wr ; Z f } f 5
{L f }

where wr is the wage rate prevailing in the rural area. Therefore, the labor demand in the rural farm sector is given by: 1 2 h A f Lf wr !1=h Zf 6

2. Solving rural non-farm productions problem Facing borrowing constraints, a potential entrepreneur in the rural area completely relies on his or her own savings to start a business. Hence, the capital input in a non-farm business cannot exceed the savings of the owner.

IGDR 4,2

An entrepreneur chooses optimal capital and labor inputs, given his own human capital h, the rural wage rate wr, the opportunity cost of using his own savings (1 r), and capital constraints. Because of the restrictions imposed on rural-urban migration in China, migrants face various costs of transportation, housing, and acquiring work permits. The net savings are (1 2 t)wuh, where t captures all kinds of migration costs. The prot maximization problem for an entrepreneur is:
{ke;t1 ;l e;t1 ;h}

106

max F ke;t1 ; l e;t1 2 1 r ke;t1 2 wr;t1 l e;t1 s:t : ke;t1 # 1 2 twu;t h

If the constraint in equation (7) is not binding, in other words, the optimal capital input ke,t 1 does not exceed the migrants own savings (1 2 t)wu,th, then the prot maximization problem has an interior solution. Otherwise, a corner solution prevails. The rst-order conditions for an interior solution are given by:
a21 b aAe hke ;t 1 l e;t 1 1 r b21 bAe hka e;t 1 l e;t 1 wr;t1

U The unconstrained capital input kU e;t 1 and labor input l e;t 1 are obtained as:

kU e;t 1

#1=12a2b a 12b b b Ae;t1 h 1=12ab 1 r 12b wb r ;t 1 |{z}

C1

"

lU e;t 1

a b 1 r a

" ! 12a 1=12ab

Ae;t1 2a w1 r;t 1

#1=12ab h 1=12ab

Following the solutions to the unconstrained capital and labor inputs in equation (9), the maximized prot of an unconstrained entrepreneur is given by:

pU e;t 1

#1=12a2b !1=12a2b " a ab b Ae;t1 h 1=12a2b 1 2 a 2 b 1 r a wb r ;t 1 |{z}

C2

10

Thus, the present value of an unconstrained entrepreneurs lifetime income is given by: W uncons 1 2 twu;t h

peU ;t 1 1r

1 2 twu;t h

! C2 h 1=12ab 1r

11

A return migrant is an unconstrained entrepreneur if the capital constraint is not binding, and the maximized prot is larger than his foregone urban income. These two conditions are equivalent to the following two inequalities: kU e;t 1 # 1 2 twu;t h or, in a more concise form:

pU e;t 1 $ 1 2 twu;t 1 h

12

12twu;t C1

$ h s1 $

12twu;t1 C2

1 where 1 s1 ; 12a b

13

On the other hand, if the savings of an entrepreneur are insufcient, then the borrowing constraint is binding. Had this entrepreneur been able to borrow, he or she would have raised more capital and established a larger rm. A constrained entrepreneur uses all his savings (1 2 t)wu,th, as the capital input. The constrained capital and labor inputs are given by: h i kC e;t 1 1 2 twu;t h lC e;t 1
1=12b Ae;t1 b12ta wa u;t h 1a=12b wr;t1

Rural entrepreneurship in China 107

14

Following the solutions to constrained capital and labor inputs in equation (14), the maximized prot of a constrained entrepreneur is given by: " Ae;t1 1 2 ta wa u;t wb r ;t 1 #1=12b h 1a=12b 15

pC e;t 1

1 2 bb

b=12b

2 1 r 1 2 twu;t h Hence, the present value of a constrained entrepreneurs lifetime income is given by: " # a a 1=12b b=12b A 1 2 t w 1 2 b b peC e ; t 1 u ; t ;t 1 h 1a=12b W cons wu;t h 1 r 1r wb r;t 1 |{z}
C3

16 A return migrant is a constrained entrepreneur if the capital constraint is binding, but the maximized prot is still larger than his foregone urban income. These two conditions are equivalent with the following two inequalities: kU e;t 1 . 1 2 twu;t h Or, in a more compact form: h s1 .
12twu;t C1

peC ;t 1 $ 1 2 twu;t 1 h
; where

17

h s2 .

12t wu;t C3

w u;t 1 1r

1a 1 s2 ; 1 2b

18

3. Solving the urban manufacturing sectors problem The urban manufacturing sector is modeled as an aggregate production, in which the rm chooses optimal levels of capital Ku and efcient labor Hu to maximize its prot:
{K u ;H u }

max

12g Au K g 2 1 r K u 2 wu H u uH u

given

{1 r ; wu }

19

The urban sector has free and unlimited access to international capital markets, thus it can always borrow and lend at a constant interest rate r. The rst-order conditions for the prot maximization problem are:

IGDR 4,2

g21 12g AgK u Hu 1 r

2g A1 2 gK g u H u wu

20

108

4. Occupational choices of households So far we have solved the problems for the rural farm sector, the rural non-farm sector, and the urban manufacturing sector. There is now sufcient information to set up the income prole for each occupation. The goal of this section is to determine rural individuals occupational choices and the corresponding income levels. In this model, rural residents are heterogeneous in their human capital, which directly affects the occupational choices. The human capital of rural residents are drawn from some distribution (such as a log-normal distribution). If a rural agents human capital is sufciently low, then his or her best choice is to work in the rural farm sector, as it requires no human capital. Otherwise, this rural agent should migrate and work in the urban sector, which rewards higher human capital. Therefore, the rst human capital threshold is determined between non-migrants and migrants. As modeled in the rural entrepreneurship section, the human capital of entrepreneurs is so essential to the protability of a business that human capital has an increasing return in the rural non-farm sector. As a result, a return entrepreneurs income is convex in his human capital whereas a permanent migrants income is only linear in his human capital. Therefore, a second threshold between permanent migrants and return entrepreneurs is generated. Lastly, for all entrepreneurs, the available capital comes solely from their savings during migration (which is linear in human capital), and it can be either lower or higher than the desired capital input (which is convex in the entrepreneurs human capital). Thus, a third human capital threshold is determined between unconstrained and constrained return entrepreneurs. Table III lists the present values of lifetime income W(h). For non-migrants, permanent migrants, and temporary migrants (including unconstrained and constrained entrepreneurs). If we compare the occupational choices pairwise, we can solve for the human capital thresholds: wr;t 1 r wr;t1 "1;t 21 1 2 twu;t 1 r wu;t1 ! 1 2 twu;t1 1=s1 "2;t 22 C2 ! 1 2 twu;t 1=s1 23 "3;t C1

Young Non-migrants Permanent migrants Table III. Occupational choices and income prole Unconstrained entrepreneurs Constrained entrepreneurs Stay in rural Migrate to cities Migrate to cities Migrate to cities

Old Stay in rural Stay in cites Return to rural Return to rural wr;t

W(h) h i wu;t1 h 1 2 t wu;t h 1 r 1 2 twu;t h 1 2 twu;t h

pU e;t 1 1 r pC e;t 1 1 r
wr;t1 1 r

3. Denition of equilibrium Denition 1. A competitive equilibrium for this economy is a set of human capital thresholds {"1t ; "2t ; "3t }1 t 1 , which determine the occupational choices of rural agents; ; a sequence of rural population {N t }1 a sequence of rural wages {wr;t }1 t 1 ; t 11 and a sequence of migration rates {ct }t1 , satisfying:
.

Rural entrepreneurship in China 109

Households problem. Given the prices {wr;t ; wu;t ; 1 r }1 t 1 , the utility maximization problem of rural households is solved. Rural farm productions problem. Given the prices {wr;t ; wu;t ; 1 r }1 t 1 , the prot maximization problem of the rural farm sector is solved. Rural non-farm productions problem. Given the prices {wr;t ; wu;t ; 1 r }1 t 1 , the prot maximization problem of the rural non-farm sector is solved. The rural labor market clears: ! Z "3t21 Z 1 1 2 hAft 1=h U Z ft N t21 l e hdFh N t21 lC e hd Fh wrt "3t21 "2t21 |{z} |{z}
Labor demand in non farm sector2

Labor demand in farm sector

Labor supply of old non migrants Labor supply of young non migrants
.

N t 21 d Fh N t d Fh 0 0 |{z} |{z}

"1t21

"1t

24

On the left-hand side of equation (24), the rst item is the farm labor demand, which has already been given in equation (6). The second and third items correspond to unconstrained and constrained entrepreneurs demand for labor, respectively. A rural agent with human capital between the second and third thresholds (h [ ("2, "3)) chooses to migrate in the rst period and to return as an unconstrained entrepreneur in the second period. Upon return, this entrepreneurs labor demand is l U e h, solved in equation (9). Since this rural agent is an entrepreneur in period t, it means that he or she was born in period (t 2 1); therefore, we need to multiply the integral by Nt2 1, which is the population of the new born in (t 2 1). Similarly, a rural agent with human capital over the third threshold (h [ ("3,1)) migrates and then returns as a constrained entrepreneur. This entrepreneurs labor demand is l C e h, solved in equation (14).

The right-hand side of the equation is the total labor supply in the rural area. Rural agents with human capital below the rst threshold (h [ (0, "1)) do not migrate and work their whole life in rural areas. The rst item represents the labor supply of non-migrants born in (t 2 1), and the second item corresponds to non-migrants born in t. . The rural population evolves according to: N t N t21 ct ; where

ct 1 2

R "2t21
"1t21

dFh

25

IGDR 4,2

Rural agents with human capital between the rst and second thresholds (h [ ("1, "2)) are permanent migrants, who leave rural areas for cities and never return. The children of permanent migrants become urban residents, R " t21 and will not be counted in rural population anymore. In equation (25), "1t22 dFh is the share of 1 permanent migrants, and ct represents the rate of change of the rural population.

110

Denition 2. Assume the urban wage wu, t is growing at an exogenous constant rate r. A balanced growth path for this economy is a competitive equilibrium, which, in addition to conditions 1-5 from the previous denition satises: 6 wr;t1 rwr;t ; for all t 0; 1; 2; . . . 7 N r;t1 cN r;t ; for all t 0; 1; 2; . . . 8 "1;t "1 ; for all t 0; 1; 2; . . . 9 "2;t "2 ; for all t 0; 1; 2; . . . 10 "3;t "3 ; for all t 0; 1; 2; . . .

26

where r and c are some constants. The focus of this paper is on the rural economy, and thus we do not model the sources of economic growth in the urban sector, such as foreign direct investment, government policies supporting urban state-owned enterprises, special economic zones, and export-oriented policies, etc. Since the sources of urban growth are not our focus (though they are extremely important for other studies), we can simply assume that the urban wage wu, t is growing at a constant rate r. Denition 2 says that on a balanced growth path, the rural wage is growing at a constant rate r, the same growth rate as the urban wage, while the rural population is declining at a constant rate c over time. The crucial determinants for the occupational choices in this model are the human capital thresholds, "s, which are all constants on the balanced growth path. 4. Model simulations In this section, the model is solved numerically. A list of parameter values is presented in Table IV. On December 1978, the 3rd session of the 11th Communist Party of China meeting was held in Beijing. During this historically important meeting, Chinas main leaders initiated the rural Household Responsibility System reform. Therefore, 1978 is taken as our initial period. Brandt et al. (2008) show that the TFP in non-agricultural non-state sector was 1.5 times that of agricultural sector, and TFP in non-agricultural state sector was 1.6 times that of agricultural sector in 1978. Consistent with the literature, we choose TFPs for three sectors in the initial period to be 2, 3, and 3.2, respectively, for the rural farm, the rural non-farm, and the urban sectors. Second, we need to set the growth rate of TFP in the rural farm sector in China. Brandt et al. (2008) calculate that the agricultural TFP increased at annual rate of 5.38 percent in China from 1978 to 2002. Rozelle and Swinnen (2004) show that the annual growth rate of agricultural TFP in China from 1979 to 1994 ranged from 3.8 to 6.1 percent depending on the types of crops (rice, wheat, maize, soybean, etc). Fan and Zhang (2002) claim that while the agricultural TFP growth rate was 5.34 percent using constant prices, it was actually 3.28 percent when using their own adjustment calculation. To be consistent with the literature, we pick l, the growth rate of TFP in the rural farm sector, to be 2.65, equivalent to an annual growth rate of 5 percent.

Parameter Meaning Af Ae Au l m z wu0 r n s t

Value

a b h g r

TFP in rural farm sector in 1978 2 TFP in rural non-farm sector in 1978 3 TFP in urban sector in 1978 3.2 TFP growth rate in rural farm sector 2.65 TFP growth rate in rural non-farm sector 2.1877 1.015820 TFP growth rate in urban sector 2.0765 1.037220 Urban wage in 1978 1.4473 Urban wage growth rate 2.84 1.0520 A parameter in human capital distribution [2 0.2, 1.2] A parameter in human capital distribution 0 Migration cost [0,0.2], 0.15 for China a ab: income share of capital in hired factors in rural non-farm sector 0.25 b 0.3 ab: income share of labor in hired factors in rural non-farm sector Income share of land in farm sector 0.6 Income share of capital in urban sector 0.3 Real interest rate 1.66 1.025720

Rural entrepreneurship in China 111

Table IV. Parameters used for Chinas economy

Third, we need to consider the growth rate of TFP in the rural non-farm sector, m, and in the urban sector, z. According to Statistical Yearbook published by NBSC (2003), the real per capita income of urban residents was 127 yuan in, 1980 and 360.6 yuan in, 1999; thus, r is set at 2.84. Brandt et al. (2008) show that the growth rate of TFP in non-agricultural sector from 1978 to 1999 was around 2. Therefore, we set the growth rate of TFP in the rural non-farm sector to be 2.18, and the growth rate of TFP in the urban sector to be 2.08. Fourth, we need to choose the migration cost, t. The literature contains various estimates of migration cost. Zhao (2002) documents that transportation and housing cost an average migrant 498.6 yuan (59.85 US dollars) in 1995. Beyond that, migrants paid 223.1 yuan (26.78 US dollars) per person in order to acquire three certicates and one card (Sanzheng Yika), which were necessary for rural migrants to stay and work in cities legally. Therefore, the sum of explicit costs was at least 721.7 yuan (86.64 US dollars) for an average migrant in 1995. According to a more recent survey conducted by the Research Team from the State Council of China, documented in the Research Team in the State Council of China (2006), 29.26 percent of migrants earned monthly income between 300 and 500 yuan (37.27-62.11 US dollars), 39.26 percent between 500 and 800 yuan (62.11-99.37 US dollars), and 27.9 percent above 800 yuan. Based on the above information, the migration cost t, is chosen to be 0.15 in this paper; in other words, 15 percent of a migrants income is spent on transportation, housing, permission, etc. Lastly, we need to choose appropriate parameters for the human capital distribution. Human capital follows a log-normal distribution, that is, lnh , N(n, s). In this paper, s 0.5 and n [ [2 0.2, 1.2], so that the median human capital ranges from 0.82 to 3.32 and the variance is between 0.24 and 4.02. 1. Simulation results We rst investigate the trend of each occupation in the rural area. Figure 2 shows that, on the balanced growth path, fractions of non-migrants, permanent migrants, unconstrained entrepreneurs, and constrained entrepreneurs are 62.80, 26.44, 8.95,

IGDR 4,2
Proportion of each occupation

The occupational choices in China 0.7 0.6

Nonmigrant Migrants Unconstrained Constrained

112

0.5 0.4 0.3 0.2 0.1 0

Figure 2. The population of rural residents in each occupation

3 Time period

Notes: The rural population in the first period is normalized to one; the migration rate (green) 26.44 percent matches migration data in China (Table II)

and 1.81 percent, respectively. Because the volume of out-migration persistently exceeds that of return migration, rural population decreases over time, as shown in Figure 3. The rural population in the model decreases at a rate of 26.44 percent, which matches Chinas data 26.5 percent (Table I). If we normalize the total rural population in the rst period to be one, then after 20 years (one period), the total rural population falls to 0.7356, after 40 years, it drops to 0.5412, and after 100 years, the rural population is only 0.2929. This model also predicts how the rural wage responds to the growing urban wage. We set the urban wage growth rate r to be 2.82, which is identical to an annual growth rate of 5.35 percent. On the balanced growth path, the rural wage rises at the same rate as the exogenous urban wage. Figure 4 shows the evolution of rural and urban wages in China. It appears that the urban wage is lower than the rural wage; however, since the urban wage is an efciency wage, paying for each human capital unit, a migrants income equals the urban wage multiplied by his or her human capital. Figure 5 shows the median income of each occupation over time. On the balanced growth path, no variation can be found in ratios between median incomes in any two occupations, as proven in Claim 3. The median income of permanent migrants is about 1.4 times that of non-migrants, and the median income of constrained entrepreneurs is about six times that of non-migrants. Rural individuals make occupational choices based on their human capital, and such self-selection can potentially have a strong implication for the rural area. On one hand, the outow of the rural young results in a brain drain in the countryside; on the other hand, the inow of return migrants bring capital back and provide more employment opportunities in their rural hometown. This naturally leads to a question: what are the effects of policies that promote rural education? If the overall human capital improves in the rural area, will there be more permanent migrants, or more

Evolution of total population in rural area (China case) 1 0.9 0.6 Rural population 0.7 0.6 0.5 0.4

Rural entrepreneurship in China 113

3 Time period

Note: One period is 20 years and the rural population in the first period is normalized to one

Figure 3. Total rural population evolution

The rural and urban wage rates in China 250

Rural wage Urban efficiency wage Urban efficiency wage *human capital

200

150 Wages 100 50 0

3 Time period

Note: On the balanced growth path, the rural and urban wages are growing at the same rate

Figure 4. Rural and urban wage evolution

IGDR 4,2

The income of each occupation in China 4,500 4,000 3,500

Nonmigrant Migrants Unconstrained Constrained

114
Income

3,000 2,500 2,000 1,500 1,000 500 0 1 2 3 Time period 4 5

Figure 5. The evolution of median income of each occupation

Note: On the balanced growth path, the median income of constrained entrepreneurs is about six times that of non-migrants, and the median income of permanent migrants is about 1.4 times that of non-migrants

return migrants, or both? To nd the answer, we need to examine the impact of human capital variation on occupational choices. In the simulation shown in Figure 6, we let the median human capital in the rural area to vary, while keeping the migration cost at the value for China (t 0.15). With the median human capital increasing gradually from 0.82 to 3.32, the rural non-migrant proportion (blue) monotonically decreases from 83 to 29 percent; the permanent migrant proportion undergoes a non-monotonic change: it rises from 14.84 to 28.32 percent and then gradually falls to 19.16 percent; the percentages of both unconstrained (red) and constrained (light blue) entrepreneurs dramatically increase from less than 1-30 percent and 20 percent, respectively. The main message shown in Figure 6 is that, changes in human capital have distinct effects on the four occupations, due to various returns to human capital across these occupations. The rural farm sector does not compensate human capital, the urban sector pays for human capital in a linear fashion, and the rural non-farm businesses exhibit increasing returns to entrepreneurs human capital. Therefore, as overall human capital improves, some rural residents will rst move from the non-migrant class to the permanent migrant class, and furthermore, to the return entrepreneur class. This explains the inverted U-shaped relation between the proportion of permanent migrants and the median human capital. When human capital increases from a very low level, most occupational switching occurs between non-migrants and permanent migrants. Thanks to the improved human capital, some would be non-migrants choose to migrate, which corresponds to the upward-sloping section in the inverted U-shape. On the contrary, if human capital rises from a relatively high level, then more switching is observed from the permanent migrant class to the return entrepreneur class.

Migration cost held the value in China = 0.15 0.9 0.8 Proportion of each occupation 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0.5 1 1.5 2 Median human capital 2.5 3 3.5
Non-mig Mig Uncons. Entrep. Cons. Entrep.

Rural entrepreneurship in China 115

Note: When the median human capital increases, percentage of non-migrants decreases, percentage of migrants increases at first and then decreases, and percentage of entrepreneurs increases

Figure 6. The proportion of each occupation and the median human capital

As a consequence, the fraction of permanent migrants drops, which corresponds to the downward sloping section. Migration costs are also crucial in determining rural migration patterns. One of our simulation exercises examines the consequences of policies that loosen or tighten the restrictions on rural-urban migration. The simulation shown in Figure 7 keeps the median human capital xed, and raises the migration cost parameter t from 0 to 0.2. At the current level of migration costs (t 0.15), proportions of the four occupations are 62.80, 26.44, 8.95, and 1.81 percent. Under a policy that loosens restrictions on labor mobility completely, in other words, t falls to zero, the occupation proportions become 57.12, 37.33, 4.83, and 0.72 percent. This indicates that, more migrants both permanent migrants and return entrepreneurs will appear whenever migration is cheaper. On the contrary, if migration becomes more costly, then a subset of permanent migrants with relatively low human capital will choose not to migrate, leading to an enlarging non-migrants class; meanwhile, a subset of permanent migrants with relatively high human capital will still migrate, but only temporarily. This contributes to a larger entrepreneurs group. Therefore, policies affecting migration costs will impact the occupational composition differently, depending on the distribution of human capital in the rural area. If migration costs increase when the rural human capital level is low, then permanent migrants are more likely to switch to the non-migrants group; however, if migration costs increase when the rural human capital is high, then permanent migrants are more likely to switch to the return entrepreneurs group.

IGDR 4,2
Proportion of each occupation

Median human capital held the value in China = 1.37 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0
Non-mig Mig Uncons. Entrep. Cons. Entrep.

116

Figure 7. The population in each occupation and migration cost

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

Migration cost

Note: When migration cost increases, proportion of migrants declines whereas that of non-migrants and entrepreneurs both increase

2. Possibilities of an empirical analysis In the previous sections, we solved the model analytically and executed several simulation exercises. While the results are interesting, a full-blown empirical analysis would, undoubtedly, provide further stronger support to our thesis. To accomplish this task, we need a dataset that satisfy all of the following criteria simultaneously: (1) the data cover education achievements of non-migrants, permanent migrants, and temporary migrants; (2) the data should include the business information (such as plant sizes, revenue, cost, prot, employee numbers, etc.) of rural entrepreneurs; (3) the dataset is a panel, with each rural individual interviewed at least twice, once when young and once when old; and (4) the data must be collected in China after the economic reforms of 1978. A dataset that satises all four criteria does not exist so far, to the authors knowledge. The dataset that most closely meets some of the above criteria is the Rural Household Survey Data, collected by Research Center for Rural Economy (RCRE) in China, which is a panel dataset with some information on migration remittances, education, and rural business. Unfortunately, this dataset lacks information on temporary migrants, an indispensable element in our research. Utilizing the RCRE dataset, Liu (2010a) shows that rural migrant savings have a positive and signicant impact on subsequent business in China, and Liu (2010b) identies the direct and indirect correlations between migration activities and rural non-farm business. Such empirical analyses are very useful and informative; however, the survey coverage does not suit

the design of our analytical model precisely. Therefore, we do not include any empirical exercises in this paper. 3. Discussions: migration issues in other economies The urban-rural income differentials. This model predicts that if rural-urban wage differentials narrow, then the rst human capital threshold will increase and the second human capital threshold will decrease (see equations (21) and (22)). For a given human capital distribution, this means more rural individuals will choose either not to migrate at all (non-migrants), or migrate only temporarily (return migrants), while fewer will choose to migrate permanently. There are other examples in the literature. For instance, the migration from Turkey to Germany is consistent with the model. As working conditions in Germany worsened for Turkish guest workers after the 1990s, an increasing number of unskilled and skilled guest workers left Germany as they saw fewer opportunities (Seith, 2006; Knerr, 2007). Knerr (2007) shows that the percentage of temporary work contracts in Germany has increased from 31.5 percent in 1995 to 80.9 percent in 2003 for young foreign workers. Many highly skilled second-generation migrants return to Turkey to take advantage of employment opportunities (Bif, 2011). Foreign talent who move out pose a potential brain drain risk for Germany and benet whichever countries they eventually settle in. The internal, rather than international migration in China the main focus of this paper is somewhat different. When temporary migrants in urban China return to their rural hometown to start businesses, they help spread the prosperity and fast growth of an urban economy to rural areas. It is true that urban areas suffer to some extent when some well-educated migrants leave; nevertheless, rural areas gain by a larger margin because human capital is a relatively scarce resource in the countryside. To sum up, the leaving of well-educated migrants for other countries presents a critical issue for Germany; however, the return of migrants from urban to rural areas ameliorates the regional income inequalities in China (Figure 8). The cost of migration. In the context of China, this paper shows that rising migration costs induce more non-migrants (those with the lowest human capital), as well as more temporary migrants (those with the highest human capital). On the contrary, if the government makes an effort to shorten the migration application process, improve working and living conditions for newcomers, and ensure more affordable transportation and accommodation, we will then expect more permanent migrants. The inuence of migration costs on migrants, both explicit and implicit[1], has been well-observed in many post-war European countries, and their experience matched our simulation predictions very well. There were two phases with contrasting policies on explicit immigration costs. From the 1950s to the late 1970s, bilateral recruitment agreements between Germany and Italy, Spain, and Turkey cut back the costs of migration immensely. Migrant workers in Germany were reimbursed for their travel costs and were provided accommodation (Mehrlaender, 1980). As a direct result of this policy effort, the share of foreign workers in total employment rose fast in the 1960s, with a peak of 10.8 percent in Germany in the 1970s (Bif, 2011). The second phase began in the early 1980s, when Germany adopted more restrictive policies towards foreign workers, which considerably made migration more difcult. Consequently, from 1991 to 2004, the migration to Germany declined from over 1.5 million to 0.7 million, whereas the migration from Germany to other countries increased from around 0.5 million to 0.68 million (Knerr, 2007). In terms of implicit costs, the level of difculty of naturalization

Rural entrepreneurship in China 117

IGDR 4,2
Proportion of each occupation

Median human capital held the value in China = 1.37 2.25 2.2 2.15 2.1 2.05 2 1.95 1.9

118

Figure 8. The rural wage and migration cost

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

Migration cost

Note: As migration cost increases, the rural wage drops

provides an important measure. For example, Switzerland has a much lower naturalization rate than Austria and Sweden, and concomitantly, half of the foreign population in Switzerland are born there, while the corresponding statistic is only 10 percent in Austria and Sweden (Bif, 2001). Therefore, the historical experience echoes our expectation that high migration costs discourage migration. Self-selection, education, and migration. This paper explicitly models the self-selection behavior of rural individuals. Human capital is the determinant in occupational choices: those with the lowest human capital choose never to migrate (non-migrants), those with the highest human capital choose to start a business (return migrants/entrepreneurs), and those with human capital in between will migrate in both periods (permanent migrants). Though business opportunities tend to be seized by the most talented and innovative, borrowing constraints prevent many young talented rural agents from starting businesses immediately; therefore, these potential entrepreneurs seek out to temporary migration as a way to accumulate their own capital (Figure 9). Similar self-selection patterns can be observed in other migration situations. For example, Chiquiar and Hanson (2002) nd that Mexican immigrants, while much less educated than US natives, are on average more educated than the residents of Mexico. Better education increases the likelihood of a Mexican to immigrate to the USA. Raijiman (2001) shows that human capital is an important determinant of Mexican immigrants entrepreneurial activities in the USA, as those who become entrepreneurs later are usually better educated. Bauder (2008) illustrates that, among all immigrants to Canada, entrepreneurs tend to have had their business aspiration and corresponding preparations prior to moving. People make their optimal immigration and business decisions according to their education background, nancial assets, human capital, social networks, etc. Fawcett and Gardner (1994) show that better educated immigrants

Median cost held the value in China = 0.15 3.2 3 2.8

Rural entrepreneurship in China 119

Rural wage

2.6 2.4 2.2 2 1.8 1.6 0.5

1.5

2 Median human capital

2.5

3.5

Note: As median human capital increases, rural wages also rises, keeping other things unchanged

Figure 9. Rural wage and median human capital

from Korea and the Philippines are more likely to choose self-employment than salaried employment. Again, education and human capital are the key determinants in occupational choices. The above discussions on income differentials, migration costs, and self-selection show that the implications and conclusions in this paper can be applied to other migration situations. Irrespective of various time and locations where migrations take place, similarities and common patterns are frequently observed, and therefore, experiences should be shared and lessons be drawn. 5. Conclusion This paper sets up a theoretical framework consistent with the observed features during the fast urbanization period in China. Since the economic reforms of 1978, China has seen a large volume of rural-urban migration. Our model focuses on human capital in attempt to understand this particular aspect of migration. Rural agents decide whether to migrate to cities when young, and whether to return to the countryside when old. Decisions in both periods result in a set of occupational choices: non-migrants who work in rural areas; permanent migrants who move to urban areas and always work there; temporary migrants who work in urban sectors when young and return to rural areas to start entrepreneurship when old. Through migration, rural individuals achieve their goals: for permanent migrants, urban sector jobs provide a source of higher income; for temporary migrants, migration is an intermediate step through which they accumulate capital for new business ventures ahead. This study offers several insights for the transition of developing countries like China: rst of all, human capital in rural areas directly inuences both outward and inward rural-urban migration, as well as the occupational composition in the countryside.

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Without migration, there would be fewer entrepreneurs due to borrowing constraints. As a result of the loosening restrictions on labor mobility, rural agents are self-selected into more diverse occupations. Human capital plays an essential role in income determination across sectors, as summarized by the inverted U-shaped relation between the permanent migrant proportion and median human capital. This suggests that education policies aiming to improve rural human capital have different effects on internal migration. If the initial human capital is sufciently low, such policies will generate a large permanent migrant class; by contrast, if the initial human capital is relatively high, then we will expect a shrinking permanent migrant class but a growing entrepreneur class. Second, the return migrants invest their savings in the rural non-farm business, which raises local labor demand and rural wages; nevertheless, income inequality is not eliminated and the rural-urban migration continues. Third, borrowing constraints hinders the rural development in two dimensions: it forces potential entrepreneurs to migrate in order to accumulate capital; moreover, it seriously limits the size of rural non-farm businesses owned by the very talented. If the Chinese government can reform rural nancial markets successfully, the rural industry will enjoy more growth. Lastly, even though labor mobility restrictions have been gradually removed, rural residents still face various kinds of implicit and explicit migration costs. Higher migration costs discourage both temporary and permanent migrants, and thus, fewer rural individuals will migrate and venture into entrepreneurship. Consequently, rural wages will decline and rural-urban income inequality will further deteriorate.
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Mehrlaender, U. (1980), The human resource problem in Europe: migrant labor in the FRG, Ethnic Resurgence in Modern Democratic States, Pergamon Press, New York, NY, pp. 77-100. Mesnard, A. (2004), Temporary migration and capital market imperfections, Oxford Economic Papers, Vol. 56, Oxford University Press, Oxford, pp. 242-62. Mukherjee, A. and Xiaobo, Z. (2007), Rural industrialization in China and India: role of policies and institutions, World Development, Vol. 35 No. 10, pp. 1621-34. Murphy, R. (2002), How Migrant Labor is Changing Rural China?, Cambridge University Press, Cambridge, MA. NBSC (2003), China Statistical Yearbook, National Bureau of Statistics in China, China Statistics Press, Beijing. Raijiman, R. (2001), Determinants of entrepreneurial intentions: Mexican immigrants in Chicago, Journal of Socio-Economics, Vol. 30 No. 5. Rapoport, H. (2002), Migration, credit constraints and self-employment: a simple model of occupational choice, inequality and growth, Economics Bulletin, Vol. 15, pp. 1-5. Research Team in the State Council of China (2006), Investigation Report on Chinas Migrants, Yanshi Press, Beijing. Rozelle, S. and Johan, S. (2004), Success and failure of reform: insights from the transition of agriculture, Journal of Economic Literature, Vol. 42 No. 2, pp. 404-56. Zhao, Y. (2002), Causes and consequences of return migration: recent evidence from China, Journal of Comparative Economics, Vol. 30 No. 2, pp. 376-94. Further reading Arcalean, C., Gerhard, G. and Ioana, S. (2009), Growth effects of spatial redistribution policies, CAEPR Working Paper No. 2007-002. Benjamin, D. (1992), Household composition, labor markets, and labor demand: testing for separation in agricultural household models, Econometrica, Vol. 60 No. 2, pp. 287-322. CECC (2009), Chinas household registration system: sustained reform needed to protect Chinas rural migrants, Congressional-Executive Commission on China, available at: http://cecc. gov/pages/news/hukou.pdf (accessed October 2009). Carter, C. and Scott, R. (2001), Will China become a major force in world food markets?, Review of Agricultural Economics, Vol. 23 No. 2, pp. 319-31. Caucutt, E., Thomas, C. and Nezih, G. (2007), The farm, the city and the emergence of social security, NBER Working Papers 12854. Gine, X. and Robert, T. (2004), Evaluation of nancial liberalization: a general equilibrium model with constrained occupation choice, Journal of Development Economics, Vol. 74, pp. 269-304. Johnson, G. (2000), Agricultrual adjustment in China: problems and prospects, Population and Development Review, Vol. 26 No. 2, pp. 319-34. NBSC (2009), China Statistical Yearbook, National Bureau of Statistics in China, China Statistics Press, Beijing. Corresponding author Jialu Liu can be contacted at: jliu@allegheny.edu

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