Vernon's international product life cycle theory

176 Part 3 The Global Trade and Investment Environment

The Product Life-Cycle Theory

Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.29 Vernon’s theory was based on the observation that for most of the twentieth century, a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopi- ers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to develop cost-saving process innovations.

Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product must be produced in the United States. It could be pro- duced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Ap- parently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries.

Vernon went on to argue that early in the life cycle of a typical new product, while de- mand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new prod- uct, but it does necessitate some exports from the United States to those countries.

Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.

As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this oc- curs, cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures be- come intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a production advantage over advanced coun- tries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries.

The consequence of these trends for the pattern of world trade is that over time, the United States switches from being an exporter of the product to an importer of the prod- uct as production becomes concentrated in lower-cost foreign locations.

PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURY Historically, the product life-cycle theory seems to be an accurate explanation of interna- tional trade patterns. Consider photocopiers: The product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox ex- ported photocopiers from the United States, primarily to Japan and the advanced countries of western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addi- tion, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a consequence, ex- ports from the United States declined, and U.S. users began to buy some photocopiers from

LO 6-2 Summarize the different theories explaining trade flows between nations.

International Trade Theory Chapter 6 177

lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch produc- tion to developing countries such as Thailand. Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photo- copiers is consistent with the predictions of the product life-cycle theory that mature indus- tries tend to go out of the United States and into low-cost assembly locations.

However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most new products were introduced in the United States, there have always been important ex- ceptions. These exceptions appear to have become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet computers, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations. This may be accompanied by globally dispersed production, with particular components of a new product being pro- duced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international trade during the period of American global dominance, its relevance in the modern world seems more limited.

New Trade Theory

The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade.30 Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized em- ployees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aero- space. For example, Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers on which each new system is ultimately in- stalled. Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line where each employee has a specialized task.

New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries in which the output required to attain econo- mies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consum- ers. Alternatively, they may be produced but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized.

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LO 6-2 Summarize the different theories explaining trade flows between nations.

LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.