What Is Wrong With Shanghai? (Part II)

Shanghai is particularly poor in innovative activities that convert inventions into useful commercial applications, as compared with the neighboring entrepreneurial areas of Zhejiang and Guangdong.

There is an important distinction between being inventive and being innovative: Inventions are acquisitions of capabilities without reference to their underlying market value. Innovations are acquisitions that are motivated by a realization of market values.

A top-down bureaucratic system, such as that in the former Soviet Union, can be quite inventive because of massive investments in science and technology by the government.

The problem is that the Soviet economy was not innovative in new technologies and processes — because it failed to convert the scientific breakthroughs into useful commercial applications. The massive R&D expenditures had very little effect on the economy as a whole.

Shanghai exhibits the classic Soviet syndrome — it is inventive, but not innovative. In 2005, universities, research institutes and government agencies in Shanghai were granted 1,895 patents. This is substantially more than in Zhejiang (841) and Guangdong (644), despite the fact that Zhejiang and Guangdong both had larger total patent counts.

Because these are non-profit institutions, these are inventive activities without reference to their market value. Shanghai under-performed in the more market-oriented patenting categories.

In 2005, there were 8,486 patents granted to firms in Shanghai — but there were 11,518 granted to firms in Guangdong. (Zhejiang had far fewer than Shanghai, at 3,892.)

The greatest difference between Shanghai and these two other provinces lies in the number of individual patent grantees. In 2005, Shanghai had only 2,222 individual patent grantees. This does not even begin to compare with Zhejiang (14,333) or Guangdong (24,732).

In one respect, Shanghai is fundamentally different from — and superior to — the former Soviet Union: Shanghai is open to foreign direct investment (FDI). So, the question is not whether it matters to have entrepreneurs — but whether it matters not to have indigenous entrepreneurs.

The answer is still yes, although the reasoning is a bit more complicated. The essence of the Shanghai model is to restrict the opportunities for Shanghai residents to become capitalists — but to create an efficient and attractive platform for foreign capitalists to set up production facilities.

This explains the paucity of asset returns to the average Shanghai households in household survey data. The low entrepreneurial income is partially compensated for by the fact that multinational companies can offer a substantially higher level of wages than the majority of indigenous entrepreneurs.

This again is consistent with household survey data that show the average Shanghai resident to have the highest wage level in the country. The average Shanghainese are the richest proletariat in the country — but among the poorest capitalists in the country.

So, one can argue that it is a wash — that lower profit incomes are made up for by higher current wage incomes.

The Shanghai model will come back to haunt Shanghai if there is an external shock. One form of such an external shock might be the rise of India as an attractive FDI location, or the rise of other regions in China that can compete with Shanghai. Local firms have a home bias in that they have a preference to operate in their home base.

The most detrimental aspect of the Shanghai model is that it has damaged the ability of local firms to attract top human talent.

One of the few ways that local entrepreneurial businesses can successfully compete with the deep-pocketed multinational companies in the talent market is that they can offer greater future payoffs — stock options or career paths to the top of the corporate hierarchy.

This is basically how Indian firms, such as Infosys and Wipro, were able to compete with IBM and GE to recruit and retain the best engineering talent in the country.

Suppressing the growth potentials of local entrepreneurs caps the value of the upside option these local entrepreneurs can offer to attract human talent.

If the perception in the market is that these local businesses cannot grow big, then these local firms will have no choice but to compete on the basis of offering current payoffs.

Multinational companies command a decisive advantage in competition on the basis of current payoffs. Greater talent flows to these corporations reinforces their policy advantages — and further solidify their market dominance.

Read Part I of this Globalist Bookshelf excerpt here.

Editor’s Note: This feature is adapted from “Capitalism with Chinese Characteristics: Entrepreneurship and the State,” by Yasheng Huang. Reprinted with the permission of Cambridge University Press. Copyright (c) Yasheng Huang 2008. All rights reserved.