149-Innovation Entrepreneurship and.pdf

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Innovation, Entrepreneurship and Governance:

The Shanzhai Handset Business

Professor Jay Mitra

Centre for Entrepreneurship Research, Essex Business School, University of Essex

and

Professor Si Chunlin

School of Management, Fudan University, Shanghai, China

Abstract

The spread of the Shanzhai phenomenon across several Chinese industries has attracted

considerable interest in policy and research circles in both China and abroad. It has also

generated a variety of opinions on the modalities, ethics and capacity for innovation and

entrepreneurship related to this phenomenon. Taking the Chinese mobile phone industry as an

example, this paper investigates the technological background and the market conditions

under which the Shanzhai Handsets emerged. Based on the specific analysis of the challenges

of the Shanzhai Handset to regulatory (government) and governance (industry) issues, the

authors propose a model of ‘innovation governance’ which could apply to the future of the

manufacturing industry involved with Shanzhai Handsets.

The relationship between entrepreneurship, innovation and governance has been considered

critical to the development of efficacious framework conditions and notions of an enterprise

culture (Baumol, 1990, 2007; Acs, 2009; Estrin, 1998, 2006). Arguments pertaining to the

absence of suitable governance structures especially in transition economies have been put

forward to suggest the need for strong institutional structures to be in place to protect

property rights. Such arguments have compared the ostensible benefits of sophisticated

intellectual property rights and governance in western countries with those of various

transition and newly industrialising nations often providing intellectual support to industry

level concerns. This literature offers little by way of explanation of local modalities, the

search of legitimacy and conditions of governance, especially the informal ones embedded inlocal and distributed networks. This paper attempts to throw new light on the subject by

examining a novel phenomenon which allows for innovation to occur both at the margin of

legitimacy and through a network-centric approach involving a range of players. Such an

occurrence raises issues about new forms of organizational innovation in particular together

with those of product and service innovation.

The authors examine organisational innovation in terms of governance issues. The paper

identifies three mechanisms of governance: industry governance, firm level governance and

government regulation, and examines the way in which these mechanisms influence or impact

on the innovation process. The paper is divided into six parts: the first part introduces some

conceptual and theoretical issues; the second part introduces the phenomenon and analyses

the technical background and market conditions related to the products on offer; the third part provides an analysis of the challenges that Shanzhai Handset manufacturers face



together with the difficulties associated with its development; the fourth part examines the

governance mechanisms of Shanzhai handsets; the fifth part is to discuss implication of the

model of ‘ innovation governance’ (IG) in the context of the increasingly-popular Shanzhai

culture; and finally, the paper concludes with a discussion on the implications of the IG model

for policy and innovation and entrepreneurship theory.

Key words: Shanzhai handsets, innovation governance, entrepreneurship

Introduction

From around 2005, a number of ‘Shanzhai Handsets’ which were not well known in the

country appeared in China’s mobile telephone market. Handsets such as “NOKLA” (not the

hand slip of NOKIA!), and “Samsang” (not wrong spelling!) began to find their way into the

market place. Shanzhai Handsets are mainly characterized by their ability to imitate famous

brand handsets, and even surpass them in aspects of appearances, functions, or price.

Numerous small-scale electronic factories that produce those odd, brand handsets are referred

to as Shanzhai Enterprises. These enterprises are identified as having no formal brands,

operating without any formal marketing channels but offering products at low prices,

generally being regarded as ‘creative’ players. A report, entitled Uncovering Secrets ofShanzhai Handset Market , from 30 Minutes Economic Update of CCTV broadcast on June,

2008 indicated that according to incomplete statistics, the output of Shanzhai Handsets in

2007 had amounted to at least RMB 150 million Yuan, which nearly equaled the total output

of handsets in China’s domestic markets.

The Meaning of Shanzhai and Shanzhai Handsets

In Chinese, ‘Shanzhai’ means villages, territories, and protective fences built in mountains.

Historically, these were strongholds of warlords built in defiance of the feudal official, and

outside the power and reach of government and officialdom. A feeling of independence and

autonomy is associated with the word Shanzhai. In our times the so-called ‘Shanzhai

Products’ are those which are regarded at best as imitation or improvised products, and, at

worst, ‘fake’ or ‘knock-off’ versions of well known brand names in mainstream markets.

Increasingly, however, they have been endowed with new brand images representing perhaps

an act of ‘commercial defiance’ to the hegemony of established brand names in the mobile

telephone business.

Shanzhai Handsets are one of the earliest Shanzhai products. The emergence of these handsets

unleashed a strong shock wave to the market, leading domestic handset enterprises that used

to occupy half the China’s handset market, such as Bird, TCL, Kejian, Panda, Amoi and

others, to close down their operations. Bird Co., Ltd., which had a net profit of RMB 245

million Yuan in 2003, suffered a loss of 539 million Yuan in 2007. Similarly, Eastcom and

Panda Co., Ltd. relinquished their hold in the market with considerable losses, while the

restructured Kejian gave up handset manufacturing in 2007. At the beginning of 2008,Lenovo declared that it would sell its handset business at the price of 100 million Yuan to 4

investment institutions.

Handset experts and critics hold different opinions on Shanzhai handsets: some consider that

the emergence of these handsets is the result of technical progress, heralding the trend of

future technological development. Others believe that these handsets violate market rules,

referring to the Shanzhai Handsets as “Shady Handsets”.

In addition to being popular in the domestic market, Shanzhai handsets are also sold in the

Middle East, other parts of Asia and Africa. Sales levels in the European market also appear

to be increasing. Even, some of the locally unknown Shanzai Handsets have become popular

brands in India, in Eastern Europe, and in Africa. Shanzhai handsets have now spawnedShanzhai computers, Shanzhai costumes, Shanzhai Spring Festival Galas, Shanzhai’ films,



and other Shanzhai products” of various brands all across China. It has now become part of

the phenomenon of popular culture.

In common with all popular phenomena, the handsets and the culture that it has generated

have received a mixed response. Critics associate the Shanzhai phenomenon with plagiarism

and the infringement of intellectual property rights. Some even consider Shanzhai’ to be an

insult to or humiliation for China. In some countries such as Pakistan and India the need for

handset IMEI certification shows that people have started to question the legitimacy of

Shanzhai versions of different products. Others with perhaps an open mind regard the

Shanzhai phenomenon as symptomatic or symbolic of the spirit of anti-monopoly and

innovation. Varied views offer appropriate measures to deal with the phenomenon. Some

think Shanzhai should be banned, others preach tolerance and the adoption of different

sanctions or measures according to their application and use.

Structure of the paper and methods

The paper is divided into six parts: the first part considers some conceptual and theoretical

issues of entrepreneurship, innovation and governance. The second part introduces the

phenomenon and analyses the technical background and market conditions related to the products on offer. The third part provides an analysis of the challenges that Shanzhai handset

manufacturers face together with the difficulties associated with its development, and the

fourth part examines the governance mechanisms of Shanzhai handsets. Part five discusses

the implication of the model of ‘innovation governance’ (IG) in the context of the

increasingly-popular Shanzhai culture; and finally, in the sixth and conclusive part the authors

discuss the implications of the IG model for policy and innovation and entrepreneurship

theory.

The paper provides a broad macro level analysis of the Shanzhai handset industry and its

location within the wider Shanzhai phenomenon. The purpose is to obtain a broad

understanding of the rise of this phenomenon in a particular cultural context. This

understanding is achieved through observation of the evolution of mobile telephone handsetsin China, the network-centric approach adopted by different Shanzhai players, the odds and

difficulties they face in competing with global brand names, and how they have organized

themselves through multiple governance structures reflecting innovative approaches to

organizational development. Most of this observation is carried out by way of secondary

search methods involving the examination of industry and government generated data. The

‘threatened species’ environment in which Shanzhai manufacturers have sought both survival

and ingenious adoption of innovation practice, makes it difficult to obtain primary data,

although the authors are exploring this ground for further research on this subject.

Part One: An Overview of Conceptual and Theoretical Issues

For the purpose of this paper innovation takes the form of an introduction of a product in newmarkets (where brand names are not necessarily affordable), whether by way of an invention

or by imitation, leading eventually to diffusion in the market (Schumpeter, 1934). We also

consider innovation in terms of the organization of its production and distribution, the

introduction of incremental benefits, and recognition in the market, which allows for the

conceptual link between innovation and entrepreneurship. While innovation is regarded as the

creation (production or initiation) of something new (Bozeman and Link, 1983),

entrepreneurship is referred to as the perception of opportunity associated with the innovation,

and the ability (organizational arrangements, learning and governance arrangements) to act on

such perception (Link and Seigel, 2007, Acs and Audrestsch, 2007, Mitra, 2009).

Networks of operation and production offer new opportunities for firms to develop products

and services (Hooh-Soi and Roberts, 2003). Networks often follow open innovation

architectures (Chesbrough, 2003) and are augmented by end –user involvement (Von Hippel,



2005), generating even greater opportunities for sophisticated and dynamic forms of product

development. They also open up possibilities for different types of transactional arrangements

and their governance.

The emergence of Shanzhai handsets in the market has raised specific questions about the

relationship between on the one hand innovation as a process which embraces imitation and

notions of governance on the other. Innovation as imitation has long antecedents. Schumpeter

(1961) argued that the “spell is broken” as soon as innovation is made with the first

innovation drawing followers leading to successful imitation making the innovation familiar

through a process of diffusion in the market. The diffusion process eventually wipes out the

entrepreneurial profit till another innovation surfaces and renders the first innovation obsolete.

This process of ‘creative destruction’ is at the heart of capitalism as far as Schumpeter was

concerned. Following Schumpeter many arguments have been made about the specific

function of imitation as innovation enabling a process of technological learning (Kim, 1997,

Kim and Winter, 2000), facilitating economic growth (Segerstrom, 1991), and as a form of

benchmarking (Massa and Testa, 2004). The growth of Asian economies from Japan to Korea

to China and India has often been attributed to imitation-oriented innovation (Kim, 1991, Kim

and Nelson 2000). Imitation’s darker side is reflected in the flourishing output of fake goodsin the hidden economy or in so-called ‘black markets’ across the world challenging and

disrupting the institutional and moderating role of patents and often the legitimate process of

buying and selling goods and services in the open market. The seemingly unstoppable growth

of the hidden economy has inevitably raised questions of trust, the value of intellectual

property and governance at firm, institutional and governmental levels.

An examination of the relationship allows for the proper consideration of new product

development in uncharted and sometimes inchoate markets where established routines and

practices can be called into question. The paper puts forward the idea of ‘innovation

governance’ with reference to three mechanisms of governance: industry governance, firm

level governance and government regulation, It examines the way in which these mechanisms

influence or impact on the innovation process, and finally points out general implication of innovation governance to the evolution of a Shanzhai culture.

The relationship between entrepreneurship, innovation and governance has been considered

critical to the development of efficacious framework conditions and notions of an enterprise

culture (Baumol, 2007; Acs and Audrestsch, 2009). At the level of the firm Coase (1937) had

examined firms and markets in terms of alternative modes of governance rather than in terms

of a production or technological function. How a firm was governed depended on differences

between various forms of transaction costs which they had to incur both within and outside

the firm. Any consideration of such costs gave rise to issues of conflict, mutuality and order

(Commons, 1932), and their management. Managing the ‘Commons triple’ (Foss, et al, 2000)

necessitated adaptation to particular environments and the use of resources. According toHayek (1945) adaptation is only possible spontaneously through markets while Barnard (1938)

identified a more ‘conscious, deliberate and purposeful’ kind of adaptation which was

dependent on co-operation between firms and possibly other stakeholders.

The extent to which there is incentive intensity, administrative controls and a legal rules

regime helps to define the meaning and value of governance either at the level of the firm or

in markets (Williamson, 1991). For governance to function effectively at both levels there is a

need for ‘soft’ (values, mores, and norms of practice) and ‘hard’ institutions (government

institutions, industry bodies and agencies). The mix of these institutions lay down certain

boundaries of business activity.

In making new products and in competing with incumbent players, new firms incur varioustransaction costs which they choose to reduce through a variety of means. In most cases firms



seek legitimacy by working within the institutional boundaries referred to above. Networks of

firms can help to reduce some of the transaction costs and offer tangible outcomes for any

search for legitimacy. Networks of operations also call for alternative forms of governance at

the level of industry and those of firms, especially when their operations reach across borders

of different countries.

However, survival in uneven playing fields can tempt firms to transgress boundaries. Such

transgression can lead to unproductive forms of entrepreneurship (Baumol, 2007) judged by

normative standards set in dominant environments, such as in Western countries. Such

standards are of course not exclusive to specific cultures. Most firms in varied cultural

environments would uphold values of integrity, honesty and fair trade as they manifest

themselves in the activities of the firm. How these values are monitored and governed will

sometimes be subject to different structures of governance.

Arguments pertaining to the absence of suitable governance structures especially in transition

economies have been put forward to suggest the need for strong institutional structures to be

in place to protect property rights. Such arguments have compared the ostensible benefits of

sophisticated intellectual property rights and governance in western countries with those ofvarious transition and newly industrialising nations often providing intellectual support to

industry level concerns.

This literature offers little by way of explanation of local modalities, the search of legitimacy

and conditions of governance, especially the informal ones embedded in local and distributed

networks. What happens when we are faced with phenomenon and innovation that occurs at

the margin of legitimacy and involving a range of players? Such an occurrence raises issues

about new forms of organizational innovation together with those of product and service

innovation.

The study of the Shanzhai handset phenomenon offers us the opportunity of re-examining

some of the theories of organizational innovation, governance and network, from the perspective of a specific but complex, social and cultural environment.

In this paper we make the connection between innovation and governance, developing a

framework which examines typologies of innovation to understand the emergence of a

phenomenon, and forms of governance which we believe are necessary to legitimize, support,

control and generate incentives for the producers of the Shanzhai innovation phenomenon. We

note the evolution of the Shanzhai phenomenon and track the process by which Shanzhai

manufacturers select, retain, and vary their actions in order to survive and grow in a highly

competitive market. Alongside this tracking exercise we examine how different forms of

governance at three distinctive levels – the firm, the industry and the state – can help to create

and augment entrepreneurial value creation. A graphical version of this approach is shown in

the diagram below.



Figure 1:

As Figure 1 shows, each type of innovation can be associated with a form of governance at a

specific level. The early stage, imitative innovation process is linked to firm level governance,

where firms seek to acquire legitimacy by learning through imitation. Thus, a form of learning

enables the Shanzhai manufacturers to define their place in the market. As the manufacturers

develop an enhanced capacity for innovation, through functional or incremental measures and

then on to new technological know-how and network-centric organizational innovation, the

complexity in the forms and levels of governance change. Each stage of development has a

mix of moderating variables, tools and factors, including learning, open innovation platforms

and networked-based activity which influences both the nature of the innovation process and

the forms of governance that are best suited to the stage of development. In referring to stages

of innovation or associated forms of governance, we note that they do not represent a linear

movement from one stage to another, but in keeping with evolutionary dynamics, there is a

complex connection within and between each of those stages of innovation and the forms of

governance.

Part Two: The Technical Background and Market Conditions

The “Turn-key” Mode Adopted by MediaTek

Handset production depends on a production network. Bird, TCL, Kejian, Panda and other brand enterprises all have their own production networks, with the significant characteristic of

these networks being mutualism. Prior to the emergence of Shanzhai Handsets, handset

manufacturers were the core players in the manufacturing process



(as shown in Fig. 1). They developed and integrated peripheral techniques such as

handwriting, Bluetooth, imaging and other techniques to develop new handsets within 6 to 9

months.

All manufacturing enterprises have, in fact, shaped a network structure, in which different

enterprises undertake different tasks:

• to manufacture moulds;

•

to design appearances; and

• to match functions.

With a handset manufacturer at the center of the network, different manufacturers in different

fields are tightly connected with each other to form a network structure which has a relatively

high density and intensity. The emergence of Shanzhai handsets did not affect the network

characteristics of handset manufacturing. What has changed, however, is the structure of the

networks .

Evolving Networks

In 2005, the MTK handset chip, produced by Taiwan chip manufacturer MediaTeck,

integrated into one handset a main board and software which required completion by a widerange of people for more than one year. In the manufacturing network, critical components

are supplied by MediaTeck, while the handset manufacturer designs handset casings, shapes

and other components, around the critical chips. A new type of handset is produced within 3

months (as shown in Fig. 2).

Chip

Handwritingtechnique

Handset manufacturers

Operation software

Camera

ScreenOthers

Fig. 2: The Manufacturing Mode with a Handset

Manufacturer the center



Conversion of the manufacturing technique network has lead to important changes in handset

development, production and marketing. Comprehensive solutions to the “turn-key” mode

launched by MediaTek, resulted in chips and operation software, even liquid crystal displays,

cameras and other components being brought together using a “one stop shop” business

model. For each Shanzhai enterprise at least two links in the handset manufacturing chain are

removed: an application platform and various software. These two links are now integrated

into the products produced by MediaTek and other chip manufacturers. As a result, the most

critical components have been packed as a semi-finished product. A manufacturer needs only

to purchase the semi-finished product, match it with a handset casing and a cell, and assemble

the handset with a relatively simple flow of operations and at low cost. The core technique

controlled by famous brand handsets now has become a common one facilitating the production of Shanzhai handsets. Consequently, handsets also can be produced by some small

businesses and individuals.

Changes in the network structure are part of the network-centric organizational innovation

process opening up opportunities for small firms and self-employed individuals in the mobile

telephone market.

The Technical Platform of Shanzhai Handsets

The outstanding features of the production network of Shanzhai handsets are the MTK

handset chips of MediaTek and comprehensive “turn-key” solutions which supply a common

technical platform for all manufacturers. The creation of the technical platform indicates

considerable progress along technological lines. With the platform, it is pointless formanufacturers to start at the very beginning of the manufacturing process. The common

platform provides effective ways to manage the diversity of products on one production line.

The idea of using technical integration within a variable range of specific applications was

generated by H Meyer and Alvin Lehnerd. They pointed out that the product platform is “a set

of interfaces and subsystems which can form a common frame, through which a series of

various products can be effectively improved and be produced”. As Figure 3 below shows

manufacturers and users are connected by way of a public or open technical platform which is

effectively an innovation tool box allowing for both to work together to achieve multiple uses

through technology exchange and integration. Von Hippel (2005) refers to such models as end

user innovation which also embraces ideas of open innovation (Chesbrough, 2003).

Handset manufacturer 2 Chip integration manufacturer

Handset manufacturer 1




Fig. 3: Manufacturing Mode with the chip manufacturer as the core



Innovation and Cost Reduction

The major function of the platform is to reduce manufacturing cost. The chip supplied by

MediaTek is a highly-integrated, multimedia baseband chip solution, which includes a mode,

a baseband chip, operation software, LED, camera head and other components that all can be

solved “in one stop”, thereby, greatly reducing handset production links and cutting down

development costs. The price of an MTK chip is 75% lower than that of Nokia and about half

that of handsets produced by larger-scale factories. A brand handset with relatively simple

functions can be sold at a price of more than 1,000 Yuan, while a Shanzhai handset with alarge screen, bluetooth, imaging, camera, handwriting, TV functions, etc. can be sold at a

price of just a few hundred Yuan. If a famous-brand handset is equipped with all the functions

of the Shanzhai handset, the selling price of such a product is likely to at least 3000 Yuan. It is

often quipped that a Shanzhai handset can be sold at “the price of a Chinese Cabbage”.

Innovation and Effective User-Friendly Functionality

Secondly, the platform enables innovation to be more effective in terms of what it offers to its

users. Chips of MediaTek and “Turn-key” solutions are only semi-finished products for

handsets. The diversified value-added solutions can be chosen for processing a handset to be a

final product. For instance, the solution can generate a main board with many different shapes

and this main board can be made into a handset with different external configurations.

Handsets can take the forms of watches, cigarette boxes, and car moulds of BMW, MercedesBenz, Porsche, and others! The technical platform built by MediaTek solved many technical

difficulties related to the original value chain, making it easier for production to realize and

adapt to specific users’ requirements. Once a user puts forward the requirements, he or she

will obtain the customized handset with particular functions within 3 days. Some “Shanzhai

Handsets” combine aesthetic originality with functions such as super-large screen,

intelligence, a TV, double cameras, a multimedia player, and a simultaneous standby of

double cards, all within one handset!. The array of functions that can be built into a handsets

is of staggering proportions.

User-led Constant Innovation

Finally, the new technical platform allows for easy integration of users’ innovation. Some

users have started to use handsets for more than just communication, as they regard the

Shanzhai handset as an item for fashion and an expression of individual style. Users often

Technology integration

Innovation users

Innovation users

Innovation users

Manufacturers -

Manufacturers

Manufacturers

Public technical platform/ innovation toolbox

Fig. 4 Diagram of Technical Platform



possess critical and essential understanding of the requirements of product performance and

can play an important role in putting forward proposals on product refinements and

innovation (Franke, Hippel 2003, 2006). It is the most discriminating consumer with the most

sophisticated set of requirements who is likely to help boost the quality of a product and a

service. Take the following Game handset for example. With an external connection handle,

the handset needs only to be put on the handle and connected with it, making games directly

controllable by the handle. This simple facility turns the handset into a complete gaming

machine. Handsets resembling “transformers” are equipped with eight speakers.

The Innovation Toolbox

New types of Shanzhai handsets are launched constantly, as the result of users’ enthusiasm

for participating in product innovation. Von Hippel (2003, 2005) considers that a

manufacturer needs to be aware of the exact consumer requirements for new products in a

hundred and one ways, and that traditional production methods makes it difficult to absorb

rapid changes and modifications generated by users. Von Hippel (2003, 2006) advises that a

manufacturer should give up traditional methods and suggests that the best way to adapt to

user led change is to provide the latter with a “Toolbox for Innovation”, so that users can

make their independent innovations in designated systems of particular products and servicesaccording to their interests. In this way, a preliminary design is created, following which the

“embryo mould” evaluated by consumers. A series of improvements are made until the

product is considered satisfactory by the user. Von Hippel’s research (2002, 2003. 2005)

shows that the “Toolbox for Innovation” is more effective than the traditional method of

production.

Innovation and Multiple Users

The public technical platform of handsets here has become the toolbox for users’ innovation,

which enables communications between an innovative user and a manufacturer to become

easier. At the very beginning, Shanzhai handsets just imitated appearances or functions of

mainstream brands, offering their ‘copy cat’ products at a very low promotion price. The

motivation of users, the integrated functions and the novel appearance of Shanzhai handsetshave changed the way these handsets are made and how they have started to attract an

increasing number of consumers. Variously models in the shape of racing cars, cigarettes, and

watches, for example meet the vagaries of the fashion conscious young consumer, while

Shanzhai handsets with “large screens”, “large keys”, traditional fashion and best fit design

ideas, appeal to the older generation. Functionality is extended when the handsets are

equipped with an LED light, helping farmers in villages for example to use it as a torch. The

multi-functional product characteristics of the handset enable consumers with a low

consumption ability (in terms of both access and cost) in China to be share in the new

technological experience.

Innovation and the Market Characteristics of Shanzhai HandsetsThe two segments of the Chinese telephony market include one in which low-end users just

buy handsets with basic functions at the lowest price, while the second segment covers high-

end users who buy expensive new model handsets with a wide range of functions and good-

looking or customized appearances. The market entry for a new product always begins with

high-end users; for example, the latest handsets are always used by merchant princes and

tycoons as well as top government officials. Their adoption helps to popularize the products

for common consumers over time. While the volume of sales increases during this process

demand in market takes on an evolutionary path of development.



1 2 3 4 5

Communications, taking photos, individuation…………

1 2 3 1 2 3 4 5

Communications, taking photos, individuation……………………

The emergence of Shanzhai handsets has upset the dynamics of the market to a certain degree.

Low-end handsets are increasingly endowed with numerous specifications. Handwriting, a

large liquid crystal screen, double speakers, double bluetooth, etc. have become part of a

basic configuration. Shanzhai products have all the functions of a famous-brand handsets all

at a far cheaper price than their branded counterparts. All functions being equal a normalmanufacturer sells a handset for a minimum of 1000 Yuan while the corresponding Shanzhai

handset is sold only at a price of few hundred Yuan. Consequently, the latter were firstly

welcomed by low-income consumers, satisfying a lifestyle desire for a luxury product. The

variety of offerings and the price also attracted the younger generation, as some young users

even purchase several handsets with different functions for use in different environments.

Changes in consumer behaviour tend to impact on the psychology of a society to a certain

extent. A typical secular society divides consumers into levels according to classes of brands

which they use. Users of Shanzhai handsets appear to embody what the media in Taiwan refer

to as the “Shanzhai Spirit” – the value of the free social spirit which is not afraid to lose one’s

face, or to make low profits in order to meet the needs and requirements of all consumers. It

generates a new spirit of innovation which allow producers and users to be part of ageneration of change in society which does not forsake traditional notions of the welfare of

the community (Li, et al, 2009) sand the minds of 1.3 billion consumers in mainland China.

Part Three: Challenges and Difficulties: Innovation and Legitimacy

Shanzhai handsets and other subsequent Shanzhai products imitate their mainstream famous-

brand counterparts while offering them at a very low price. Some Shanzhai handsets even

surpass the imitated products in appearance, functions and prices. This has led to the creation

of a movement loosely referred to as the “Shanzhai Phenomenon”, by both its admirers and

its detractors.

The first disputable focus concerns intellectual property rights. Professor Ge

Jianxiong in Fudan University argues (2009) that most of “Shanzhai Products” are

The source of the original handset’s customer value

Low-end users

High-end users

E v ol u t i on a r y d e v e l o pm e n t p a t h

High-end users

Low-end users

Note: Successful products can meet customer value; different market segmentation

corresponds to different combinations of key value. The blank area indicates that somevalue sources are not important to the market segmentation.

The source of the Shanzhai Handset’s Customer value

Fi ure 5: The Value Matrix



unauthorized goods, most of which are characterized by plagiarism, copycat activity

and spoof; only a fraction present uniqueness that can stand out in the market place.

Pointing to features of the “Shanzhai Culture” like plagiarism, imitation and fake

products, he puts forwards the view that “we can’t tolerate it excessively”. Others

point out that innovation was once the key-word to describe the “Shanzhai” spirit

when the first products emerged in the market place. Still others refer to how

Shanzhai producers are now increasingly “naked” in their ambition and how their

products have deteriorated with the adoption of malicious forms of plagiarism. An

investment expert Wang Ran states in his own blog article ‘Spread of Shanzhai

Culture is a Disgraced Thing’ that a Shanzhai product is now synonymous with a

counterfeit product, which will remind people of infringement of intellectual property

rights, shady handwork workshops, inferior quality, and other crimes. New laws and

business sanctions should be applied to the treatment of these products in the market

instead of the current norm of tolerance by both institutions and the market. Such

views suggest that attempts at legitimizing both Shanzhai products and the enterprises

involved in the phenomenon should not be allowed to acquire any form of cognitive

or socio-psychological legitimacy (Aldrich and Baker, 2004, Aldrich, 1999) necessary

for any form of embedding in both the market and in society.

The Shanzhai handset also arouses controversy overseas. For example, a German

magazine commented that the ‘Shanzhai’ is “infringing on intellectual property rights

unscrupulously”.

Concerns and observations referred to above raises serious questions about the

legitimacy and acceptance of new products, the production and development process,

the methods of organization and business models. These questions tend to reflect

popular notions of poor regulation and a leaky intellectual property rights

infrastructure in China. Media and institutional campaigns in the Western world have

been obsessed with these issues about China. However, not much attention has bee

given to the value of innovation by imitation or event to the ingenious methods andtechniques adopted in newly industrialized countries to develop new products,

experiment with organizational design that reflect certain social values of community

involvement. When both sets of arguments are taken on board various economic

arguments and business management models tend to get blurred. Is market

equilibrium affected adversely by innovation through imitation? When is imitation a

legitimate process of innovation and when does it acquire a sense of notoriety? If

brand –based hegemony is punctured by smaller rivals is that bad for the industry and

the market in which it operates? Must developing and new industrialized countries be

dependent on products and services from developed nations being embedded in local

markets before they can embark on their own innovation pathways? Can anything be

learnt from the adaptive, entrepreneurial responses to technologies, production

methods and organizational structures that emerge and evolve in developing countries?

The questions above reveal a complex and challenging economic environment in the

global market place. They raise issues about transparency and competitiveness,

regulation and governance which allow all players a level playing field without too

many constraints being imposed by those first in the market. While random and

unregulated markets affect operators in all environments (as the recent economic

crisis has revealed in relation especially to financial service operators in the western

world), there is a need to address issues of governance, regulatory frameworks and

institutional structures which do not stifle innovation and opportunity creation. The

following paragraphs deal with these issues in relation to Shanzhai handsets.



Regulating Shanzhai: Imitation and InfringementShanzhai handsets are often referred to “handsets leaning on brands”, as there appears

to be a general suspicion of infringement of intellectual property rights. It is

understood that once infringement is deemed an issue, governments should supervise

the production and sale of such products strictly. China’s objective is to build aninnovative country, adhering to an independent innovation trajectory. The government

supports and encourages innovation, and protects intellectual property rights like

patents, brands, and copyright as part of its economic development objective.

The determination of infringement needs certain principles and guidelines with the

need to consider the scope and boundaries of legal protection. Infringement cannot be

affirmed as long as imitation is not within the scope of legal protection for intellectual

property rights like protected patents, trademarks, and brands. It is generally believed

that except where there is an obvious demonstration of illegal activity such as in

smuggling, illegitimate production, the operation of counterfeit products, assembly

and renovating handsets, the majority of the products do not cross the legal boundary.

It is hard to judge any notion or practice of infringement under current laws. At

present, China has set up and perfected a series of intellectual property protection

systems geared to international standards; yet it is undecided whether to stipulate new

laws and regulations aimed at Shanzhai products.

Brands, Values and Society

A brand is a comprehensive reflection of internal quality and external characteristics

of a product, it is a bridge for consumers and enterprises to communicate, and is also

a promise of a product value. However, a brand cannot exist without a market;

without a clear market issue the brand is a mirage. Shanzhai handsets offer economic,

social and personal value to a wide range of consumers, which enables their producers

to establish a broad market foundation. While imported branded products cater to arising upper middle and rich consumer class, Shanzhai handsets have a mass appeal.

While the brand producers are concerned with the vagaries of a select market place,

their Shanzhai counterparts explore mass, social acceptance of products which open

up opportunities for social mobility an personal consumption. These differences

account for both their places in the market with selectivity being the driver for the

foreign brands and mass market availability being the spur of the Shanzhai makers. If

the approach of the latter engulfs the former’s position because of the nature of the

consumer market place then that is an issue of competiveness at the level of firms.

Recent research evidence indicates that half of 1.3 billion Chinese (or 650 million

Chinese) use mobile phones and that more than a quarter of these users are Shanzhai

handset users. These users are referred to as “common or grassroots people”. TheShanzhai handset is, therefore “the handset of the common people” and “the handset

of grassroots”. The main objective of public services is to provide the society with

more and better public utilities and products. Therefore, the issue of public demand

cannot be left out any consideration of legal and institutional matters.

Understanding the Value Chain

If the government is to supervise and block survival opportunities of Shanzhai

handset producers it will have to deal with the complete industry chain that has been

established around this phenomenon. MediaTek Handset’s chip shipment exceeds 200

million sets; making it the second largest handset chip company in the world. It has a

market share of more than 70% of the mainland handset chip market. A manufacturer

of a Shanzhai handset is essentially an integrator, who integrates all the end points onthe handset chain such as a design firm, a handset test business, or a factory.



Depending on the functions of the chips supplied by MTK, the design firm’s work is

like embroidery on silk products. The parameters of handsets are nearly the same for

all standard products - a touch screen, a surround sound, MP3/MP4, a million-pixels

camera. If a handset is more expensive, it will have additional functions including, for

example, double-card standby, a digital television, and JAVA. With MTK rushing into

the mainland handset market ahead of others, Taiwan’s industry supply chain is well

established with manufacturers of quartz and wireless communication components, IC

design, IC access, medium-small-sized panel, PCB, and LED. In the mainland,

specialized factories produce liquid crystal screens, earphones, cells, chargers, walk

pens, and even camera lens, dust screen, and other such “embroideries”. So a mature

industry chain has already been formed. Statistics show that, in Shenzhen by 2007,

there were nearly 140 handset manufacturers, 36 plan integration firms, 140 main

board research and development enterprises, 50 appearance and structure design

businesses, and 300 bluetooth manufacturers, all are integrated with the handset

manufacturers. In addition, there were 3000 sales operators at all levels and 150

auxiliary transportation logistics enterprises (Xu Chao, et al 2007).

The financial crisis is a prompt for the development of strategies that expand domesticdemand in China. A prevailing view among many consumers in China indicates that

the quality of Shanzhai products is the same as those of foreign brand products.

Intensifying Shanzhai’s national consumption can enable enterprises with good-

quality products to have a larger domestic market, enabling Chinese firms and the

national economy to tide over the financial crisis.

Shanzhai handsets’ challenges posed by market rules and government regulations can

cause a plurality of economic and social issues. As for “Shanzhai”, can the

government regulate it? Does it really need to regulate it?

Part Four: Governance and Shanzhai

China is the largest handset market in the world. Foreign brands in China include

Motorola and Nokia while the famous domestic brands are, among others, Amoi, Bird,

Lenovo, Konka, and TCL. Survey data issued by Internet Data Center at the first half

of 2008 shows that foreign capital brand handsets account for 60% of the market share,

while the market share of the Shanzhai handset is 23.1%. This suggests that home-

made brand handsets are in a particularly awkward position in that that they are

caught in a pincer type attack both foreign-brand and Shanzhai handsets. Most

domestic brand handset firms show a heavy loss, save of them are resold and some

have even withdrawn from the competition stage. Foreign brands such as Nokia and

other manufacturers are also attempting to avoid the competitive pressures from

Shanzhai handsets by moving into the laptop market.

The Shanzhai handset has become a “heckler” disrupt the stage occupied by famous-

brand handset manufacturers. As a result of the financial crisis, the predominance of

the Shanzhai handset is likely to be more obvious. The cost of a Shanzhai handset will

be about 150 to 200 Yuan less than that of a famous-brand handset, and even though

brand handset prices were reduced by 15%20%, (compared with a Shanzhai handset)

in 2007, it still has no price advantage. Shanzhai handset manufacturers reduce costs

by saving technology monitoring fees, which tend to raise problems for governmental

testing laboratories. These handsets have no relevant technical data prompting brand

manufacturers to push government departments to impose strict measures for

managing and regulating the Shanzhai rebels.

On December 18, 2008, the Industry and Information Department released a notice fora handset IMEI number registration, inspection and management policy. The



Telecommunication Terminal Test Technology Association under the IID was

expected to inspect and issue IMEI identification numbers to domestic handset

manufactures. IMEI has been the unique identification number of a handset; and only

with the IMEI, can a handset can be used on GSM/UMTS network. Without a legal

IMEI, a Shanzhai handset can just use a fake “ID” or many Shanzhai handsets can

share one “ID”. As a result, in July, 2008, handsets exported to Pakistan were locked,

resulting in the interruption of communication of a few hundred Chinese Shanzhai

handset users. If the administration department and operators run strict surveillance

tests, Shanzhai handsets will just have two alternatives: one is to formally apply for a

corresponding IMEI number; the other is to purchase a lawful IMEI number.

Professor Han Kaili, who supports Shanzhai handset marketing, questions the

legitimacy of the way a handset gains access to the network via a handset number

rather than an IMEI number. The Shanzhai handset belongs to a legal business

operation. Before the introduction of IMEI number registration, the market had more

than 600 million handset users. This calls into question the feasibility of the measure

introduced. Since the handsets purchased in the past can still be used today, it would

be diff icult to distinguish a handset produced “before” the IMEI number policy isintroduced from one produced “after” that event. Even if every handset needs an IMEI

identification number, it is not too difficult a problem to provide a decoding service

for users.

The challenge is, therefore, to choose between putting an administration system in

place or to allowing market mechanisms to solve diff iculties and challenges posed by

Shanzhai handsets.

Difficulties facing the “Shanzhai” manufacturers : Brands and Imitation

The Shanzhai handset manufactures have no stable brands and lack formal marketing

channels, so it primarily chooses to produce the handsets by copying others brands.

Mere imitation in the long run is not sustainable and this reality poses difficulties forShanzhai handset manufacturers.

Competition in the current international market has passed the stage of product

competition and moved into an era of brand competition. Chairman Woodruff of

Coca-Cola telling remark that all large banks would rush to provide loans to Coca

Cola in the event of a fire destroying the company, is indicative of the importance of

brands. In outwitting brand players of mobile telephones, Shanzhai handset

manufacturers can be a victim of their own success.

Intellectual property rights are embedded in brands, trademarks, patents, and

technical know-how. While building up a tangible product, an enterprise should also

operate its own intangible assets or knowledge assets. The operation of its materialassets goes hand in hand with its knowledge assets. By leaning on the brands of others

Shanzhai manufacturers can acquire certain material benefits but they cannot develop

a brand. Copying and imitating enables a Shanzhai handset manufacturer to produce a

duplicate of an “original edition”; and make money in the process of selling only the

duplicate. This process does not allow manufacturers to build up their own brands.

Rather, and in effect, they are publicizing the brands which they have copied. If

Shanzhai handset manufacturers want to overcome this brand deficit it is not

sufficient for them to remain in the shadow world of imitation.

Product Development

The other difficulty for Shanzhai manufacturers is the absence of product maintenance

and after-sale service together with quality assurance. From the design of a handset

and the supply of raw material to the production and assembly of all links, the



Shanzhai product is dependent on the division of labour and functions of and the links

in the industry value chain – the search for chips, software solutions, die sinking,

production and marketing. Popular handsets incorporate the functions of MP3s, digital

cameras, radio and digital videos, and in some handsets other functions such mobile

TV and GPS navigation can be found too. Unless Shanzhai manufacturers leave out

other important links such as research, design, and technical testing, which all

famous-brand handset producers value, and unless they reach agreements with

manufacturers of integrated chips, GPS, and molds and other functions, it would be

difficult to reduce costs and put products on the markets quickly. The paucity of

technical data based on industry specifications makes it rather difficult for the handset

to be tested. Coupled with the lack of maintenance and after-sale service the Shanzhai

manufacture can face serious problems.

Complaints received by Consumption Association are about “terminals” in mobile

communications. The majority of these complaints are about Shanzhai handsets. In

many people’s minds, “Shanzhai” has begun to be associated with unoriginal and even

fake products, which have “not been tested in the sun”. Even among those more

tolerant of Shanzhai products, there appears to be a reluctance to purchase newShanzhai products. This negative perception is a far cry from the views linked to the

ideas of free spirit, suggesting a waning of the rebel Shanzhai!

Part Five: The Innovation Governance Mechanisms

The Shanzhai phenomenon appears to face twin challenges – one for institutions and

competitors in terms of the legitimacy of the products, and the other for the Shanzhai

manufacturers themselves as they encounter their own problems of development. It is

clear that imprudent legislation which seeks to curtail or remove Shanzhai products

from the market would perhaps be impossible to achieve in practice. In some places,

the Shanzhai handset market has gone partly underground. Even then the products

continue to generate interest. Given that markets, institutions and the Shanzhai producers all face specific problems, concerted action by all three parties, industry,

government and Shanzhai firms – need to be encouraged. Such action in itself can be

regarded a innovative as it calls for the development of new forms of governance that

can best realize the productive value of entrepreneurship and innovation.

Forms of governance

Three means of governance could be considered - industry governance, government

governance and enterprise governance.

Industry governance: Disrupting and gaming

The turbulence in the mobile telephone handset market caused by Shanzhai handsets

could be regarded as a typical case of disruptive innovation studied by ClaytonChristensen. Christensen (1997) discovers that “disruptive innovation” affects many

leading businesses which often tend to lose their leading position when major

technological or market change occurs. These changes provide opportunities for new

incumbents. Christensen differentiates the two types of disruption: one is new-market

disruption and the other is low-end disruption.

The popularity of Shanzhai handset should be attributed to the practice of low-end

disruptive innovation. The so-called low-end disruptive innovation means saving cost

first, by unceasingly digging up customers’ basic requirements, analyzing the non-

basic requirements in products and services, so as to reduce costs and to expand

outputs, and finally realizing small profits and a large volume of sales. Shanzhai

handsets take the ‘low-end’ route way and even though they never advertise, their

popularity fizzles across a wide community of users.



The process of low-end disruption is in fact a game. The Shanzhai handset can be seen as an

intruder while the incumbent is a “temple”. For disruptions caused by “Shanzhai”, the temple

may have no way to deal with it, temporarily or in the long run. When the incumbent becomes

aware of the damages to its position from the intruder and plans to fight back, it is already too

late. The rigid organisational arrangements of the incumbent caused by their internal cultures,

values, and processes (typical of large firms), offer no solutions to the problems of rapid and

disruptive changes of technologies and the market. Disruptiveness drive the failure of often

efficient but rigid organizations.

The occurrence of disruptive innovation does, however, follow a process resembling

the game process between the “Shanzhai” and the “Temple”. One of the frequently-

used strategies in a game pattern is to obtain help from the third party. In the game

process, one of the coping strategies used by “temple” is that of “crashing”. The other

strategy is to borrow “identification numbers” or “industry rules” and to take

administrative means. The former strategy just means a kind of “technical error” for

the Shanzhai handset, which can be dealt with by technical means. The effect of the

latter strategy is to push Shanzhai to a corner through the introduction of measures by

the third party. The use of the IMEI measure is a good example.

Perhaps the most important strategy for the “temple” is to adjust its own act and to

“reply in kind”. For example, Nokia has started to make use of its own advantages of

scale and scope to move into the low-end handset market; a handset type at the price

of 500 Yuan or so has functions equaling those of the home-made handset after

careful research of products such as the Tianyu Langtong which is honored as the

“Shanzhai King”.

Dynamic Strategic Change

Firms in nearly all newly-developing industries, particularly high-tech and monopolized

industry, have depended on high profit margins for a long time. The business models of these

“temples” of fortune have ignored the ordinary or common user and consumer who do not play any part in the making of these profits. Their early entry in emerging markets have been

characterized by the continuation of the production marketing and selling of products in the

same vein as they have done in developed economies. The emerging of Shanzhai, has

disrupted the complacency of the “temples”. Their overspreading advertisements do not work,

their research and development teams to be at a loss to understand the consumption

requirements of common people, and extravagant profits appear to be eroding with time.

In effect there are two related battlefields, one in China, where Shanzhai handsets are

disrupting mainstream market, and the other is in the international market, where

mainstream international manufacturers facing low-end disruptions generated by the handset

chips of MediaTek. If we estimate the handset requirements all over the world to be 1 billionfor one year, the handset chip output of MTK in 2006 accounted for 5% of that global market,

rising to between 13% to 15% in 2007(150 million chips), and reaching 220 million in 2008.

250 million handset chips are expected to be produced in 2009. MTK is second largest

handset chip supplier after Qualcomm. No wonder experts are talking about the future of

handsets belonging to either a “Qualcomm Era” or an “MTK Era”!

From the third quarter of 2007, handset chip shipment of MTK has exceeded that of Freescale

which ranked second in the world. In addition, the global financial crisis has had negative

impacts on the market, so handset chip giants such as Texas Instruments, Freescale, and

others etc. are facing the dilemma of either to sell their handset chip business or to allow these

units to continue operating independently. A batch of patriarch-level handset baseband chips

manufacturers, including, Texas Instruments, Freescale, Agere, ADI, and NXP, have stepped

out of the historic stage gradually, and only three of the first–team handset chip



manufacturers are now left to compete in the market place – Qualcomm, MTK and ST-NXP-

EMP (ST-NXP-EMP is a joint venture, which focuses mainly on European and American

handset manufacturers). The global handset sales volume is approximately 1.2 billion, of

which MTK’s share accounted for 12.5%. (see the rise in the position of MTK’s

competitiveness from Fig. 6 (steady growth status of the operating income of MTK).

Figure 6: Operating Income Variation Chart of MTK

Operating income (New Taiwan Currency/ 100 million)

The games between the “Shanzhai” and “Temple” both at home and abroad continue

unabated. China Mobile Telecommunication’s entry into a “3G” era, has intensified the gameamong WCDMA, CDMA2000 and TD—SCDMA, making it complex and as it moves into a

new stage. China Telecom started to conduct CDMA-EVDO service test partially at selected

places on March 16, 2009, while China Unicom also decided to bring forward 3G mobile

phone number distribution to April 152009in four cities – Shijiazhuang, Baoding,

Tangshan and Qinhuangdao. The regular handsets cannot enter the market before a network

entrance certificate is acquired. Acquisition of the network entrance certificate needs at least 2

months. Starting a war on the 3G handset in advance gives rise to a lack for 3G handsets,

which seemingly offers an opportunity for the Shanzhai handset to enter the market with their

characteristic speed and networked-worked flexibility of operations.

Qualcomm, the joint venture ST-Ericsson, Broadcomm and other chip tycoons are

monopolizing WCDMA chip market. Even though on the 2008 Beijing InternationalCommunication exhibition, MTK showed off its WCDMA/EDGE baseband chip MT6268,

claimed that the chip had passed IOT tests carried out by well known international operators,

and sent chip samples to some handset manufacturers, it is still not certain whether the

handset with a MTK chip can swing the WCDMA terminal bidding initiated by China

Unicom in the immediate future.

Intense competition among operators of China Unicom prompts them to take the mode of

customizing handsets when promoting 3G business. They will form a powerful “third party”

which can help the “temple” to fight against the Shanzhai under these new circumstances. On

March 17, 2009, Forbes revealed that the US subsidiary of ZIE Corporation was attempting to

build up partnership with large-scale operators like Sprint, Verizon Wireless, AT&T, etc. so as

to increase its market share. Evidence shows that the mode of a consumer purchases a handset,

and then choosing a network is being replaced by a new mode of an operator of China Mobile



bundling a network with a handset, and offering a handset for free “at the expense of netting

in”. International handset corporates are launching their own on-line software shops in the

hope of strengthening the user’s stickiness to smart handset products through more software

applications, and enabling a win-win arrangement by cooperating with operators.

In such a case, the Shanzhai position of Shanzhai handsets does not change. Instead, it

acquires a different profile. Since related products do not go through the national certification

test, and the business and financial operations are irregular at the best of times, the Shanzhai

handset is unable to be part of an operator’s 3G handset large scale customization and batch

procurement programmes. Even if a certain number of Shanzhai 3G handsets appear in the

market they just can realize some primary functions such as high-speed web-surfing and

video call. The core advantage of a 3G network system including the supply of high-speed

data business, and all videos, media, web-searching can be compromised due to lack of

support from official channels. In the long run, the success of hand-hold equipments depends

instead of software. The new mode of making profits raises a higher requirement for a

research regime for handset enterprises. The dependence on handset terminal manufacturing,

on solutions provided by MTK, without technical knowledge accumulation and independent

research activity, can pose serious problems for China’s Shanzhai manufacturers.

Internal Governance: Firm-Level Self-governance and “Becoming Regular”

Suspicions about the infringement of exclusive rights of trademarks of famous-brand handsets,

have led various regional industry and commerce to investigate Shanzhai manufacturers. The

Bureau of Industry and Commerce in Xinjiang Uygur Autonomous Region has organized four

investigative actions since October, 2007, confiscating 20,000 faked and counterfeit handsets

in the process. One hundred and sixty eight brands are involved in these products. Shenzhen,

the “base camp” of the Shanzhai handset, has been exposed several times by CCTV. Local

executive departments investigate the entire electronic market within a district, cracking down

severally on faked and counterfeit Shanzhai handsets from one factory to another. Other trade

and commerce organizations in Zhejiang Province, Shanxi Province, Shijiazhuang of Hebei

Province, and Suzhou of Jiangsu Province, also organize similar executive investigative

actions aimed at the Shanzhai handset manufacturers.

Despite the cleaning-up process the Shanzhai handset continues to prosper in the open

market.. Shanzhai, now has its own code of conduct and discipline resorting to internal

governance measures in common with good network systems. Self-interest has begun to

restrict high-imitation handsets from infringing on others exclusive trademarks, such actions

being regarded as being harmful to consumers’ lawful rights and interests and to the image of

the industry. Many manufacturers and distributors of the Shanzhai handset also regard high-

imitation handsets as “individuals who bring disgrace to their groups”, so they take positive

attitudes towards closing down the faked and counterfeit Shanzhai handset manufacturers. An

‘e-pal’ named “super-moderator” leaves a message on a forum: “we insiders also agree thatfaked Shanzhai handset should be cracked down. High-imitation handset is always sold by

purchasing casings for assembly without any technical contents. From this point, the media’s

exposure is a good thing. So only by developing businesses together without variation, we

just can go further; having our own brands is inevitably the trend of the future.”

Many Shanzhai handsets do not borrow trademarks of famous-brand handsets. They are

called “Shanzhai products” because they do not go through the net-entry test. Referred to as

the “regular” Shanzhai handsets, their manufacturers hope to distinguish themselves from

other “irregular” ones, and to set up their own autonomous associations. In December, 2007, a

Shanzhai “alliance card” was shown on line in preparation for the China’s Shanzhai

Association. In the draft regulations of the “China Shanzhai Economic Innovation

Association”, “Shanzhai” is redefined as “high-imitation, creation, innovation and production”. The Association required that members should “not have records of



manufacturing and selling faked or inferior goods, or of infringement of intellectual property

rights like trademarks, patents, copyrights, etc.”, demonstrating that the Shanzhai

manufacturers have developed their own self-regulating environment. The establishment of

the Shanzhai Association can help to specify and restrict illegality and infringement of IPR. It

can also help with the absorption of technology and originality in a legally constituted

environment, which in turn should allow for the faster and more stable growth of Shanzhai..

Inside of Shanzhai other changes are taking place. One of the motives is competition among

Shanzhai handsets” when disrupting and occupying part of the field of foreign-and home

handset brands. The other motive stems from pressure of brand “temples”. Before 2007, there

were more than 2000 enterprises involved in handset manufacturing in Shenzhen. As a result

of low-level and homogenized competition among a great number of manufacturers,

oversupply, severely overstocked products, and the continual clearance of goods with reduced

profit margins, and even the sale of goods at a price lower than cost became the norm. For

some Shanzhai manufacturers maintaining their current operational status was more than

struggle.

Competition comes not only from domestic market but also from global market. In overseasmarkets, price competition for the home-made Shanzhai handset had reached its nadir. Unless

handset manufacturers run business without profits it was not possible consider any further

price reductions. Since some of these handsets were manufactured without adequate quality

control, handset distributors home and abroad created psychological obstacles due to their

fear of being regarded as being dishonest by their customers because of the low quality of the

products.

If competition means selecting the superior and eliminating the inferior, internal competition

spurs Shanzhai to be stronger as a group. A survey shows that the market share of Shanzhai

handsets has grown to 25% in China, and the exported Shanzhai handsets have even a higher

share of the market. Diversified value innovation in low-end market rather than infringements

of intellectual property rights or tax evasion, appears to be driving this growth. MTK

provides Shanzhai enterprises with an open innovation platform. The solution purchased by

Shanzhai enterprises from MTK is merely a circuit diagram. Although a number of main

boards with different configurations can be drawn from the circuit diagram technology

inputting is needed to complete the process. Most of research and development personnel are

engineers who had worked in former domestic handset enterprises, and in firms such as Nokia,

Motorola. Most auxiliary manufacturers in China are first-class operators.

In this scenario of intense competition, a batch of large-scale Shanzhai handset manufacturers

is positively applying for registration of their brands in order to build their own “Shanzhai”.

The existence of lots of Shanzhai brands suggests that Shanzhai handsets are moving from

imitation to innovation, as they seek variation after retaining their specific technical andorganizational skills in order to survive in the market. Here innovation takes the form of

integration of functions. Shanzhai handset manufacturers are building up their own brands

and stepping out of the arena steeped in “brand difficulties”.

If Shanzhai handsets want to overcome problems of quality assurance they would be expected

to participate in the net-entry technology test and build up their own quality assurance,

maintenance and after-sale service system. In the trade this process is described as “being

married” or “being regular”, “Being married”, “being regular” and “accepting surrender” all

mean that Shanzhai handset manufacturers hope to cast off their own image of imitative

“Shanzhai”, and the values associated with that tradition.

The Chinese classical novel Water Margin describes the process of formation, developmentand evolution of “Shanzhai”. In the initial stage of formation of Shanzhai, a lot of greenwood



Baw cocks united in Shanzhai, confronting the feudal official, “enforcing justice on behalf of

Heaven”. Then Shanzhai was just a “united hall”. Subsequently Shanzhai was converted into

a “loyalism hall”, and the Baw cocks accepted “amnesty and surrender” to the then royal

court. When the above story is applied into the situation of Shanzhai handsets, it means that

Shanzhai manufacturers may insist on Shanzhai while seeking cooperation with regular

manufacturers, or “accept amnesty and surrender” (accept to be purchased or merged), and

even “adaptation” (accept others’ investment in them).

The morphing process is paradoxical in the sense that for the Shanzhai producer not

surrendering is to die, while surrendering is to die quicker! It has proved difficult for many

Shanzhai manufacturers to surrender to the IMEI registration process and survive. But why is

surrendering the same as dying quicker? The Anycall story provides a clue. A handset

imitating Anycall boasts of good quality and performance. The above handset is produced in a

factory in Shenzhen. When the factory is discovered and visited by Anycall management, the

visitor offers the Shanzhai producer an opportunity to manufacture handsets with the original

brand Anycall. Much to everyone’s surprise the visitor’s offer is rejected. The reason for the

refusal of the opportunity is because developing a famous-brand handset means high logistic

costs and the production of large quantities. This in turn implies that the response to marketwill be slowed down and the cost advantages of imitative production will be lost. This story

shows why regular handset manufacturers were unable to expand their business in the third or

fourth market or even in rural markets. These markets were left the Shanzhai makers.

“Shanzhai King” K-Touch which changed into a regular manufacturer in 2006 took the first

place in the domestic handset market in 2007 relying on subcontracting for their production.

In 2008, its much vaunted move into brand handset development led to an advertisement

investment of more than 100 million. It gained brand premium together with increased cost,

but realised retarded growth!

In becoming ‘regular’ manufacturers must accept formal certification from tests carried out

by the Beijing Center of Handset Test Identification (CTI). “The Beijing CTI is merely like a

freeway toll station, which is unable either to speed up or to assure safety. The only effect isletting you line up and pay more money,” says one e-pal named “Reasonable Analysis” on a

“Network of the Shanzhai Handset”, “any innovation or expansion must have 17 or 18 official

seals of license authority, which is the fatal reason for domestic handsets to resort to “high

diving” after the glory of occupying half of the market.”

As operation risks become higher with official crack downs, and since the traditional channel

is unwilling to sell the Shanzhai handset without a brand and after-sale service provision, a

large number of operators are joining the ‘regular’ bandwagon. In Shenzhen, a batch of large-

scale Shanzhai handset manufacturers is proactively applying for licenses and registering

brands, preparing for regularization. Deputy Managing Director Liu Wenquan of AHONG

Communication points that each Shanzhai handset manufacturer, in fact, hopes to get rid of

the title of Shanzhai handsets. For those Shanzhai handset manufacturers which have beenregular or are becoming regular, they have experienced the initial stage of accumulating

capital, and are about to step into a new development stage of establishing their own brands.

“Some manufacturers and distributors are still doing Shanzhai handset business, because they

are still in the process of primitive accumulation of capital.”

State Level Governance and Government Regulation: Tolerance and Regulation

Handset industry governance and internal governance of Shanzhai handsets all need a proper

social and economic environment, which requires proper administrative governance.

The Shanzhai handset belongs to a kind of “shady handset” at first, which is because China

stipulated a handset license system in 1998 so as to avoid repeated investment in handset

projects and to guarantee a robust development of the national mobile communication

industry. Consequently, handset production licenses become scare resources. A large number



of handsets without licenses sprung up in the market. On October 12, 2007, the removal of the

administrative control in handset manufacturing industry led to the disappearance of the

concept of ‘shady handsets’. The change in policy indicates that the government is adopting a

different approach to administrative governance in relation to the handset industry.

Table 1 Change of China’s Handset License System

Approval system Suspension of

approval

Examination and

approval system

Cancellation of

licenses

Implementation

time

In 1998 In 2000

In 2005

In 2007

Objective of

policies

Controlling repeated

investment, and

protecting national

industry

Slowing down speed

of issuing handset

licenses and reducing

scales

Enabling the

manufacturers with

technology and capitals

to obtain opportunities,

and simplifying

procedures to avoid

reselling licenses

Cracking down license

deals, decreasing entry

standard, and

introducing

competition

mechanismImplementation

conditions Licenses were issued

by Ministry of

Information Industry in

January, 1999; in 2002,

licenses were issued at

a slower speed and the

scale was reduced

After Anycall, no

other enterprises

gained licenses

independently

National Development

and Reform

Commission approved:

the first batch of

handsets spring up into

the market in February,

2005

Retaining “net-entry

permit” system of

communication

equipment, no concept

of shady handset

Shortcomings License deals,

corruption in the

industry, and private

capitals were restricted

License deals,

corruption in the

industry, and private

capitals wererestricted

The manufacturers

without licenses were

still producing in a

shade

The handset license system embodies strict supervision on handset entry, which is

unfavorable to the early stage development of the handset industry. Entry barriers restrict

investment of private capital, and some manufacturers acquire privileges and protections.

Elimination of restrictions means tolerating the Shanzhai handset and is good for creating a

tolerant and fair-competition environment for the handset industry, thereby, effectively and

fundamentally putting an end to disadvantages of industry-entry restrictions.

Tolerance is favorable for the development of China’s handset industry today. China is the

manufacturing center of the world, which includes not only OEM enterprises that supply

manufacturing and production for various global brands but also numerous small-sized

manufacturing enterprises and Shanzhai manufacturers. In order to pursue rapid profit returns,

all Shanzhai manufacturers begin with imitations at the early period of development.

Innovations always start from imitations. According to statistics given by State Intellectual

Property Office and National Association of Industry and Commerce, 61% of patents are

completed and applied by folk innovators.

It is common practice in many countries to take a tolerant attitude towards new industries.

Tolerance of the Shanzhai phenomena can be found at both home and abroad. China has

“Shanzhai”, while the US has the “garage”. “Garage” entrepreneurs imitate frequently. For

instance, AMD imitated others’ integrated circuit at the beginning of its establishment; 5

years later, AMD self-designed 2901; at the end of the last century, it launched the K7 seriesCPU. DELL, which was set up in 1984, shared lots in common with those of Shanzai



manufacturers, prosperous in streets selling electronic products.

The growth history of Japanese and Korean enterprises shows that they also make use of

Shanzhai methods in large numbers during the early period of development. Sony purchased

foreign products for analyzing and researching at the early period. It also conducted all kinds

of combinations and innovations on the basis of digesting the core technology, and finally, itlaunched into the market the products with more functions and better quality than those

original ones.

In Hong Kong in the 1950s and 60s, many small Shanzhai factories lacking equipment and

management existed in the cabins built at the foot of Lion Mountains. After moving into

buildings founded by the government along the districts of Tuguawan and Shixiawei, the

industries of Hong Kong grew out of the Shanzhai factories. Shanzhai stands for Hong Kong

men’s spirit of diligence, with which to both combating and pursue change.

Tolerance can be classified into three types:

•

negative tolerance, which does not seek any action;• neutral tolerance, which means observing changes without being involved; and

• positive tolerance – including intolerance of “badness” so as to prevent badness and

to advocate goodness.

Adopting a similar three pronged strategy experts classify handsets into three types: the first

one belongs to smuggled shady handsets which should be strictly cracked down; the second

type includes fully copied models or partially imitated handsets, which raise issues of

intellectual property rights and other manufacturers’ brands. Such handsets are illegal; the

third one is unfamous-brand handsets which can be frequently seen in the market, and which

can quickly reflect the consumer’s requirements for the market by making use of handset chip

suits. These experts regard the emergence of Shanzhai handsets to be a great innovation in the

handset industry of our country, and to be a meaningful revolution in the handset industry

chain.

The positive attitude also includes constructive interventions. In order to lead the Shanzhai

handset to establish its own brand in Shenzhen, a shopping mall was constructed to sell

regular handsets. The mall was used for exhibition and promotion of the Shanzhai handset to

the public. Now, a batch of large-scale Shanzhai handset manufacturers are actively applying

for trademark registration as they explore prospects of regularization.

The constructive intervention process means reducing net-entry test fees. The reason of not

taking the net-entry test for the Shanzhai handset is the following two: firstly, manufacturers

cannot afford net-entry test fees; secondly, they have no time to waste for the long-drawn-outtest. It would take several hundred thousand Yuan and at least one and a half months to test a

particular handset At present, only one laboratory, a non-profit institution under government

control, in Beijing conducts the net-entry test. The expensive test fee and the prolonged net-

entry test time does not help with the adaptation to the requirements of the market where

changes happen in minutes. If the service in the aspect of net-entry could be improved, or a

competitive mechanism could be introduced in the administration of the net-entry, they could

have productive outcomes.

The “Shanzhai Culture” and Innovation Governance

Reverse Innovation

The Shanzhai phenomena have spread to all industries of manufacturing. It is interesting to

note how the “Temple” is learning from the “Shanzhai”. For example, VIA along with



Microsoft sets up an “Open Super-mobile Industry Strategy Alliance”, helping customers

finish designing a complete laptop, which copies the operation mode of “Shanzhai handsets”.

The first fifteen downstream manufacturers include Tsinghua Tongfang, E-Lead, YiLi, Great

wall, CZC and fitting manufacturing partners like SanDisk and AMI. For VIA, copying the

operation mode of “Shanzhai handsets” has the two advantages: first, it can challenge Intel

and AMD with the help of lots of manufacturers in the mainland; second, it can cut down the

time of research, production and product shipment to accelerate market response and to

reduce cost.

The Spread of Shanzhai

A combination survey carried out by China Youth Daily and QQ.com shows that e-pals have

different comments to make on “Shanzhai culture”. Within one week, 2,169 persons

completed the survey on line; among them 38.7% of persons regard Shanzhai culture as a

duplicate culture; 33.7% regard it as a fake culture; 30% regard the core of Shanzhai culture

in fact to be a kind of plagiarism; and 24.9% regard Shanzhai to be a synonym for inferior

quality. However, a small number of ‘net friends’ consider that Shanzhai products are

economical and practical and that Shanzhai culture is very promising particularly for new

product development and innovation.

As the Shanzhai phenomena spreads certain features remain constant across a range of

products and services. Firstly, the Shanzhai phenomenon is based on a specific platform. In

manufacturing industry, technical integration brought about by improvements and adoption of

manufacturing technologies provide for a technical platform for Shanzhai manufacturers. The

platform of the Shanzhai phenomenon in culture and entrainment industry is a tolerant and

loose environment of respecting differences, and maintaining diversity, and a relatively

convenient and cheap expressive technique which is owned by the common people.

Secondly, the appearance of Shanzhai products and Shanzhai culture is dependent on a broad

market space and a mass base. The cultural field is generally the stage of a few “cultural elite”.

Shanzhai culture enables ordinary people to participate in cultural discourse and providesthem with an opportunity for seeking novelty, expressing their appeal and self-amusement.

Some people consider that Shanzhai in the culture field comes from rebellion against the

mainstream, challenge to authority, imitation of elite, and release of grassroots’ depressions.

Thirdly, by depending on others’ brands, Shanzhai manufacturers bring disruptive impacts

and shocks for mainstream manufacturers. In the manufacturing industry, their imitations lead

to a disturbance of the effect of regular brands and of the regular market order. It also prompts

mainstream manufacturers to change their strategies. In the culture and entertainment field,

elite behavior, discourse and products are challenged while they are copied. For example, the

‘Shanzhai Spring Festival Gala’ challenged the more exclusive CCTV Spring Festival Gala.

Fourthly, Shanzhai culture needs comprehensive governance. It’s easy for Shanzhai productsto infringe on intellectual property rights. So Shanzhai products should be guided properly so

as to avoid some negative social consequences. The future development of Shanzhai culture is

not clear. It might gradually disappear as it competes for diversification. It may “accept

surrender” to the “Temples”, both in China and abroad to adapt. In addition, some typical

Shanzhai models may build their own brands. For instance, on October 9, 2004, Variety &

Art channel of CCTV launched a talent show named Avenue to Stars, which advocates

healthy and elegant art appreciation and builds a platform for the ordinary citizen to showcase

their talents.

Part Six: Conclusions and Problems for Future Investigation

The Shanzhai phenomenon which is both fashionable and controversial in China, and which

attracts attention from all over the world, has a complicated and profound social economic background. The paper analyzes the technical level and market foundation of the phenomenon,



points out the internal mechanism and environmental conditions, and considers Shanzhai

phenomenon to have the broadest mass base under certain conditions of technological,

economic and social change. It challenges market monopolists and mainstream fashion with

its unique way while hovering at the edge of intellectual property rights issues, imitation and

innovation. The survival and development of the Shanzhai phenomenon needs comprehensive

governance of administration, industry and inside. The findings in this paper suggest that the

as the Shanzhai manufacturers struggle to survive in a highly competitive market place, their

strategies for varying their methods of operation tend to follow an evolutionary pattern

depending on the type of innovation they consider necessary for their growth and

development. The selection and retention of technologies, networked links, compliance with

registration and co-operation with both global brand players and government legislation, is

accompanied by different forms of learning. As figure 7 below shows, each of the stages

through which they evolve and learn offers positive and negative outcomes. The way in which

they navigate their way through these stages is dependent on the trade-offs between these

outcomes. Governance plays a significant role in helping these manufacturers make

appropriate choices, with different and relevant forms of governance reflecting the nature of

the evolution of the Shanzhai phenomenon.

Figure 7:

It is still unclear which key factors have the biggest influence on the development of Shanzhai

manufacturers. Secondly, Shanzhai has helped to bring expensive knowledge-based, hi-tech

products, brands, patents, etc. to ordinary people. How can these models be developed to

enable consumption expand domestic demand in China. Fourthly, changes in the market

development activities of large brand names appear to have been the result of competition by

Shanzhai manufacturers. What can brand manufacturers learn from this process to operate

more effectively in emerging economies and to generate new business models. Finally, the

network-centric structure and its evolution in the Shanzhai market place calls for a network-

oriented governance structure involving government, industry and firms. How can these



network governance structures be established so as to legitimize and gain from Shanzhai

business models?

Shanzhai lies in that fuzzy state between productive and unproductive or rent-seeking types of

entrepreneurship (Baumol, 1997). Their effective governance could obtain more productive

value in terms of both their legitimacy and also in relation to the realization of new

opportunities. Shanzhai offers an network-based organizational construct which embraces

both social and economic values. Its manifestation in a Chinese cultural environment does not

necessarily make it difficult to understand Their counterparts in American “garages” and

other cultural spaces suggests that there is something to be gained from the commonality of

such phenomena.

___________________________________________________________________________

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