Academic journal article The Cato Journal

Rent Seeking and Entrepreneurship: Internet Startups in China

Academic journal article The Cato Journal

Rent Seeking and Entrepreneurship: Internet Startups in China

Article excerpt

Against all odds, China has developed one of the most vibrant Internet industries in the world. According to Atomico (2015), which tracked venture capital (VC)-funded startups in the world, there were 156 Internet startups that had been founded in 2003-14 and that had become billion-dollar companies (based on market capitalization) by the end of 2014 after initial public offerings (IPOs). The United States leads the list with 86 companies, followed by China's 30, and Sweden's 5. All Chinese billion-dollar startups are consumer-related, while billion-dollar startups in other countries include business applications, games, and others. Similarly, the Wall Street Journal tracked unlisted VC-funded startups and identified 78 of them whose market valuation (measured by financing terms in the most recent round of funding) had exceeded one billion dollars in March 2015 (Table 1). The list includes startups in the Internet as well as other sectors. Again, the United States leads the list with 50 ventures, followed by China's 8. All Chinese ventures are Internet-related, if Xiaomi, which tops the list of all startups and sells smartphones on the Internet, is also counted as an Internet company (Dow Jones Venture Source 2015). In short, Chinese startups are numerous, vigorous, and most successful in Internet-based consumer business.

Startups are manifestations of entrepreneurship and innovation. Vibrant startups indicate that the Chinese business environment is conducive to entrepreneurial and innovative activities. This is at odds with the general impression that China is nowhere near a business-friendly country. The Chinese institutions are considered inadequate or hostile to entrepreneurial activities. For example, the costs of starting a business in China are high, protection of property rights is inadequate, contract enforcement is lax, and financial market development is immature. Moreover, China ranks as one of the worst among the emerging countries in terms of corruption (La Porta et al. 2004), which fuels rent-seeking activities. It has been demonstrated in the literature that rent seeking undermines entrepreneurship (Baumol 1990; Murphy, Shleifer and Vishny 1990).

If rent seeking is prevalent in China, as suggested by the high-profile anticorruption campaigns in recent times, why are innovative activities so vibrant in the Internet industry? We argue in this article that rent seeking in the real sector actually encourages innovations in the Internet sector to uncover the hidden opportunities unrealizable in the real sector. Regulations designed by rent seekers always create distortions in the market, from which extra profits are generated. In China, such distortions are often reflected in above-normal prices, which benefit producers, especially large producers, while depressing consumption. A stylized Chinese startup in the Internet industry creates a new business model that offers goods or services to satisfy unfulfilled consumer demand in the real sector. Low prices are a common feature of their business models. In China, Internet trade is analogous to the underground economy in other countries where small traders escape regulations. Despite the siphoning of talent and resources into rent-seeking activities, the fact that China is an open economy allows the local startups to tap entrepreneurship from international sources to undertake innovative activities. The startups also leverage international institutions to protect the value of their innovations. The sheer size of the Chinese market heightens the value of innovations, which in turn offsets the high risk of startup ventures.

Scholars often asked why private business activities remain robust in China despite weak institutions. The conventional explanation for this paradox is that informal institutions supplant the formal ones. For example, informal financial instruments make up for the weaknesses of the formal financial institutions in allocating financial resources (Allen, Qian and Qian 2005), and personal relations and informal contracts make up for the weak institutions in contract enforcement (Yu and Zhang 2008; Kwock, James and Tsui 2013). …

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