Product cycle theory is both supply-side (cost of production) and demand-side (income levels of consumers) in its orientation. Each of these three stages that Vernon described combines differing elements of each.
Stage I: The New Product
Innovation requires highly skilled labor and large quantities of capital for research and development. The product will normally be most effectively designed and initially manufactured near the parent firm and therefore in a highly industrialized market due to the need for proximity to information and the need for communication among the many different skilled-labor components required.
In this development stage, the product is nonstandardized. The production process requires a high degree of flexibility (meaning continued use of highly skilled labor). Costs of production are therefore quite high. The innovator at this stage is a monopolist and therefore enjoys all of the benefits of monopoly power, including the high profit margins required to repay the high development costs and expensive production process. Price elasticity of demand at this stage is low; high-income consumers buy it regardless of cost.
Stage II: The Maturing Product
As production expands, its process becomes increasingly standardized. The need for flexibility in design and manufacturing declines, therefore the demand for highly skilled labor declines. The innovating country increases its sales to other countries. Competitors with slight variations develop, putting downward pressure on prices and profit margins. Production costs are an increasing concern.
As competitors increase, as well as their pressure on price. The innovating firm faces critical decisions on how to maintain market share. Vernon argues that the firm faces a critical decision at this stage—either to lose market share to foreign-based manufacturers using lower-cost labor or to invest abroad to maintain its market share by exploiting the comparative advantages of factors costs in other countries. This is one of the first theoretical explanations of how trade and investment become increasingly intertwined.
Stage III: The Standardized Product
In this final stage, the product is completely standardized in its manufacture. Thus, with access to capital on world capital markets, the country of production is simply the one with the cheapest unskilled labor. Profit margins are thin, and competition is fierce. The product has largely run its course in terms of profitability for the innovating firm.
The country of comparative advantage has therefore shifted as the technology of the product’s manufacture has matured. The same product shifts in its location of production. The country possessing the product during that stage enjoys the benefit of net trade surpluses. But such advantages are fleeting, according to Vernon. As knowledge and technology continually change, so does the country of that production comparative advantage.