Structured uncertainty: a pilot study on innovationin China’s mobile phone handset industry

Li Tang1• Michael Murphree2

• Dan Breznitz3

Published online: 7 August 2015� Springer Science+Business Media New York 2015

Abstract This paper explains why many small and medium-sized (SME) private high-

technologyChinesemanufacturing firms survive and thrive within an institutional and political

system arrayed against them. We use the mobile phone handset industry as an illustrative case

of the vitality and capabilities of Chinese SMEs. We argue that in capitalizing on the advan-

tages offered by the global fragmentation of production, while also being constrained by an

institutional climate of structured uncertainty, Chinese non-state firms have chosen a pattern of

incremental innovation in their search for competitive advantage. Despite falling outside

central government innovation plans and engaging in practices inimical to nurturing novel

product innovation capabilities, these firms have a sustainable business model based on niche

tailoring, rapid product introduction and utilization of standardized components.

Keywords Structured uncertainty � Fragmentation of global production � Incremental

innovation � Mobile phone handset industry � Emerging economies

JEL Classification L52 � L63 � O14 � O25 � O31 � R58

1 Introduction

Innovation has long been lauded as the engine of sustainable economic growth (Schum-

peter 1934; Solow 1957; Arrow 1959). Developed and developing country governments

prioritize fostering ‘‘innovation’’ in their national development agendas (OECD 2008;

NRC 2007; Baumol 2002; Romer 1990). China is no exception.

& Michael Murphreemichael.murphree@moore.sc.edu

1 School of Public Economics and Administration, Shanghai University of Finance and Economics,Shanghai 200433, China

2 Darla Moore School of Business, University of South Carolina, Columbia, SC 29208, USA

3 Munk School of Global Affairs, University of Toronto, Toronto, ON M5S 0A7, Canada

123

J Technol Transf (2016) 41:1168–1194DOI 10.1007/s10961-015-9432-9

Since the early 2000s, Chinese political elites have promoted a national development

and innovation strategy known as ‘‘indigenous innovation’’ (zizhu chuangxin) (Huang et al.

2013). As explicitly stated in the 15-year ‘‘Outline of the National Plan for Medium- and

Long-term Scientific and Technological Development (2006–2020)’’ (hereinafter the

Outline), China aims to become an innovative society by 2020 (SCPRC 2006).1 Studying

the Outline shows that the goal of ‘‘indigenous innovation’’ is to produce novel product

innovation, predominantly by large state-owned national champion companies (Cao et al.

2009; Mei 2012; Sun and Du 2010). A few selected national champions—firms believed to

possess the necessary technical and human resources to achieve ‘‘innovation’’—are

showered with resources. In sharp contrast, private firms, especially small and medium

enterprises (SMEs), are largely absent from China’s national innovation blueprint (An

et al. 2006; OECD 2008).

Further, as the Outline explicitly seeks novel product innovation across a set of pre-

determined industries, incremental innovation by private firms is not even considered

innovation. Despite independently investing heavily in R&D and seeking creative inno-

vation niches, SMEs are routinely denied access to both patient and impatient capital.

SMEs have also seen technology promotion and innovation incentive policies in place

since the 1980s stripped away from them. Interviewees have noted that the central gov-

ernment has become increasingly hostile to small enterprises, tightening regulations,

restricting access to permits and taking away valuable subsidies. China’s financial system,

however, has been unable to make up for the withdrawal of state largesse as the state-

owned banks rarely loan to SMEs (Tsai 2002; Wu et al. 2008; Xiao 2011; Zhou 2009).

Despite the planned promotion of large national champion enterprises and the with-

drawal of support, and increasingly hostile treatment of SMEs, China’s SMEs have

flourished. There has actually been an inversion of the importance of SOEs and SMEs in

the high technology sectors of the economy. The SOE portion of China’s high technology

exports declined from 38.08 to 12.5 % between 2002 and 2012 while that of private

enterprises grew from 4.3 to 37.6 % (NBSC 2003, 2013). Today, the vast majority of

indigenous innovation in China can be found small private firms pursuing a combination of

incremental innovation and a hybrid of imitation and innovation (An et al. 2006; Gu

2007).2 SMEs’ incremental innovations are a source of sustained competitive advantage.

In rapidly changing industries such as mobile electronics, firms able to set new stan-

dards and control essential technologies are thought to have the greatest and most sus-

tainable competitive advantage. In China’s mobile handset industry, however, SMEs

concentrate on innovation at the margins, offering incremental innovations on established

platforms. They use fast followership to rapidly adopt, indigenize and improve upon

technologies introduced by large, usually foreign, firms. Their ability to consistently adapt

has enabled their continued vitality. Understanding the capabilities of Chinese SMEs and

how these have been created offers insight into the value of incremental innovation even in

rapidly changing industries, and a potential strategy for firms worldwide.

Since the observed innovation outcomes differ from the central plans of the Chinese

government, this paper addresses the puzzle: how do China’s SMEs flourish in a system

1 The term ‘‘indigenous innovation’’ was first explicitly proposed as national policy in the Outline.Indigenous innovation includes technological, production, organizational and market innovation. In practice,indigenous innovation is often used interchangeably with radical technological innovation or invention.2 Foreign invested enterprises also invest heavily in research and development. However, the centralgovernment takes an ambivalent view of innovation by foreign invested enterprises. Innovations fromforeign invested enterprises are thus not usually considered indigenous innovation.

Structured uncertainty: a pilot study on innovation in… 1169

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arrayed against them? How do they maintain their competitive advantage even as core

technologies are being invented and reinvented elsewhere?

2 Literature review

The study of innovation as the source of sustained economic development can be traced to

Joseph Schumpeter’s seminal piece The Theory of Economic Development (1934). After

Schumpeter’s work, however, innovation largely vanished from mainstream economic

development theory and was viewed as the residual (Solow 1957; Abramovitz 1956). With

the rise of Silicon Valley, Japan and the Asian Tiger economies, however, social scientists

began to consider the role of innovation in economic development and the role of gov-

ernment in fostering innovative capabilities (Amsden 1989, 2003; Johnson 1982; World-

Bank 1993; Saxenian 1994, 2007; Hall and Soskice 2001).

Despite the long-term dominance of Western economies and innovation systems, by the

1990 and 2000s, the global innovation axis appeared to be shifting increasingly toward

East Asia (Giget 1997; Saxenian 2007; Schmiele 2012; Lynn and Salzman 2007a, b). The

rise of emerging economies as centers for innovative activity impels researchers to con-

sider the limitations of current theories of innovation. Existing theories are based on the

experience of firms in the capitalist West. Current innovation theory fails to consider how

and what kinds of knowledge are generated and transferred in emerging economy contexts.

This demands scholarly attention. Existing innovation and economic development or

growth theories take Western-style formal institutions and incentives for firm innovation in

western economies as givens (Breznitz 2007; Breznitz and Murphree 2011). These

mechanisms include rule of law, effective intellectual property protection, financing

infrastructure, and credible commitment of government to these mechanisms. Where these

institutions are present, it is generally argued that innovation and successful economic

performance should ensue. The challenge for policy makers is thus to get the institutions

right and innovation should follow.

However, these well-established, but often unstated, mechanisms of support for inno-

vation activities in western societies barely hold in emerging economies. Theories which

assume such institutions already exist, or must exist, cannot provide much insight into the

performance of emerging economies where these institutions and incentives are largely

missing. Although the supposedly requisite formal government organizations and institu-

tions do exist in emerging economies, their behavior deviates greatly from the Weberian

bureaucratic norms or standards assumptions of Western institutional theory (North 1990).

Furthermore, existing studies of innovation and development in emerging economies

have tended to strongly emphasize the role of the central government as planner and guide

(Amsden 1989, 2003; Johnson 1982; Lundvall 1988, 1992). More recent studies have

backed away from the view of an essential central government ministry or formal structure,

emphasizing instead government flexibility and co-evolution with industry (Amsden and

Chu 2003; Calder 1993; Evans 1995; Samuels 1994). Studies of China have tended to

emphasize the outsize role of the central government as coordinator and planner in the high

tech industry, emphasizing the importance of SOEs, indigenous standards, and centrally

administered and funded plans (Cao et al. 2009). Studies looking at the local level in China

have mostly found the government is effective in promoting industrial growth and

investment but not innovation. Such innovation as appears to be occurring is often

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attributed more to returnees (Saxenian 1994, 2007) or foreign invested enterprises as

sources of information, tacit knowledge, training and demonstration.

We take a different approach to the generation, transfer and cultivation of innovation

capabilities in China. The innovation successes by private firms have come not via central

government fiat or directed lending into the construction of new industries. Unlike the

classic late-development model, national champions and central-government planning

have played a much less significant role in the development of China’s most innovative

firms. As noted above, national champion SOEs play an increasingly minor role in the high

technology economy. Instead, small and medium enterprises, aided by local and provincial

government policies, are the loci of much innovation (Liao and Yu 2013). This exception

means our ideas regarding the major actors for innovation and locus of developmental

policy need to be reconsidered.

Finally, existing theories of emerging and mature market economies’ innovation and

development are still based on a static view of national-level economies. Where the

international system is engaged in current theory, it is mostly seen through the lens of FDI

or the global trade in completed goods or licensable intellectual property. This ignores the

reality of the current system of globalization: the global fragmentation of production

(Arndt and Kierzkowski 2001; Athukorala and Yamashita 2006; Baldwin and Clark 1997;

Ernst 2005; Sturgeon 2002). The fragmentation of production means specific activities and

stages of production are standardized and outsourced or offshored (this process is also

known as modularization or unbundling). Fragmentation creates multiple points of access

to the global economy and multiple sectors and subsectors of industries in which firms or

regions can concentrate and innovate. Existing innovation and growth theories developed

under an assumption of nationally-oriented and vertically-integrated companies cannot

predict the capabilities of and innovation accomplishments by firms operating on specific

niches within a fragmented industry. They also offer poor frameworks on which to build

national innovation policies tailored to the reality of globalization.

This pilot study begins development of a theory to account for the innovation capa-

bilities of Chinese—and by extension emerging market—firms. It utilizes the current

reality of the global fragmentation of production to show how firms are able to easily enter

and specialize in niches within a given industry, in this case mobile phone handsets. It also

goes beyond current institutional theory by utilizing the novel theoretical construct of

‘‘structured uncertainty’’ to help account for the incentives and structures for innovation by

SMEs. Together, fragmentation and structured uncertainty can account for both the

capabilities and sustained vitality of China’s SMEs in this sector.

Specifically, we confine our examination to the following two interrelated research

questions: (1) What are the main characteristics of innovation behavior among Chinese

private firms in the mobile handset industry, and (2) How do they survive and thrive under

the climate of structured uncertainty?

As an initial pilot study, we focus on the experience of private SMEs in a single

industry.3 While there are likely to be industry-specific dynamics at work, the same

technological forces such as rapid change and platform technologies dominated by foreign

3 In Chinese economic parlance, firms are usually classified by their ownership type. There are six legalcategories of firms plus a seventh ambiguous category: getihu (private businesses with fewer than sevenemployees), siying (private enterprises of any size—the subject of this paper), jiti (collective enterprises),guoyou (state-owned enterprises), waizi (foreign invested enterprises) and hezi (joint ventures). The seventhcategory, minying, refers to any firm that is neither state-owned nor foreign invested. While this includescollective enterprises, the term today is mostly synonymous with private enterprises. This paper is based oninterview research with small private enterprises.

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companies are at work in many other high technology rapid innovation industries including

consumer electronics, telecommunications backbone equipment, and software.4 Thus, our

conclusions, while tentative, suggest a possible mechanism governing innovation in private

SMEs in China as well as other emerging economies. Further, it offers a new avenue for

future research both across different industries and countries.

The next section introduces the key explanatory notions of this study: the global

fragmentation of production and structured uncertainty. This is followed by a description

of the research method employed in this study. We then analyze the innovation practices of

China’s mobile handset firms and how they respond to the business environment in which

they operate. The paper concludes with a discussion of limitations, policy implications and

future direction.

3 Key notions and propositions: fragmentation of productionand structured uncertainty

A defining feature of the world economy today is the global fragmentation of the pro-

duction of goods and services. Different from Fordist production wherein a single firm

performs all actions from raw material extraction through logistics, component production,

assembly, sales and after sales service, these tasks are now increasingly performed by

different firms, often in different locations (Arndt and Kierzkowski 2001; Athukorala and

Yamashita 2006; Baldwin and Clark 1997; Breznitz 2007; Ernst 2005; Sturgeon 2002).

This spatial dispersion of component production and integration across national borders is

referred to as the fragmentation of global production. Unlike vertical integration oriented

toward national economies, individual organizations, states or regions can integrate

themselves into the global chain of production by specializing in specific stages of pro-

duction with cross-border dispersion of component production. Firms can focus their

resources on their ‘‘core capabilities’’ in design, integration, production, marketing, or

distribution, while outsourcing or offshoring the rest of the value chain to other highly

specialized firms (Sturgeon 2002). As evidence of the spread of fragmented production,

77 % of total world trade in 2006 consisted of trade in intermediate, as opposed to final,

goods (Sturgeon and Memedovic 2010).

Uncertainty is inherent to the innovation process. Firms cannot know ex ante if their

research will be successful, if the research results will have commercial value, or if newly

introduced products will find market acceptance. This uncertainty, often bundled into the

catch-all term ‘‘risk’’ is supposedly mitigated by market forces: firms accept higher risks so

long as the potential returns are proportionately greater. Governments use formal institu-

tions to help counteract uncertainty. Property rights and a functional legal system are

4 A recent product example of firms utilizing rapid incremental innovation as a survival strategy underconditions of structured uncertainty is the two-wheeled hands-free electric scooter sold under brands such as‘‘IO Hawk’’ and ‘‘Phunkeeduck’’. After its invention and subsequent presentation at the Canton Trade Showin 2014, Chinese factories began reverse engineering the product and making new versions with slightcosmetic or, increasingly, material modifications. The competing brands have increased the weight capacity,battery life, and speed while producing as rapidly as possible. Emphasis on speed to market has benefitedfirms with manufacturing experience and tight supply chain linkages have made rapid price reductionspossible. The basic design remains, but Chinese manufacturing firms make rapid improvements based on theskills they possess, whether in batteries, structure or sourcing and production. With the number of competingbrands rapidly increasing, new market entrants are simultaneously forced to lower prices and add newfeatures—cosmetic or material—in order to compete (Pierce 2015).

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considered essential to mitigating uncertainty. Property rights allow entrepreneurs to

appropriate the gains from their research while the legal system allows them to ensure they

will be able to enforce claims against agents attempting to free-ride on their assumption of

risk.

For public policy, governments are thus encouraged to reform and improve their formal

legal institutions in order to reduce uncertainty and increase firms’ willingness to take on

risk. Even where the traditional formal institutions are absent, systems of exchange based

on repeated interactions and socially embedded trust have emerged to also facilitate

business activity. Institutions, both formal and informal, are thus considered the antidote to

the challenges presented by uncertainty.

A great challenge arises, however, where formal institutions are present, yet do not

function as intended or expected. This situation, which we call ‘‘structured uncertainty’’ is

present in China and many other emerging economies. Whether through internal political

development or external pressure from international development and financing agencies,

the governments of emerging economies have created many of the requisite formal

institutions described above. However, these institutions frequently lack social and cultural

legitimacy, are flouted by elites, or circumvented by well-placed agents seeking advan-

tages. Further, the process of institutional development often means there are different state

and non-state actors with claims over the right to enforce laws or enact policies (Breznitz

and Murphree 2011). As a result, firms cannot fully know when, where, and under what

circumstances, a given policy or formal institution will be utilized. Further adding to the

confusion, as there are formal institutions in place, even where culturally or socially

accepted practices, such as relying on personal connections, predominate, it is possible for

state agents to use their legal authority to counter these established social and cultural

practices.

In the case of China, structured uncertainty emerged as a product of legal and institu-

tional reforms taking place in apolitical economic system dominated by the Communist

Party and an authoritarian state structure. As economic reforms proceeded, it was expe-

dient for government officials—especially at the local level—to ignore or circumvent

national laws, while enforcing others. Local practices for providing investment capital,

registering new enterprises, solving contract disputes, and seeking labor or resource inputs

evolved, often conflicting with current national laws but tolerated and even encouraged as

expedient by local officials cultivating rapid GDP growth (Chang 2009; Gold et al. 2002;

Tsai 2002).

We therefore propose that a new type of institutional environment exists in China and

other emerging economies, one of structured uncertainty. For firms in China, structured

uncertainty may be thought of as an agreement to disagree about the goals and methods of

policy or business practice, a condition leading to intrinsic unpredictability and, hence, to

inherent ambiguity in implementation. This ambiguity leads to tolerance of multiple

interpretations and implementations of the same policy. Structured uncertainty thus

cements multiplicity of action—politically by government officials and in terms of busi-

ness strategy by firms—without legitimizing a specific course or form of behavior as the

proper one. Rather than simple anarchy, however, there remains the potential for seemingly

arbitrary yet rapid enforcement of laws and regulations at any point in time. Actors cannot

know when, if, or who will decide that a certain practice is permissible. Such a capricious

environment means firms must take certain actions in order to ensure their ability to exist,

function, and thrive. Large firms have independent resources sufficient to buffer them-

selves against some aspects of structured uncertainty. SMEs, in contrast are forced to adopt

various strategies to cope with the ambiguous environment in which they operate.

Structured uncertainty: a pilot study on innovation in… 1173

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Structured uncertainty differs from risk and other commonly considered forms of

uncertainty in that the reward structures differ. Structured uncertainty cannot be mitigated

by cross subsidization (a common technique for addressing market or investment uncer-

tainty) or through the creation of multiple products to increase the chances of success.

Under normal conditions of uncertainty, governments are encouraged to create or improve

institutions. For structured uncertainty, however, the institutions are already in place. It is

their presence, rather than their absence, that is the source of uncertainty. Their socially

unreliable implementation, yet potential for use, creates uncertainty for firms. Further, a

reward mechanism is not built into structured uncertainty. Firms face structured uncer-

tainty as a cost of doing business, not an accepted risk justified by higher potential returns.

Facing standard risk and uncertainty, firms will use investment hedging, insurance and

diversification strategies. Governments will implement and strengthen legal institutions

and protections for firms. In contrast, firms subject to structured uncertainty exhibit very

different behaviors in business practice and investment.

We find that firms subject to structured uncertainty engage in a type of sustained fast

followership, emphasize short-term economic returns, utilize proven technologies, and

seek local government protection from potential national political or legal interference.

These behaviors shape the actual types of innovative activity which can and will take place

by a firm, regardless of the resources available. Structured uncertainty thus acts as an

impediment to novel product innovation but actually facilitates and increases the incentive

(and potential) in other types of innovation. Accordingly, Chinese SMEs are more con-

servative and risk-adverse, and pursue short-term profits, knowing they are susceptible to

varying institutional influences and changes, and never knowing whether they will be able

to appropriate the fruits of their own actions. They are disincentivized to pursue long-term

research projects or projects with higher degrees of risk since the rules of the game could

change before potential rewards materialize.

The sections that follow introduce our case study, SMEs in China’s mobile phone

handset industry. The case study shows how SMEs in this industry actually innovate, as

well as the pressures to which they are subject. It therefore shows how enterprises facil-

itated by the fragmentation of production, but constrained by structured uncertainty, enter

and thrive in a rapid innovation-based high technology industry in China.

3.1 Case study: China’s mobile handset industry

This research explores patterns of innovation under structured uncertainty in China’s

mobile handset industry. This industry was chosen for its intrinsic importance to the

Chinese economy and polity, as well as its representativeness. Mobile telephony is a rapid

innovation-based industry with quick product turnover and obsolescence. New technolo-

gies replace older ones with great frequency. The industry is dominated by a few large

platform technology-creating firms. By studying SMEs in this industry, we can also

understand how SMEs in other industries with similar innovation and competitive

dynamics are likely to react to conditions of structured uncertainty.

In terms of intrinsic importance, China’s mobile handset industry has experienced

impressive development over the last two decades. China has been the world’s largest and

fastest growing market for mobile telephony (Foster and Reinsch 2010). In 2012, China

became the world’s largest market for smart phones; sales of these devices now far exceed

those of simple call and text devices (Savitz 2012). The number of mobile phone sub-

scribers reached 1.293 billion in April 2015, with a penetration rate of 80.6 subscribers per

100 habitants (MIIT 2015a, b). China is also the world’s largest production center for

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handsets of all kinds, producing more than 1.6 billion cell phones—85 % of global out-

put—in 2014. In the same year, China exported 115.4 billion USD worth of phones to more

than 200 countries (MIIT 2015c).

The industry is also considered politically important. Information technology, including

the handset industry has been named as a strategic industry in the 10, 11 and 12th 5-year

plans (2000–2015). China’s central government has promoted a diverse body of policy

instruments to foster innovation in the mobile cell phone industry. In practice, large state

owned enterprises have received the lion’s share of resources for developing new tech-

nologies. Policy instruments designed to foster innovation in private SMEs, remain rela-

tively modest and underdeveloped in China. For example, a 2011 study found that of 600

randomly selected companies in Beijing’s Zhongguancun High-Tech Science Park (the top

science and technology zone in China, usually compared to Silicon Valley), 60 % of the

firms which received government R&D grants were state-owned or large-scale enterprises.

In contrast, less than 20 % of firms receiving R&D grants were private SMEs (Guo and

Meng 2011). China’s venture capital industry also tends to behave more like private equity

and fails to invest in promising high tech start-ups, usually preferring more certain returns

in hotels and traditional manufacturing. Furthermore, as has been explored elsewhere,

China’s banking system is reluctant to extend loans to SMEs due to ill-devised incentive

structures and institutions for assessing risk (OECD 2008, 2011). The collective result is a

shortage of patient and impatient capital available to small Chinese firms. Nonetheless,

small firms continue to thrive. Two different types of innovative business models have

evolved in the handset industry: top-down indigenous innovation promoted by the central

government and the bottom-up incremental innovation of SMEs (Marukawa 2010). The

importance of the mobile handset industry, as an integral part of the strongly promoted ICT

industry, provides a broad illustration of China’s SMEs’ innovation capabilities. Further,

combined with its policy relevance, the mobile handset manufacturing sector is an ideal set

for examining how innovation occurs under structured uncertainty and outside the bounds

of the usual rules of innovation.

Research on the mobile telephony industry in China has found abundant evidence that

SMEs innovate. This research has explored a variety of factors contributing to the emer-

gence and evolution of the Chinese mobile handset industry (Kao and Lee 2010; Sun et al.

2010; Yu 2005; Zhu et al. 2009). Much of the research, however, concentrates on tech-

nological push and market pull factors. Gao (2011) and Guo and Guo (2011) argued that

spatial overlap of industrial clusters and specialized markets are the main driving forces of

the boom in gray market phones known as shanzhai.5 Although shanzhai is sometimes used

to refer to outright counterfeit phones or close brand knock-offs, it refers most generally to

phones produced by small firms which lack official state-issued production licenses as well

as relatively unknown independent brands. Shanzhai firms are considered ‘‘gray market’’

since many do produce imitation foreign branded phones, sometimes deliberately mis-

spelling the brand to avoid copyright violation (e.g. ‘‘Sumsang’’, ‘‘Sansung’’, ‘‘Nokla’’, or

‘‘Nckia’’). The emergence of these small producers has been significant as many firms now

producing their own independent brands began in this niche market. Their competitive

strengths remain the same, however, efficient component integration and manufacturing

combined with incremental innovations and rapid time to market.

5 As there is no universal standard definition of what constitutes a shanzhai mobile handset, for this paper,the term shanzhai is used only to denote firms without official government production licenses, whether theiroutput infringes intellectual property rights or merely consists of relatively unknown niche Chinese brands.

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Integrating the global value chain (GVC) perspective, (Sun and Du 2010; Sun et al.

2010) used the handset industry to illustrate how firms in emerging economies can improve

innovation capabilities by focusing on R&D and marketing. Nonetheless, the role of

China’s institutional setting combined with the global context of production is under-

investigated. In an attempt to contribute to the body of empirical knowledge in this area,

this paper integrates structured uncertainty and the increasing fragmentation of global

production into to the analysis framework to explore Chinese SMEs’ innovation behavior.

3.2 Propositions

The fragmentation of global production impacts firms’ behavior through at least two

mechanisms: market opportunity and access to technology. Such impacts are particularly

pronounced in the telecommunication industry which exhibits an extremely high level of

modularization, much like garments, electronics and other information technology hard-

ware (Lynn and Salzman 2007a; Helg and Tajoli 2004). In highly modularized industries,

firms have many narrow production chain niches into which they can insert themselves.

This means firms are able to begin production for an industry without mastery of the entire

production chain, thus facilitating entrepreneurship and firm creation, even with limited

resources.

The mobile phone handset industry, particularly in the smart phone era, has two core

technology platforms around which phones can be built: an integrated circuit and software

operating system. MediaTek (a Taiwanese semiconductor firm) developed a ‘‘turn-key’’

one-stop solution for the integrated circuit. Combining integrated circuits, reference

design, and interface together, MediaTek provides an open platform for both original

equipment manufacturers (OEM) and original design manufacturers (ODM) to easily

change interfaces between various components (Hu et al. 2011). Google’s Android oper-

ating system allows smart phone manufacturers to develop phones able to connect to an

existing ecosystem of software applications, thus increasing their value to users, while

saving firms the difficulty of developing such an operating system and software application

ecosystem themselves. With these basic platforms, mobile handset manufacturers do not

need to worry about compatibility of each component in discrete modules. They can enter

the production chain at different stages, confident that so long as they conform to these

platform technologies, their components or final products will be compatible. Such spe-

cialization would be impossible without the fragmentation of global production. Frag-

mentation provides profitable opportunities for firm entrance into this industry. Thus our

first proposition related to firms’ innovation behaviors is as follows:

Proposition 1: The global fragmentation of production facilitates entrepreneurship by

lowering barriers to entry and providing multiple viable points to access global value

chains.

Pursuing innovation is fraught with risk, regardless of where this innovation is positioned

along the production chain. As novel-product innovation means high levels of resource

investment and high risk (Kline and Rosenberg 1986), firms, like all other rational

economic actors, are reluctant to commit themselves to cutting-edge, high-risk, expensive

R&D over the long term without some degree of assurance they can reap the profits later

on. Indeed, Arrow’s research suggests this is why market forces result in systematic under-

investment in research and development (1959). Given the already high disincentives to

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novel product innovation, a hostile institutional environment where gains cannot be

assured means firms will turn to incremental innovations which can be made more quickly

at a comparatively lower cost (Christensen 1997).

As stated earlier, Chinese firms face a climate of structured uncertainty. Policies and

government incentives can change without warning. Local government regulations can be

overruled by provincial or central government ones. Firms cannot know for how long their

current institutional environment will remain unchanged and their chosen business model

permitted. Rational SMEs are thus unable and unwilling to bear the risks brought by

radical technological innovation. On the other hand, incremental innovation is a rational

way coping with structured uncertainty. Incremental innovation requires fewer resources

and, generally, less time to yield commercializable results. Incremental innovation thus

limits the consequences of failure and increases the chances of success.

SMEs are not necessarily constrained to incremental innovation. Under favorable

institutional climates, startups and other small firms can make intense investments in

unproven technologies or research avenues in the hope of generating new platform-creating

technologies. This is why, for example, much American novel pharmaceutical develop-

ment is carried out by small startups which are then acquired by established firms once

their research shows promise. Even where technologies are currently established and

standardized, there are opportunities for firms with suitable constellations of resources and

institutional climate to push to redefine an industry. Under structured uncertainty, however,

the inability to ensure long-term payoffs or even permission to continue operation in a

sector discourage such long-term investment and R&D strategies. Thus the second

proposition of our paper is as follows:

Proposition 2: Constrained by structured uncertainty, China’s SMEs opt to seek

sustained competitive advantage by excelling in incremental innovation.

As structured uncertainty presents an impediment to operating a business, firms must seek

a means of mitigating this uncertainty. This cannot be done through seeking institutional

reform in China’s system—as political power is not directly exercised through public

opinion or voting. Instead, firms seek protection from shifts in central government policy

and practice at the local government level. Local authorities are closer to the firms and

have a vested interest in their sustained vitality. They are thus more inclined to work with

and seek to aid SMEs.

Reforms since 1978 have produced a ‘‘mosaic effect’’ in the Chinese economy (Segal

and Thun 2001). Economic reforms have created a de facto federal structure of adminis-

tration; top-down synchronization and planning is increasingly ineffective (Montinola et al.

1995; Qian and Weingast 1996, 1997). Along with its evolution toward more decentralized

governance, disparate regional economies have enjoyed escalating implementation

autonomy as well as enforcement deviations from central planning.

As a result of their policy and administrative independence, local authorities act as an

active and flexible facilitator to promote regional economic development and cope with

various kinds of barriers to innovation in all classes of enterprises in their territory. At the

same time, China’s cadre selection and evaluation system encourages officials to strongly

promote local economic growth by rewarding economic, investment, export and

employment growth (Oi 1999; Nee 1992). Local governments’ development efforts are

dedicated to promoting all kinds of production actives, such as through allotting land, tax

rebates, and offering export subsidies within their respective jurisdictions. Despite recent

moves, most notably by Shanghai’s Municipal Government, to end the practice of making

Structured uncertainty: a pilot study on innovation in… 1177

123

formal economic growth targets, GDP growth remains the singular focus of most Chinese

authorities.

Local government support for economic development has led to a high degree of

cooperation and mutual assistance between SMEs and ambitious local bureaucrats. From

the firms’ perspective, structured uncertainty can be coped with by finding allies. Thus,

managers not only try to construct and maintain horizontal and vertical alliances with

suppliers and buyers (Boisot and Child 1996; Oerlemansa et al. 2013), but also rely on the

local state for resources and support such as obtaining permits, avoiding fines, getting R&D

subsidies, and/or mitigating some unexpected risks such as periodic crackdowns on unli-

censed activities such as producing phones without production, patent or copyright

licenses. Such synergism between localities and business managers encourages promotion

of incrementally innovative industries as these can yield rapid results and lead to quick

economic expansion. In the same vein, the desire for easily quantifiable short-term eco-

nomic returns discourages long-term novel product innovation which requires more capital

and longer time horizons than either party can offer. The third proposition outlined in this

research follows:

Proposition 3: Assistance for SMEs by local officials buffers structured uncertainty,

while further encouraging incremental innovation.

4 Methodology

Considering the under-investigated situation of this domain, we adopted an inductive case

study approach for this paper (Eisenhardt 1989; Eisenhardt and Graebner 2007). The

‘‘three legs of qualitative stool’’—in-depth interviews, document analysis and observa-

tions—were combined as recommended by Hall and List (1999, p. 291). Information on

China’s mobile handset industry and government policy documents was first collected

from a variety of sources. Using this archival data, we developed a semi-structured

research protocol designed to explore the innovation climate, challenges, and strategies of

different actors in the mobile handset industry: firm managers and founders, officials in

local government offices, and Chinese innovation scholars. Relying upon insider’s

knowledge, website news (both in Chinese and English), as well as previous studies on this

topic, we first constructed a dataset of the three types of interviewees. We then asked each

targeted interviewee, whether they accepted an interview or not, to nominate other indi-

viduals who could be asked to give information or provide their opinion on the topic. In

total 34 interviews were conducted between the summer of 2011 and spring 2013. Table 1

summarizes the interviewed entities: twenty-four firms, six government offices and asso-

ciations and four innovation scholars. We also conducted three observational field visits to

Shenzhen’s mobile phone wholesale markets, the manufacturing and distribution base for

small SME branded and shanzhai cell phones. The firms interviewed ranged from SMEs

less than 2 years old to two of China’s leading mobile telephony hardware firms. This was

not a representative random sample. Rather, our interviewees constituted a sample of

convenience developed through the snowball method. Given the dual nature of China’s

mobile handset market: grey market activity (many firms started by producing imitation

phones) and fierce competition, many firms were unwilling to discuss their history,

development, or current status. As a result, the case selection was based on a combination

of a convenient sample and the snowball method (Armakolas 2001; Creswell 1998; Weiss

1994). The sample is thus biased towards successful firms. By using the snowball method

1178 L. Tang et al.

123

Ta

ble

1Interviewee

profiles

Entity

Interviewee

code

Industrial

niche,

responsibility,orresearch

focus

Headquarters/

office

location

Founding

year

Yearentered

mobileindustry

Employment

R&D

personnel

Mobilephone,

electronics

andventure

capital

firm

sFA

Designhouse,manufacturer

Shenzhen

1999

2010

*2000*

*100

FB

Designhouse,brand

Shenzhen

2001

2005

*400

*80

FC

Designhouse,brand

Shenzhen

2005

2008

*800

*100

FD

Designhouse,brand,manufacturer,OEM

Shenzhen

2009

2010

*80

*50

FE

Designhouse,brand

Shenzhen

1985

1997

*6500*

*2000*

FF

Chip

board,ODM

Shenzhen

2006

2008

*80

*10

FG

Chip

board,ODM

Shenzhen

2012

2012

*50

*20

FH

Chip

board,ODM

manufacturer

Shenzhen

2013

2013

*60

*10

FI

Designhouse,brand,manufacturer,OEM

Shenzhen

2005

2005

*450

*120

FJ

Designhouse,brand,manufacturer

Shenzhen

1992

2003

*1000

*100

FK

Chip

board,ODM

Shenzhen

2005

2005

*400

*30

FL

Chip

board,ODM

Shenzhen

2002

2003

*1000

*120

FM

Solutionprovider,manufacturer

Shenzhen

2005

2005

*180

*100

FN

OEM

Shenzhen

2012

2012

*40

*10

FO

ODM

Shenzhen

2012

2012

*40

*10

FP

Designer

house,ODM

Shenzhen

2006

2007

*350

*30

FQ

Solutionprovider

Huizhou

1983

2007

*300

*150

FR

Designhouse,solutionprovider

Suzhou

2005

2005

*80

*60

FS

Designhouse,solutionprovider

Shanghai

2009

2009

*40

*25

FT

ODM

Shanghai

2005

2005

*2000*

*1000

FU

Solutionprovider

Shanghai

2009

2009

*20

*15

FV

Designhouse,solutionprovider,OEM

Beijing

2002

2003

*700

*600

FW

Electronicsdesignhouse,brand,manufacturer

Shanghai

1991

N/A

*40

*25

FX

Venture

capital

Shanghai

2008

N/A

N/A

N/A

Structured uncertainty: a pilot study on innovation in… 1179

123

Ta

ble

1continued

Entity

Interviewee

code

Industrial

niche,

responsibility,orresearch

focus

Headquarters/

office

location

Founding

year

Yearentered

mobileindustry

Employment

R&D

personnel

Government,industrial

associations,and

academ

ics

GA

Localindustrial

developmentpromotion

Shenzhen

GB

Localscience

andtechnologypromotion

Shenzhen

GC

Intellectual

property

law

court

Beijing

GD

Intellectual

property

research

Beijing

AA

Sem

iconductorindustry

Shenzhen

AB

Mobilephoneindustry

Shenzhen

UA

Urban

planning

Beijing

UB

Industrial

economics

Shanghai

UC

Softwareandmicroelectronics

Beijing

UD

Economicsandmanagem

ent

Beijing

Sitevisits

Mingtongmobilephonemarket

Gaokedemobilephonemarket

Longshengmobilephonemarket

Someinterviewed

firm

shaveonly

beenin

themobilehandsetindustry

since

theirfounding;otherswereoriginally

electronicsmanufacturersandlaterenteredmobilephone

industry

Theem

ploymentnumbersmarked

with(asterisk)*arethose

ofthewhole

company,includingthose

arenotworkingdirectlyin

themobilehandsetdivisionofthebusiness

1180 L. Tang et al.

123

and introducing this element of success bias, the challenges these firms face and the means

they have devised to overcome them are even more significant.

On the whole, the interviewed firms represent a tiny slice of the thousands of SME

handset firms and their component producers in Guangdong province. This is a snapshot of

a portion of a vibrant industry. It does not constitute a statistically significant portion of the

national, or even local, production system. Hence, this research is a pilot study, setting up

implications for future larger scale research.

To validate data from different sources and interviews, each semi-structured interview

touched on all of the same themes, enabling us to triangulate responses with high credi-

bility. Considering the small size of our sample, the method of agreement (Mill 1872) was

utilized to explore cases with different characteristics and similar values on the study

variable-innovation behavior. To encourage involvement and reduce potential suspicion,

we promised all interviewees that we would conduct an accuracy check before we would

publish the results and that we would give each participant a study report of our findings

upon request. Follow-up calls and e-mails were also carried out for further clarification.

The analysis which follows uses data from the transcripts of the interviews to illustrate

the innovation patterns and pressures facing SMEs in the mobile telephony handset sector.

To protect the identity of our interviewees, information or quotes are identified as

‘‘Authors’ Interview’’.

5 Analysis

The interviewed SMEs have managed to build and maintain market share even in the smart

phone era through their ability to capitalize on niche markets. While earlier research into

shanzhai phones took place in the 2G handset era, it seemed unlikely at the time that those

simple hardware-based firmswould be able to thrive as smartphones becamemore affordable.

Even during our interviews, both government offices and Association AB (which represents

over 500 firms at all levels of the mobile communications industry from components to

network operators) expressed skepticism that SME phone brands could survive in the feature

and software rich 3G and 4G mobile era. A representative from Association AB explained:

The advent of 3G and widely available smartphones poses a big challenge for small

brands. The growth of smartphones is squeezing out 2G GSM models. Further,

MediaTek chips can’t support smart phone applications so there is a lack of this

crucial resource for shanzhai firms to move into smartphone production. Most

importantly, major foreign brands and new large Chinese brands have cut their prices

to compete and deal with the challenge of small niche brands. This has eroded the

advantage once held by SMEs. (Authors’ Interview)

Despite these statements, our interviews confirmed that their business models remain

viable even for smartphones. The availability of the open source Android operating system

and continued provision of sophisticated but readily available mass produced chipsets from

MediaTek and, increasingly, Chinese semiconductor firms has enabled SMEs whose

business is based on integration and incremental improvement to continue to thrive.

Lacking advanced software or hardware development capabilities, these firms cluster in the

fiercely price-competitive low end of the smart phone market. As operating system and

integrated circuit creators seek to maintain market share and dominance over the stan-

dardized architecture (software and hardware) of mobile phone handsets, Android oper-

ating systems and the necessary supporting chipsets remain widely available and affordable

Structured uncertainty: a pilot study on innovation in… 1181

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for SME producers. Market researchers have confirmed that while major brands have made

inroads into the lower-end market once dominated by SME brands, there remains a long

tail with significant domestic and foreign potential. According IHS Research, in 2014

foreign brands (Samsung, Apple, and Vivo) accounted for 32.6 % of China’s smartphone

market and Chinese national champions (Lenovo and Coolpad) accounted for 21.53 % of

the market. Newly emergent Chinese brands headquartered in Shenzhen or its neighboring

city of Dongguan (Huawei, Oppo and ZTE) accounted for a further 20.94 % (IHS 2015).6

The long tail of firms accounts for 10 % of the total smartphone market. Shenzhen’s small

brands compete in this niche, with total sales of over 40 million phones in 2014. The SMEs

covered in this research are thus part of 10 % of the overall Chinese smartphone market.

This is a decline from the nearly 20 % market share SME-produced phones enjoyed in the

2G era (Barboza 2009) but remains impressive given the lower prices for branded

smartphones as well as rising disposable incomes in China. Further, as discussed below,

many of Shenzhen’s SME brands have found markets overseas, further expanding their

competitive space.

The Shenzhen mobile handset industry remains important even as the broader elec-

tronics industry restructures. In both Shanghai and Shenzhen, the interviewed officials and

those in the industry associations noted how important the sector was as a source of

employment, and a source of demand for locally produced electronics components for

whom export markets were growing more slowly. Association AB’s interviewee explained

the importance of the sector:

The (foreign) branded firms are moving final electronics assembly operations into the

interior provinces in search of cheaper land and labor. Nonetheless, there are still

over 100 enterprises in Shenzhen employing a total of 300,000–500,000 workers

making phones and the electronic components that go into their production.

(Authors’ Interview)

Proposition 1 argued that the global fragmentation of production enables rapid firm

creation and market entry by SMEs. Interviewees’ perspectives provide evidence the

fragmentation indeed enabled their firms to begin operations. None of the 23 handset or

electronics firms interviewed currently has, or even is interested in developing, a vertically

integrated production system. Locally and globally available affordable and efficient

component suppliers account significantly for the rise and success of China’s mobile

handset industry. As some traditional electronics sectors such as tabletop phones and fax

machines decline in China, their component suppliers have begun looking for new

customers. These components firms offer low prices in order to gain new sources of

demand and maintain their market share.

With necessary components readily available, SME mobile phone companies need only

integrate the components to build phone handsets. Some firms go even further and just

provide designs for phones as there are contract manufacturers available who can provide

the component sourcing and assembly services. These designs are based on integrating

common chipset and operating system platforms. This industrial ecosystem means small

companies or even individual merchants can manufacture their own branded cell phones.

Indeed, a banner in the Mingtong Mobile Phone Market exhorts vendors to ‘‘Carry out

Indigenous Innovation; Build Your Own Famous Brand.’’ With the components and human

6 While not the subject of this research, the largest Chinese brands have similarly benefitted from the locallyavailable production chain, often using the same suppliers as the SME brands with whom we spoke. Ourcomponent supplier interviewees mentioned major brands such as Coolpad and Huawei as their customers.

1182 L. Tang et al.

123

resources available, firms have responded. Small brands in the Mingtong Market included:

Tomorrow, Royalstar, Sunup, DCCV, Daxian, Jugate, M-Horse and Enmac.

Each of these small brands seeks to capture a particular niche market. Enmac for

example sells phones for the Middle Eastern market which have an automatic silent

function during daily prayer times as well as Korans and compass functions for finding

east. SMEs’ ability to release small batches of niche phones is enabled by the fact that the

brands need not master all elements of mobile phone technology. Association AB stated

directly:

SME brands have worked in Shenzhen because there was already a complete

industry chain. Once the chips could be procured from MediaTek, MStar, Zaixun, or

Ruiming, then a small team could design the phone, get any necessary components

from within a 2-h radius of the Huaqiangbei area, and assemble the phones.

(Authors’ Interview)

Speaking with individual firms, interviewees described the same production process, and

its viability. A chief engineer with Firm FE described the process of securing components

and combining them in innovative ways: ‘‘Handset manufacturing is like traditional

Chinese medicine. You can find each herbal element (component) to make the final

product effective’’ (Authors’ Interview). Firm FJ explained that it was not necessary to

master all of the segments of mobile phone technology:

We do not care to develop our own chips. Let those firms who are good at doing

those things do that. We make the phones. It’s like we are making a salad when we

make phones. You grow the cucumber; you grow the tomatoes. And I’ll put it all

together. (Authors’ Interview)

As many of the necessary components for mobile phones are commoditized and

standardized parts, once the chipset is procured from MediaTek or its Chinese and

Taiwanese competitors (MStar, Zaixun, Ruiming), only a small team is necessary to design

and assemble the phones. Within the framework of production fragmentation, small firms

in Shenzhen can concentrate on design and re-combination of existing technologies

without having to develop core component design or production capabilities in-house. As a

result, they can be highly specialized in the types of phones they design and produce, able

to make multiple models in short periods of time. Relying on standardized chipsets allows

for rapid firm creation and sales initiation.

The maturity of these technologies is what enables SMEs to initiate production. An

industry analyst in the Association AA which represents Chinese firms making and uti-

lizing semiconductors explained how high demand and ready availability of necessary

components—especially chipsets and software—make it possible for firms with relatively

few resources to enter the market, thus facilitating entrepreneurship:

The two necessary conditions for development of SME-based mobile handset

industry development are: the huge demand for mobile handsets and the maturity of

the components and basic technologies for handset production. With these two, firms

are able to quickly enter the market and find willing customers. (Authors’ Interview)

However, the fragmentation of production complicates the ability of these small brands to

expand beyond their design or production-related niche. Using standardized core

components removes the need to perform platform-level ‘‘novel’’ innovation, but ensures

the capabilities for doing so are not easily fostered in the firm. Firms thus develop

competitive capabilities specific to their niche without understanding, or investing in,

Structured uncertainty: a pilot study on innovation in… 1183

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capabilities for other parts of the production or value chain. This makes small firm brands

and entrepreneurship possible but may constrain their ability to grow and leave them

reliant on outside suppliers. Despite the limitations of this approach, the nature of a

platform-based industry reliant on a common architecture and standards makes it possible

to rely on others to develop the standard, utilize it and then innovate at the margins. As

Google seeks to establish its Android operating system as a global standard available on

multiple branded platforms—like Windows on PCs—a smartphone operating system will

remain readily available and independently improvable for small manufacturers. Similarly,

just as Intel made its processors available to any computer manufacturer, MediaTek and

her Taiwanese and Mainland competitors have a strong incentive in ensuring as large a

market as possible for their chips. Providing them as an easy solution for SME

manufacturers ensures continued demand not only for the most expensive high end chips

but also for legacy systems, thus prolonging the profitability of any given line. Together,

this means the business aspect of remaining niche focused will remain viable.

In principle, a firm may later attempt to martial its resources, seek external financing or

partnerships in order to expand beyond its current niche. Some Chinese firms such as

Lenovo have been able to expand from a narrow product range into controlling multiple

stages of a full industry. Under structured uncertainty, however, there are strong institu-

tional forces making it difficult for private SMEs to even consider moving out of their

current industrial niche.

Proposition 2 in this paper argues that under structured uncertainty, firms will

emphasize incremental innovation. Adopting a strategy of incremental innovation makes

sense for firms innovating at the edge of standardized technologies. At the same time,

however, even if firms wish to move into different product lines or innovation types, they

are constrained. Interviews again suggested this was indeed the case for mobile handset

SMEs in Shenzhen.

Our interview evidence clearly shows that structured uncertainty encourages short time

horizons and incremental innovation. The objective of central government innovation

policies is novel product innovation and substitution of domestic technologies for foreign

ones, as seen in the empirical measure of reducing reliance on foreign technologies from

fifty percent to no more than thirty percent by 2020 (SCPRC 2006). To accomplish these

types of innovation, Chinese firms must engage in sustained long-term R&D projects that

necessarily carry significant risk, as well as requiring significant patient capital and

support.

However, the political economic situation facing China’s SMEs makes realization of

this goal impossible. Interviewees confirmed that SMEs cannot overcome the structured

uncertainty they face in terms of the long term viability of their market, their business

licenses, or the government permission for them to operate. Accordingly, these firms seek

to maximize their profits while they can; relying on short-term incremental improvements

is the best means of doing so.7 In the interviews, a consistent problem cited was the lack of

clear and consistent sectoral policies. Managers in Firm FB and FE as well as the professor

at University UA explicitly stated lack of clarity about long-term government intentions

was a big concern for firms’ innovation practices. Interviewees said they coped with

uncertainty about the future by trying to innovate rapidly in the short term.

7 It is possible to build viable and sustainable businesses following this incremental innovation model;however, this approach will not yield the novel product innovation and technology independence sought byofficial government plans and programs.

1184 L. Tang et al.

123

SME interviewees universally expressed an ambivalent view about long term R&D

projects. Even China’s most innovative and powerful technology firms which actually have

the wherewithal for radical innovation opt not to do so because, as venture capital Firm FX

described: ‘‘Huawei and ZTE’s industry positions in the future will depend on their

operational capacity; their position will continue to rise because of their pragmatism and

production, not chip innovation’’ (Authors’ Interview). For SMEs, the incentive is even

lower as explained by Association AA: ‘‘the opportunity cost for fundamental chip

innovation is too high in Shenzhen and the rest of mainland China’’ (Authors’ Interview).

Interviewees noted that resources invested would be tied up for a long period of time, thus

preventing their profitable application in the short term. Without guarantees of the ability

to appropriate potential higher returns in the long term, interviewed firms saw no advan-

tages to taking on this much risk.

Another uncertainty driving firms to seek incremental improvements is the short tenure

of government officials. In general, China’s bureaucratic turnover means the sponsors of a

given promotion or permission in the local political economy will not remain in their

positions for a long period of time. This means firms cannot rely on any given policy to last

long enough to build a sustained long-term R&D effort around it. For officials seeking to

promote innovation, with a short tenure, government officials’ motivation is to yield the

strongest economic growth statistics in the shortest time possible. This means encouraging

firms (and business models) which generate employment, investment and growth whether

or not they build long term novel product innovation capabilities. Accordingly, their

incentives are to support a political economy which does not foster the building of long

term capabilities. Hence firms are encouraged to engage in short term thinking and

projects.

A further example cited by interviewees was the variability of intellectual property

protection. Firms in Shenzhen have seen implementation of intellectual property laws

range from strict—making imitation strategies risky—to completely lax—thus challenging

firms who seek to create new designs or products. SMEs engaged in both business

strategies are thus incentivized to act as quickly as possible before another policy and

implementation shift occurs. At the time of our interviews, enforcement was somewhat lax

as noted by half of the interviewees. As stated by Firm FJ’s CEO: ‘‘…The key is that you

must get out new models quickly. Many companies copy our designs so we have to stay

ahead of them’’ (Authors’ Interview). However, in the following months, enforcement

rapidly tightened in preparation for the Shenzhen Universiade, thus squeezing those firms

which operated under an assumption of lax IP enforcement. However, the tightening did

not last as it was shortly superseded by general loosening to strengthen domestic economic

growth as the global economy lagged in the long aftermath of the 2008 Financial Crisis.

The recent increase in intellectual property infringement lawsuits across China suggests

another tightening phase in intellectual property enforcement is now beginning. In 2013,

there were 91,187 intellectual property infringement cases (copyright, trademark and

patent) filed in China, 97 % of which were between Chinese litigants (Yin 2014). At the

same time, however, commitment to strong IP enforcement remains unclear. An IP judge

in Court GC explained the conflicting view of many officials toward intellectual property

rights, a view which does not encourage confidence in the long-term viability of one IP

strategy or another:

These two forces are inseparable. IP is to protect innovation. If there is no IP, there

will be no innovation. But overprotection is not conducive to innovation. So the

question is how to set the right degree of protection. We must uphold the correct use

Structured uncertainty: a pilot study on innovation in… 1185

123

of technology neutrality and the doctrine of non-infringing use for technology. If use

is not significant, then it is not infringement. (Authors’ Interview)

Given the history of fluctuating policies, moves toward tightening IP protection also

increase uncertainty. State commitment to hard intellectual property rights is far from

certain. In 1979, China began facing the need to adopt a Western-style intellectual property

system in accordance with the ‘‘Agreement on Trade Relations’’ with the United States

(Butterton 1996). Through the 1980s, reforms began pushing for a legal framework able to

work with a market-based economy. Early reforms such as the 1982 Trademark Law and

1984 Patent Law often left much ambiguity over the status of intellectual property—such

as the legal ownership and right to exploit discoveries made while employed by state

research organizations or firms (La Croix and Konan 2002; Maskus 2002; Yu 2006).

Nonetheless, as evidenced by much US consternation in the 1990s, enforcement of even

China’s existing IP laws was weak and sporadic, usually limited to a few spectacular raids

of distribution centers or factories for infringing goods just before US-China trade

negotiations. Enacting laws and failing to enforce them, or enforcing them in a seemingly

arbitrary fashion did not instill confidence in the reliability of the IP protection system.

Showing the confusion and arbitrary nature of IP enforcement, and the uncertainty with

which the Chinese economy is imbued, Firm FW’s interviewee explained her experiences

with the courts in Guangzhou:

We brought an IPR infringement complaint to the Guangzhou Number Two Middle

Court against a local company that copied us in 1995 and the court told us: ‘A bowl

of rice, why don’t you let them have their bowl of rice when you already have

yours?’ (Authors’ Interview)

A final challenge stemming from conditions of structured uncertainty facing China’s SMEs

is that China’s financial system also constrains their ability to access patient, or even

impatient investment capital, thus further limiting the ability to conduct long-term novel-

product R&D. China’s banking system remains entirely state-owned and is therefore

subject to the same political pressures as other government actors. Researchers have noted

that bankers are reluctant to loan to SMEs (Tsai 2002; Wu et al. 2008; Xiao 2011; Zhou

2009). This reluctance stems from several features of structured uncertainty. First, bank

employees worry about risks to their jobs should they make loans to SMEs which fail. In

contrast, making loans to established- and central government-favored state enterprises is

unlikely to result in recriminations. Second, given the climate of uncertainty surrounding

the long-term viability of SMEs’ business models and niches, it is difficult for loan officers

to determine the likelihood of payoff or risk involved in making loans. Without knowledge

of the long-term viability of these firms, or the sectors in which they operate, risk cannot be

easily priced. Finally, banks are strongly encouraged, like government officials, to support

short-term economic growth and employment generation. They tend to make loans to

enterprises in established and proven niches, rather than those which may be exploring

alternatives. In all three areas, loans to SMEs are strongly disadvantaged.

Without access to capital, firms are forced to self-invest based on their profits, a method

three firms specifically noted. None of the SME firms we interviewed had taken loans to

pay for expansion or development. Lack of investment capital means there is no ability for

a firm to make long term commitments to sustained high cost and high risk R&D projects.

Instead, relying on necessarily limited internal resources, they will engage in short term

activities they are able to self-finance. This means firms must seek the most rapid means of

innovation—incremental improvements to established technologies and products. As

1186 L. Tang et al.

123

before, this emphasis can yield a sustainable competitive advantage for firms, but will not

produce novel product innovation capabilities.

What form does innovation under structured uncertainty therefore take? All interviewed

firms without exception argued that tailoring incremental innovation to customer needs

was their crucial competitive strength. Interviewees all argued that established interna-

tional brands often overshoot the cell phone market with variegated phone functions that

many customers do not need or are unwilling to pay for. The local mobile phone industry

association noted that the handset models from the then five leading global brands (Nokia,

Sony Ericsson, Samsung, LG, and Motorola), provide many functions but are very

expensive.8 This leaves specific but price sensitive markets segments available for Chinese

SMEs. As explained by Association AB after considering the experiences of its member

firms: ‘‘Responding to dynamic unfilled market niches, firms have the opportunity to

innovate and differentiate their goods from their competitors’’ (Authors’ Interview).

SME handset firms target specific consumer groups with incremental and integrative

innovation. For example, Firm FQ develops smart phones which cater to senior citizens,

with characteristics of a simple interface, large keyboard, hearing aids and broadcast radio

receiver functions. Firm FI explained that incremental improvements actually helped them

avoid competition with better funded large firms: ‘‘We are a niche firm with highly spe-

cialized products. We actually avoid competition with the large scale famous brands like

Apple and Lenovo’’ (Authors’ Interview). Firms FP and FH, similarly cited their niches:

‘‘Our phones are specialized smart phones for children, the elderly and rugged outdoors-

men. This is our niche and has been since we started in 2006.’’ ‘‘We market our phones to

populations with specialized needs like the elderly, students and other specific groups’’

(Authors’ Interviews). For the senior citizen market niche, phones with larger speakers or

screens are particularly popular. Many parents purchase phones with hardware tracking

capabilities so they can monitor their children’s whereabouts. Firm FG explained how

marketing to niche segments works:

In our niche, we tend to produce small runs of specialized phones, not usually more

than 10,000 in a given type. This is the minimum order size set by our contract

manufacturers. We also don’t earn a lot for each phone, only 10–30 RMB profit

apiece (Authors’ Interview).

Emerging market mobile telephony providers offer firms another potential niche. Firm FK

offers phones with tri- or quad-SIM capabilities as most emerging countries have multiple

carriers with steep interconnection charges; having multiple cards can make calls cheaper

by selecting the appropriate SIM to avoid interconnection or roaming charges.9 Indeed the

first dual-SIM capability in mobile phones was an innovation by China’s small handset

manufacturers.

Another niche innovation is phones with built-in television or broadcast radio antennae.

These make it possible to watch broadcast TV or listen to radio broadcasts on a GSM

phone for free. This caters to customers who cannot afford the costs of data-streaming or

8 None of the interviewees mentioned Apple. It is possible that Apple’s unique operating system andapplication environment meant it was seen as an outsider and not considered a direct competitor with asimilar substitutable product.9 SIM stands for ‘‘Subscriber Identity Module’’, a memory chip used to identify a device on mobiletelephony networks. With multiple SIM cards, phones are able to switch from one network carrier to anotherwhen needed. In the case of Dual-SIM Active capabilities, a handset can connect to two networks simul-taneously. Calls can be switched manually or via software from one network to another without dropping acall.

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live in areas with poor mobile data connectivity. Such phones are particularly popular in

Latin America, an emerging overseas market for China’s mobile handsets.

The evidence that such innovation as takes place remains incremental is also clear. Even

for SMEs which hold invention and design patents (four of our interviewees), only one

holds any patents outside of China. Although Firm FT has more than 1000 patents and

Firm FJ holds 100 patents, most of these are for design innovations—for which they are

granted 5 year patents from the State Intellectual Property Office. As design innovations

constitute the vast majority of patents held by SME handset firms, the majority of their

R&D efforts are devoted to modifying and improving cell phone models. They do not

produce radically innovative products, of the type which can receive invention patents. In

sum, China’s mobile handset SMEs integrate existing technologies (SIM cards, broadcast

media, speakers, location tracking) in new ways to create desirable and highly cost

effective products (Radas and Bozic 2009).

If structured uncertainty results in constrained innovation practices by SME handset

firms, how are they able to operate in the first place? As discussed above, structured

uncertainty is a cost on business. Proposition 3 argues that local government support

enables firms to continue operations even under conditions of structured uncertainty. The

local government provides resources to SMEs helping them to operate despite often thin

profit margins. All interviewed firms mentioned support—both direct and indirect—which

they received from the local government and described it as a welcome benefit for

improving their margins and competitiveness. The local government also, within the range

of its constrained powers, interpretations of national policy which benefit entrepreneurship

and incremental innovation.

One interviewed firm stated that the Shenzhen government provided various resources

and tax breaks on R&D activities including innovation rewards, project funding, and

reduced land use fees. Some companies have dedicated employees and teams which look

for such support opportunities from different levels of the government. For instance, Firm

FT set up two divisions namely Enterprise Planning Department (qihua bu) and Com-

munist Party Member Department (dangzhi bu) to take charge of managing relations with

the state and Communist Party, respectively. High-value talents who join Firm FT enjoy

preferential policies for earning a coveted local hukou (resident permit). According to the

interviewee, this preferential policy has significant benefits in attracting talent, some of

whom had previously worked for Motorola or Nokia.

There are several signals indicating the existence of local protection toward mobile

firms. The aggregation of mobile handset firms contributes hugely to local economic

development in Shenzhen. A conservative estimate from 2009 found that approximately

two hundred thousand people were employed in Shenzhen’s mobile handset manufacturing

firms. These companies generated nearly 40 billion RMB in annual sales (Dong 2009).

Local bureaucrats are clearly aware of the scale and importance of the mobile handset

industry. Accordingly, the handset industry receives local government support.

The two local government offices disclosed that the Shenzhen and its various district

governments did not aggressively enforce ‘‘gray’’ areas in intellectual property enforce-

ment. When we asked their opinions toward intellectual property rights protection, all

interviewees took a rather tolerant and even sympathetic tone toward firms which bend

copyright or patent laws. SMEs were widely praised for their contribution to the local

economy and innovative characteristics. This does not mean outright piracy is tolerated.

Government office GB, responsible for local promotion of science and technology-based

industry, explained: ‘‘As long as shanzhai phones are not simply copying the existing

brands but have merged in some innovative elements, they are a good thing…shanzhai is

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the great equalizer’’ (Authors’ Interview). Association AA agreed: ‘‘China must go through

the imitation-innovation-practice for the whole industrialization process before it begins

developing its own brands and technologies’’ (Authors’ Interview).

The three university innovation scholars agreed with the local government officials

concerning the benefits of shanzhai phenomena. Shanzhai creates a large number of new

jobs for workers both of low and high skill levels. The vast majority of employees hired by

Shenzhen handset firms are migrants from the countryside, many of them hold a ‘‘tem-

porary residence permit’’ tied to their current employer. If handset firms shut down due to

IPR disputes, collectively, the number of layoffs and potential for social unrest would be

significant.

Within their jurisdiction, the Shenzhen municipal government and sublevel adminis-

trative branches give priority to strengthening the mobile handset industry. When asked for

specific interventions from the local government, all SME handset firm interviewees

mentioned not only R&D subsidies but also passive protection of their business through lax

enforcement of IP infringement laws. The strong support of the local government, for

clearly positive industry investment and R&D programs and also in tacit acceptance of

grey-market aspects of many SME’s products, shows the degree of government support for

this industry.

Further, the Shenzhen government and its district subsidiaries have been instrumental in

encouraging local mobile handset firms to expand their presence overseas, particularly as

the central government has made it more difficult for unlicensed firms to sell their products

within China. Seven of the interviewed firms are aggressively pursuing international

markets since the domestic market is increasingly saturated while the global market is still

developing. Further, Firm FI noted: ‘‘Domestic market competition is too fierce so we

emphasize exports where the margins are better’’ (Authors’ Interview). Firm FG stated it

only earned 10–30 RMB profit per phone. Competition in the domestic market was

described by Firm FN as ‘‘chaotic and intense,’’ forcing firms without famous brands to

deeply discount their phones, resulting in much lower margins.

In addition to higher margins due to less intense competition, these same interviewees

told us that developing overseas markets enables them to take advantage of policy loop-

holes and export tax rebates. As disclosed in the interviews, companies increasingly

produce for export in order to reduce taxes on imported components like their chipsets.

Association AA stated that firms receive tax benefits or import rebates on their mother-

boards or chips so long as they export:

This is significant for many companies. The chips come from abroad and the

motherboard manufacturers are purposely located in export-processing-zones. As a

result, taxes will be assessed on output if they sell it domestically. If they export,

however, the tax burden is greatly reduced. (Authors’ Interview)

At first glance it seems odd that the export tax rebate loophole is not addressed by the

central or local government. However, China’s central government’s ignoring revenue loss

in the short run is not surprising since these rebates encourage the development of Chinese

brands. Further, the firms most likely to be hurt by effectively subsidizing overseas sales

are established foreign brands. For the local government, the advantages in sustaining

employment, local demand for electronic components and encouraging new firm creation

are sufficient incentives in themselves to encourage exports, even at the cost of tax

revenue.

Taken together, local government support enables SMEs to pursue the incremental

innovation approach (Park and Luo 2001; Wong and Chan 1999). In other words, it can be

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argued that it may be in local bureaucrats’ self-interest to sidestep the national agenda of

indigenous innovation to gain short-term advantages for themselves and local industry.

Developments by SMEs in the mobile handset industry are thus unlikely to further the

national policy of creating wholly Chinese technology and new novel innovations. Indeed,

both government office GB and the representative industry associations admit that the

innovations by Shenzhen firms, particularly SMEs, remain incremental. Office GB

explained: ‘‘In Longgang, production of phones was and is mostly progressing. There was

little R&D performed in the past although this is starting to change. The industry is moving

from production-based to R&D-based’’ (Authors’ Interview). Similarly, Association AA

stated: ‘‘China is still not able to do everything independently. Sophisticated production in

China is still actually Taiwanese or foreign-controlled. Truly Chinese factories are not the

most cutting edge yet’’ (Authors’ Interview).

Protection and strong support by the local government has fostered the vitality of the

mobile handset industry in Shenzhen. It has enabled firms to trust that their markets and

production model are relatively protected from policy shifts for the short to medium term.

It has also provided some small amounts of research capital to help offset risks by firms

emphasizing short-term gains. This has further strengthened the ability of firms to operate,

thus making their incremental innovation-based business model viable.

6 Conclusion and discussion

China’s economic accomplishments since 1979 are legion. The upgrading of the economy

is similarly impressive. This paper has explored an underappreciated sector of China’s

economy—the entrepreneurship and innovation by SMEs. In the mobile handset industry,

these firms capitalize on the global fragmentation of production to find niche opportunities

for firm creation. Utilizing standardized components and systems—notably MediaTek

chipsets and Google’s Android operating system—the firms are able to rapidly introduce

phones able to be used anywhere in the world. Building upon these platforms, small firms

are able to provide niche innovations in order to serve specific markets which may be

overlooked by major brands producing sophisticated but general products.

While the global fragmentation of production facilitates entrepreneurship in China, the

SMEs which enter the mobile handset industry are constrained by China’s institutional

climate of structured uncertainty. Although uncertainty is usually mitigated by institutional

reforms, the very nature of the formal governance and legal institutions in China increases

uncertainty. Firms adapt to these conditions by adopting short term profit making strategies

and seeking incremental innovation. These enable firms to profit without taking long-term

risks which may be undermined by uncertain political developments. Aiding firms in their

quest to operate in this climate, the local government in Shenzhen supports the activities of

SME handset firms. This takes the form of direct R&D subsidies as well as tax incentives

for exports, and the willingness to accept businesses which lack certain operating or

production licenses as well as those potentially infringing on intellectual property rights.

Doing so helps sustain local industry, growth and employment.

Nonetheless, challenges remain for China’s private SMEs. They are on the periphery of

the mobile handset industry. Within China, they control roughly 10 % of the smartphone

market, but their individual size and market share is dwarfed by that of the largest domestic

and foreign brands. SMEs often have thin profit margins and are either ignored or, at times,

suppressed by the central government. They thus have to exist at the fringes. For many

SMEs in emerging economies, particularly those attempting to follow a state-led economic

1190 L. Tang et al.

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development strategy with large state-owned enterprises and formal government industrial

upgrading plans, the condition of China’s mobile phone handset SMEs is very familiar. For

firms which exist at the margins of standardized global industries—usually the first niches

in which emerging market firms can enter—or are outside central government plans, the

experience of China’s SMEs is highly illustrative, showing that innovation and sustainable

competitive advantage are attainable.

Indigenous innovation, especially radical technological innovation is deemed by the

Chinese central government as the key to survival in the global economy. However, this

study shows that radical innovation is not the only winning strategy. In fact the story of

successful incremental innovation or hybrid innovation practice abounds around the globe.

Some leading technology firms such as Huawei and ZTE began as incremental innovators,

using and improving upon imported and licensed technologies before attempting to

develop their own core proprietary technologies (Fosfuri and Giarratana 2009; Breznitz

and Murphree 2011; OECD 2008, 2011). The success of Taiwan’s PC industry also sug-

gests that instead of pioneering development of technologies, rapid imitation and adap-

tation can be another effective alternative for countries to close the gap with advanced

economies (Saxenian 1994). Building firms with incremental innovative capabilities is the

first step—and one best promoted in the global economic and national institutional cli-

mates facing most emerging economy firms.

Acknowledgments This research was funded by the National Science Foundation under grant SES-0964907 and National Science Foundation of China (Award No. 71303147). The findings and conclusionsare those of the authors and do not reflect the opinions of the National Science Foundation. The authors takefull responsibility for any remaining errors.

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