Size Matters: Economy-Wide Scale Effects

Abstract

Size matters in an innovation economy. On the supply side, a large country usually has a higher GDP and large population. A higher GDP means that both its public and private sectors can commit more resources to innovation, hence higher R&D spending. On the demand side, a large population can contribute to large domestic demand. Domestic demand from large countries benefits innovation through economies of scale, economies of scope, and wealth effects. The first channel is through economies of scale. Demand from large countries helps reduce R&D costs per unit of output and enhances incentives for production-side R&D investment. Second, economies of scope can be better achieved through sizable demand, which also contributes to innovation. Diversified demand is conducive to the success of product differentiation strategies, which in turn encourages firms to increase their investment in innovation. Lastly, wealth effect affects consumers’ participation in innovation, and also facilitates technological advancement. As consumers’ spending power continues to improve, the proportion of consumers directly participating in innovation is also rising. This raises the overall investment in R&D resources.

In addition to domestic demand (consumption) and supply (R&D spending), international trade is also a key driving force for innovation. We believe trade can foster innovation via three channels: Economies of scale, learning, and competition. First, trade allows companies to expand business scale and generate more profit, which is conducive to diluting the fixed cost for R&D and innovation. Second, companies learn advanced technologies and improve production efficiency through trade. Third, international competition encourages innovation. In our view, the boost from learning is likely stronger when companies lag behind in technological knowhow, while the momentum from competition is likely more important for groundbreaking innovations.

However, changes in the external environment in recent years may pose challenges for China. We believe deglobalization, including trade protectionism, will hinder corporate development, and make it more difficult for companies to develop advanced technologies. The US has managed to lead key technological revolutions such as semiconductors, personal computers, and mobile internet. We believe this is because US companies have leveraged the global market to promote new products and support high R&D spending, and kept improving themselves through international competition.

Despite changes in the external environment, we expect the rise of the digital economy to offer new opportunities through trade. Because of the replicability of data, the cost of data duplication is close to zero. Therefore, scale effects can be better leveraged in the digital world. We think the digital economy will also help improve human resources and talent development, strengthen the scale effect, and thus benefit technological innovation. We think the digital economy can help expand the scale of trade in both goods and services, and enable more companies to benefit from trade.

Digital economy also offers new opportunities in demand-driven innovation. We expect the digital economy to accelerate consumption-led innovation. In a digital economy, products and services are more closely integrated, further underscoring the importance of local demand. Big data helps companies effectively understand consumer needs and facilitate technological innovation. A digitalized economy provides consumers with new models of product innovation for consumer goods. A digital economy also reduces the cost of consumer participation in technological innovation and helps increase the proportion of consumers participating in innovation.

2.1 Large Countries Have Advantages in Innovation

Size matters in an innovation economy. Large countries have various advantages, including large R&D spending by both the government and the private sector, and large domestic demand that comes with a large population, which in turn could stimulate consumption-led R&D. Furthermore, large countries are more prominent in international trade, which also helps foster innovation.

2.1.1 Size Matters in R&D Spending

Large economies enjoy natural advantages in R&D spending. Figure 2.1 shows changes in R&D spending of major innovative countries across the globe, indicating that technology powerhouses such as the US and China have invested much more in R&D than other countries.

Fig. 2.1

The US and China's R&D spending has significantly exceeded the spending in other countries. Source OECD, CICC Global Institute

Having the highest level of R&D expenditure in the world is an important reason why the US led global innovations after World War II. According to the Organization for Economic Co-operation and Development (OECD), the US's annual R&D expenditure in the 1980s was almost half of the aggregate R&D spending of other major countries and approximately four times the R&D spending of Japan, which is also an innovative country. The US's share of global R&D spending remained at around 30% until 2018, and contracted amid rapid expansion of Chinese R&D investment (Figs. 2.2). The US federal government budget report for 2020 listed a wide range of technological projects in the areas of national defense, public health, energy, aviation and aerospace, agriculture, and the environment and climate. The report also outlined R&D projects on network and information technologies as well as cross-institution projects that focus on frontier technologies such as the national nanotechnology program.¹

Fig. 2.2

The US of global R&D spending has remained larger than that of other countries. Source OECD, CICC Global Institute

China's massive R&D spending is very helpful for spurring innovation. First, the size of the spending affects the probability of innovation success. High R&D spending makes it possible to explore multiple technological options, and increases the probability of making breakthroughs. The success of science R&D is accidental, and requires exploration of multiple options. High spending and ample human resources can facilitate simultaneous exploration of these multiple options, and ensure a higher tolerable error rate. For example, in the process of pharmaceutical R&D, companies that cover a large number of therapies tend to have good achievements.² In the Manhattan Project, the major technological option for the R&D of atom bombs was uranium fission, but the simultaneous exploration of plutonium fission reaction paved the way for final success. We believe a larger R&D network is more helpful in attracting resources, promoting knowledge-sharing, enhancing R&D returns, and diluting R&D spending per unit of product.

Second, a country can solve global problems by embarking on large R&D projects. The world now faces a number of serious challenges such as climate and energy issues. Successfully combating these challenges requires worldwide cross-disciplinary cooperation.³ As overcoming these challenges requires ample human resources and heavy spending, larger economies enjoy competitive advantages over their smaller counterparts. For example, the EU earmarked EUR3.8bn in 2014–2020 to fund the Horizon 2020 program that focuses on R&D of clean energy technologies.

2.1.2 Large Domestic Demand Benefits Innovation

Innovation is an economic activity with positive externalities. Either increasing the economic returns of innovative activities or reducing the cost of innovative activities enhances the motivation of innovative activities. In both these aspects, demand in large countries plays a positive role. Compared to small markets, the large markets in large countries bring advantages in three aspects: Economies of scale, economies of scope, and wealth effects.

Economies of scale improve efficiency of innovation. Demand from large countries is reflected in their large populations, but more importantly, in large spending power. We believe a large country’s demand is mainly reflected in the country’s domestic demand supported by its population.⁴ China’s domestic demand is equivalent to around 64% of demand in the US in 2019—a significantly higher proportion than from other countries (Fig. 2.3). As the domestic demand of each G20 country accounts for more than 90% of its GDP in 2019, we use GDP to measure macro-level demand and GDP per capita to measure income per capita in the analysis below (Fig. 2.4).

Fig. 2.3

Ratio between China and US GDP and their domestic demand. Source Wind, CICC Research

Fig. 2.4

Domestic demand and GDP of G20 countries (2019). Source Wind, CICC Research

The economies of scale for innovation created by a large country’s demand are mainly reflected in two aspects—i.e., “learning-by-doing” and the sharing of R&D costs. Learning-by-doing plays an important role in the production processes of technological innovation. To a degree, even if inputs of R&D and human resources are not intentionally increased, repeated production activities alone could also lead to efficiency improvement and technological advances. Such a learning-by-doing mechanism is only effectively realized with demand in large countries.

More importantly, the large-scale production supported by the demand in large countries can reduce the unit R&D cost of products and improve overall motivation for R&D at companies. Consumer demand accounts for the main part of domestic demand. China has the world’s second largest consumer market in 2021.⁵ In 2019, China’s retail sales reached US$6trn,⁶ much higher than developed countries such as the UK, Germany, and Japan, and second only to the US. The gap between retail sales in China and the US is narrowing, and we believe that China will likely become the world’s largest retail market in the future.

Economies of scope increase intensity of R&D investment. Economist Paul M. Romer believes that monopoly profit is the engine of market R&D⁷ as the excess earnings generated by monopolies are to a degree the internalization of the positive externalities of innovation. Product differentiation through innovation at companies is an important method for obtaining monopoly profits. The success of this supply-side differentiation strategy depends on whether the demand side has sufficiently diversified demand. Research shows that the diversity of consumer preferences encourages firms to innovate to meet the needs of different consumers; once companies find such needs in the market and apply them to R&D and production, innovation pays off better.⁸

China has a large population with diverse consumer needs. The 2020 censuses in China and the US show China’s population at 1.41bn and the US population at 333mn. China’s large population induces the complexity and variety of consumer needs as well as diverse market segments in the country. In China, the combined market shares of top brands in major consumer-related industries such as clothing, food, housing, and transportation are lower than they are in the US, underscoring the diversity of demand in China (Fig. 2.5). Amid diverging consumption in different market segments, companies are gradually exploring needs and promoting innovations for specific consumer groups and scenarios. Innovations spring up in specific market segments of industries such as F&B, catering, and automobiles. For example, eating habits vary greatly in different regions of China, resulting in fragmented market shares in various segments of the country’s catering market (Fig. 2.6).

Fig. 2.5

Combined market shares of top three brands in major consumer-related industries in China and the US (2020). Source Euromonitor, Marklines, CICC Research

Fig. 2.6

China’s catering market has many different segments. Note Data based on 2017 revenue. Source Frost & Sullivan, CICC Research

Some studies claim that diversified demand could reduce the market size of specific products, although it increases the number of submarkets. This would reduce the earnings incentives in specific markets, thereby adversely affecting innovation.⁹ The adverse effects of diversification further underscore the economies of scale created by demand in large countries. China has a population that is more than three times the population of the US. Even a small market segment in China has a larger number of consumers on average than in the US. The sizeable diversified demand in China has eventually produced economies of scale that are conducive to innovation. For example, although JD.com and Alibaba are the leading e-commerce platforms in China, Pinduoduo manages to thrive by relying on consumers in tier-3 and tier-4 cities and rural areas, showing that the diversity of demand in large countries has a positive effect on innovation.

Wealth effects promote input of supply-side resources for innovation. Supply-side resources such as R&D and human resources are crucial to the innovation process, but the input of supply-side resources also depends on demand. For example, the GDP per capita of the US once used to be more than 30 times that of China’s. The number of Chinese students studying abroad then substantially exceeded the number of Chinese students returning home (Fig. 2.7). China had relatively low income levels then, and it was difficult to attract talent. This led to a significant outflow of skilled labor. However, as the gap in per capita GDP between China and the US narrows and domestic demand becomes a main driver for economic growth, China’s attractiveness for skilled labor has improved since 2003, and the ratio between the number of Chinese students studying abroad and the number of Chinese students returning home has been declining quickly.

Fig. 2.7

Ratio of US GDP per capita to China GDP per capita; the ratio of Chinese students studying abroad to the number returning home. Source Wind, CICC Research

R&D investment is a similar situation, and at the micro level, it reflects consumer participation in innovation. Consumer participation in innovation refers to the technological innovation by consumers through independent design & production, cooperation with companies, or open-source cooperation in R&D as well as product innovations. Consumer innovation can result in R&D spending such as spending on material purchases, mailing, and tool purchases. Thus, consumer willingness to innovate R&D resources is also highly correlated with per capita GDP (Fig. 2.8). Research by Eric von Hippel shows that in some developed countries, consumer investment in technological innovation exceeds investment in business.¹⁰

Fig. 2.8

Percentage of consumers participating in innovation; per capita GDP in select countries. Source Sichel et al., Household Innovation and R&D: Bigger than You Think, the review of income and wealth, October 2020; Chen et al., Household sector innovation in China: Impacts of income and motivation, Research Policy, May 2020., CICC Research

2.1.3 How International Trade Facilitates Innovation

In addition to domestic R&D demand and R&D supply, international trade is also a key driving force to innovation. International trade also promotes innovation through economies of scale, learning, and competition, highlighting the importance of scale effects. The development of information technology reduced the communication cost between companies in the past four decades. International trade gradually transformed from traditional inter-sector and intra-sector trade to a cooperative production model based on a global value chain. Under this model, traditional “trade of goods” is replaced by “trade of tasks”, and companies only need to focus on one part of the production process and one specific task.

Under the global value chain system, we believe that engaging in international trade will benefit innovation. Numerous studies have shown that companies engaged in international trade are likely to have higher production efficiency and stronger capability and willingness for innovation. Data shows that export companies in China have a higher number of patent applications and approvals than non-exporting ones (Fig. 2.9). This is especially true in technology-intensive manufacturing sectors such as instruments and apparatuses, electrical and machinery equipment, and transportation equipment.

Fig. 2.9

Export companies in China have a higher number of patent applications and approvals than non-export ones. Note (1) Number of patents includes both applications and approvals; (2) we winsorized 5% of the data. Source Chinese industrial enterprises database (2012), China innovative enterprise data base, CICC Research

How does international trade promote innovation? Past research shows there are three mechanisms: Economies of scale, learning, and competition (Fig. 2.10).

Fig. 2.10

How international trade promotes innovation. Source CICC Research

First of all, economies of scale play a central role. International trade allows companies to expand markets and generate more profit, which is conducive to diluting fixed cost for R&D and innovation. According to the Schumpeterian hypothesis, companies with higher profit are more incentivized to innovate. In addition, these companies are likely to spend the gains from international trade on R&D to improve the competitiveness of their products globally. This creates a positive cycle in which exports and innovation reinforce each other.

Another important mechanism to promote innovation through international trade is learning. Through international trade, companies learn advanced technologies and improve production efficiency. Specifically, companies can learn via exporting, importing, and foreign direct investment. First, companies learn via feedback from foreign clients—i.e., “learning by doing.” Second, companies learn from importing intermediate goods technologies and expertise. Third, studies show that foreign direct investment produces positive spillover effect both horizontally (via employees) and vertically (via upstream and downstream) along the industry chain, boding well for innovation by domestic companies.¹¹

Thirdly, international competition encourages innovation. Full competition helps screen companies, and enables efficient and innovative firms to seize more market share (i.e., the pro-competition effect). These companies are likely to gain higher market share and profit, which may facilitate innovations and allow these companies to remain competitive.

In sum, economies of scale focus on the role of demand, while learning and competition emphasize the role of supply. In addition to gaining higher market share and profit through trade, we believe it is more important to learn from and compete with strong names via trade to accomplish constant self-improvement and maintain strong positions.

As China catches up and gradually becomes a frontrunner in certain technologies, we expect the role of learning to wane and the role of competition to become more important. That said, we think economies of scale are crucial in each and every stage of development, stressing the significance of large scale. Unlike Western developed economies, modern industrialization started late in China, and China had been learning and catching up for a long time. At one stage, advanced global technologies were not accessible to most Chinese companies, and technological innovations in China were mainly driven by learning from overseas advanced technologies. However, more and more domestic sectors have become leaders in global technologies in recent years thanks to accelerating technological advances in China. As a result, a rising number of Chinese companies have become creators of groundbreaking innovations. These companies have become not so much learners as competitors with advanced global companies. Such competition encourages them to innovate, boding well for improving production efficiency.¹² Research shows that for companies at the forefront of technologies, more intense competition tends to result in lower profits and thus more incentive for these companies to seek excess profit through innovation, contributing to the “escape-competition effect”.¹³

Which Chinese sectors are at forefront of global technologies? Thanks to over three decades of development, China has gained certain advantages in technologies such as 5G, artificial intelligence (AI) applications, and hardware manufacturing. In addition, a number of innovative companies have emerged. For internet service, select Chinese companies have become globally competitive. However, China still lags behind the US in semiconductors, software, and cloud computing (Fig. 2.11).

Fig. 2.11

Revenue distribution of global technology sectors (2019). Source Wind, Bloomberg, CICC Research

2.2 Digital Economy Offers Opportunities Amid New External Environment

While large countries benefit from scale effect in innovation, the external environment has changed significantly in the past two years, and “deglobalization” may weigh on corporate operations, investment, and innovations, in our view. The US government has since 2018 adopted a series of trade protectionist measures such as imposing additional tariffs on goods imported from China, and including Chinese companies in its “Entity List.”

US government has also tightened reviews of the industry chain. The US government in June 2021 released a 250-page “100-day supply chain review report” that covers a wide range of industry chains such as semiconductors, batteries, key raw materials, and pharmaceutical manufacturing. We note the 100-day supply chain review report mentioned China 341 times, many more times than other major trading partners or competitors of the US such as Japan (70), South Korea (58), Canada (37), Germany (18), and Russia (7).

Despite changes in the external environment, we expect the rise of the digital economy to offer new opportunities (Fig. 2.12). The replicable and non-rival features of data better facilitate economies of scale, in our view. As a result, digital transition can boost innovation through international trade, and promote more consumption-led innovations in the digital era.

Fig. 2.12

Next decade in China: digital economy. Note Economic cycles are based on nominal GDP and one unit on the left axis represents 1%. Source Wind, United Nations Population Division, CICC Global Institute

2.2.1 Digital Economy Boosts Innovation from Trade

We believe the digital economy will improve economies of scale and enhance the boost from learning and competition, thus strengthening the momentum of innovation from trade. We think the digital economy can help expand the scale of trade in both goods and services, and therefore foster innovation. In our view, the digital economy can strengthen growth momentum from learning, and contribute to more corporate innovation under a similar scale of trade. We also expect the digital economy to stimulate competition, and facilitate companies’ upgrading towards the parts of the global industrial value chain with higher added value.

We believe trade can promote innovation via three channels, but they affect different companies to varying degrees. We believe the boost from competition is stronger for leading Chinese companies as they already enjoy a high market share, and supply-side self-innovation is thus more important. Meanwhile, we believe the momentum from economies of scale is more important for other companies as they rely on further profit growth to spur innovation, and demand-side pull is crucial.

Apart from the boost from economies of scale, learning, and competition, we think the digital economy can also help improve human resources and talent development. For trade to stimulate innovation in the end, we believe human resources should also play a key role. Amid changes in the global center of economy and technology, human capital first flowed to Europe before flowing to the US. This enabled the US to surpass Europe to become the world’s largest center for innovation. We believe China can become a center for innovation in the digital-economy era if it can: 1) Take full advantage of high-quality learning resources across the world and turn its advantages in population into competitive edges in talent; and 2) utilize overseas talent resources to boost domestic innovation.

2.2.1.1 Digital Economy and Economies of Scale

While trade protectionism may weigh on select companies, we think the digital economy can improve trade conditions, increase the scale of trade, and thus stimulate innovation. We believe the digital economy will enable more companies to trade, especially small- and medium-sized companies. On the demand side, the digital economy helps expand the regional coverage of trade, reduce trade barriers, and enhance efficiency in matching. On the production side, the digital economy facilitates coordination and corporate decision making. Specifically, we think digital technologies can mitigate the restrictions in time and space, and make more trade in services possible.

From the demand side, we think the digital economy can reduce cost of trade. The cost of trade mainly comes from distance (such as transportation cost, trading cost, and contract cost) and cultural differences (such as costs arising from differences in languages and legal systems), in our view. We think the digital economy can significantly reduce the cost of trade and increase the scale of trade. Research shows a 1% increase in distance reduces trade volume by 1–2% in traditional trade, but the drop is milder at 0–0.5% in a digital economy.¹⁴ Meanwhile, a 2019 study on eBay found machine translation helped increase US exports to Latin American countries by 17–21%.¹⁵

In addition, the digital economy can improve efficiency of matching. The difficulty in matching buyers and sellers restricts the market coverage of companies, but we believe digital technologies can provide more useful information, reduce the cost of matching, and thus improve matching efficiency. Research¹⁶ shows that merchants with ratings have 25% higher revenue on average than merchants without ratings in cross-border e-commerce.

From the production side, we think the digital economy can enhance efficiency in coordination. We expect digital technologies to facilitate coordination along the value chain, and the industrial internet to improve matching between producers and suppliers. We believe digital technologies can also strengthen coordination within companies. For example, a large number of companies turned to digital tools such as the software company Zoom for business coordination during the pandemic, which helped lower communication costs and mitigate the negative impact of COVID-19 on corporate operations.

In addition, digital economy can assist in corporate decision making. We expect digital technologies to help companies identify consumer demand and better target their clients on the back of big data analysis. This bodes well for improving flexibility in decision making, in our view. Research¹⁷ shows that more market information bolsters corporate sales growth.

For service trade, we think digital economy can also improve tradability of services. Service products usually require face-to-face transactions between producers and consumers, and sometimes even real-time transaction is needed. However, we expect the digital economy to remove such restrictions. For example, online platforms allow for things like remote teaching and video-based remote medical diagnosis. We expect tradability of technology-intensive services such as education and healthcare under the digital economy to improve (Fig. 2.13). Meanwhile, new generations of telecom technologies such as 5G further raise the speed of data transmission and allow more service products to become tradable.

Fig. 2.13

Digital economy improving tradability of services. Note Technology intensity is based on the proportion of employees with post-graduate educations, while tradability is measured by (import value + export value)/total sector output. Source Eckert, F., Ganapati, S., & Walsh, C., Skilled tradable services: The transformation of US high-skill labor markets, 2019., CICC Research.

2.2.1.2 Digital Economy and Learning

In addition to amplifying the technological spillover from trade and foreign direct investment, we think the digital economy will also expand channels for companies to learn from advanced knowledge and technologies. This will stimulate corporate innovation, in our view.

Digital technologies help to improve technological spillover from trade. Through trade, companies acquire technology and knowledge via feedback from export clients, learning from imported intermediate goods, and the benefiting from the positive spillover of foreign direct investment (FDI). For example, professional consulting services and analysis of data on sector imports, exports, and FDI are likely to help companies better understand sector development trends, optimize product structure, and improve mode of trade. In addition, digitalization of professional knowledge and internet communications should facilitate analysis of product components and related discussion on R&D, thus benefiting corporate innovation.

Furthermore, digital economy also optimizes the mode of learning. Path dependence may prevent companies from dealing with R&D challenges if they only rely on in-house R&D staff to do so. However, we think global knowledge sharing platforms will help address this issue. They not only expand the pool of knowledge and ideas, but also contribute to increased diversity as knowledge and ideas may come from people in different parts of the world with different ways of thinking. This should improve the chances of success, in our view. For example, InnoCentive is an online platform for innovation resources, and it boasts over 500,000 registered users from about 200 countries and regions. It allows companies to post the unsolved problems and unmet needs of their R&D activities on the platform in the form of challenges; it invites users across the world to offer their solutions and provides reward for qualified solutions.

2.2.1.3 Digital Economy and Competition

We think the digital economy can empower companies and improve their competitive edges. However, we also believe the digital economy can have a contrasting impact on producers along the global industrial value chain.

On one hand, we believe the digital economy may reduce the added value of production and make it harder for companies in the middle of the industrial value chain to move to the two ends with higher added value. The digital economy can change the relative importance of factors of production, and mechanization is likely to reduce the value of low-cost human resources. As a result, technology-intensive sectors with high added value may flow back to developed countries from developing countries. This may squeeze the added value of developing countries along the industrial value chain, in our view. The curve of value distribution along the industrial value chain may thus become steeper, boding ill for innovation by producers because a lack of incentives from profit may discourage them from innovating.

On the other hand, we also think the digital economy can also empower producers and facilitate their upgrading at the two ends of the industrial value chain. Data is an underlying asset for the digital economy, and it has zero marginal cost but enormous economies of scale as well as network effect. In international trade, intermediate producers can leverage big data to target clients more precisely and obtain market feedback faster. We also expect the digital economy to enhance companies’ learning capabilities. This should facilitate their expansion towards R&D, design, marketing, and other parts of the industrial value chain with higher added value, and help them secure a better position in the global market, in our view. In addition, we think companies can also explore hidden knowledge with technologies such as machine learning, and thus expand their knowledge base. Supported by big data, machine learning can identify overlooked information in design and production, and enable companies to differentiate themselves in production. This should contribute to a flatter curve of value distribution along the industrial value chain. We think this bodes well for innovation by producers because they are likely to have more profit to invest in innovation.

2.2.1.4 Digital Economy and Talent

Human capital is crucial for innovation. Over the past century, the destination of global human capital flow shifted from Europe (e.g., Germany and the UK) to the US, which has grown into a global center of innovation driven by the rapid development of its high-tech sectors supported by top-notch international talent. Research shows that people born outside the US account for a higher proportion of US patents, and their patents are more important in technologies and value than the patents contributed by people born in the US.¹⁸

For China, we think the digital economy can help turn the country’s advantages in population into competitive edges in talent, therefore laying a solid foundation for innovation. Digital economy can accelerate the accumulation of human capital. We think distance education and digital platforms can speed up the spread of knowledge. For example, students can remotely access courses at universities worldwide thanks to online education. We note the cumulative page views for open courses from the Massachusetts Institute of Technology from Chinese users is lower than from English-speaking countries such as the US and India, but page views would significantly increase if we take into account such foreign courses hosted on domestic online platforms. Therefore, we believe digital platforms can help overcome language barriers, and accelerate the spread of knowledge. In addition, we think digital platforms help Chinese human capital access top-notch overseas resources. That said, average page views at both MIT and at domestic online platforms for Chinese people with postgraduate degrees are still at an average global level, implying large upside potential for utilizing overseas resources. Furthermore, digital transformation can facilitate the collision of ideas. For companies, we think digital platforms and technologies help pool global talent for R&D activities and brainstorming for decision making. For schools, we believe digital platforms and technologies can facilitate academic communication, thus mitigating geographical restrictions on the exchange of ideas and boosting innovation.

2.3 Consumption-Led Digital Innovation in Large Countries

We believe that the digital economy can enhance the role of innovation with sizable demand in large countries. Local demand is important in the digital era as it gives rise to scale effect. Digital technologies help bring about a better understanding of consumer needs and provide new ways for consumers to take part in innovation.

2.3.1 Digital Economy Accelerates Consumption-Led Innovation

Products and services are more closely integrated in a digital economy, further underscoring the importance of local demand. Simon Kuznets has proposed different development models for large and small economies. He believes that large economies have comparative advantages in independent development and innovation and can achieve Schumpeterian growth, while small economies rely on specialized earnings generated by free trade, namely Smithian growth.¹⁹ Kuznets’s ideas are based in an era in which manufacturing played a dominant role. However, in the digital economy, an important feature is that demand increasingly exists in the form of digitalized services; the tradability of services is poor. Thus, localized services are particularly important for product innovation.

This means that the advantages of the Schumpeterian growth model for large countries based on local demand are likely to become more obvious than in the Smithian growth model for small countries. A significant number of products featuring technological innovation would eventually rely on localized services to reach consumers. Localized service demand reduces the speed of overseas innovative products entering the Chinese market. Domestic companies focusing on technological innovation can seize opportunities from the time lag to catch up with their counterparts. They can rely on their advantages in services to compete with overseas firms in the near term and gradually catch up with overseas companies in technology.

The case of smart speakers is a good example of the importance of the local market. The Amazon Echo smart speaker was launched in 2014, and it became popular globally thanks to its superior interactivity and open systems. Given China’s significant local market, tech giants such as Alibaba entered the smart speaker market in 2017, and Alibaba has become a leader in the Chinese smart speaker industry. Smart speakers are not essentially a hardware business, and providing quality service is key. Although the Echo features advanced technologies and superior performance, the smart speaker still uses English to interact with users in China. Echo mainly connects with foreign platforms such as Spotify, Pandora, and Amazon Music, and cannot provide localized services in China. Thus, China’s local smart speaker products such as the Tmall Genie can succeed in the domestic market thanks to their lower prices and more localized services.

Big data helps firms understand consumer needs and facilitates technological innovation. Improved efficiency guiding supply-side innovation through the demand side depends on the supply side’s grasp of demand. In the digital economy, the effects of big data on innovation are mainly reflected in companies having larger amounts of data and a better understanding of the needs of consumers, thereby enabling them to promote innovation. China has well-developed e-commerce platforms, and the penetration rate of online consumption is high. Each user of e-commerce platforms is an individual with personal characteristics and an awareness of social media. Internet firms can access information on consumer preferences by noting the user’s browsing habits.

Douyin, with its A/B algorithm, helps better assess user needs. Douyin is a short video platform based on big data and intelligent algorithms. It adopts a single-column model to display content, emphasizes an immersive user experience, and has high requirements for content quality. Thus, the platform requires highly accurate algorithms. Douyin adapted to user needs in its initial stage, and the platform has evolved to meet more precise user needs thanks to its frequently updated and upgraded A/B algorithm. The process of the algorithm is divided into three parts: Labeling content, labeling persons, and recommending individualized content to users based on the labels.

When it comes to labeling content, labels are first defined according to entity and semantic labels, then content is labeled as various categories—first, second, and third levels. For example, a piece of content could be labeled as anime, Japanese anime, Naruto (a Japanese anime series), and Naruto Uzumaki (a main character of Naruto). Labels that are more detailed require the input of more resources and can grasp user needs more precisely.

Douyin also labels persons by analyzing the behavior of users based on their habits when using its app, then labels the users and optimizes the labels. In this process, the firm uses real-time machine algorithms. Labeled users with continuously optimized and upgraded labels are also called user portraits.

After that, the intelligent label-based recommendation comes into play. Through the A/B test, platform algorithms count newly labeled videos that users like and comment on, create new label portraits through continuous optimization, and match users with newly labeled similar videos. Thus, algorithm training is deepened to realize user-centered customized content.

China’s large market has generated significant amounts of data. IDC statistics show that global big data storage volume reached 41ZB in 2019, and data generated in China accounted for about 23% of the global volume, ranking No.1 in the world. China’s significant amount of data can improve the accuracy of algorithms and provide fertile ground to optimize Douyin algorithms. Companies with larger amounts of data provide training for algorithms that is more adequate. This helps companies drive all-round innovations in their products, attract more users, generate more data, and create a virtuous cycle.

Relying on big data and intelligent algorithms, Douyin accurately captures user portraits and grasps user needs to facilitate precise positioning and drive all-round innovation (Fig. 2.14). The firm applies innovations to products and services in its business ecosystem, and it uses real-time and extensive big data to build a flexible supply chain. Douyin promotes the development of new business models and ecosystems in the industry through short videos and live-streaming e-commerce, and drives innovations in exploring demand in consumer-related industries.

Fig. 2.14

Douyin captures user portraits and assesses user needs. Source Jusha Xueyuan, CICC Research

A digitalized economy provides consumers with new models of participation in product innovation. Digitalization helps companies better and more comprehensively understand consumers and allows consumers to express their needs in new ways, creating new models for consumer participation in technological innovation. Among the new models, consumer crowdfunding (a combination of group buying and pre-purchases to raise funds for a project online) is a mature and effective model for consumers to participate in technological innovation.

Under the crowdfunding model, companies could have direct contact with consumers to “connect innovation and consumers,” providing unlimited possibilities for both entrepreneurs and consumers. As digitalization continues to advance, we believe that additional entrepreneurs will use the crowdfunding model to display their creative ideas and showcase their brands to consumers.

For example, data from china.com.cn shows that the Xiaomi Youpin crowdfunding platform launched 655 crowdfunding projects as of December 31, 2020. These crowdfunding projects had 2.74mn participants, and the highest number of participants of a crowdfunding project for a single product was about 176,000.²⁰ Through crowdfunding platforms, consumers support brands willing to innovate, promote innovations in products and consumption, and accelerate product innovations in consumer-related industries.

The rise of Generation Z consumers has created an opportunity for the growth of Xiaomi’s crowdfunding platform. Xiaomi targets younger users, and it has sought to produce “the first mobile phone for young people” since it was founded. With the rise of Generation Z, young people’s consumption behaviors have also changed, and they are more willing to try new methods of consumption. In recent years, Xiaomi’s crowdfunding platform has launched products that are popular among Generation Z consumers, such as “the first mattress for young people” and “the first set of wooden furniture for young people.”

2.3.2 Digital Economy Reduces the Cost of Consumer Participation in Technological Innovation

We divide the costs of technological innovation into four categories²¹: Design costs, communication costs, production costs, and payment and other transaction costs. Design costs include the labor cost of making product innovation plans and the cost of completing product designs . Communication costs arise from communication between departments of a company and between companies because product innovation and R&D often involve cooperation between multiple departments of a company or even multiple companies. Production costs are needed to transform innovations into products or services. Payment and other transaction costs also exist in innovation. As China’s per capita GDP is still low, it is difficult for consumers to pay to participate in technological innovation. Thus, the proportion of consumers participating in innovation in China is much lower than that in developed countries.

We believe that the development of the digital economy will change this situation, reduce the cost of consumer participation in innovation, and promote consumer participation in technological innovation. First, digitalized and modular production designs reduce design costs. Second, the popularity of open-source communities and development of the internet cuts communication costs. Third, the popularity of large-scale customized manufacturing lowers production costs for products and means that consumers participating in scientific and technological R&D only need to pay for R&D design, which helps scientific and technological innovators transform innovative designs into real products. Fourth, with the rise of internet-based financial services, various convenient payment methods such as Alipay and WeChat Pay have reduced payment costs. In particular, Alipay charges a transaction fee of 0.6–1%, substantially lower than overseas payment-service providers.

For example, in the US, non-card-issuing payment service providers such as Visa and MasterCard charge fees of 2–2.5%, and card-issuing payment service providers such as American Express charge fees of 3–3.5%. To summarize, we believe that the development of the digital economy will increase the proportion of Chinese consumers participating in innovation and facilitate the transition from the current corporate innovation model to the coexistence of three models (corporate innovation, independent consumer innovation, and open-source cooperation) in China’s consumer-related industries.