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). Internet startups are not a part of this story, however. The vitality of the Chinese Internet startups is not a manifestation of the working of informal institutions. Instead, the Chinese Internet industry functions under a set of private rules installed by the platform operators, who work as national champions to protect the domestic market from foreign penetration. The bureaucrats support and endorse such rules, which govern Internet trade more effectively than public regulations. More importantly, these rules reinforce rather than undermine the power of the state. The platform operators also invest in public goods that underpin the growth of the Internet industry. The Chinese Internet startups thrive in spite of weak institutions because they work under an umbrella provided by the platform operators. With a commitment to protect state interests, the platform operators are able to keep the government's hands off the market and therefore create a safe haven for startups. The umbrella contains a set of private rules that, while safeguarding the state interests, promote entrepreneurship and competition to enrich the platforms.
The remainder of this article is organized as follows. First, a theoretical background is provided for the relationship between the state and entrepreneurship. Second, we discuss the unique combination of weak institutions and strong organizations that underlie the development of China's Internet industry. Next, we present a case study of Chinese Internet startups in taxi app, retail, and O2O (online to offline) businesses, highlighting the Internet economy as a complement to real sector deficiencies. Finally, we explain how the Internet platform operators create a favorable business environment for the Internet startups while compromising with the state interests.
The State and Entrepreneurship
It is well documented in the literature that the state has an important role to play in promoting entrepreneurial activities. The state has to establish and maintain good institutions that reduce transaction costs and risks in business undertakings. For example, institutions that protect property rights and enforce contracts are considered critical for the development of a market economy in which private enterprises play a major role in resource allocation (North 1990). While establishing and maintaining good institutions is important for the functioning of the markets, the state has to refrain from intervening in the markets if private enterprises are to thrive. The inclination of the state to intervene encourages rent-seeking activities that undermine private entrepreneurship. Rent-seeking activities are likely to be rampant when the state is potent but prone to the influence of private interests due to weak institutional constraints (Lin 2009). Rent seeking occurs not because of a lack of laws and regulations, but because laws and regulations are not institutionalized and can be applied in a discretionary way by the authorities (Schneider 2002).
Baumol (1990) has demonstrated that entrepreneurship can be directed to productive or unproductive activities. When more entrepreneurship is directed toward unproductive activities, such as rent seeking, less entrepreneurship will be available for productive activities, such as starting new businesses. Whether entrepreneurship is directed toward productive or unproductive activities depends on the reward system in the society. Widespread corruption indicates that rent seeking yields good returns in a society. In the same vein, Murphy, Shleifer, and Vishny (1990) have argued that when more of a nation's talent is allocated to distributive functions, such as rent-seeking-oriented regulations, less talent will be devoted to creative functions, thus impeding the nation's growth potential.
According to the above theoretical assertions, we should not expect private entrepreneurship to thrive in China given its weak institutions. For example, institutions for property rights protection and investor protection are apparently inadequate (Allen, Qian, and Qian 2005). Although privately owned business firms have already been recognized by the PRC Constitution, state expropriation of privately owned firms remains a real risk (Hsia 2007). Market entry is strictly regulated in certain industries to protect established firms (Djankov et al. 2002). Contract enforcement remains difficult in general (Kwock, James, and Tsui 2013). The weaknesses in property rights protection and contract enforcement not only discourage risk-taking business ventures, but also prompt the investors to seek political connections (Li et al. 2008), which nurture rent-seeking behavior.
Economic growth is still possible under weak institutions if a strong state has sufficient capacity to chart the course of economic growth by coordinating private actions (Wade 1990). However, state-led growth is normally not conducive to private entrepreneurship, although the bureaucrats themselves may act like entrepreneurs as in the case of China (Oi 1995, Chen 2016). Baumol, Litan, and Shramm (2007) classified capitalism into four kinds: state-led, oligarchic, big firm-led, and entrepreneurial. The taxonomy depends on who dictates the resource allocation in the economy. China could easily fall into the category of state-led capitalism, in which the state rather than private entrepreneurs dictates the allocation of resources. There are observations that, in recent years, state and state-controlled enterprises have advanced their power in allocating resources at the expense of private firms (guo jin min tui) (Adams 2011). Huang (2008) has demonstrated that in the post-1978 Chinese economic development course, when the state increased its power in resource allocation, private entrepreneurship receded...