The　competitive　advantage　of　cluster　firms　includes　the　cost　(basic)　and　the　innovation　(long-term)　advantages.　As　a　new　virtual　organizational　structure　of　firms,　cluster　could　effectively　combine　SMEs＇　innovation　vitality　with　the　innovation　scale　economy　of　cluster,　cultivating　SMEs＇　distinguished　innovation　capabilities.　This　paper　starts　with　the　horizontal　as　well　as　vertical　level　of　cooperation　and　competition　behavior　among　the　cluster　firms.　Then　it　explores　the　cluster　innovation　mechanism　for　the　Chinese　SMEs,　and　its　potential　external　economic　and　non-economic　effects　on　the　Chinese　SMEs.　It　is　concluded　that　cluster　innovation　will　be　a　feasible　option　for　the　Chinese　SME　industrial　cluster　in　gaining　innovation　advantage　in　the　long　run.　(c)　2006　PICMET.