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International Trade Theories:

Product Life Cycle Theory & Competitive Advantage Theory

T.J. Joseph

Product Cycle Theory


Introduced by Raymond Vernon in 1966 Differs from previous trade theories

Focus on the product, not its factor proportions


Puts less emphasis on comparative cost doctrine

Increased emphasis on technologys impact on product cost


the innovation,

the effects of scale economies

Explains international investment

Product Cycle Theory: Vernons Premises


Vernon uses two technology-based propositions:
Technical innovations, leading to new and profitable products, require large quantities of capital and skilled labor The product and the methods for manufacture go through different stages of maturation

Stages of the Product Cycle


Most manufactured products have a kind of life cycles, similarly to the human beings: New-product phase (I), Growth phase (II), Maturity phase (III), Decline phase (IV) (V)
Phase I: Product is produced and consumed only in the innovating country. Phase II: Production is perfected in the innovating country and increases rapidly to accommodate rising demand at home and abroad. The innovating nation has a monopoly in both the home and export markets.

Phase III: The product becomes more or less standardized and the innovating firm may find it profitable to license other domestic and foreign firms to manufacture the products. Thus the imitating country starts producing the product for domestic consumption
Phase IV: The imitating country begins to undersell the innovating country in third markets, and production of the product in the innovating country declines Phase V: The imitating country starts underselling the innovating country in the latter's markets as well, and production of the product in the innovating country declines rapidly or collapses Production moves to low cost production locations

The Product Cycle Model


Phase I Phase II Phase III Phase IV Phase V

New Product

Maturing Product

Standardized Product

Source: Raymond Vernon, International Investment and International Trade in the Product Cycle, Quarterly Journal of Economics (May 1966), pp.190-207

International Product Life-Cycle


Most new products initially conceived and produced in the US in 20th century US firms kept production close to the market
Minimize risk of new product introductions Demand not based on price yet; production cost not an issue

Limited initial demand in other advanced countries


Exports more attractive than production there initially

With demand increase in advanced countries


Production follows there.

With demand expansion elsewhere


Product becomes standardized production moves to low production cost areas Product now imported to US and to advanced countries

The Product Cycle and Trade Implications


Explains the competitive evolution of a product, shifting location of production and export to other countries Same firm moving production locations Changing pattern of trade is due to shifting location of production Therefore, country of comparative advantage would change Explains international investment recognizing the mobility of capital (factor mobility) across countries Limitations
Most appropriate for technology-based products Some products not easily characterized by stages of maturity

National Competitive Advantage


(Porter, 1990)

Why does a nation achieve success internationally in a particular industry? Why are firms based in a particular nation able to create and sustain competitive advantage against its global competitors in a particular field?

Overview
Introduced by Michael Porter, a famous Harvard business professor in 1990 Conducted a comprehensive study of 100 industries in 10 nations to learn what leads to success Believes the standard classical theories on comparative advantage provides only a partial explanation They do not say why these countries are more productive compared to others A nation attains competitive advantage if its firms are competitive And, firms become competitive through innovations Innovation either technical improvements to the product or to the production process

The Diamond of National Advantage


Four determinants of National Competitive Advantage (Porters Diamond)
1. Factor Conditions 2. Demand Conditions 3. Related and Supporting Industries

4. Firm Strategy, Structure and Rivalry

1. Factor Conditions
Key factors of production (or specialized or advanced factors like skilled labour, capital and infrastructure) are created, not inherited They are difficult to duplicate, and create competitive advantage

Non-key factors (basic factors) like unskilled labour can be obtained by any firm and do not generate sustained competitive advantage Lack of resources actually helps countries to become competitive (Eg: Switzerland, Japan, Sweden)

2. Demand Conditions
Sophisticated domestic market is an important element in producing competitiveness

Makes firms to sell superior products as the market demands high quality
Closeness to such consumers enables the firm to learn the needs & desires of consumers [same argument as in the first stage of Product Cycle Theory]

Helps the firm to be competitive in the global market


Example: French Wine industry

3. Related and Supporting Industries


A set of strong related and supporting industries is important to the competitiveness of firms

Includes suppliers and related industries


local suppliers cluster around producers (upstream and/or downstream industries), and add to innovation

Advantages of such clustering or agglomeration:


Potential technology knowledge spillovers

Disadvantages:
Potential poaching of your employees by rival companies Increase in competition, decreasing profit margin Ex: Detroit and Silicon Valley in U.S.

4. Firm Strategy, Structure and Rivalry


Strategy
Investment plans, use of labour force all depends on the countrys capital market and labour market i.e., conditions in the home market

Structure
Management styles
But, there is no single managerial, ownership or operational strategy universally appropriate

Rivalry
Intense competition spurs innovation Example: Japanese automobile and electronics industries

Determinants of National Competitive Advantage: Porters Diamond


Firm strategy, structure, and rivalry Factor endowments Related and supporting industries Demand conditions

Note: Governments can influence all four

So What for business?


First mover implications
invest to be first, particularly in global industries or in markets which can support a few firms

Location of production is a key variable Government Policy implications


Govt. plays an important role in Porters diamond model. Govt. can influence through: Subsidies to firms, either directly or indirectly Taxes applicable to corporations, business, etc. Educational policies affecting labour skills Enforcement of standards

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 21st century present to the firms of today Cyinkota, et al. (2003)

References
International investment and international trade in the product cycle, Raymond Vernon, Quarterly Journal of Economics, 1966, (pp.190-207) The Competitive Advantage of Nations, Michael E. Porter, Harvard Business Review, March-April, 1990. Porters Competitive Advantage of Nations: An Assessment, Robert M. Grant, Strategic Management Journal, Vol.12, pp.535-548 (1991) International Business, Charles W L Hill and Arun Kumar Jain, Tata McGraw-Hill: New Delhi. International Business, Michael R. Czinkota, Ilkka A. Ronkainen, Michael H. Moffett, (pp. 129-133)

References
1. Chapters 5, International Business by Charles W. Hill and Arun K. Jain, Tata McGraw Hill publication. 2. Chapter 2, International Business by Oded Shenkar and Yadong Luo, Wiley publication.