Today’s schedule

1. Today’s schedule • Finish “Democracy and Development” [Luo et al.] • Summarize the use of IV’s • Fixed Effects • Is Sharecropping Inefficient? [Shaban]  p. 39 • A simple example: Does irrigation affect yields in China’s agriculture? • Does Privatization lead to better performance in China’s rural industries? [Li and Rozelle] • Start on: PSM / D-in-D / Experiments

2. Summarize the use of IV’s • Overcome simultaneity bias / measurement error / unobserved heterogeneity • Definitions of an IV • Correlated with endogenous variable • Affects outcome variable ONLY through its effect on the endogenous variable • Test for a good IV • Statistical tests (necessary/not sufficient) – 5% • Logical tests – 95%

3. Things to watch out for in your IV analysis a.) pass logic test … but first stage correlation is weak  “weak IV” can mean second stage is measured insignificant / but, really significant b.) careful of “nature of IV” … what “part of variability” of the endogenous variable are you using c.) be careful of “old rules” and “simple fixes” Y = a0 + a1*X + a2Z + e … but worried about X being endog. Use: Xt-1 as an IV for Xt … lagging is better but far from enough All policy variables are good IVs in equations of private behavior … NO WAY … policy makers are not stupid, blind and irrational If you use fixed effects, don’t need IV … and vice versa … NOT necessarily!!!

4. Lecture 03Fixed Effects, Sharecropping and the Privatization of China’s Rural Industries Scott Rozelle Stanford University

5. The Puzzle of Sharecropping Alfred Marshall lobbied Congress to have it banned in the US The Government of India still has many laws and regulations banning sharecropping Why? The argument is that “Sharecropping is inefficient” Yet: Steven Cheung, a development economist from Chicago and one of the earliest economists to try to “put institutions into the study of development” … argued that he can show that “sharecropping is NOT inefficient”

6. Introduction • I choose this topic because sharecropping is an ancient institution that is prevalent in many parts of the world irrespective of whether or not it is “inefficient” • It is an institution that involves a lot of economics (trade off between efficiency and risk, adverse selection, moral hazard, etc.). • It has fascinated and continue to fascinate many development economists. There is a large literature on sharecropping tenancy. Indeed, some trace the first attempts by development economists to explain institutions and understand their role in the process of development to the study of sharecropping (Johnson, 1950s; Cheung, 1960s; etc.) • It is a good way to teach “fixed effects”

7. Plan for Today • What is Sharecropping? • What is the (theoretical) “problem” with sharecropping? [why did Marshall hate it?] • Is it really inefficient? [empirical approach to testing for the inefficiency of SC … answer is “yes”] • So why do people choose it?

8. Jumping to the last point (because I will probably not have time to cover completely … really should take 1 or 2 classes to cover properly) • Perhaps the best answer in the literature is: • Sharecropping (SC) is sometimes optimal in a second best world • Second best happens because “risk is important” … and “there are no credit or insurance markets in agriculture” [remember Binswanger and Rosenzweig, lecture 01) • This already helps explain: • Why SC might be more prevalent in India (where the monsoons are so risky) … sunspots determine if the monsoon is big or small (and, a big or small monsoon determines if the harvest is big or small) … • Why SC is higher when farm prices are low and interest rates are high (the risk to farmer of being able to cover his/her fixed cost rise … if there is a bad harvests and revenues are down, farmers can’t make interest payments, they can lose their farm … as many did in the 1980s)

9. What is Sharecropping? • Sharecropping is a system of agricultural production where a landowner allows a sharecropper to use the land in return for a share of the crop produced on the land. • There are a wide range of different situations and types of agreement. The share varies from country to country also across regions within a country, although 50-50 division is more common. Input costs are sometime also shared between landlord and tenant.

10. Alternative Tenancy Contracts • Fixed Wage: Landlord brings the land (her own) and pays the agricultural laborer a fixed wage • Fixed Rent: Tenant brings the labor (his own family) and pays the landlord a fixed rent [in the literature, always comparing the efficiency of these alternative institutions …

11. The “Problem” of Sharecropping • The institution of sharecropping has always had a bad name. • Alfred Marshall lobbied Congress to have it banned in the US • The Government of India still has many laws and regulations banning sharecropping • Why does SC have such a bad reputation? • The argument is that “Sharecropping is inefficient” Because they get only part of the return, they will naturally reduce their effort … (sometimes called “Marshallian” inefficiency)

12. Why is it “Marshallian” inefficient? • The problem from the view point of the tenant: Max Profits: Ys = *F(ks,ns) + w(1-ns) (1) ns, Where Ys is the tenant’s income,  is the share of the output that is taken by the tenant, F(.) is the output function, ksand ns are land and labor (normalized to 1) tenant puts on farm production, and w is the off farm wage, which produces off farm income of (1-ns)*w.

13. Optimizing Problem (1) • Choosing capital and labor allocation, the first order conditions are: ∂Ys/∂ns = *Fn’(.) - w = 0 (2) ∂Ys/∂ks = *Fk’(.) = 0 (3) The inefficiency is because  Fn’(.)=w; the tenant under use labor (n) because he/she does not get full return to his/her effort. • So would tenant put on more or less labor (n)? • Because the return is lower (only get  of output, F) … to get equation (2) to balance … need to raise the value of Fn’(.) … this can happen if the labor (n) is reduced (because when there is diminishing marginal returns and Fn’’(.) < 0 … then Fn’(.) is larger when the amount of labor (n) is smaller ….

14. Optimization (2)What about land (k)? • How much land would the tenant use if the contract did not have any contingencies against its use? ∂Ys/∂ks = *Fk’(.) = 0 (3) • Since Fk’(.) = 0, the tenant will use the land as much as possible. [this was first pointed out by D. Gale Johnson in 1950s, who then showed that it was because of this that sharecropping contracts typically had very detailed arrangements that told the tenant how he/she can use the land – e.g., like the date before which tractors can not be used].

15. But is sharecropping completely inefficiently? How do tenants use fertilizer? • In many places in the world (including India and California) there is a sharing rule with fertilizer. For example, if the output is shared 50-50, then fertilizer is almost always shared 50-50. How does this help? • Now tenant’s problem is to maximize Profits: Ys = *F(ks, ns, fs) + w(1-ns) - *pf* fs(4) ns, ks, fs Where fs is the amount of fertilizer put on the crop, pf is price of fertilizer, and the sharecropper only has to pay for  of the fertilizer, the rest, 1- , being paid for by the landlord. In this case, the first order conditions are: ∂Ys / ∂ns =  * Fn - w = 0 (5) ∂Ys / ∂ks =  * Fk = 0 (6) ∂Ys / ∂fs =  * Ff -  * pf = 0 (7) and the “efficient” amount of fertilizer is being applied (Ff = pf).

16. Field-side Picnics on “Spreading fertilizer Day” (for the landlord and his family) • What do you think happens on the day that fertilizer is being applied? Where is the landlord? • If you guessed by the side of the field watching, that is right? • If he was not watching, what might the tenant do? Of course: take the extra fertilizer to the market and sell it and put the money in his/her pocket … and “under-utilize” fertilizer (from the landlord’s point of view)

17. The inefficiency of sharecropping:A numerical example

18. Crop Production – on own land (or rented-in land for a fixed rent) Food Output -- kgs 5450 5400 5300 5100 4800 4400 3800 3000 1 2 3 4 5 6 7 8 Weeks of Labor (Assume the tenant has only one variable input of production – labor)

19. Economics of Farming on own land (5 acres)Each manweek is worth $300 to the household (could produce that much in garden in private plot … or that is how much leisure is valued) Point of profit maximization: marginal revenue equals to marginal cost … therefore, when household farming by itself, they will put in 5 weeks of labor and produce 5100 kgs of grain and earn: 3600 dollars

20. Farming and returns – by household itself Food Output -- kgs 5400 5300 5100 4800 4400 3800 3000 1 2 3 4 5 6 7 8 Weeks of Labor

21. Crop Production – Sharecropping on 50-50 At end of season, split returns (½ and ½) with the landlord Food Output -- kgs Returns to landlord 4400 1/2 2700 2650 2550 2400 2200 Returns to Tenants 1900 1/2 1500 1 2 3 4 5 6 7 8 Weeks of Tenant’s Labor

22. Economics of Farming on share tenancy: Note reduction in effort (from 5 weeks of work to 3 weeks … because only get part of return! Each manweek is worth 300 RMB to the household (could produce that much in garden in private plot … or that is how much leisure is valued) Sharecropping

23. Farming and returns – Sharecropping on 50-50 basis At end of season, split returns (½ and ½) with your partner Food Output -- kgs Returns to landlord 1/2 2700 2650 2550 2400 2200 Returns to tenant 1900 1/2 1500 1 2 3 4 5 6 7 8 Weeks of Labor

24. And sharecropping can be full efficient if… • The “efficient” view of sharecropping is based on the work of D. Gale Johnson (1950) and especially Cheung (1968, 1969). • The main argument is that worker’s effort can be monitored and enforced. • Contracts offered by the landlord would stipulate in great detail regarding the size of plot, the tenant’s share, the intensity of cultivation, field and crop management, etc.

25. Farming and returns – Sharecropping on 50-50 basis At end of season, split returns (½ and ½) with your partner Food Output -- kgs Returns to landlord 1/2 2700 2650 2550 2400 2200 Returns to tenant 1900 1/2 1500 If labor is fully monitorable, landlord specifies that fixed wage worker or tenant put in 5 weeks 1 2 3 4 5 6 7 8 Weeks of Labor

26. Summary of Progress So Far • What is Sharecropping? • What is the (theoretical) “problem” with sharecropping? [why did Marshall hate it?] • Is it really inefficient? [empirical approach to testing for the inefficiency of SC … answer is “yes”] • So why do people choose it? Now the question is:

27. Are Sharecropping really inefficient? Subject to empirical test • So now we know what Marshallian inefficiency is … • And, we know that it is theoretically a problem if work effort can’t perfectly be monitored and enforced. • But the alternative is true (“efficient”) if it can be perfectly monitored and enforced. • A BASIC QUESTION: is SC really inefficient, or which alternative argument is true? This need to be answered by empirical test.

28. First, test based on a “naïve” modelSet up the “naïve” model Y = a0 + a1*Z1 + a2*Z2 + a3*Dsc + ε (2) Where Y is yield or Intensity of Input Use Z1 are household/village characteristics--things such as: education of the farmer age of the farmer location of the village Z2 are plot specific characteristics such as: quality of land other etc. Dsc = a dummy variable … 1 if farmer is farming as Sharecropper and 0 if farmer is cultivating his own plot RESULTS: In line with the theory, a3 <0 in most empirical studies. However, a3cannot be interpreted as the causal effect of incentives on productivity or input intensity, because…

29. Endogeneity .. • True equation: Y = a0 + a1*Z1 + a2*Z2 + μn + a3*Dsc + e (3) So what would happen if we just naively run an OLS regression without μn? Y = a0 + a1*Z1 + a2*Z2 + a3*Dsc + ε(4) What is wrong if we do OLS? ε = μn + e • Cov (Dsc, ε) ≠ 0, (may be + or -)

30. Omitted variable problem Y = a0 + a1*Z1 + a2*Z2 + a3*Dsc + μn + e (5) Biased and Inconsistent Possible Sources of Endogeneity • (1) omitted soil quality (a3 <0 might be due to the fact that worse quality plots are sharecropped), in which case the productivity on owned plot may be higher, this can not be attributed to Marshallian inefficiency • (2) omitted farmer’s characteristics (a3 <0 might be due to the fact that least able farmers or with worse access to working capital sort into sharecropping), again, this can not be attributed to Marshallian inefficiency • (3) omitted income opportunities (a3 >0), a poor sharecropper may have few alternative income opportunities and thus farm the labor more intensively despite the disincentive effect identified by Marshall.

31. Remedies • Instrumental variable method: find instruments for Dsc • Fixed effects model (Shaban, 1987 “Testing between Competing Models of Sharecropping” Journal of Political Economy)

32. So how did Shaban address this? Unlike the naïve model, Shaban was very clever in using a dataset which includes significant number of sharecroppers that also happen to cultivate own land. Therefore, his analysis is able to compare the average input intensities and output per area on owned and sharecropped land of the same household by holding constant household characteristics, such as management, access to non-traded inputs and prices of inputs and outputs

33. What to test? • To test whether landlord is able to effectively monitor tenant’s effort and activities • The levels of variable inputs applied to own and sharecropped plots follow: (i) No supervision: (ii) With supervision: (iii) With assumption of F(X,t) to be linearly homogeneous in all inputs and variable inputs (X) are normal, then (i) implies: SC is inefficient (marshall is right) i=1,…,n. (1) i=1,…,n. (2) i.e., labor can be monitored … like Cheung … like the case where the landlord “makes” the tenant put on 5 weeks of labor for all I=1, …,n. (3) 3 weeks … 5 weeks

34. How to interpret the regression? • Step 1: get the set up of the “problem” clearly in your mind • Step 2: What is the test: Is Sharecropping Inefficient? • Step 3: How large is the inefficiency (last 6 rows, p. 907) … use a “decomposition analysis” defined in equation 9, p. 903

35. Key to Shaban: He picked a sample of farmers that just happened to be cultivating BOTH their own plot PLUS a Sharecropped plot Sharecropping plot Owner cultivated plot N (whole sample) = 2268 households and 9389 plots n (Shaban’s “tricky” sample) = 352 households and 1420 plots

36. Basic Set-up of Shaban • A system of 8 input equations, i.e., family male labor, family female labor, …, fertilizer and other inputs. • Control plot specific effects • Control for village effects

37. Are all of the factors accounted for in the regression table? YES! • There are 8 dummy variables (one for each village in the sample (village A to H) • Irrigated Area (row 9, p. 906) • Plot Value (row 10) • 3 Soil Variables (rows 1-3, p. 907) Vil. B Vil. A Vil. C Vil. E Vil. F Vil. D Vil. H Vil. G Why does Shaban include village dummy variables? Because the rules in one village may differ from another … why would that matter? For example: if landowners in Village A provided ½ of fertilizer; but those in village H did not.

38. Estimation Method • For each input equation, the input intensity variable on the left hand side is the difference in the weighted average of that variable on own and sharecropped plots, similarly each of the right hand variables is the difference in the weighted average of that variable on own and sharecropped plots (e.g., Equation 7).

39. Estimating Impacts of SC on Input Intensity Y = a0 + a1*Z1 + a2*Z2 + a3*Dsc + μn + e Y = labor/ha Z1 = household effects Z2 = plot effects μn= unobserved effects Problem? Endogeneity

40. Estimating Impacts of SC on Input Intensity Y = a0 + a1*Z1 + a2*Z2 + a3*Dsc + μn + e SC institutions hh effects plot effects Own plot SC plot

41. Get rid of OBSERVED & UNOBSERVED EFFECTS by SUBTRACTING (4) – (5)

42. Equation to be estimated 3 plot-specific variables Constant term Or in the case of India – 7 dummy variables (1/village) Where are the hh effects? Observed AND unobserved?

43. How to interpret the table? • Step 1: get the set up of the “problem clearly in your mind • Step 2: What is the test: Is Sharecropping Inefficient? • Step 3: How large is the inefficiency (last 6 rows, p. 907) … use a “decomposition analysis” defined in equation 9, p. 903

44. Test: Is Sharecropping Inefficient? • It is on page 906 • There is a “separate test for each village” • In how many villages is sharecropping inefficient? [in 6 of the 8 villages] [why not in the other 2 … we don’t know, but it could be that all rental is between relatives … that there is very little rental … that villages are small … this is what you want to do in your “field work” … find out in qualitative terms what is happening so you can tell an even “richer” story] • Test: joint F-test of all of the coefficients across each row … are they jointly different from zero? [see footnote at bottom of table 3 and discussion of the test on p. XXX in the text]

45. How to interpret the table? • Step 1: get the set up of the “problem clearly in your mind • Step 2: What is the test: Is Sharecropping Inefficient? • Step 3: How large is the inefficiency (last 6 rows, p. 907) … or what is the magnitude? Use a “decomposition analysis” defined in equation 9, p. 903

46. Equation (9) from the paper Where 1i, 2i, 3i and 4i are defined as the proportion of the mean difference E(Δxi) that can be attributed to irrigation, plot value, soil and tenancy, respectively.

47. X1 = family male labor E(X1o) = 90 mandays/ha E(X1s)=60.1 mandays/ha Owner cultivated plot Sharecropping plot ΔX1: 29.9 (mean difference) There are four potential sources of differences: Irrigation / soil / value of the land + sharecropping inefficiency …

48. So for what inputs are the inefficiencies greatest? • The reduction of labor on the Sharecropping plot is much greater than fertilizer (which actually is higher on the SC plot versus the OC plot … liquidity constraint?) • Why? Because it is difficult (or impossible) to monitor on-farm labor!

49. Interpreting the decomposition numbers … percent • Total difference (ΔX1) is: 29.9 mandays/ha • That due to Sharecropping (SC): 62.5% x 29.9 = 18.7 mandays/ha 62.5 22.7 8.6 6.2

50. What would be the test, if we did a “real experiment” like an agronomist? X1 = family male labor E(X1o) = 90 mandays/ha E(X1s)=71.3 mandays/ha Sharecropping “part of the plot” Owner cultivated “part of the plot” ΔX1: 18.7 (mean difference) Then ALL of the difference is due to sharecropping inefficiency … because all plot characteristics are the same … only need to do a “t-test” of the difference in means Or: in regression form: ΔX1 = α0 + e (or regress delta X on a constant AND nothing else)