Trade Implication of the Product Cycle

Product cycle theory shows how specific products were first produced and exported from one country but through product and competitive evolution shifted their location of production and export to other countries over time. Figure 3.4 illustrates the trade patterns that Vernon visualized as resulting from the maturing stages of a specific product cycle. As the product and the market for the product mature and change, the countries of its production and export shift.

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The product is initially designed and manufactured in the United States. In its early stages (from time t0 to t1), the United States is the only country producing and consuming the product. Production is highly capital-intensive and skilled-labor intensive at this time. At time t1, the United States begins exporting the product to other advanced countries, as Vernon classified them. These countries possess the income to purchase the product in its still new-product stage, in which it was relatively high priced. These other advanced countries also commerce their own production at time t1 but continue to be net importers. A few exports, however, do find their way to the less-developed countries at this time as well.

As the product moves into the second stage, the maturing product stage, production capability expands rapidly in the other advanced countries. Competitive variations begin to appear as the basic technology of the product becomes more widely known, and the need for skilled labor in its production declines. These countries eventually also become net exporters of the product near the end of the stage (time t3). At time t2 the less-developed countries begin their own production, although they continue to be net importers. Meanwhile, the lower cost of production from these growing competitors turns the United States into a net importer by time t4. The competitive advantage for production and export is clearly shifting across countries at this time.

The third and final stage, the standardized product stage, sees the comparative advantage of production and export now shifting to the less-developed countries. The product is now a relatively mass-produced product that can be made with increasingly less-skilled labor. The United States continues to reduce domestic production and increase imports. The other advanced countries continue to produce and export, although exports peak as the less-developed countries expand production and become net exporters themselves. The product has run its course or life cycle in reaching time t5.

A final point: Note that throughout this product cycle, the countries of production, consumption, export, and import are identified by their labor and capital levels, not firms. Vernon noted that it could very well be the same firms that are moving production from the United States to other advanced countries to less-developed countries. The shifting location of production was instrumental in the changing patterns of trade but not necessarily in the loss of market share, profitability, or competitiveness of the firms. The country of comparative advantage could change.

Although interesting in its own right for increasing emphasis on technology’s impact on product costs, product cycle theory was most important because it explained international investment. Not only did the theory recognize the mobility of capital across countries (breaking the traditional assumption of factor immobility), it shifted the focus from the country to the product. This made it important to match the product by its maturity stage with its production location to examine competitiveness.

Product cycle theory has many limitations. It is obviously most appropriate for technology-based products. These are the products that are most likely to experience the changes in production process as they grow and mature. Other products, either resource-based (such as minerals and other commodities) or services (which employ capital but mostly in the form of human capital), are not so easily characterized by stages of maturity. And product cycle theory is most relevant to products that eventually fall victim to mass production and therefore cheap labor forces, But, all things considered, product cycle theory served to breach a wide gap between the trade theories of old and the intellectual challenges of a new, more globally competitive market in which capital, technology, information, and firms themselves were more mobile.

Strategic Trade Part II

Repetition

Some firms in some industries have inherent competitive advantages, often efficiency based, from simply having produced repetitively for years. Sometimes referred to as “learning-by-doing,” these firms may achieve competitive cost advantages from producing not only more units (as in the scale economics described above) but from producing more units over time. A government that wishes to promote these efficiency gains by domestic firms can help the firm move down the learning curve faster by protecting the domestic market from foreign competitors. Again similar in nature to the infant industry argument, the idea is not only to allow the firm to produce more, but to produce more cumulatively over time to gain competitive knowledge from the actual process itself.

Externalities

The fourth and final category of strategic trade involves those market failures in which the costs or benefits of the business process are not borne or captured by the firm itself. If, for example, the government believes that the future of business is in specific knowledge-based industries, it may be willing to subsidize the education of workers for that industry, protect that industry from foreign competition, or even aid the industry in overcoming the costs of environmental protection in order to promote the industry’s development. This argument is similar to those used by governments in the 1970s and 1980s to support the development of certain industries in their countries (e.g., microelectronics in Japan and steel in Korea) which was then referred to as industrial policy. In fact, this strategic trade argument could be used in support of Michael Porter’s cluster theory, in which society and industry would reap benefits of reaching critical mass in experience and interaction through promotion and protection.

Although the arguments by proponents of strategic trade are often seductive, critics charge that these theories play more to emotion than rational thought. Industries do not often learn by doing or reduce costs through scale, and governments are infamous for their inability to effectively protect (and unprotect, when the time comes) in order to promote industrial development and growth. Protection and state-supported monopolists are often some of the world’s least efficient rather than most efficient. And as always, there is no assurance that foreign governments themselves will not react and retaliate, again undermining the potentially rational policies put into place in isolation. A final note of caution about strategic trade goes back to the very origins of trade theory: many of the benefits of international trade accrue to those who successfully divorce the politic from the economic.

Strategic Trade Part I

Often criticized as being simplistic or naïve, trade theory in recent years has, in the words of one critic, grown up. One fundamental assumption that both classical and modern trade theories have not been willing to stray far from is the inefficiencies introduced with governmental involvement in trade. Economic theory, however, has long recognized that government involvement in trade. Economic theory, however, has long recognized that government can play a beneficial role when markets are not purely competitive. This theory has now been expanded to government’s role in international trade as well. This growing stream of thought is termed strategic trade. There are (at least) four specific circumstances involving imperfect competition in which strategic trade may apply, which we denote as price, cost, repetition, and externalities.

Price

A foreign firm that enjoys significant international market power—monopolistic power—has the ability to both restrict the quantity of consumption and demand higher prices. One method by which a domestic government may thwart that monopolistic power is to impose import duties or tariffs on the imported products. The monopolist, not wishing to allow the price of the product to rise too high in the target market, will often absorb some portion of the tariff. The result is roughly the same amount of product imported, and at relatively the same price to the customer, but the excessive profits (economic rent in economic theory) have been partly shifted from the monopolist to the domestic government. Governments have long fought the power of global petrochemical companies with these types of import duties.

Cost

Although much has been made in recent years about the benefits of “small and flexible,” some industries are still dominated by the firms that can gain massive productive size—scale economies. As the firm’s size increases, its per unit cost of production falls, allowing it a significant cost advantages in competition. Governments wishing for specific firms to gain this stature may choose to protect the domestic market against foreign competition to provide a home market of size for the company’s growth and maturity. This strategic trade theory is actually quite similar to the traditional arguments for the protection of infant industries, though this is protection whose benefits accrue to firms in adolescence rather than childhood.

The competitive advantage of nations

The focus of early trade theory was on the country or nation and its inherent, natural, or endowment characteristics that might give rise to increasing competitiveness. As trade theory evolved, it shifted its focus to the industry and product level, leaving the national-level competitiveness question somewhat behind. Recently, many have turned their attention to the question of how countries, governments, and even private industry can alter the condition within a country to aid the competitiveness of its firms.

The leader in this area of research has been Michael Porter of Harvard. As he states:

National prosperity is created not inherited. It does not grow out of a country’s natural endowments, its labor pool, its interest rates, or its currency’s values, as classical economics insists.

A nation’s competitiveness depends on the capacity of its industry to innovate and upgrade. Companies gain advantage against the world’s best competitors because of pressure and challenge. They benefit from having strong domestic rivals, aggressive home-based suppliers, and demanding local customers.

In a world of increasingly global competition, nations have become more, not less, important. As the basis of competition has shifted more and more to the creation and assimilation of knowledge, the role of the nation has grown. Competitive advantage is created and sustained through a highly localized process. Differences in national values, culture, economic structures, institutions, and histories all contribute to competitive success. There are striking differences in the patterns of competitiveness in every country; no nation can or will be competitive in every or even most industries.

Ultimately, nations succeed in particular industries because their home environment is most forward-looking, dynamic, and challenging.

Porter argued that innovation is what drives and sustains competitiveness. A firm must avail itself of all dimensions of competition, which he categorized into four major components of “the diamond of national advantage”:

  1. Factor conditions: The appropriateness of the nation’s factors of production to compete successfully in a specific industry. Porter notes that although these factor conditions are very important in the determination of trade, they are not the only source of competitiveness as suggested by the classical, or factor proportions, theories of trade. Most importantly for Porter, it is the ability of a nation to continually create, upgrade, and deploy its factors (such as skilled labor) that is important, not the initial endowment.
  2. Demand conditions: The degree of health and competition the firm must face in its original home market. Firms that can survive and flourish in highly competitive and demanding local markets are much more likely to gain the competitive edge. Porter notes that it is the character of the market, not its size, that is paramount in promoting the continual competitiveness of the firm. And Porter translates character as demanding customers.
  3. Related and supporting industries: The competitiveness of all related industries and suppliers to the firm. A firm that is operating within a mass of related firms and industries gains and maintains advantages through close working relationships, proximity to suppliers, and timeliness of product and information flows. The constant and close interaction is successful if it occurs not only in terms of physical proximity but also through the willingness of firms to work at it.
  4. Firm strategy, structure, and rivalry: The conditions in the home-nation that either hinder or aid in the firm’s creation and sustaining of international competitiveness. Porter notes that no one managerial, ownership, or operational strategy is universally appropriate. It depends on the fit and flexibility of what works for that industry in that country at that time.

These four points, as illustrated in Figure 3.5, constitute what nations and firms must strive to “create and sustain through a highly localized process” to ensure their success.

Porter’s emphasis on innovation as the source of competitiveness reflects an increased focus on the industry and product that we have seen in the past three decades. The acknowledgment that the nation is “more, not less, important” is to many eyes a welcome return to a positive role for government and even national-level private industry in encouraging international competitiveness. Including factor conditions as a cost component, demand conditions as a motivator of firm actions, and competitiveness all combine to include the elements of classical, factor proportions, product cycle, and imperfect competition theories in a pragmatic approach to the challenges that the global markets of the twenty-first century present to the firms of today.