The Product Cycle Theory

The product cycle theory (PCT) of trade builds on the imitation lag hypothesis in its treatment of
delay in the diffusion of technology. However, the PCT also relaxes several other assumptions of
traditional trade theory and is more complete in its treatment of trade patterns. This theory was
developed in 1966 by Raymond Vernon.
The PCT is concerned with the life cycle of a typical new product and its impact on
international trade. Vernon developed the theory in response to the failure of the United States -
the main country to do so - to conform empirically to the Heckscher-Ohlin model. Vernon
emphasizes manufactured goods, and the theory begins with the development of a new product
in the United States. The new product will have two principal characteristics: (a) it will cater to
high-income demands because the United States is a high-income country; and (b) it promises, in
its production process, to be labor-saving and capital-using in nature. (It is also possible that the
product itself - for example, a consumer durable such as a microwave oven - will be labor-saving
for the consumer.) The reason for including the potential labor-saving nature of the production
process is that the United States is widely regarded as a labor-scarce country. Thus, technological
change will emphasize production processes with the potential to conserve this scarce factor of
production.
The PCT divides the life cycle of this new product into three stages. In the first stage, the new
product stage, the product is produced and consumed only in the United States. Firms produce in
the United States because that is where demand is located, and these firms wish to stay close to
the market to detect consumer response to the product. The characteristics of the product and the
production process are in a state of change during this stage as firms seek to familiarize
themselves with the product and the market. No international trade takes place.
The second stage of the life cycle is called the maturing product stage. In this stage, some
general standards for the product and its characteristics begin to emerge, and mass production
techniques start to be adopted. With more standardization in the production process, economies
of scale start to be realized. This feature contrasts with Heckscher-Ohlin and Ricardo, whose
theories assumed constant returns to scale. In addition, foreign demand for the product grows,
but it is associated particularly with other developed countries, since the product is catering to
high-income demands. This rise in foreign demand (assisted by economies of scale) leads to a
trade pattern whereby the United States exports the product to other high-income countries.
Other developments also occur in the maturing product stage. Once U.S. firms are selling to
other high-income countries, they may begin to assess the possibilities of producing abroad in
addition to producing in the United States. If the cost picture is favorable (meaning that
production abroad costs less than production at home plus transportation costs), then U.S. firms
will tend to invest in production facilities in the other developed countries. If this is done, export
displacement of U.S.-produced output occurs. With a plant in France, for example, not only
France but other European countries can be supplied from the French facility rather than from
the U.S. plant. Thus, an initial export surge by the United States is followed by a fall in U.S.
exports and a likely fall in U.S. production of the good. This relocation-of-production aspect of
the PCT is a useful step because it recognizes - in contract to H-O and Ricardo - that capital and
management are not immobile internationally. This feature also is consistent with the very large
amount of direct investment by U.S. firms in Western Europe during the 1960s and 1970s and, in
a more recent context, by Japanese firms in rapidly growing countries in Asia (such as China,
South Korea, and Taiwan).
Vernon also suggested that, in this maturing product stage, the product might now begin to flow
from Western Europe to the United States because, with capital more mobile internationally than
labor, the price of capital across countries was unlikely to diverge as much as the price of labor.
With relative commodity prices thus heavily influenced by labor costs, and with labor costs
lower in Europe than in the United States, Europe might be able to undersell the United States in
this product. (Remember that Vernon was writing in 1966; it is less true today that Europes
labor costs are lower than those of the United States.) Relative factor endowments and factor
prices, which played such a large role in Heckscher-Ohlin, have not been completely ignored in
the PCT.
The final stage is the standardized product stage. By this time in the products life cycle, the
characteristics of the product itself and of the production process are well known; the product is
familiar to consumers and the production process to producers. Vernon hypothesized that
production may shift to the developing countries. Labor costs again play an important role, and
the developed countries are busy introducing other products. Thus, the trade pattern is that the
United States and other developed countries may import the product from the developing
countries. Figure 1 summarizes the production, consumption, and trade pattern for the
originating country, the United States.
In summary, the PCT postulates a dynamic comparative advantage because the country source of
exports shifts throughout the life cycle of the product. Early on, the innovating country exports
the good but then it is displaced by other developed countries - which in turn are ultimately
displaced by the developing countries. A casual glance at product history yields this kind of
pattern in a general way. For example, electronic products such as television receivers were for
many years a prominent export of the United States, but Europe and especially Japan emerged as
competitors, causing the U.S. share of the market to diminish dramatically. More recently, Japan
has been threatened by South Korea and other Asian producers. The textile and apparel industry
is another example where developing countries (especially China, Taiwan, South Korea, and
Singapore) have become major suppliers on the world market, displacing in particular the United
States and Japan. Automobile production and export location also shifted relatively from the
United States and Europe to Japan and later still to countries such as South Korea and Malaysia.
This dynamic comparative advantage, together with factor mobility and economies of scale,
makes the product cycle theory an appealing alternative to the Heckscher-Ohlin model.
There is no single all-encompassing test (such as the Leontief test of Heckscher-Ohlin) to verify
empirically the product cycle theory. Instead, researchers have examined particular features of
the PCT to see if they are consistent with real-world experience. For example, new product
development is critical to the PCT, and it is often the result of research and development (R&D)
expenditures. Therefore, economists hypothesize that, in the U.S. manufacturing sector, there
should be a positive correlation between R&D expenditures and successful export performance
by industry. A number of tests indicated this result, including those by Donald Keesing (1967)
and William Gruber, Dileep Mehta, and Vernon (1967). Kravis and Lipsey (1992) found that
high R&D intensity was positively associated with large shares of exports by U.S. multinational
companies (MNCs. Further more, over the last 25 years, greater shares of U.S. MNC exports
have come from overseas production, which is consistent with the direct-investment and export-
displacement features of the PCT. In addition, in 1969, Louis Wells examined the income
elasticity of demand of the fastest growing U.S. exports and found that trade in high-income-
type products indeed grew more rapidly than other products - again, an occurrence consistent
with the PCT.
Among the many other empirical works is Gary Hufbauers (1966) study on trade in synthetic
materials. Hufbauer found that the United States and other developed countries tended to export
new products while developing countries tended to export older products. Gruber, Mehta, and
Vernon (1967) also discovered that research-intensive U.S. industries had a high propensity to
invest abroad. This is consistent with the maturing product stage of the theory. In 1972, John
Morrall found that U.S. industries that were successful exporters also tended to have relatively
high expenditures on nonpayroll costs such as advertising, sales promotion, and so forth. This
finding is consistent with the product cycle theory since production of new products involves
such spending. Many other studies of PCT features have shown consistency between real-world
experience and aspects of the theory.
Raymond Vernon (1979) later suggested that the PCT might need to be modified. The main
alteration concerns the location of the production of the good when the good is first introduced.
Multinational firms today have subsidiaries and branches worldwide, and knowledge of
conditions outside the United States is more complete than it was at the time of Vernons original
writing in 1966. Thus, the new product may be produced first not in the United States but outside
the country. In addition, per capita income differences between the United States and other
developed countries are not as great now as in 1966, so catering to high-income demands no
longer implies catering to U.S. demands alone. Even with this modification, the salient features
of scale economies, direct investment overseas, and dynamic comparative advantage still
distinguish the product cycle theory from the Heckscher-Ohlin model.
One hesitates, however, to distinguish the product cycle theory so clearly from the Heckscher-
Ohlin model. Elias Dinopoulos, James Oehmke, and Paul Segerstrom (1993) constructed a
theoretical model that has PCT-type trade emerging as a result of differing factor endowments
across countries. The model utilizes three production sectors in each country: an innovating high-
technology sector, and outside-goods sector that engages in no product innovation, and a
sector that supplies R&D services to the high-technology sector. Like H-O, there are only two
factors (capital and labor), identical production functions across countries, and constant returns
to scale. Assuming that the R&D sector is the most capital-intensive sector, a capital-abundant
country produces a great deal of R&D. This enables a firm in the high-technology sector in that
country to obtain a temporary monopoly in a new product - with patent protection - and then to
export the product. After the patent expires, production occurs abroad with some export from
that location. While a complete explanation is beyond the scope of this book, Dinopoulos,
Oemke, and Segerstroms model generates PCT-type trade as well as intra-industry trade (a
concept discussed later) and a role for MNCs. Thus, Heckscher-Ohlin and the product cycle
theory may well be complementary, not competing, theories.
In similar fashion, James Markusen, James Melvin, William Kaempfer, and Keith Maskus (1995,
p. 209) introduced the idea of a life cycle for new technologies containing elements of both the
Dinopoulos, Oehmke, and Segerstrom model and the product cycle model. Noting the growing
importance of technology in the trade of industrialized countries, Markusen et al. Suggest that,
just as there is a product cycle for consumer goods, there increasingly appears to be a cycle for
techniques of production and machinery, as techniques and machines developed in industrialized
countries eventually find their way into labor-abundant developing countries.
This technology cycle is driven by the capital-abundant, high-wage countries where there is both
a cost incentive and a sufficient market demand to warrant new labor-saving technology and new
product development. The capital-abundant countries thus produce a flow of new products and
innovations, with firms often protected by a temporary monopoly via patents to produce for the
home market. Since the new labor-saving technologies are not consistent with the relative factor
abundances in the labor-abundant developing countries, those countries initially have little
economic incentive to acquire the innovations. Consequently, capital-abundant countries export
the new products utilizing the new technology. Eventually, however, as incomes start to rise in
developing countries and even new technologies are produced in the developed countries, the
machines embodying the original new technology are exported by capital-abundant countries
and the final products start being produced in the labor-abundant countries. Later, as in the
product cycle theory, the machines themselves may be produced in the developing countries and
exported fro them.
Raymond Vernon has argued that, for many manufactured goods, comparative advantage may
shift over time from one country to another. This is because these goods go through a product
life cycle. This life cycle involves a stage during which goods are invented and tested in the
market place. During this period of time, the production of the good also undergoes considerable
experimentation.
Later, when the product is successful and becomes firmly established in the marketplace, a
standardization process occurs. During this period, competing products from different
manufacturers take on an increasingly common appearance, and the manufacturing processes
used to make the good also become more and more identical. At this point, the product has
matured. It may be sold for many years in this stage, or it may be displaced over time by new
inventions.
How does the product life cycle relate to comparative advantage? The answer is simple. Early in
a products life, the country that invents the product has comparative advantage. As the country
exports the good to the rest of the world, and as the product becomes increasingly more
standardized, it is possible for competing firms in other countries to begin to gain market share,
if these firms have a cost advantage in large-scale manufacturing. In such instances, comparative
advantage shifts from the inventing country to countries where manufacturing costs are lower.
Note how this model can be used to reconcile the Leontief paradox. Let us assume that the
United States is an innovating country that produces many new products. The United States will
have comparative advantage in recently invented manufactured goods. Because these goods have
yet to become standardized, their production is apt to be quiet labor intensive. Investment in
fixed capital is likely to be postponed until it becomes certain what features are most popular
with the public and how best to automate the production of the good. Thus, U.S. exports will
tend to be labor intensive. And, because standardization involves the adoption of more capital-
intensive production techniques, if later the United States loses comparative advantage in a good
and begins to import it, this good will tend to be capital intensive.
The product life cycle model is a model that has limited applicability. It represents an attempt to
explain trade in manufactured products that require some degree of technical sophistication in
their invention, design, and development. In some cases, the theory seems to fit the facts. For
instance, color television was invented in the United States, and in the early days of the product,
the United States produced and exported this good. Then, over time, the production of color
televisions has shifted almost entirely to countries such as Japan, Taiwan, Korea, and elsewhere.
For other sophisticated products, such as computers and aircraft, the model seems to do less well.
The United States, which took the lead in the development of these goods, still retains substantial
comparative advantage despite the fact that each is now a relatively mature product. These
examples point to the fundamental weakness of the product life cycle model - its inability to
generalize its predictions about the timing of changes in the location of comparative advantage.