1. Explain the product life cycle theory its connection with FDI.

The Product Life Cycle Theory set forth by Vernon (1966, 1971) has intended to address the
apparent inadequacy of the comparative advantage framework in explaining trade and foreign
investment and to concentrate on the issues of timing of innovation, effects of economies of
scale and, to a lesser extent, the role of uncertainty. Product life cycle theory also seeks to
explain how a company will begin by exporting its products and eventually undertake foreign
direct investment (FDI) as the product moves through its life cycle. Besides that, the theory
also says that for a number of reasons, a countrys export eventually becomes its import. The
theory has suggested three stages in the life of a product, there are new product stage,
maturing product stage and standardized product stage. FDI occurs in the later two stages,
there are in the maturing product stage and standardized product stage.
In new product stage, a firm introduces an innovative product in response to a felt
need in the domestic market. As the fortunes of the product are not known, it is produced in a
limited quantity and is sold mainly in the domestic market. Export are either non-existent or
take place in a limited way, gradually growing late in a new product stage. Overall, in this
stage, a product is produced in the home country only, as its fortunes are not yet known. The
production process is kept close to the research department that has developed the product.
Next, for the maturing product stage, as the product picks up in consumer acceptance
and popularity, demand for it rises both in domestic as well as in foreign markets. The
innovating firm sets up manufacturing facilities abroad to expand production capacity, and to
meet growing demand from domestic and foreign consumers. Domestic and foreign
competitions begin as the product emerges clear winner in the market. Near the end of the
maturity stage, attempts are made to produce the product in the developing countries. Two of
the characteristics of this stage are a decline in the need for flexibility and an increased
concern for cost rather than product characteristics. However, as the product matures, the
demand increases while there is also an increase in standardization, which leads to a lower
need for flexibility and higher expectations of economies of scale and long term
commitments. Overall, in this stage, the firm directly invests in production facilities in
countries where demand is high thus necessitating own production facilities.
Standardized product stage is the last stage in the product life cycle theory. Here,
market for the product stabilizes. The product becomes a commodity, the market becomes
price sensitive and the manufacturers are motivated to search for low cost producing countries
in order to bring down the cost of production. As a result, the product begins to be imported
into the innovating firms home country. In some cases, imports may result in winding up of
domestic production facilities. Overall, in this stage, increased competition creates pressures
to reduce production costs. In response, the company builds production capacity in low-cost
developing nations to serve its markets around the world.
The advantage of product life cycle is its flexibility in explaining not only why trade
takes place and also why FDI replaces trade. Next, product life cycle theory also has many
takers, for example, the product life cycle model suggests that many products go through a
life cycle during which high-income, mass consumption countries are initially exporters, then
lose their export markets and finally become importers of the product.