Running head: INNOVATION NETWORKS IN THE INFORMAL ECONOMY
Innovation networks in the informal economy: the case of shanzhai 山寨 innovation
Julia Seidel
1496255
MA Asian Studies: Politics, Society Economy
Supervisor: Dr. Rogier Creemers
Leiden University
2 INNOVATION NETWORKS IN THE INFORMAL ECONOMY
Abstract
This thesis is about shanzhai 山寨 as an innovation system. Shanzhai innovation is a phenomenon that takes place in the informal telecommunications sector in China. The production process of shanzhai mobile phones is embedded in a dynamic system of different actors that each take over a specific role in the production process. Through the network, actors acquire knowledge and information from each other and technology is shared openly.
This interactive learning process accelerates the innovation process of new products and designs. The shanzhai network creates a wealth of knowledge and resources for mobile phone producers. This approach may enable businesses to grow and become innovative firms. The rapid growth of the internet company Xiaomi can be attributed to the characteristics of shanzhai innovation in their business model. To what extent shanzhai innovation can become a model for innovation will be analyzed.
3 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Acknowledgments
I would like to thank my thesis supervisor Dr. Rogier Creemers for his valuable and constructive support while writing my thesis. I would also like to thank my family for their love and support during my studies. I am grateful for the smart and inspiring people I have met throughout my studies and that have made this an incredible journey.
4 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Contents
1. Introduction ...... 5 2. Literature Review: The Informal Economy ...... 7 2.1. The Informal Economy: a definition ...... 7 2.2. Innovation Networks and the informal economy ...... 8 2.3. The Informal Economy in China ...... 10 3. Introduction Shanzhai ...... 13 3.1. Historical context of Shanzhai ...... 14 3.2. Shanzhai as a cultural phenomenon ...... 15 3.3. The development of shanzhai businesses in the mobile phone sector ...... 17 3.4. Technological progress ...... 19 3.5. Shanzhaiji production and the innovation network ...... 20 3.6. Description of Shanzhaiji ...... 22 3.7. Defining shanzhai innovation ...... 24 3.8. The difference between shanzhai and counterfeit phones ...... 25 4. Shanzhai innovation in the case of Xiaomi ...... 27 4.1. User-centeredness ...... 27 4.2. Network orchestration ...... 28 5. Discussion ...... 29 6. Conclusion ...... 32 7. References ...... 33
5 INNOVATION NETWORKS IN THE INFORMAL ECONOMY 1. Introduction
Through the economic and social reforms, the informal economy has evolved into an important factor in China’s economic development. It is an essential source of employment for many social groups, and it is a place where constant innovation is a necessity for businesses to survive. Shanzhai innovation is a phenomenon that takes place in the informal economy in China. Foremost, the production of shanzhai mobile phones has attracted much attention. Shanzhai mobile phones are often critiqued as being counterfeits. However, shanzhai mobile phones are created in a dynamic production process that results in unique adaption and innovative features. In this environment, businesses share their technology openly and can freely adopt innovations from others. These networks enable the innovation process to accelerate and allow businesses to be extremely flexible and adaptive to new trends. To what extent these dynamics can be scaled up and expanded to larger networks poses an interesting question.
The research question of this thesis is whether shanzhai innovation can be a model for small-sized businesses to grow. It will be investigated how shanzhai innovation has translated into a business model for growing mobile phone company Xiaomi.
The analysis is divided into the following sub-sections. The first section of this thesis will start by reviewing the characteristics of the informal economy before introducing the theoretical framework of the Innovations Systems Theory. The second section will analyze the cultural implications of the shanzhai phenomenon. Shanzhai is a diverse social, political and technological phenomenon. In order to understand what implication the popularity of shanzhai may have on its innovation system, the historical and cultural background need to be taken into account. The third section will explore the economic and political factors that enabled the emergence of shanzhai.
6 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Further, the innovation networks of shanzhai businesses will be analyzed. It will become clear that consumers and producers motives play an essential role in the production process.
The fourth section, will analyze Xiaomi’s business model concerning the characteristics of shanzhai innovation. The final section will discuss what potential shanzhai business have to become integrated into a formal environment. It will be argued that shanzhai innovation can be beneficial for companies to expand, however, further social and political reforms are necessary to enable the growth of shanzhai businesses. The final section will offer the conclusions drawn from this research.
7 INNOVATION NETWORKS IN THE INFORMAL ECONOMY
2. Literature Review: The Informal Economy
The goal of this section is to provide an overview of the different debates surrounding the informal economy in China. Before going into depth by discussing the informal economy in
China, the different approaches in studying the informal economies of developing countries, in general, will be given. The informal economy has played a significant role in China’s economic reforms. Informal networks continue to be an important source of employment and industrial development.
2.1. The Informal Economy: a definition
In recent years, the informal economy in developing countries has become a field of inquiry in terms of economic development and innovation. The informal economy can be described as a part of the economy that is unrecognized and unregulated by the government.
Defining and measuring the informal economy is difficult, because informal work is neither legal nor illegal. Owners of micro- and small-scale businesses as well as self-employed individuals or people employed by informal businesses count towards the informal economy
(Becker, 2004). People are likely to be involved in informal and formal work relations simultaneously. Informal work consists of a range of different economic activities, this can include workers such as taxi drivers, street vendors, manufacturers or domestic workers
(Charmes, 2016; Xin, 2001). Workers are, therefore, less likely to receive employment benefits or any other form of compensation apart from their wage (Charmes, 2016). “Casual employment, kinship or personal and social relations rather than contractual arrangements with formal guarantees” characterize business relations (International Labour Organization,
1993). Thus, informal or casual contracts make employees and businesses vulnerable to exploitation as their unofficial status deprives them of accessing institutional support.
8 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Four dominant schools of thought have evolved that each describes the emergence, the composition and role of informal economies from a specific perspective (Becker, 2004;
Chen, 2012). The various schools of thought can be summarized in the following way (Chen,
2012); the Dualistic school of through sees the informal sector as a distinct part of the economy. The informal economy is created by a mismatch of between people’s skills and the structure of the formal economy. The Legalist approach ascribes the emergence of the informal sector to an unfavourable bureaucratic system for entrepreneurs. People tend to avoid the cumbersome bureaucratic process that is involved in formalizing their business. Further, the Voluntary school of thought argues that entrepreneurs in the informal sector deliberately want to avoid regulations, such as taxation and controls, by staying in the informal sector. Finally, the Structuralist approach argues that the informal economy is a result of formal businesses taking advantage of the informal sector to reduce their costs. For instance, by outsourcing parts of the production or service components for informal enterprises, legitimate companies can lower the costs for their production. It can be said that the fundamental differences lie in what factors either motivate or drive people into the informal sector. Moreover, it can be said that people are motivated to operate informally to reap benefits, or their economic, political and social situation does not allow them no to seek formal work. It will become clear that when looking at a specific context, a mix of different factors contribute to the reasons why people work formally or informally. To investigate how the informal economy, despite possible constraints, can be innovative, can be done by analysing the informal innovation networks.
2.2. Innovation Networks and the informal economy Innovation is seen as the diver of economic growth. However, in the context of the informal economy, it is still understudied (Charmes, 2016). Analyzing the process of innovation can be done by looking at networks or systems of innovation within the informal
9 INNOVATION NETWORKS IN THE INFORMAL ECONOMY economy (De Beer, Fu & Wunsch-Vincent, 2016; Fu, Diez & Schiller, 2013). The National
Systems of Innovation theory, assumes that knowledge is the fundamental resource of a modern economy (Lundvall, 2010). The theory focusses on how flows of technology and information are distributed within a network of people, enterprises and institutions (OECD,
1997). The government plays a central role in creating a framework in which interaction can take place between the public and private sector, research institutions and the government.
The ongoing learning process can thereby lead to the creation and diffusion of innovations
(Johnson, 2010). Hence, innovation takes place in contexts where information and knowledge can be exchanged and integrated effectively.
The theory has previously been applied innovation networks in the formal economy, but has become a tool to analyse the dynamics of informal networks as well (Fu, Diez &
Schiller, 2013). The network that will be analysed in this thesis is centred on the mobile phone industry in Shenzhen. A range of different actors, such as suppliers, designers, integrators, retailers, financiers etc., constitutes the network that will be analysed. Actors’ roles may be informal and formal and can consist of government institutions. Informal institutions are an important factor of informal economies (Harris-White, 2017). In this case, the government plays a direct role in shaping the economic, political and societal conditions of the informal economy. Nevertheless, the governments’ influence cannot be seen as supportive of the informal economy. Moreover, a lack of government support leads informal actors to create alternative institutions that substitute for government institutions (Tsai, 2018).
In the informal economy people acquire their skills through ‘learning-by-doing' and by copying from others. Innovation occurs through adopting or improving goods and services
(De Beer et al., 2016; Fu, Diez & Schiller, 2013). The approach of “open innovation” is is helpful in explaining the reasons behind this process. “Open innovation” describes the way businesses incorporate and adapt external innovations or ideas into their innovation process.
10 INNOVATION NETWORKS IN THE INFORMAL ECONOMY This also includes that they make their technologies available to others and collaborate with firms in their environment (Chesborough, 2006). “Open innovation” can be seen as an ongoing trend in the mobile phone industry in China. For specific industries it can be more beneficial for businesses to invest less in their internal research and development and instead engage with other companies in the sector to collaborate and exchange (Lee, Lee, Song &
Kim, 2008).
The network is formed by informal and formal business relationships. Research has shown that business relationship in the informal economy are closely linked to maintaining social relations. Actors that are dependent on each other, sustain their ties by building trust through personal favors (Fu, Diez & Schiller, 2013, p. 638). This is a crucial strategy for by businesses to gain more certainty in an informal environment. To make a comprehensive analysis of the innovation process actors and their roles need to be identified. However, informal relations make the network more difficult to analyse as social relationships may be hidden from outsiders.
2.3. The Informal Economy in China
Since 1978 the Chinese government has implemented a series of economic and social reforms. The informal economy plays a unique role during the economic transition of a state- led economy towards a market-driven economy. Since the 1990s the state-sector became increasingly privatized, which decreased the employment opportunities in the public sector.
The informal economy became a reservoir for workers that were laid-off from the state sector, because many of the laid-off workers that did not find re-employment in the private sector became small-scale entrepreneurs (Hurst, 2009).
While the structural adjustments were still ongoing in the private sector, entrepreneurs had to seek support to set up a business through private or informal networks. These private networks evolved into informal institutions that substituted for lacking government
11 INNOVATION NETWORKS IN THE INFORMAL ECONOMY institutions (Ibid.). For instance, state-run banks were not able to provide the necessary financial support to private entrepreneurs. Therefore informal banks were created would satisfy the demand of private entrepreneurs need for credit. It can be said that the self-reliance of the private sector on its own institutions is still relevant and small and medium sized businesses still acquire much their funding through private channels (Allen, Qian & Qian,
2005; Tsai, 2018).
Next, to laid-off workers, informal migrants constitute a large part of the informal economy. Since the household responsibility system was implemented, people from rural areas migrated to the cities to seek employment. Internal migrants took on low- or unskilled work in the manufacturing industries in urban areas (Xin, 2001). Even though migrants may have been employed at a formal company, their contracts were often flexible and temporary.
Their chances of obtaining residential status in the cities they reside are low. The household registration system hinders rural migrants from obtaining an official status in urban areas.
As a result, people are left in a so-called ‘floating status' without proper access to social welfare or protection. Self-employment became a viable option for many migrants.
Since they cannot access the public welfare systems in the cities, they are better of being self- employed rather than staying in a work relation with a formal employer (ibid.)
There are several competing views on how informal work affects economies as a whole. It can be said that the effects of informal work have yet to be fully understood and gathering reliable data and accounting for informal work is difficult (Charmes, 2012). On the one hand, the growth of an informal economy has pointed towards a mismatch between government intervention and the economy. For instance, missing state regulations can lead to unfair competition for the formal economy. By undercutting prices and evading taxation, the informal economy can potentially weaken the economy as a whole. This development can erode the government’s capability to implement further economic reforms (Liao & Chen,
12 INNOVATION NETWORKS IN THE INFORMAL ECONOMY 2011; Stan & Ștefănescu, 2018). Not only could this lead to destabilizing economic growth, but it can also have adverse effects on social equality. Moreover, people may be stuck in informality without access to social welfare. This lack of support leaves them in an economically and socially disadvantaged situation from which they cannot escape (Jütting,
Parlevliet & Xenogiani, 2008).
On the other hand, it has been argued that the informal sector’s contribution to a country’s GDP is often underestimated due to a lack of clear definitions (Charmes, 2016).
The informal economy can contribute to the economy in a way that it satisfies the demand for cheaper goods. Especially among social groups that have a lower income, the informal economy provides products and services at a lower cost (Becker, 2004). It is argued that the low prices are not only a result of cutting taxes or labour costs, but they are also created through the ingenuity of products and production processes. In that matter, the informal economy may be the driver of innovation and economic growth (Harris-White, 2017;
Kraemer-Mbula & Wunsch-Vincent, 2016). The informal economy is an environment in which businesses have to “operate under extreme conditions of survival, scarcity and constraints.” (Kraemer-Mbula, Wamae, & International Development Research Centre 2010, p. 138).
Informal employment China is deeply interwoven with the formal sector and both sides are dependent on each other. Through the economic and social reforms, informal networks became an indispensable of the development of the private sector. Informal institutions bridge structural shortcomings of the government and migrant workers make up the majority of the workforce in urban manufacturing. It has be questioned to what extent informal businesses are able to translate their innovation system to a formal environment.
To sum up, it can be said that the informal economy constitutes an important part of
China’s economy. Nevertheless, defining the informal economy is challenging, since range of
13 INNOVATION NETWORKS IN THE INFORMAL ECONOMY different economic activities count towards the informal and formal economy. Throughout the transition period, the informal economy has been a buffer against economic shocks caused by the reforms. Informal work relations make up a large proportion of the manufacturing jobs in urban areas. On the one hand, the economy benefits from the informal sector through low labour cost and un-bureaucratic relations. On the other side, tax evasion and under regulation can harm formal businesses and undermine government control.
Several perspectives on how to define informal economy and its characteristics have emerged. Thereby each approach captures an important aspect of the informal economy, but rather than selecting one approach over the other, it is more useful to analyse the informal economy from a holistic perspective. The National Innovation System theory allows us to study the informal economy from the perspective of an innovation system that revolves around the exchange of knowledge. Through this approach, networks in the informal economy can be identified and innovative processes captured. With regards to China’s informal economy it can be argued that shanzhai has become one of the most dynamic and innovative phenomenon. It is necessary to analyse shanzhai from a broader perspective, before going into depth with its innovative practices.
3. Introduction Shanzhai
In this section, shanzhai will be introduced from a popular and cultural perspective.
Shanzhai has various definitions in different contexts. Before going more in-depth whit shanzhai innovation and the informal economy, is important to understand what shanzhai entails in a cultural and historic context. It will become why shanzhai has become such an important part of China’s mobile phone industry.
14 INNOVATION NETWORKS IN THE INFORMAL ECONOMY 3.1. Historical context of Shanzhai
The word shanzhai derives from the Chinese novel 水滸傳 commonly translated as the ‘Warriors of the March' or ‘The Water Margin'. The word shanzhai is generally referred to as “mountain fortress” or “stronghold” in English (Sin, 2016). This story is seen as one of the four great classic novels of Chinese literature. The outlines of the story are said to date back to the early Song period and have been passed on in various variations and storylines
(Han, 2016). The gist of the story is that men, who become outlawed by society, find shelter in a mountain fortress. They are located far away from any government control and live by their own rules. From their base, the bandits surge out to fight crime and corrupt government officials on behalf of the weak. Even though their acts were often brutal, and they attacked the government, they were rehabilitated by the emperor and served him in the imperial army
(Sin, 2016). The heroic legends of the bandits fighting for justice captured people's imagination. However, people's admiration for the rebels' culture and lifestyle would not stay without controversy. Throughout the centuries, the novel received critique from official sides.
The stories were even blamed for causing chaos and leading to society's decay. The novel was officially censored for glorifying the gruesome acts of the bandits and for legitimizing their self-righteousness. This critique did not seem to influence the popularity of the novel among society. The opposite occurred when the government banned the stories; it made people were even more captivated by it (Sin, 2016).
Historically, the stories of the self-righteous bandits became part of common folklore.
The ‘hero-bandits' found their way into contemporary popular culture through television and cinema. First, the legends were featured in series and movies produced outside of mainland
China. The TV series later became popular in China in the early 2000s (Cui, 2012). This way, younger generations became familiar with the stories and the so-called ‘shanzhai culture'.
15 INNOVATION NETWORKS IN THE INFORMAL ECONOMY However, this popularity would only be a prelude to the trend that would develop the years after.
3.2. Shanzhai as a cultural phenomenon
The height of the shanzhai phenomenon was arguably in 2008 when ‘shanzhai’ became the word of the year. Yang (2016) argues that the reasons why shanzhai became such a huge trend at this particular moment in time all leads down to the combination of the following factors; The technological advancement of mobile phone production in Shenzhen, the immense popularity and growing demand for cheap, alternative phones and the rise of online forums, where shanzhai became a hotly debated topic. The rise of online culture and the spread of “user created” content created a platform for shanzhai to grow and evolve its cultural potential. Especially in online forums, people found a place to express their discontent or mock dominant cultural values (Zhang & Fung, 2013; Xu, 2017). When the traditional media caught on to the trend, shanzhai became a phenomenon beyond the internet.
Shanzhai established itself as a popular phenomenon and many people wanted to become part of it. People participated by labelling themselves or others as a part of the shanzhai- spirit. Hence, anything that was seen as a knock-off or ironic re-creation of something popular would qualify as ‘shanzhai' (Chubb, 2015; Yang, 2016).
It can be said the media coverage pushed the debates about shanzhai onto a new level.
The phenomenon itself soon became a widely discussed topic, where people questioned the values of an imitation culture and debated whether this form of entertainment could be linked to grass-roots political protest. In some debates surrounding shanzhai in relation to the spin- offs of cultural festivities were seen as an attempt to counter the dominant cultural values by deconstructing and appropriating them (Zhang & Fung, 2013; Zhang & Zhang, 2011).1
1 The Shanzhai Gala was one of these cultural events. The goal of the Shanzhai Gala, was arguably to create an alternative entertainment show to the CCTV Spring Festival Gala. Lg
16 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Shanzhai ranges from various tech-products to clothing brands, food, artists and debates about cultural values. In relation to shanzhai as innovation, it can be said that proponents have made use of the popularity to gain more acceptance for shanzhai as an innovation system. In many articles describing the production of shanzhai phones, the historical myth is used as a tool to explain the reasoning and culture behind the shanzhai networks (Huang, Tse
& Ma, 2009; Lindtner, Greenspan & Li, 2015). The way in which informal businesses are portrayed as ‘shanzhai’ shows that proponents of shanzhai try to establish a link between the production process and the cultural phenomenon. By attaching shanzhai to historical background and in line with the cultural values, it may lead to positive public image and help shanzhai innovation to become more acceptance in society in general (Lee & Hung, 2014;
Huang et al., 2009).
However, it is debatable whether this popularity is beneficial for shanzhai businesses.
Debates about the meaning of shanzhai have led people to disregard the imitation culture and question its cultural value. It can be said that shanzhai is trapped in a discourse on whether it can be seen as a legitimate cultural product or whether they should be disregarded as silly imitation (Cui, 2012). This debate is still ongoing and arguably complicates the ascendance of shanzhai innovation into the formal economy. In the next chapter, the background of shanzhai businesses in the mobile phone sector in Shenzhen will be described.
the founder of the Shanzhai Gala was assembled a crew of amateur actors and performers that were supposed to perform a knock-off version Spring Festival Gala, that would appeal to people that could not take part in the New Year’s ritual of viewing the Spring Festival Gala together with their families (Chubb, 2015).
17 INNOVATION NETWORKS IN THE INFORMAL ECONOMY 3.3. The development of shanzhai businesses in the mobile phone sector
In the early 2000s, a new type of bandit mobile phones was invented. These mobile phones were not only knock-offs from their original counterpart, they were equipped with special features that would enhance the mobile phone itself. These mobile phones were named Shanzhaiji (山寨机) and were the first products associated with the contemporary
Shanzhai phenomenon. The trace of Shanzhaiji leads to Shenzhen, a city in southern China which is known for its large manufacturing sites and often referred to as the “Silicon Valley of Hardware” (Wired UK, 2016). Shenzhen’s environment is often compared to an “open source ecosystem” and is seen as the optimal place for the development of new technological products (Bunnie’s Studios, 2014). In this section, the developments that shaped the emergence of Shanzhaiji in Shenzhen will be reviewed. Subsequently, the way in which businesses produce and innovate their mobile phones will be analysed in the next section.
Shenzhen became the first Special Economic Zone (SEZ) in 1980 and has since then flourished into becoming a manufacturing hub. By gaining a special economic status,
Shenzhen became an attractive place for foreign investors (Lu & Tao, 2012). Moreover, political pragmatism and economic experimentation paired with a low-wage labor force turned Shenzhen into an integral part of the global manufacturing supply-chain (Bach, 2017;
Lüthje et al 2013). Shenzhen has been a role model in many regards for China's economic and political reforms and it can easily be said that shanzhai is a result of this development.
The economic, political and technological conditions in Shenzhen created an environment in which Shanzhaiji could enfold.
In the course of the reforms of opening up, foreign investment started flowing into the
SEZ. Several manufacturing companies were opened that started to produce electronic parts and hardware. These manufacturing plants were mostly subcontractors of international electronics corporations. They were in charge of development, production and assembly of
18 INNOVATION NETWORKS IN THE INFORMAL ECONOMY electronic components for their clients. Fast-paced production at a low cost seems to be the desired outcome of subcontracting and Shenzhen manufacturers were able to fulfil this (FHI
Mobile Limited, 2013). The hierarchy between the manufacturers and the international corporation is clearly defined. The subcontractors are specialized in the production and assembly process, the design knowledge and ownership of the product lies in the hand of the international corporation (Hu, 2008).
Next, to the large production sites, small local businesses also settled in Shenzhen and they started producing electronic components. These were sold on electronic markets throughout the city. A popular place to buy and sell electronic parts is the Huaqiangbei (华强
北) area (Wired UK, 2016; Yu Jia, 2008). With the rapid development of the city, the markets have grown into major shopping malls. All kinds of manufacturers and service providers can be found there and they offer quick and cheap access to all kinds of technologies (Tocha,
2018; Wired UK, 2016). The environment in which developers, producers and vendors are working is described as an open innovation environment where people can easily negotiate access to other people's technology and knowledge (Lindtner, Greenspan & Li, 2015). In these spaces, informal and formal businesses co-exist and the boundaries between informal and formal are blurry.
The transformation of the city demanded laborers and these predominantly came from the surrounding rural areas. They were either recruited to work in factories or people decided to migrate to the city to seek employment (Lindtner, Greenspan & Li, 2015). With little or no formal education, these workers are succumbing to low wages and harsh working conditions.
The migrant population plays an important role in the development of shanzhai products.
While they take part in the production and they were initially also the largest target groups of shanzhai products. It is said that the producers of Shanzhaiji were migrant workers that
19 INNOVATION NETWORKS IN THE INFORMAL ECONOMY worked in factories of large cell phone producers by day and assembled their own counterfeited mobile phones by night. This earned them the nickname of “moonlight workers” (Hennessey, 2012). It can be assumed that migrants that previously worked in large manufacturing companies may have switched to work in the informal sector (Xin, 2001). As we will see in the following section, the production process of shanzhai phones is more sophisticated than what migrants assembling mobile phones by night. It involves several actors in a network of designers, system integrators, suppliers and vendors.
3.4. Technological progress A key turning point for the production of mobile phones was the import the MTK chip. The chip integrated multimedia functions, a software platform and application software
(Li, 2015, p. 141). Independent Design Houses (IDH) became an important part of the production process of shanzhai phones. The IDHs specialized in the integrating the MTK chips and in adding additional functions to them on demand (Dong & Flowers, 2016, p. 239).
This made the production process shorter and lowered the entry barriers for smaller handset producers to produce mobile phones (Li, 2015; Yang, 2016; DCCC, 2015). Businesses without extensive previous knowledge of the mobile phone industry were able to produce their own phones and sell them for a fraction of the price of branded phones.
Initially mobile phone manufactures had to acquire an official license. The telecommunications sector was strongly regulated by the state. Only a limited number of licenses were issued and sold to manufacturers. While more and more informal businesses entered the mobile phone market, officially licensed mobile phone manufacturers were confronted with strong competition. Attempts on breaking down on shanzhai manufacturers were futile, as the number of informal producers had grown out of proportion. As a result, the licensing system was abandoned in 2007 (Liao & Chen, 2011). The reasons why the licensing system was lifted are unclear, but it can be argued that it was a response to the ongoing
20 INNOVATION NETWORKS IN THE INFORMAL ECONOMY developments in the mobile phone industry and that deregulation has been a step to support more competition in the telecommunications sector.
Altogether, economic, technological and political factors enabled shanzhai innovation to evolve and manifest itself in the manufacturing culture of Shenzhen. The establishment of the
SEZ attracted international manufacturing companies to operate in Shenzhen. At the same time, more and more migrants came to seek employment in the city. The migrant workforce created demand for cheap and alternative phones. With the innovation of the MTK chip costs and production time was lowered, which ultimately led to abandoning the regulatory system on mobile phones production. The following section will explore more closely at the production of Shanzhaiji and the innovation process.
3.5. Shanzhaiji production and the innovation network
Research on the production process has shown that a network of different actors comes together to produce a Shanzhaiji (Dong & Flowers, 2016; Wallis & Qiu, 2012). The shanzhai business has a central role in coordinating and outsourcing the production steps to contractors. The IDH is responsible for the design of the MTK chips. This includes the placement of components of the mobile phone such as battery, antenna and camera on to the circuit chip (CNOEM Phone, 2015). Other materials and parts are also outsourced and produced by external suppliers. The assembly of the mobile phone is also likely to take place at an external manufacturing business (Dong & Flowers, 2016). The finished product is distributed to wholesalers and retailers before it is sold to the customers (Dong, 2014).
The network consists of formal and informal relationships. Often these businesses only have few employees which makes it easily manageable for people to communicate directly with their network. The short lines of communication make the development and adaptation of products fast and flexible. In addition, people within the network know each other well. This allows them to build trust and establish social relations that are often referred to as guanxi (关
21 INNOVATION NETWORKS IN THE INFORMAL ECONOMY
系) in the Chinese context (Fu, Diez & Schiller, 2013; Wallis & Qui, 2012). Guanxi is a social system of giving and paying back favours and are an integral part of maintaining and establishing business relations.
Within the network, businesses collaborate on several levels. The environment can be described as an “open source ecosystem” that includes sharing design and the materials that are used in the production process of a product. This “open source” ecosystem, also called gongkai (公开), enables businesses to trade their knowledge and technologies with each other
(Bunnie's studios, 2014; Lindtner et al, 2015). Moreover, businesses can build on other businesses expertise, research, and development (Hu et al, 2011). The close and often informal links between entities contribute to the sharing environment and make it easy for new businesses to enter the market and become part of the ecosystem. However, smaller shanzhai businesses may depend on intermediaries to negotiate prices with other actors
(Dong & Flowers, 2016). Sourcing Agents can support up-starting firms or smaller businesses to begin their production. The Sourcing Agents do not only provide smaller firms with necessary contacts but are also a source of funding. Since acquiring financial support from banks often not an option to these small businesses (244).
In this sharing, yet competitive and fast-paced environment, businesses are under the pressure to produce something that stands out from other products and meets the price-quality expectations. Lowering the costs can partly be achieved through avoiding taxation and not performing official product test. Further, shanzhai businesses only invest little in product promotion, since it is the responsibility of the retailer to promote and sell the product (Dong
& Flowers, 2016; Hu et al, 2011). Low entry barriers for new businesses and a lack of official control are also factors that contribute to a low production cost (Dong, 2014).
22 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Shanzhaiji initially had a confined consumer base. This group was constituted of migrant workers that sought connectivity to stay in touch with relatives and acquire information about new employment possibilities. This social group was not able to afford the branded phones and the demand for an alternative was high. Large phone companies often overlook this market segment, referred to as “bottom of the pyramid” and do not produce for that niche
(Dong & Flowers, 2016). Shanzhai businesses filled the gap by making phones that were affordable and reflected upon the specific needs of this group. It was necessary for shanzhai businesses to maintain close contact to their consumer group. That way businesses are able to catch up on trends and design phones that met the needs of their buyers (Wallis & Qiu,
2012).
3.6. Description of Shanzhaiji
Shanzhaiji can broadly be placed into two categories. On the one hand, Shanzhaiji assimilate the design of a branded phone that customers find appealing. It is, however, enhanced with features that the original does not have. An example of this adaptation is the
Dual-SIM card system that was integrated into shanzhai phones. It is a SIM-card holder that could be used for two SIM-cards. This was especially useful for migrant workers that travelled in and out the Special Economic Zone for work. Later, this feature became so popular that international mobile phone producers picked it up and started implementing it in their phones (Chubb, 2015; Dong & Flowers, 2016) Another popular feature was the volume enhancing speakers. The Shanzhaiji came with an additional set of speakers so that users could listen to music on their phones in noisy surroundings. This was popular among construction workers that wanted to listened to music during work. On the other hand,
Shanzhaiji producers can innovate phones by mixing and matching them with features that are normally not associated with the functions of mobile phones. For example, phones with an integrated ultra-violet lamp (Bunnie's studios, 2009; Chubb, 2015). This was particularly
23 INNOVATION NETWORKS IN THE INFORMAL ECONOMY handy for people that had to scan paper money to make sure that the money is not fake.
Another shanzhai phone was disguised as a cigarette box (Bunnie's studios, 2009).
These adaptations go beyond the normal usage of a mobile phone and many of the Shanzhaiji that were invented are extraordinary combinations of everyday objects and mobile phones. In this regard, the options are limitless. In many cases, it can be argued that the technology used in enhancing copies and combining objects is not cutting-edge technology. Dong (2014) terms this type of innovation a “catch-down” innovation. This type of innovation is seen as only improving existing innovation. It is also limited to less advanced types of technology and does not operate with high end or technologies that are more sophisticated.
All in all, it can be said that Shanzhaiji evolves out of a complex production process that requires different actors to work together closely by building formal and informal relationships. Up-starting and growing shanzhai businesses benefit from the network around them, but it is seemingly difficult to study as informal connections remain hidden from outsiders, because business owners run the risk of being exposed and shut down by officials
(Lee & Hung, 2014). Further, Shanzhaiji fulfil the demand of a niche market. User- centeredness plays an important part in the innovation and design process. Businesses have exclusive insights into the needs of their target group and easily become aware of the trends in the mobile phone sector. Therefore, it can be said that shanzhai businesses that are able to incorporate customer feedback effectively are more likely to succeed. At the early stages, the network of shanzhai businesses was close-knit and confined to the city. With the implementation of further reforms and the opening of the telecommunications sector, shanzhai networks also started to take shape outside of Shenzhen.
One of the most debatable issues surrounding shanzhai innovation is the question whether shanzhai products distinguish themselves from counterfeiting products. In this case,
24 INNOVATION NETWORKS IN THE INFORMAL ECONOMY it will become clear that consumer-centeredness also plays a crucial role in driving shanzhai innovation.
3.7. Defining shanzhai innovation
The range of bandit mobile phones is immense. For some phones, the resemblance with the original is strong. Even the operating systems have the same functions and design as the original. Shanzhai is often seen as counterfeiting and bandit phones are labeled counterfeit and shanzhai interchangeably. Regardless of whether a product has additional features or not.
From the perspective of a consumer, it there are different motivations for purchasing a counterfeit or a shanzhai phone. This section will look at why shanzhai innovation distinguishes itself from counterfeiting and how it achieved this through user-centeredness.
3.7.1. Counterfeiting
Shanzhai is often translated as "copy" or "counterfeit" in English. Whereas ‘copy' and
‘counterfeit' are different words in Chinese, namely, fuzhi (复制) and weizao (伪造). The word fuzhi refers to an object that is the replica of the original. In the realm of creative production, this word does not have a negative connotation (Han, 2016). Instead, creating a copy that matches up to the original is seen as a work of art in itself. In the context of mobile phones, emulating the design and software of a branded phone can be done with such accuracy that it is not easily detectable for the untrained eye. Often only small irregularities give away that it is not an original phone. Producing these types of phone is called counterfeiting. Weizao (伪造) has been the standard way to describe counterfeit goods that increasingly circulated in China since the 1980s (Yang, 2016).2
2 A counterfeit is an unauthorized copy that appears to be valid but is illegal. The negative consequences of counterfeiting are manifold and there have been several debates on fighting
25 INNOVATION NETWORKS IN THE INFORMAL ECONOMY 3.8. The difference between shanzhai and counterfeit phones
It has to be said that the production process of shanzhai and counterfeit phones may be very closely related. Moreover, businesses may be producing both types at the same time. By looking from the perspective of producers and consumers’ motivations, a difference between shanzhai and counterfeiting can be established.
As discussed in the previous section, shanzhai phones incorporate imitative and innovative features. While producers of counterfeit phones aim to make the best copy,
Shanzhaiji producers want to stand out from the rest. Therefore, Shanzhaiji producers interfere with the original creatively and playfully. This includes showing off their products as being overtly fake and different (Qin, Shi, Stöttinger & Cavusgil, 2017). Research on the motivation of consumers to buy shanzhai products reveals a difference between the motivation of buying a shanzhai and counterfeit phone. Consumers intentionally buy shanzhai in order to make use of the additional features (Cordell et al., 1996).
Moreover, the functionality and new features are the primary motivators for people to buy a Shanzhaiji. Unlike buyers of counterfeit goods where the intention is to take on a particular social status (Qin, Shi, Song, Stöttinger & Tan, 2018). Price and quality play important roles in both categories. Consumers of counterfeit and shanzhai products take into account that the quality of the products is inferior to the original. The technology can be unstable, and the features of shanzhai product may not perform reliably. Buyers seem to be satisfied with the
counterfeiting in China. Counterfeiting is a growing global phenomenon that affects domestic and international businesses. Counterfeit goods can damage the reputation of a brand leading to a loss of consumer trust in the original product. In some cases, counterfeits can have severe consequences for consumers. For instance, when users are tricked into believing they are using a genuine product, while the counterfeit product may be inaccurate or faulty in its functions. This can expand to affecting the economy as a whole and even impair country’s trade relations (“frontier economics”, 2017; Cordell, Wongtda & Kieschinck, 1996).
26 INNOVATION NETWORKS IN THE INFORMAL ECONOMY price-quality trade-off. They are aware of purchasing a lower quality product, in which they risk buying a low-functioning or fraudulent device (Ming, 2014; Qin et al., 233).
What makes Shanzhaiji stand out further is the practicality of features that are directly aimed at a specific type of user. While large mobile phone producers generally cater their products to a vast range of consumers from different social and economic backgrounds, it can be assumed that they have less direct contact with their vast consumer base. Phone producers that copy branded phones, may be more attentive to the trends of their target and respond by copying phones that are in high demand. At this point, shanzhai clearly distinguishes itself from the original brand and the counterfeit good because the products target a much smaller demographic of consumers. Shanzhai producers have to understand the needs of their target group, which in return binds the consumers to the product.
With increasing popularity, Shanzhai producers were forced to invent creations that would make them stand out and catch the attention of their customers. Shanzhai became a creative expression of the producers where the playful features stood in the foreground.
Moreover, these products do not only represent the shanzhai businesses themselves but are also a representation of the consumer’s identity. The identification with shanzhai from a producer and consumer perspective has made shanzhai into its brand3. Some shanzhai businesses advertise their product being ‘shanzhai’, and buyers and sellers of shanzhai seem to take pride when buying these products. They stand out for being domestically designed and produced and are framed as a form of ‘Chinese innovation’ (Lindtner & Li, 2012; Wallis
& Qiu, 2012). This way of framing is one of how shanzhai businesses can increase the popularity of shanzhai phones and acceptance among Chinese consumers.
3 According to Kotler (1991), “name, term, sign, symbol, or design, or combination of them which is intended to identify the goods and services of one seller or a group of sellers and to differentiate them from those of competitors” can define a brand. (as cited in Keller, 1993, p. 2)
27 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Overall, it can be said that shanzhai innovation does itself apart from counterfeiting and imitative productions. The shanzhai network does not only have the capability to transfer technological knowledge between entities, but it is also a communicative system between producers and consumers. Without the external input from consumers, shanzhai innovation would not have been successful. Paying attention to users’ needs makes people feel connected and they purchase the product with a sense of pride. Nevertheless, shanzhai innovation will continue to be under scrutiny, as shanzhai phones will continue to imitate features of higher end technology.
4. Shanzhai innovation in the case of Xiaomi
In the following section, it will be discussed how shanzhai innovation may operate in a larger business network. This will be done by looking at the internet company Xiaomi.
Xiaomi has grown from a small niche, user-centred and software developing business to a high-end mobile phone and smart device producer. The company orchestrates the ecological chain of its mobile phone production and is at the interface between manufacturers, designers and consumers (Mobile Internet, n.b.)4. Xiaomi's development from selling inexpensive smartphones to becoming a leader domestic smart device production will be explored more closely.
4.1. User-centeredness The company was founded in 2010 started to sell an operation software for smart phones called MIUI. From the start, user-centeredness was at the core of Xiaomi’s product development. The first customers were only a smaller group of technologically experienced
4 Xiaomi is known for its competitively priced high-end mobile phones and these phones the company offers a range of lifestyle products including smart TVs, Mi Band, Mi Air Purifier and Mi Electric Scooter (Xiaomi Global Community, n.d.). Domestically, Xiaomi is already the largest producer of mobile phones while it is becoming increasingly popular in international markets as well (Xiaomi Corporation, 2019).
28 INNOVATION NETWORKS IN THE INFORMAL ECONOMY users. When users installed MIUI they were able to give feedback on the operating system
(Shirkey, 2015). The users' expertise was used to improve the software and customize it to the users’ needs in the next update. These updates were launched on a weekly basis, so that users would quickly experience an improvement (Wong, 2014). Much appeal was found in this model constant feedback and users became known as "Mi Fans" or mifen (米粉). Xiaomi continues to nurture its user community by publishing the latest information on updates and products online and users can engage by posting questions and by sharing their experiences.5
Through this interaction, Xiaomi is able to communicate with its users and binds people to thei products through engagement (Kline, 2017). This kind of two-way communication plays an important role in shanzhai innovation. The extensive engagement with its users makes
Xiaomi stand out from other mobile phone companies.
4.2. Network orchestration After gaining expertise in the field of operating systems, Xiaomi moved on to producing mobile phones. The company has launched almost 20 smart phone models in high-end and low-price categories over a short period of time (Mi Phones, n.d.).
Xiaomi's mobile phones are produced through collaboration with Independent Design
Houses (IDH) and Original Design Manufacturers (ODM) in Shenzhen. While IDHs take over designing the mobile phone, ODMs offer already finished produced mobile phones.
These phones are then optimized with the software and labelled by Xiaomi (Joseph, 2019).
By outsourcing the design and manufacturing Xiaomi reduces the costs for production
(TechDesign.com, 2016). In addition, the company builds on the expertise of IDHs and
ODMs to manufacture phones. These companies conduct their own research and
5 Mi Global Community: For more insight on online forums hosted by Xiaomi visit: https://c.mi.com/oc/forum-1898-1.html
29 INNOVATION NETWORKS IN THE INFORMAL ECONOMY development, which shortens the production cycle of a smartphone and allows Xiaomi to release more phones in a shorter period of time.
The collaboration of Xiaomi with different partner companies is further enhanced through diversifying the product range. Xiaomi outsources the development of other smart devices by collaborating with companies that are specialized in the area. Xiaomi is mainly involved in the final design stage and labelling of the product. These companies benefit through the collaboration by gaining access to distribution channels and market insights (Wang, 3 May
2019). Thereby Xiaomi builds a network where technological knowledge and market insights are exchanged. It can be said that one of the main successes of this network collaboration is it that Xiaomi's was able to cut costs for consumers.
5. Discussion From the perspective of small or medium sized business, operating in a shanzhai environment can be beneficial to secure resources and advance technological knowledge and market insights. The strengths of this innovation system lie the capability to absorb and implement new technology at a high pace and subsequently create products that respond to the demand of consumers. It can be said that even though, the shanzhai network is partly based on informal or social relations, shanzhai businesses are very competitive and market- driven. The price-quality trade-off is significant for producers and customers and therefore creates a strong incentive to advance existing technologies and push innovations. It can therefore be advantageous for the development of the mobile phone industry to integrate the economic output of the informal sector.
In the current context, businesses may face several obstacles in becoming formal. This includes for example, access to subsidies and obtaining financial services from conventional banks. Small businesses may further be discouraged to transition into the formal economy by bureaucratic hurdles. In addition, to mature as a business, skilled and trained employees are
30 INNOVATION NETWORKS IN THE INFORMAL ECONOMY needed. Since many skills that are obtained in the informal economy are acquired through learning by doing, it may be difficult to train employees for higher skilled working processes when the resources are not available within the network. Consumers’ demand plays a central role product development in the shanzhai innovation system. One of the drawback for growing businesses could that the products do not appeal to a wider consumer segment. To what extent businesses are able to adapt to the needs of a larger consumer base is debateable.
In terms regulating shanzhai innovation it is unclear whether the government will be able to implement policies that could encourage businesses to formalise. The restrictive policies towards migrants settling in urban areas such as Shenzhen can be seen as the greatest social barrier towards formalisation of networks. Further, the question remains to how informal and social relations that are partly in place to protect businesses from government interventions can be translated to a formalised environment.
Currently, the unregulated modes of entry to the mobile phone market push down prices and marginalize producers’ profits. It can be said that fierce competition may create a race to the bottom in mobile phone manufacturing. Technological advancement is likely to exacerbate this process. Hence, businesses may be discouraged to take greater risks in expanding when they face increasing competition from below.
In addition to the structural and regulatory obstacles, the acceptance of shanzhai innovation in the current social and political context is still debateable. Legitimacy plays an important role for growing businesses as it can secure the access to resources and societal support in the longer term (Rutherford & Buller, 2007; Lee & Hung, 2014). Research has shown that, customers, financiers and employees are more likely to endorse a company when they have a certain level of trust in a company. Businesses are more likely to expand their production and hire new employees when they have a certain degree of certainty that they will receive returns on their investments. Since the emergence of shanzhai as a popular
31 INNOVATION NETWORKS IN THE INFORMAL ECONOMY phenomenon, people purchased shanzhai products with a sense of pride for shanzhai being domestically produced. However, at the same time the value and significance of shanzhai have been consciously under scrutiny. One of the mechanisms employed by supporters of shanzhai innovation has been to obtain greater legitimacy by framing shanzhai from a historical and cultural perfective (Lee & Hung, 2014). It can be said that framing shanzhai is an ongoing process, but its outcomes can not be fully anticipated.
User-centeredness and network orchestration are two of the main characteristics of
Xiaomi’s business model and it overlaps with the practices of shanzhai innovation. Xiaomi was able to create a competitive edge by integrating user feedback and quickly responding to the needs of the target group. Xiaomi has adapted its user-centeredness model to its crowdfunding platform. On this platform, customers can directly fund products they want to buy (Techkou.net, 2019). Thereby Xiaomi able to foresee trends and can enter collaboration with producers and integrate the products in its product range. It can be said that while the company continues to grow and expand to new markets, user-centeredness may become more challenging.
It can be said that at the early stages of Xiaomi’s mobile phone production, shanzhai innovation has played an important role. Xiaomi gained its expertise from external contractors and build phones through collaboration. Xiaomi continues to build on collaborations as it strives towards becoming an IoT company that integrates smart devices in its online network. Therefore, Xiaomi constantly enters new collaborations with companies to enhance its smart devices range (Mobile Internet, n.b.). Collaborating has the advantage that it lowers the costs of developing a new device and increases the amount of products available to consumers. Xiaomi thereby sets the standards, but under which conditions knowledge and technology are exchanged within the network is unclear.
32 INNOVATION NETWORKS IN THE INFORMAL ECONOMY There have been some drawbacks in which companies misused the Xiaomi brand name to market their product (Techkou.net, 2009). Just as other smart phone producers, Xiaomi is not immune to its products being counterfeited. How the company responds to its technology being appropriated is unclear. It can be said that in order to sustain the brand a certain amount of protection of its innovations and technologies needs to be upheld. Furthermore, Xiaomi faced production shortages of its smart phones devices. The shortage is said to have been caused by mismanagement of the production process (Li, 2019; Wang, 17 March 2019).
While Xiaomi is currently able to reap the benefits of collaboration with partners, these collaborations may become obsolete as the companies mature themselves. It can be said that the shanzhai innovation approach may shift towards a more closed system of collaboration.
6. Conclusion
This analysis has shown that shanzhai innovation is an important part of China’s telecommunications sector. By applying the National Innovations Systems Theory, innovative capacity of shanzhai networks has been made visible. Building these networks through formal and informal business relations creates a dynamic knowledge and technology transfer that enables innovations. In addition to the relations between actors, shanzhai products are enhanced through the incorporation of customer feedback. Producers are motivated to stand out from counterfeited phones by inventing combinations of features and gadgets that appeal to the customers. It can be said that shanzhai innovation has a competitive advantage for small to medium sized business operating in a local environment. It has become clear that shanzhai businesses in the mobile phone industry face several constraints that are typical for businesses in the informal economy.
The case of Xiaomi describes how shanzhai innovation can be a possible approach for businesses to expand. Xiaomi has been successful in resembling a shanzhai innovation process through the transfer of knowledge and cooperation with external partners.
33 INNOVATION NETWORKS IN THE INFORMAL ECONOMY Establishing a user community to gather input and expertise and trends have been the fundament of Xiaomi’s success. Through the implementation of a collaborative network,
Xiaomi had to invest less on internal research and development. This has lowered the costs for its devices and created an advantageous price-quality trade-off for its consumers. Xiaomi continues to be the interface between consumer input and device manufacturers as it expands its product range. The discussion has shown that the growth of the company may impede the shanzhai approach to the extent that Xiaomi may not be able to incorporate the needs of a larger and diversified customer-base. Further, challenges in the supply chain have shown that
Xiaomi may have to shift away from depending too much on external collaborations.
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