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Business Evolution in China

10/21/2009 --

China's particular brand of liberalization creates entry penalty for newer, more efficient firms.

ANN ARBOR, Mich. — Extensive study on industry evolution has produced fairly set models on the ways in which technical innovation drives success and determines winners and losers in the market. A few large, early-entry firms typically grow at disproportionate rates to dominate an industry, thanks to their economies of scale and capacity to invest in process innovations.

But these established models assume a seamless, free-market backdrop. What about economies in transition, namely China? Ross professor Brian Wu, along with professor Sea-Jin Chang of the National University of Singapore Business School, studied the post-liberalization shakeout in China. They found that existing models may need tweaking when it comes to transition economies.

Wu's research shows new entrants in China's economy may have higher productivity than incumbents. But, paradoxically, these new entrants also have lower survival rates than incumbent firms, after controlling for productivity and scale economies. According to established models, such a divergence between efficiency and survival shouldn't exist. Why is that?

"History matters," says Wu.

Beginning in 1978, China took a gradual reform approach in shifting from a planned economy to a market economy. During this process, China adopted an "open door" policy to encourage foreign investment, which allowed the entry of non-state firms, provided state-owned enterprises with more autonomy and incentives, and reformed ownership structure. This gradual process was facilitated by the decentralized economic structure in China. These policies generated some promising results, but the decentralized nature of China's economy also led to redundancies on the national level. Local administrators were held accountable for their own regions, so the priority was to maximize local growth.

During the last decade, China moved to promote market competition, which created a Schumpeterian "gale of creative destruction" during its post-liberalization period. New firms entered Chinese industries in unprecedented numbers to compete with incumbent firms, resulting in significant industry shakeout. This process of creative destruction is moderated by two important institutional factors. First, among both new entrants and incumbents, a variety of ownership structures, ranging from state to foreign ownership, came to co-exist due to China's gradual reform. At the same time, because of China's decentralized economic structure, each region in China has experienced a different degree of market development and market openness, which created heterogeneous institutional environments for selection. So China's liberalization process is best characterized by the interplay between economic and institutional forces.

Older firms have deeper local ties and more political capital with the right people, which is a major factor for success in China. This means that new entrants should require a much higher level of efficiency in order to compensate not only for scale disadvantages, but also for social and political capital deficits. Such divergence is particularly salient among conventional ownership types and in regions where market economies are less developed and markets are less open for competition.

"If the incumbent really knows the local government well, the incumbent is going to have social and political capital, which creates an advantage," Wu says. "So the shakeout did occur, but that is accompanied by this divergence between efficiency and exit rates."

Wu's research has implications both for firms entering China and for policymakers in China and other transition economies.

He says companies looking to enter China and entrepreneurs already there need to understand "institutional frictions" and plan for them. "If you can figure out what the specific barrier is, you can do something about it," he says.

They also need to take a deep look at the competitive environment in their particular industry, both regionally and nationally. Just because a market is growing doesn't mean the competition is decreasing.

For policymakers, the study shows that leaders in transitional economies should consider ways to remove those institutional barriers.

"The liabilities of newness and the efficiency needed to compensate for those liabilities prevents more firms from entering the market — and that causes overall economic inefficiency for the country," Wu says.

Though the study looked at China, Wu thinks the context is applicable to other countries that have gone through — or will go through — economic deregulation or a change in government.

—Terry Kosdrosky



For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu