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INNOVATION will be crucial to China’s economic strategy for several decades to come. Clarity on this issue， therefore， is vital. However， some discussions on innovation in China fail to grasp the core issue， imagining that its key lies in matters such as “greater creativity in schools.” In particular such discussions do not distinguish between two fundamentally different types of innovation. The first is“cost innovation” – the use of technology， managerial strength， etc. to reduce costs. The second is “product innovation” – the introduction of entirely new products such as the iPhone， iPad， iWatch etc.， This article analyses why “cost innovation，” not “product innovation，” will be the key mode for China over the next several decades. Two extremely successful smartphone companies， the U.S.’s Apple and China’s Xiaomi， will be used to illustrate the general principles.
To understand different innovation strategies in fundamental economic terms， it should be noted that as productivity increases there are two ways to translate it into competitive advantage：
The same product can be produced at a cheaper price.
The price can be kept the same and a superior product produced.
Apple is currently the world’s clearest example of the second strategy. Apple’s general policy does not reduce prices on new products – when it has done so， as with the cheaper iPhone 5c， they have generally been a failure. Apple’s strategy is to continuously produce greatly improved， best of all entirely new， products – the iPod， iPhone， iPad etc. This strategy of “maintain the price， raise the quality” is therefore accurately termed “product innovation.”
Xiaomi is an outstanding example of the other strategy， “cost innovation.” Xiaomi is the world’s most valuable startup with a value of over US $40 billion. Xiaomi does engage in some product innovation – its use of social media and its timing of product releases， for example， are superior to Apple’s. But the fundamental competitive advantages of Xiaomi consist in price and value. Xiaomi produces a phone whose quality is comparable to the iPhone for less than half the price. The outstanding value proposition of Xiaomi is that of quality， which is equal to 90 percent or more of the iPhone， for around 50 percent of the price.
Success in this strategy does rely on an engineering standpoint on the quality of the product. If the quality of Xiaomi’s phones was only 50 percent of Apple’s， it would have no competitive advantage， even at 50 percent of the price. It is only because a Xiaomi phone delivers more than 90 percent of the functionality of an iPhone for less than 50 percent of the price that Xiaomi has a competitive edge. But this does not alter the fact that the fundamental advantage of Xiaomi over Apple is cost， and not a better product. Xiaomi exemplifies innovation in keeping costs down. “Cost innovation，” not innovation in producing a superior product， thus equals “product innovation.” This difference determines the strategy of the two companies – including marketing. Xiaomi’s style of launching products is similar to Apple – to the extent that Xiaomi’s CEO Lei Jun dresses in similar style to Steve Jobs. This led to misguided Western criticism of Xiaomi， but in reality it illustrates Xiaomi’s strong strategic sense.
When a company’s strategy is product innovation its emphasis must be on how different its product is from any previous one. The classic visual expression of this was the advert announcing Apple’s Macintosh computer at the 1984 Super Bowl – the most famous single advertisement ever. It showed a woman in a colorful outfit smashing the grey images of a uniform， totally regimented society – a visual interpretation of the message “the Macintosh is like no other computer before， it is vastly more individual and creative.”
But if the strategy is cost innovation then， in competition among relatively advanced technological products such as smartphones， marketing strategy must emphasize how similar the cheaper product is to the more expensive one – ideally there should appear to be no difference except price.
The reason for this is that the immediate suspicion of any customer who sees a product selling for just half the price of another is that it is only half as good. Therefore everything must be done to convince the customer that the quality of the cheaper product is the same as that of the more expensive one.
Xiaomi， therefore， should not be criticized for the similarity of its product launches to Apple’s， because this illustrates the company’s strategic strength – everything about a Xiaomi phone is as good as an iPhone but the price is 50 percent cheaper.
This explains the branding rationale for Xiaomi’s “high quality parties” for key customers， skillful use of social media etc. It is to maintain the product’s image of high quality – “as good as Apple.” Xiaomi’s fatal weakness in marketing would be to confirm any suspicions that its lower price is due to lower quality.
But if the Xiaomi marketers’ job is to maintain the high quality image， its engineers’ job is to keep the price down while maintaining quality. Xiaomi’s huge success rests on two different strengths： the excellence of its branding in projecting an image of product quality， and the excellence of its engineers in ensuring that the product really is of high quality. But the overall strategy remains “cost innovation” – Xiaomi is not fundamentally attempting to produce a better product than the iPhone， it is attempting to produce a product as good as the iPhone at a much cheaper price. The reason why “cost innovation” can be the only foundation of such a successful strategy as Xiaomi’s is because China is no longer a low-wage economy. The Economist calculates that China’s average factory worker earns US $27.50 per day， compared with US $8.60 in Indonesia and US $6.70 in Vietnam – China’s manufacturing wages are three times as high as Indonesia’s and four times as high as Vietnam’s. China， therefore， cannot compete on price through low wages， instead it must rely on keeping prices down through innovations in technology， management， logistics etc.
This contrast between Xiaomi and Apple exemplifies the necessary strategic direction for innovation in Chinese economy as a whole over the coming period. This is because whichever innovation strategy is more effective cannot be separated from the overall level of a country’s economic development.
China’s per capita GDP in 2014 in IMF Purchasing Power Parity （PPP） was 24 percent of that of the U.S. This means， in approximate terms， that the productivity of China’s overall economy was slightly under one quarter of that of the U.S. Even with the most correct policies in China， and despite the recent overall slowing of that of the U.S.， it will evidently take China several decades to close that gap. Therefore for several decades China， on average， will be behind the “technological frontier” set by the most productive and advanced economies.
As China will be behind the “technological frontier”in the majority of economic sectors， it is unrealistic to believe it can carry out Apple’s strategy of maintaining the same price， or raising it while producing a superior product. By definition， this generally means expanding the technological frontier – which China will not be able to achieve. Instead China’s strategy must necessarily be cost innovation – to produce the same， or more precisely， a qualitatively comparable product， but at a lower price.
Xiaomi’s success， therefore， is attributable to a skillful- ly executed strategy in line with China’s economic fundamentals. The alternative strategy， “product innovation，”the attempt to compete by producing a phone which is qualitatively better than the iPhone could not succeed in China.
To avoid misunderstanding， it should immediately be clarified that this approach achieves middle ground. It does not imply that China cannot introduce any new products， or that China’s companies have become extremely skilled solely at incremental improvements even of leading products. It merely means that product innovation competitiveness cannot be the dominant mode for China’s successful competitiveness. To illustrate this historically， China’s per capita GDP in 2013 was 21 percent of that of the U.S. – the “technology frontier” economy. This is equivalent， relative to the U.S.， to the position of Japan in 1951 and South Korea in 1982. At those times， Japan and South Korea， as with China today， were no longer dominated by agricultural populations， but had evolved into upper middle-income economies. In the respective decades that followed， Japan and South Korea led the world in steelmaking， shipbuilding， construction equipment and similar midtechnology industries – those in which China is becoming dominant today. But Japan and South Korea at that time did not equal the U.S. in “product innovation，” due to the huge gap in per capita GDP， and it would be utopian to believe that China can.
The outstanding successes among China’s companies– Huawei， Wanxiang， CIMC and Xiaomi to take only a few examples – are by those that have mastered cost innovation. This is because they have combined innovatory skill with China’s macro-economic fundamentals.
China’s rising wages make innovation the key to its economic development. But China’s macro-economic fundamentals determine that “cost innovation” not“product innovation” will be the decisive factor for China’s companies for several decades to come.
To understand different innovation strategies in fundamental economic terms， it should be noted that as productivity increases there are two ways to translate it into competitive advantage：
The same product can be produced at a cheaper price.
The price can be kept the same and a superior product produced.
Apple is currently the world’s clearest example of the second strategy. Apple’s general policy does not reduce prices on new products – when it has done so， as with the cheaper iPhone 5c， they have generally been a failure. Apple’s strategy is to continuously produce greatly improved， best of all entirely new， products – the iPod， iPhone， iPad etc. This strategy of “maintain the price， raise the quality” is therefore accurately termed “product innovation.”
Xiaomi is an outstanding example of the other strategy， “cost innovation.” Xiaomi is the world’s most valuable startup with a value of over US $40 billion. Xiaomi does engage in some product innovation – its use of social media and its timing of product releases， for example， are superior to Apple’s. But the fundamental competitive advantages of Xiaomi consist in price and value. Xiaomi produces a phone whose quality is comparable to the iPhone for less than half the price. The outstanding value proposition of Xiaomi is that of quality， which is equal to 90 percent or more of the iPhone， for around 50 percent of the price.
Success in this strategy does rely on an engineering standpoint on the quality of the product. If the quality of Xiaomi’s phones was only 50 percent of Apple’s， it would have no competitive advantage， even at 50 percent of the price. It is only because a Xiaomi phone delivers more than 90 percent of the functionality of an iPhone for less than 50 percent of the price that Xiaomi has a competitive edge. But this does not alter the fact that the fundamental advantage of Xiaomi over Apple is cost， and not a better product. Xiaomi exemplifies innovation in keeping costs down. “Cost innovation，” not innovation in producing a superior product， thus equals “product innovation.” This difference determines the strategy of the two companies – including marketing. Xiaomi’s style of launching products is similar to Apple – to the extent that Xiaomi’s CEO Lei Jun dresses in similar style to Steve Jobs. This led to misguided Western criticism of Xiaomi， but in reality it illustrates Xiaomi’s strong strategic sense.
When a company’s strategy is product innovation its emphasis must be on how different its product is from any previous one. The classic visual expression of this was the advert announcing Apple’s Macintosh computer at the 1984 Super Bowl – the most famous single advertisement ever. It showed a woman in a colorful outfit smashing the grey images of a uniform， totally regimented society – a visual interpretation of the message “the Macintosh is like no other computer before， it is vastly more individual and creative.”
But if the strategy is cost innovation then， in competition among relatively advanced technological products such as smartphones， marketing strategy must emphasize how similar the cheaper product is to the more expensive one – ideally there should appear to be no difference except price.
The reason for this is that the immediate suspicion of any customer who sees a product selling for just half the price of another is that it is only half as good. Therefore everything must be done to convince the customer that the quality of the cheaper product is the same as that of the more expensive one.
Xiaomi， therefore， should not be criticized for the similarity of its product launches to Apple’s， because this illustrates the company’s strategic strength – everything about a Xiaomi phone is as good as an iPhone but the price is 50 percent cheaper.
This explains the branding rationale for Xiaomi’s “high quality parties” for key customers， skillful use of social media etc. It is to maintain the product’s image of high quality – “as good as Apple.” Xiaomi’s fatal weakness in marketing would be to confirm any suspicions that its lower price is due to lower quality.
But if the Xiaomi marketers’ job is to maintain the high quality image， its engineers’ job is to keep the price down while maintaining quality. Xiaomi’s huge success rests on two different strengths： the excellence of its branding in projecting an image of product quality， and the excellence of its engineers in ensuring that the product really is of high quality. But the overall strategy remains “cost innovation” – Xiaomi is not fundamentally attempting to produce a better product than the iPhone， it is attempting to produce a product as good as the iPhone at a much cheaper price. The reason why “cost innovation” can be the only foundation of such a successful strategy as Xiaomi’s is because China is no longer a low-wage economy. The Economist calculates that China’s average factory worker earns US $27.50 per day， compared with US $8.60 in Indonesia and US $6.70 in Vietnam – China’s manufacturing wages are three times as high as Indonesia’s and four times as high as Vietnam’s. China， therefore， cannot compete on price through low wages， instead it must rely on keeping prices down through innovations in technology， management， logistics etc.
This contrast between Xiaomi and Apple exemplifies the necessary strategic direction for innovation in Chinese economy as a whole over the coming period. This is because whichever innovation strategy is more effective cannot be separated from the overall level of a country’s economic development.
China’s per capita GDP in 2014 in IMF Purchasing Power Parity （PPP） was 24 percent of that of the U.S. This means， in approximate terms， that the productivity of China’s overall economy was slightly under one quarter of that of the U.S. Even with the most correct policies in China， and despite the recent overall slowing of that of the U.S.， it will evidently take China several decades to close that gap. Therefore for several decades China， on average， will be behind the “technological frontier” set by the most productive and advanced economies.
As China will be behind the “technological frontier”in the majority of economic sectors， it is unrealistic to believe it can carry out Apple’s strategy of maintaining the same price， or raising it while producing a superior product. By definition， this generally means expanding the technological frontier – which China will not be able to achieve. Instead China’s strategy must necessarily be cost innovation – to produce the same， or more precisely， a qualitatively comparable product， but at a lower price.
Xiaomi’s success， therefore， is attributable to a skillful- ly executed strategy in line with China’s economic fundamentals. The alternative strategy， “product innovation，”the attempt to compete by producing a phone which is qualitatively better than the iPhone could not succeed in China.
To avoid misunderstanding， it should immediately be clarified that this approach achieves middle ground. It does not imply that China cannot introduce any new products， or that China’s companies have become extremely skilled solely at incremental improvements even of leading products. It merely means that product innovation competitiveness cannot be the dominant mode for China’s successful competitiveness. To illustrate this historically， China’s per capita GDP in 2013 was 21 percent of that of the U.S. – the “technology frontier” economy. This is equivalent， relative to the U.S.， to the position of Japan in 1951 and South Korea in 1982. At those times， Japan and South Korea， as with China today， were no longer dominated by agricultural populations， but had evolved into upper middle-income economies. In the respective decades that followed， Japan and South Korea led the world in steelmaking， shipbuilding， construction equipment and similar midtechnology industries – those in which China is becoming dominant today. But Japan and South Korea at that time did not equal the U.S. in “product innovation，” due to the huge gap in per capita GDP， and it would be utopian to believe that China can.
The outstanding successes among China’s companies– Huawei， Wanxiang， CIMC and Xiaomi to take only a few examples – are by those that have mastered cost innovation. This is because they have combined innovatory skill with China’s macro-economic fundamentals.
China’s rising wages make innovation the key to its economic development. But China’s macro-economic fundamentals determine that “cost innovation” not“product innovation” will be the decisive factor for China’s companies for several decades to come.