Tacit Local Alliance and SME Innovation in China

This paper addresses the puzzle of how Chinese small and medium-sized enterprises (SMEs) in the mobile handset industry overcome an environment of “structured uncertainty” and innovate. We find that a combination of the global fragmentation of production and a tacit alliance between local government and industry makes it possible for SMEs to innovate. The fragmentation of production creates opportunities for firms to enter the handset industry in a variety of niches, each of which affords certain capabilities for innovation. The tacit alliance mitigates uncertainty, making it possible for firms to incrementally innovate in niches provided by the global fragmentation of production. The tacit alliance only partially counters the condition of structured uncertainty facing SMEs. As a result, firms remain incentivized to seek short-term profits and minimize long-term R&D risks, thus limiting potential for novel-product innovation