The world's makers of shampoo, cosmetics, soft drinks, and other consumer goods have long coveted the Chinese market. Now, with rapid economic growth, demand is taking off. Packaged foods already constitute a $47 billion category that is expanding by 8 percent a year—a pace rarely seen these days in developed markets, where sales of some types of consumer goods are stagnating or even shrinking (Exhibit 1).

Most foreign consumer goods companies position their products at the top of China's market pyramid. In effect, this approach involves building a premium brand aimed at the wealthiest 5 to 10 percent of consumers, mainly concentrated in the biggest and most sophisticated markets, such as Beijing and Shanghai. A few global companies, including Coca-Cola, Nestlé, and Procter & Gamble, have achieved billion-dollar sales with this strategy, but the rest have found it difficult to exceed $100 million in annual revenue—no more than 1 to 2 percent of their worldwide business.

Foreign companies will continue to slug it out in the premium segment because the market is still growing and margins are fat enough to earn a reasonable return. But whether foreign players...