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 in
local 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 Chinas 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 of
Shanzhai 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 Chinas 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 Chinas 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 spawned
Shanzhai 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 handsets
in 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 new
markets (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). Imitations darker side is reflected in the flourishing output of fake goods
in 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 to
Hayek (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 various
transaction 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 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 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 wide
range 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
Handwriting
technique
Handset manufacturers
Operation software
Camera
Screen
Others
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 for
manufacturers 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
Handset manufacturer 3
Handset manufacturer 5

Handset manufacturer 4
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 a
large 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, Mercedes
Benz, 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 services
according 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 Hippels 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 handsets
have 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 Handsets
The 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 normal
manufacturer 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 ones
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 a
generation 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 handsets customer value
Low-end users
High-end users
E
v
o
l
u
t
i
o
n
a
r
y

d
e
v
e
l
o
p
m
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 some
value sources are not important to the market segmentation.
The source of the Shanzhai Handsets Customer value
Figure 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 cant 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 and
techniques 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 Infringement
Shanzhai 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. Chinas objective is to build an
innovative 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 a
rising 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 formers 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. The
Shanzhai 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 Handsets 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 on
the 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 firms 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, Taiwans 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 domestic
demand 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 Shanzhais 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 for
a 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 difficult to distinguish a handset produced before the IMEI number policy is
introduced 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 difficulties 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 for
Shanzhai 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 material
assets 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 peoples 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 new
Shanzhai 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 Clayton
Christensen. 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 billion
for 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 firstteam 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 MTKs share accounted for 12.5%. (see the rise in the position of MTKs
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 Telecommunications entry into a 3G era, has intensified the game
among WCDMA, CDMA2000 and TDSCDMA, 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 International
Communication 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 users 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 operators 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 Chinas 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 that
faked 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 medias
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 Chinas 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 overseas
markets, 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 and
organizational 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, development
and 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 everyones surprise the visitors 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 market
will 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 is
letting 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 been
regular 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 Chinas 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
mechanism
Implementation
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 were
restricted
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 Chinas 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 series
CPU. 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, it
launched 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
mens 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 consumers 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-out
test. 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 provides
them 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. Its easy for Shanzhai products
to 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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