Abstract
This paper addresses the question: why have China's SMEs managed to thrive and innovate within a national institutional environment that is arrayed against them? We find that the global fragmentation of production and a tacit alliance with local government make it possible for SMEs to innovate. The fragmentation of production creates opportunities for firms to enter the mobile 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 the niches provided by the global fragmentation of production. However, the tacit alliance only partially counters the condition of structured uncertainty facing SMEs. As a result, firms remain incentivised to seek short-term profits and minimise long-term R&D risks, thus limiting potential for novel-product innovation.
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