Daimler, the German parent of Mercedes-Benz, just announced that it's upping its investment in China to the tune of almost $3 billion. Everything in China happens though joint ventures, so Daimler's partner, Beijing Automotive Corp. (BAIC) is involved. But what's really important in the master plan for Mercedes: small cars and small engines.

No less a luminary than CEO Dieter Zetsche, Mercedes' "Dr. Z," put the move in proper context (this is from Automotive World):

As early as 2020, at least one in five premium compact cars is expected to be sold in China. In the light of this enormous growth potential, we are resolutely switching to attack mode with the local production of our new compacts"….

His comments were echoed by Ulrich Walker, who runs Daimler's China operations:

[Our smaller cars]  constitute the 'Young Mercedes' product family in China, which today accounts for about 40% of our sales"…

Luxury is no longer about size

In the West, customers still expect luxury cars to be large. But that preference is changing, slowly at home and more rapidly in the developing world. Luxury there can be about a strong brand and great features — the dimensions of the package don't need to be USA-huge.

It's still difficult for carmakers like Mercedes to make this argument in established markets. However, they are looking to bring their smaller vehicles into those environments. But luxury auto growth rates are going to much higher in countries like China, so there Mercedes can be more bold.

This is important because Mercedes doesn't want to poach Chinese customers from other carmakers — it wants to get them early. And to do that, it needs smaller platforms that offer affordable, entry-level luxury: that first addictive taste of the best.

And this isn't limited to features

Daimler and BAIC will also start constructing small-displacement engines — 4-cylinder powerplants — that will propel its family of small luxury cars. If none of this sounds likes your father's Mercedes, that's because it definitely isn't.

But China will enable Daimler to set up an incubator of sorts, refining its approach to small luxury, perfecting the technology, and then using it to establish its more diminutive vehicles classes in the West.

This will be extremely useful for the U.S. market, where rising, government-mandated fuel-economy standards are forcing luxury carmakers to totally re-examine their lineups.

But will this undermine the brand?

Delivering small luxury in China will ultimately be good for Daimler as a carmaker. The question is, Will the very existence of small Mercedes-Benz automobiles anywhere in the world undermine the brand's plutocratic image in the developed world?

The answer is yes, but it doesn't really matter. Growth rates in China are expected to be robust in the coming years. Mercedes can afford to be seen as…smaller than it has been, even at the risk of cheapening itself with its longstanding customers elsewhere in the globe.

There is a more significant problem, however. By focusing on compacts, Daimler may be ceding the potentially large — an highly profitable — Chinese large SUV market to competitors. But then again, it's eyeballing a future that fits with its global strategy, which is decidedly friendly towards micro-luxury.

Daimler is betting that over time, the stigma of small will fade. It's a hefty bet. It may never win in the developed world. But in China, it could see the risk pay off…big time.