Entry into China: Do Small

Firms Do Better?

Marshall W. Meyer

Tsai Wan-Tsai Professor

The Wharton School

University of Pennsylvania

The conventional wisdom:

Big firms “go out”

“The conquest of new markets . . .”

It is enough to mention the commercial crises that, by their periodical return, put the existence of the entire bourgeois society on its trial, each time more threateningly. In these crises, a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises, there breaks out an epidemic that, in all earlier epochs, would have seemed an absurdity—the epidemic of over-production. . . And how does the bourgeoisie get over these crises? On the one hand, by enforced destruction of a mass of productive forces; on the other, by the conquest of new markets, and by the more thorough exploitation of the old ones. That is to say, by paving the way for more extensive and more destructive crises, and by diminishing the means whereby crises are prevented.

Marx and Engels, The Communist Manifesto

The MITI version of Marx

. . . the Ministry of International Trade and Industry (MITI), sometimes intervened in business conduct in ways that limited competition. Beginning in the 1950s, for example, MITI was involved in setting production volume in industries such as textile, paper and pulp, chemical fertilizer and steel. MITI allowed companies in these industries to form cartels to facilitate the implementation of government “administrative guidance,” a phrase used in Japan to refer to government intervention not backed by specific laws. The Fair Trade Commission was silent about this practice until the 1970s, when it declared that such cartels would be prosecuted even if formed under MITI guidance . . .

Michael E. Porter and Mariko Sakakibara, 2004. “Competition in Japan,” Journal of Economic Perspectives, 18 (1): 27-50.

Received internationalization theory

We summarize the picture presented by the literature on internationalization as follows. Firms grow in response to managerial and other slack (Penrose, 1959). At some point, they outgrow their possibilities in the domestic market, whether or not they have succeeded in occupying the whole of the domestic market space. They then look for opportunities to expand abroad (Ansoff, 1965). But, given the liability of foreignness, the spatial distances and the institutional barriers involved, operating abroad is costlier than operating in the domestic market (Hymer, 1976). Firms therefore need some competitive advantage to compensate for the extra costs of first moving and then operating abroad (Caves, 1982), and firms that have grown domestically on the back of some competitive advantage are now well placed to move abroad to exploit that advantage (Dunning, 1988). Thus, firms that do move abroad tend to be large and oligopolistic (Knickerbocker, 1973).

Max Boisot and Marshall Meyer, 2008. “Which Way through the Open Door,” Management and Organization Review 4 (3): 349-365.

But do big firms do better when entering

China?

Marx to MITI to contemporary internationalization theory share the following:

• They are home country-centric. It is as if the host country makes little or no difference to market entry.

• They are firm-centric. It is as if the structure of the market and, more broadly, the culture and history of the host country make little or no difference to market entry.

My hypothesis: China’s market structure and Chinese culture and history invert the received wisdom that big firms do better.

Empirical research Journal of Marketing, 72 (May, 2008): 1-13.

Almost all of the effects are as expected. However, the negative effect size on successful entry was not expected and is not easily explained. Nor is this effect unique to either China or India; rather, it appears to hold in both countries.

There are many explanations for these results, including the capacity of small

firms to create network ties Despite increasing attention to the role of social ties in emerging economies, few studies have explicitly distinguished the differential roles of business versus political ties. Drawing on relational governance and institutional theories, this study offers a contingent view of business and political ties in China. The findings from a survey of 241 Chinese firms indicate that business ties have a stronger positive effect on performance than political ties, and both effects depend on institutional and market environments. Business ties are more beneficial when legal enforcement is inefficient and technology is changing rapidly, whereas political ties lead to greater performance when general government support is weak and technological turbulence is low. These findings indicate that firms operating in China should be cautious in their use of business and political ties and adapt their tie utilization to changing institutional and market environments.

Shibin Sheng, Kevin Zheng Zhou, and Julie Juan Li, “The Effects of Business and Political Ties on Firm Performance: Evidence from China.” Journal of Marketing, 75 (January, 2011): 1-15.

China’s market structure: fragmentation

and hyper-competitive

Normally, fragmented and hyper-competitive are synonymous. A fragmented market is one where with many players, none with market power. Margins, as a consequence, are thin.

I distinguish fragmentation, the number of markets in a country, from hyper-competition, the number and the market power of players within these markets.

I don’t think you can understand China without this distinction. China consists of many different markets, both regional and vertical, the latter consisting of cities, counties, towns, and villages. And most are hyper-competitive.

Market structure: Regional fragmentation

A huge literature on domestic trade barriers or “border effects” in China. Two key points:

• China’s decentralized economy sustains trade barriers between provinces, though these barriers seem to have diminished somewhat with infrastructure development and legal reform, e.g., the 2008 Anti-Monopoly Law provisions banning administrative monopolies.

Market structure: Vertical fragmentation

• Traditional market structures remain durable, especially in rural China. Village and town-level markets remain distinct even though they may be only minutes away from each other. And markets in county-level cities increasingly resemble large municipalities. Recall that Mao was unable to suppress periodic rural markets and these markets flourished following economic reform (1973—).

Market structure: Hyper-competition

Here the academic literature is less well organized. However:

• The dominant modes of competition in China have been price wars and, recently, competition for capacity (resulting in redundant capacity, like U.S. railroads in the late 19th century).

• Local government subsidization appears to sustain small, inefficient players (think of the solar photovoltaic panel industry).

Market structure: Concentration and

performance

The usual relationship of industry concentration to performance does not obtain in China.

• We have explored the concentration-profitability relationship using the Chinese National Industrial Census from 2004 to 2007.

• We find consistently a negative relationship of concentration to profitability (and export intensity).

• These results are not due to ownership (e.g., local government monopolies) and are not due to superior efficiency of small firms (we have controlled productivity).

The inference is that Chinese markets are truly hyper-competitive.

The cultural underpinnings of

fragmentation and hyper-competition

Two dominant themes in Chinese culture:

• Power distance. Not only is there traditional respect for authority, but people seek positions of authority.

• Collectivism. There is high in-group loyalty and, as a consequence, high out-group prejudice. Regional dialects persist and regional stereotypes abound.

As a consequence:

• “It is better to be the head of a chicken than the tail of a phoenix.” Or the tail of a cow. Or to stand behind a cow.

How should large firms operate in China?

The problem is adapting to fragmentation and hper-competition. This means acting small profitably.

• Fragmentation requires small size.

• If you are a large firm, this means dis-integrating the firm into small operating units.

• Hyper-competition requires a powerful profitability constraint.

• The combination of a dis-integrated organization and powerful profitability constraints pits units into competition with each other.

• Can you manage this?

And small firms?

• Unique management practices

– http://www.bbc.co.uk/news/world-asia-china-22803132

• A compelling proposition for the consumer

– http://www.purenzgreenshell.com/aquaculture/quality-assurance/quality-assured.cfm

• A niche industrial market

– http://www.glidepathgroup.com/home-gb

A possible model?

The Haier model should be studied as one solution to the problem. Under the model:

• The firm is broken into 2000+ teams, called ZZJYTs, each with a full set of financial statements.

• Each rural marketing team is responsible for one or two counties.

• The teams are highly competitive. They bid against each other for targets. Compensation is based on performance against targets.

• The targets are challenging. There is an internal M&A market, and teams missing their targets can be taken over by other teams.

Teams also have extraordinary powers.

• Teams can take over the operations of non-performing retail outlets.

• Teams are empowered to engage local coordinators, not Haier employees, who build connections with village opinion leaders.

• Teams are also empowered to create joint ventures with successful retailers to extend their operations. These JVs are independent legal entities operating within the Haier network.

This model may not be for everyone

The Haier model may not be for everyone. It fragments

the organization paralleling the fragmentation of the

market. It internalizes the hyper-competitive

marketplace. Haier appears to have accepted

fragmentation and hyper-competition and adapted to

them rather than seeking to contain them, which

Western firms seeking unified strategy and execution

prefer to do.

The many markets of China

County level Zhou Yunjie (at left)

President, Haier Electronics (HK)

Jiaozhou County, Qingdao Haier store

Town level Mr. Wang

Owner, Yufeng store

Ligezhuang Town

Jiaozhou County, Qingdao

Village level Ms. Wei Zhen Hong

Village-level Coordinator

Xiaoyao Village

The bottom line . . .

The structure of the market will determine how you will enter China.

Received internationalization theory says bigger is better. This reflects the experience of Western firms that have learned how to consolidate markets through either efficiency gains or market power. Recall John D. Rockefeller’s comments about “ruinous competition” and how he dealt with it—brutally.

The fragmentation and hyper-competition characteristic of Chinese markets may invert received internationalization theory and require innovative and potentially uncomfortable strategies and organizational designs.