5 – Theories of International Trade

Introduction:

The key question at this point is why one country’s business firms should migrate to another country when that country’s industries likewise create and market goods. What is the foundation of international business? Several theories have been created to explain the fundamentals of international business.

5.1 International Trade Theories: Mercantilism

Mercantilists believed exporting more than imports was the only way for a country to become wealthy and strong. An inflow of bullion or precious metals, particularly gold and silver, would compensate for the resulting export surplus. As a result, the government had to do everything it could to boost the country’s exports while discouraging and restricting imports (particularly the import of luxury goods).

The central claim of Mercantilism was that “a nation’s wealth and success are reflected in its stock of precious metals such as gold and silver,” as gold and silver were the currency of trading nations at the time. The fundamental principle of mercantilism is maintaining a trade balance in which exports exceed imports. The mercantilist theory urged government action based on this idea. That is, they aimed to boost exports while minimising imports. It meant that tariffs and quotas would regulate imports, while exports would be restricted through subsidies.

Criticism

1. According to the theory, commerce is a zero-sum game in which a gain by one results in a loss by another. Adam Smith and David Ricardo illustrated the approach’s shortsightedness by demonstrating that commerce is a positive game or a situation where all countries benefit.

 

2. Mercantilists determined a country’s wealth by the amount of precious metals it held. In contrast, today, we evaluate a country’s wealth by its stock of human-made and natural resources that may be used to produce commodities and services. The higher the stock of usable resources, the greater the flow of commodities and services to satisfy human desires and raise the nation’s standard of living.

5.2 Absolute Cost Advantage Theory

According to Adam Smith, trade between two nations is based on absolute advantage. When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity but is less efficient than (or has an absolute disadvantage concerning) the other nations in the production of another, both nations can benefit by each specialising in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage. The resources are used more efficiently due to this process, and the output of both commodities increases. Smith says, “Whether advantage which one country has over another by natural or acquired means is irrelevant.”

Assumption

Adam Smith believed that free commerce benefited all nations and passionately promoted a laissez-faire regime (i.e., As little government interference with the economic system as possible). To illustrate, consider two countries A and B that have absolute variations in the costs of manufacturing a commodity, X and Y, respectively, at a lower absolute cost of production than the other. The following are the absolute cost differences:

In the above example, country A has an absolute advantage in producing X (since 10X is greater than 5X), and country B has an absolute advantage in producing Y. (for 10Y is greater than 5Y). This is represented as (10X of A)/ (5X of B) >1> (5Y of A)/ (5Y of B) (10Y of B).

Trade between two countries will benefit both if A specialises in producing X and B in producing Y, as illustrated below:

Commodity  Country 	Production before trade (1)		Production after trade (2)		Gains from trade (2 – 1)
	X	Y	X	Y	X	Y
A	10	5	20	—	+10	-5
B	5	10	—	20	– 5	+ 10
Total production	15	15	20	20	+ 5	+5

 

Criticism

1. The theory is hazy and unclear.

2. According to this idea, every country should be able to produce certain products at a lower cost than other countries while producing other products at a higher cost than other countries. Only under such conditions does international trade take place. However, most developing countries do not have the absolute advantage of producing any commodity at the lowest possible cost, despite the fact that they participate in international trade. As a result, Smith’s analysis is flawed and impractical.

Case: Absolute Cost Distinction

According to Adam Smith, the Father of Economics, the basis of international trade was absolute cost advantage. There may be a circumstance when two countries can produce a commodity. Still, the cost of producing the commodity in one country is significantly lower than the cost of producing it in the other. In such a circumstance, the commodity will be manufactured in the country with the lowest manufacturing costs. This is detailed further down. Suppose:

Ten days of labour in India can generate 100 units of cotton, or In India, 10 days of labour might result in the production of 50 units of jute.

In Pakistan, 10 days of labour might produce 50 units of cotton, or In Pakistan, ten days of labour may produce one hundred units of jute.

In this scenario, the same labour days in India can generate either 100 or 50 units of cotton. Cotton and jute have a cost ratio of 100:50, or 1 unit of cotton Equals 1/2 unit of jute. Similarly, the cost ratio in Pakistan is 50:100-, or 1/2-unit cotton = 1 unit jute or 1 unit cotton = 2 units jute.

Absolute cost discrepancies exist when one of the two countries can produce the commodity at a significantly lower cost than the other. In the preceding example, India has an absolute advantage over Pakistan in cotton output, whereas Pakistan has a similar absolute advantage over India in jute production. India’s supremacy in cotton production can be reflected in the fact that:

100 cotton units in India/50 cotton units in Pakistan > 50 jute units in India/100 jute units in Pakistan

Now, if India and Pakistan are a part of the same country, each will specialise in only one item, namely cotton production in India and jute production in Pakistan. The division of labour between the two regions should increase total output. This is exactly what happens when these two countries engage in international trade. India will specialise in cotton production and export a portion of its output to Pakistan, as opposed to importing jute. India will be willing to engage in trade if it can obtain more than half a unit of jute for one unit of cotton (this is the cost ratio within India). On the other hand, Pakistan is willing to exchange up to two units of jute for one unit of cotton. As a result, commerce between the two countries will be very profitable, ranging from 1/2 to 2 units of jute for one unit of cotton. As a result, international trade will undoubtedly occur in the presence of a significant cost differential. However, trading between the two countries will not be long-term or permanent.

There is now relatively little commerce on this basis. Figure 5.2 depicts this condition.

 

The production-possibility curves for India and Pakistan are shown in Figure 2.1, with 1 unit of cotton equaling 1/2 unit of jute and 1 unit of cotton equaling 2 units of jute, respectively. Line AB depicts India’s position, where the distance along the Y axis, i.e., OA (cotton), is double the distance along the X axis, i.e., OB (jute). Similarly, line AC represents Pakistan’s position, where the distance along the Y-axis, OA (cotton), equals half the distance along the X-axis, OC (oil) (jute). BC is the amount of pure surplus that can be allocated between the two countries if trade occurs. Any exchange rate between B and C will be beneficial to both countries.

5.3 Theory of Comparative Cost Advantage

According to the Comparative Cost Theory, if free trade is allowed, countries will tend to specialise in the business (production and marketing) of those items with a comparative low-cost advantage and import other goods with a comparative cost disadvantage. This specialisation contributes to the mutual benefit of the countries involved in international trade.

In 1817, David Ricardo illustrated the Comparative Cost Theory. He applied a two-country, two-commodity model. His model’s conclusions are as follows:

1. Trade between two countries is lucrative when one country produces one good at a lower cost than another, and the latter produces another good at a lower cost.
2. Trade between two countries is also advantageous when one country produces more than one product efficiently, but one of these products is produced more efficiently than the other.
3. Both countries can engage in international trade if one country specialises in a product that is more efficient than the other.

Theoretical Assumption

The assumptions of the comparative cost advantage theory are as follows:

1. There are only two countries in the world.
2. They both manufacture the same two commodities.
3. Both countries have comparable tastes.
4. The single component of production cost is labour.
5. The labour supply remains constant.
6. All labour units are homogeneous.
7. The labour cost, i.e., the number of labour units used to manufacture each commodity, determines the prices of the two commodities.
8. The law of continuous returns governs production.
9. Technological knowledge remains constant.

• Trade restrictions between the two countries are based on the barter system.
• Production factors are perfectly movable within each country but perfectly stationary across borders.
• There is free trade between the two countries, with no trade barriers or restrictions on commodity movement.
• Trade is free of transportation costs.
• In both countries, all production elements are completely utilised.
• Because the worldwide market is ideal, the exchange rate for the two goods is the same.

Theoretical Explanation

Assume that in England, a unit of wine requires 120 men for a year, while a unit of fabric requires 100 men for the same time period. In Portugal, however, the same amount of wine and cloth required 80 and 90 men, respectively. As a result, England employs more labour than Portugal in producing wine and textiles. As a result, Portugal has a distinct advantage in wine and fabric. Producing wine and exporting it to England are two of Portugal’s major advantages. Because the cost of producing wine for 80/120 men is cheaper than the cost of producing cloth for 90/100 men. On the other hand, it is in England’s best interests to specialise in fabric manufacturing, where it has the least comparative advantage. Because the cost of producing fabric in England is lower (100/90 men) than that of producing wine (120/80 men),. As a result, commerce benefits both countries.

Theoretical Derivatives

The benefits hoped for from this theory are as follows:

1. Efficient allocation of global resources.
2. Maximizing global output at the lowest possible cost.
3. Product pricing in global markets has become more or less equal.
4. Global demand for resources and products will be optimised.

Case Study: Comparative Cost Distinction

A second possibility is that two countries can manufacture two commodities. The production factors may be distributed so that one country can create both commodities cheaper than the other. Still, the greater advantage lies in producing one commodity rather than two. As a result, specialisation is required. This is detailed further down.

Suppose:

In India, 10 days of labour might yield 100 units of cotton or jute. Ten days of labour in India may create one hundred units of jute.

In Pakistan, 10 days of labour might result in the production of 40 units of cotton or In Pakistan, 10 days of labour might produce 80 units of jute.

In this case, the internal cost ratio of cotton and jute in India is 100:100, or one unit equals one jute unit.

Similarly, in Pakistan, the internal cost ratio between cotton and jute is 40:80, or 1 unit of cotton = 2 units of jute.

The comparative cost difference suggests that one of the two countries has an absolute advantage in producing one commodity. In this case, India has a clear advantage in manufacturing both items because it can produce cotton and jute at a lower cost than Pakistan. However, India has a comparative edge in cotton production over jute:

100 cotton units in India/40 cotton units in Pakistan > 100 jute units in India/80 jute units in Pakistan

On the other hand, Pakistan has cost disadvantages in producing both items. Still, its comparative cost disadvantage in jute production is less than in cotton production. To put it another way, Pakistan enjoys a comparative cost advantage in the same jute production as cotton:

80 jute units in Pakistan/100 jute units in India > 40 jute units in Pakistan/100 jute units in India

International commerce will benefit both countries if one specialises in the production of the commodity for which it has a comparative cost advantage. As a result, India will be willing to concentrate on cotton and export a portion if it can acquire more than one unit of jute for one unit of cotton. On the other hand, Pakistan will specialise in jute if it obtains one unit of cotton for every two units. Any rate of 1 to 2 jute units for 1 cotton unit will benefit both countries. Under these conditions, international trade is advantageous and thus feasible between the two countries. Figure 5.2 explains the notion of comparative advantage.

The line AB in the illustration depicts the production-possibility curve for India and is based on a cost-ratio of one unit of cotton equaling one unit of jute. Line AC, based on the internal cost ratio of l unit of cotton = 2 units of jute, explains the production-possibility curve for Pakistan. BC is a pure economic surplus that the two countries will share through trade. Any exchange rate between B and C will benefit both countries.

1. Theories have been criticised:

For a very long time, the Ricardo-developed and Mill et al.-modified classical theory of comparative cost held a monopoly on the market. It was regarded as the most appropriate explanation of the foundations of international trade. Prof. Samuelson adds, “If theories, like females, could win beauty contests, the comparative advantage would undoubtedly rate high in that it has an aesthetically logical form.” Despite its popularity, several modern economists, such as Bertil Ohlin and Frank Graham, have critically examined the thesis. Ohlin characterises the idea as awkward and harmful, i.e., overly complicated and unreal. Furthermore, it is based on an unrealistic premise, and as a result, it has been severely criticised as follows:

2. The labour cost assumption is no longer valid:

The most direct criticism levelled at the theory is due to its assumption of labour costs. The assumption of the labour theory of value, upon which it is built, has long been abandoned. In practice, all costs are now assessed in terms of money. As a result of the failure of this major support, the argument falls flat. In this case, it may be argued in favour of the theory that condemning it only based on this assumption would be unjust. Because of the prevalent conviction in the labour theory of value, Ricardo stated the theory regarding labour costs. However, even if the assumption of labour costs is dropped and cost disparities are expressed in monetary terms, the theory’s core premises remain valid.

3. Labour is not the only factor:

Another criticism of the comparative cost theory is that it considers labour as the sole production factor. In the modern enterprise, variables such as ‘money’ and ‘entrepreneur’ are more important than labour. On this basis, limiting the cost of production to labour costs is exceedingly impractical and renders the theory worthless.

4. Unreasonable assumption of constant costs:

The classical theory is founded on the unrealistic assumption of constant costs in actual life. However, all productions are liable to rising costs or declining returns after a certain point. As a result, extra quantities beyond this point can only be manufactured at a higher cost. As a result, with each rise in output, the cost ratios in the two countries may be altered to the point where they represent equal differences rather than comparative disparities. As a result, the law of growing costs suggests another limitation of comparative cost.

5. Overemphasis on the supply side:

Ohlin critiques the theory for ignoring demand conditions entirely. He considers the idea “little more than a condensed description of supply conditions.” Classical economists justified the cost difference only based on supply conditions due to their assumption of constant costs. As we have seen, costs are not constant; rather, they fluctuate in response to variations in output, which depend on the level of demand.

6. Static theory:

The theory is static because it takes many things for granted and assumes they are unchangeable. Assumptions such as “full employment” and “constant and fixed supply of factors of production” are distant from reality. Everything in the real world is changing. As a result, the idea does not fit into the dynamic nature of today’s world.

7. The assumption of complete mobility of factors within a country and perfect immobility of factors between countries is invalid:

Ohlin considers this notion to be harmful and deceptive. If the components are mobile within a country, why are there salary variations in different jobs and interest rates in different regions? He considers the classical notion of comparative costs a clumsy analytical tool. Ohlin challenges the traditional concept of the immobility of production factors between countries as the foundation of international trade. For him, factor immobility is not only a trait of international trade but also exists within various regions of the same country.

8. The assumption of perfect competition is implausible:

The comparative cost theory, like other classical economists’ theories, is founded on perfect competition. However, modern economists have convincingly demonstrated that perfect competition does not occur anywhere. What we have here is a form of imperfect competition.

9. Absence of transportation expenses:

The theory implies that transportation costs are absent. However, transportation costs do influence the direction and volume of international trade. There are various industries where transportation costs are higher than production costs. A commodity cannot be traded internationally unless the difference in manufacturing costs between the two countries exceeds the cost of transporting it from one country to another. As a result, transportation costs are just too significant to be overlooked. For example, Germany was once one of the main coal exporters, but several nearby German ports found it more cost-effective to import coal from Britain. Transport expenses outweighed the comparative advantage in this case.

10. Based on a two-country – two-commodity model:

The theory has also been questioned because it considers only two countries with only two commodities to exchange. In practice, commerce is multilateral and involves many countries. However, this is not a damaging complaint. Even removing this assumption will not result in a significant change in the theory’s essential components.

• Comparative advantage and specialisation: According to Professor Graham, the theory falls apart when we discover that comparative advantages would never result in complete specialisation by two countries that engage in international trade. This is possible when one country is large, and another is small. The little country can completely specialise because “it can sell its surplus to the other country.” However, the larger country cannot have such complete specialisation because

(a) it will not be able to meet all of its requirements entirely from the foreign country, and

(b) If it fully specialises in a particular production, its surplus output will be of such magnitude that the importing small country will not entirely absorb it.

5.4 Theory of Relative Factor Endowment

Eli Heckscher and Bertil Ohlin, two Swedish economists, established the factor proportion theory of international trade, also known as the modern theory of international trade. Heckscher proposed the Modern Theory of International Trade in a 1919 paper. Bertil Ohlin, his pupil, elaborated on it in a research paper published in 1924 and then in his book “International and Inter-regional Trade,” published in 1933. This idea does not contradict, but rather supports, the Comparative Cost Theory of International Trade. According to comparative cost theory, international trade occurs due to differences in comparative costs. However, it sheds little information on the mechanisms explaining the disparity in comparative costs. On the contrary, the modern theory of international commerce elucidates the causes of variation in international trade.

Theory Representation

According to this notion, different countries worldwide have varied levels of factor endowment. For example, certain countries have a relatively large labour supply, but others have a relatively large supply of capital. The prices of the factors change because of differences in factor endowments. Their relative scarcity or availability determines the price difference between the factors. The costs of the commodities change due to differences in the pricing of the factors. As a result, according to this hypothesis, the fundamental reason for differences in comparative costs is a difference in factor endowment. Thus, international trade occurs due to differences in factor endowments and, as a result, price differences.

Each country will export the commodity in which such a factor is employed, whose supply is comparatively abundant and price is significantly lower. On the other hand, it will import that commodity in the manufacturing of which that factor is employed, the supply of which is somewhat rare, and the price is substantially higher. This theory contends that supply conditions alone determine the pattern of international trade. BO Sodersten states, “Some countries have a lot of capital, whereas others have a lot of labour.” According to the hypothesis, countries with much capital will export capital-intensive commodities, while those with a lot of labour will export labour-intensive goods.”

Definitions

Salvatore states, “The Heckscher-Ohlin Theory suggests that the most fundamental source of trade is a difference in relative factor endowments and factor prices between nations.” According to this theory, each nation will export the commodity in which a large amount of relatively abundant and cheap factor is used and import the commodity in which a large amount of relatively rare and expensive factor is used. The theory also predicts that trade will reduce the disparity in factor prices across countries.

“The immediate cause of inter-regional trade is always that commodities may be bought cheaper in terms of money than they can be produced at home,” says Ohlin, “and this is the situation of international trade.”

Theoretical Assumptions

Some of the theory’s assumptions are outlined below:

1. This theory concerns two countries, two commodities, and two variables. As a result, it is known as the 2 2 2 model.
2. Each commodity has the same production function in both countries.
3. Factors move within a country but are immobile between countries.
4. All markets have ideal competition. As a result, (i) all factors are fully engaged, (ii) factors are compensated based on their marginal productivity, and (iii) commodity prices are equal to their marginal productivity.
5. There are no restrictions on the interchange of products, implying that free commerce prevails between two countries.
6. Consumer tastes and preferences are the same in both nations.
7. The manufacturing technique used in both countries is the same.
8. There is a lack of transportation costs.
9. Factor endowments fluctuate among countries.
10. Goods can be categorised based on factor intensity, such as capital-intensive goods against labour-intensive goods, and so on.
11. The production function of all items is first-degree homogenous. It means that if all factors of production are doubled, output will be doubled.

5.4.1 Theoretical Explanation

“International trade is a subset of inter-regional trade,” says Ohlin. Varied regions have different factor endowments; for example, some places have an abundance of labour but a scarcity of capital, whereas others have an abundance of capital but a scarcity of labour. Diverse goods have different production functions, which means that different elements are combined in different proportions to produce different commodities. Some things are created by combining significant labour with a small proportion of capital. Other things are manufactured with relatively little labour and a large proportion of capital. As a result, each location is ideal for manufacturing commodities with a relatively ample supply of the needed ingredients. An area is not suited for producing commodities for which the fundamental ingredients are in short supply or nonexistent. As a result, different locations have varying capacities to produce various commodities. Differences in factor endowments are thus the primary cause of international commerce and inter-regional trade.

“The immediate cause of inter-regional trade is always that commodities may be bought cheaper in terms of money than they can be produced at home,” says Ohlin, “and this is the situation of international trade.” Heckscher accepted the classical idea of comparative costs in his 1919 article, “The Effect of Foreign Trade on the Distribution of Income,” and stated that international trade occurred due to differences in comparative costs. However, traditional theory failed to explain the disparity in comparative costs. Heckscher responds to this question by citing the following reasons for differences in comparative costs:

1. Disparity in factor endowments
2. Variation in factor intensities

The immediate cause of international commerce, according to the Heckscher-Ohlin Theory of International Trade, is a difference in relative commodity prices. The difference in relative prices of commodities is caused by a difference in the amount of factor endowment, such as capital and labour, between the two countries. As a result, there is a disparity in the relative supply and demand for factors. The prices of the elements differ as a result of these variances. The difference in relative pricing of commodities occurs due to differences in factor prices, and this disparity is the primary cause of international commerce.

Because domestic prices are high, goods that require scarce factors on a large scale are imported. On the contrary, because domestic costs are cheap, commodities that require abundant ingredients on a huge scale are exported. For example, if capital is plentiful in the United States, it will be comparatively cheap. As a result, the United States will export capital-intensive goods. On the contrary, if labour is plentiful in India, it will be relatively inexpensive. As a result, India will export labour-intensive items.

5.4.2 Relative Factor Endowment Concept

The abundance or scarcity of Heckscher-Ohlin theory variables has been described using two criteria:

Relative Factor Endowment Price Criterion

The price criteria of factor endowment indicate that a country where capital is relatively cheap and labour is relatively expensive is referred to as a capital abundant country, even if the capital in that country is relatively small. On the other hand, if capital is comparatively expensive and labour is relatively cheap, a country is said to be capital-scarce, even though the quantity of capital in the country is substantially greater. In other words, the criterion of factor abundance or scarcity is the price of the factor rather than its quantity.

Physical Relative Factor Endowment Criteria

The physical criterion of factor abundance or scarcity states that if a country’s capital ratio is greater than its labour ratio compared to another country, it is referred to as a capital-intensive country. Similarly, if a country’s labour ratio is higher than its capital ratio compared to another country, that country is referred to as a labour-heavy country. In other words, the physical quantity of the elements serves as the foundation for this criterion.

5.5 Theory of Country Similarity

Staffan B. Linder, a Swedish economist, created this idea based on his observations of international trade patterns from the 1970s. This idea holds that developed countries trade more with other developed countries. The developed countries account for around 34 percent of overall global exports.

This fact slams Heckscher-factor Ohlin’s endowment hypothesis on its own. The H-O theory states that the incentive to trade is strongest among nations with dramatically diverse factor endowments. This means that commerce would be dominated by rich manufacturing and developing countries producing primary products (i.e., natural resource commodities like oil and petroleum) and labour-intensive items.

Theoretical Fundamentals

The following are the three key elements of this theory:

1. Differences in factor endowments:

It explains the trade in natural resource-intensive goods and how domestic demand affects a nation’s manufactured exports.

2. Preference similarity boosts trade between two industrialised countries:

Linder also claims that the more similar the demand preferences for manufactured goods in two countries (for example, the United States and the United Kingdom), the more intense the potential trade-in manufacturers between them. If two countries have the same or similar demand structures, their consumers and investors will desire items with comparable levels of quality and sophistication, a phenomenon known as preference similarity. This resemblance fosters trade between the two industrialised nations.

3. The most important factor in the demand structure is the average per capita income:

To explain the demand structure’s determinants. According to Linder, the most important factor is average per capita income. High-income countries will desire high-quality luxury consumer products and sophisticated capital goods, whereas low-income countries will demand low-quality necessity consumer goods and less sophisticated capital goods. As a result, a wealthy country with a comparative advantage in manufacturing high-quality, modern goods will find large export markets in other wealthy countries where such commodities are in high demand.

Staffan B. Linder classified international trade into primary products and manufactured goods. According to Linder, disparities in factor endowments explain trade in natural resource-intensive products but not in manufactured commodities. He contends that domestic demand determines a country’s manufactured export range. Industrialized nations dominate international commerce in manufactured products because states will only export things they create at home and manufacture only goods with high domestic demand at home.

5.6 Product Life Cycle Theory

In the mid-1960s, Raymond Vernon proposed the idea of the product life cycle.

Vernon maintained that the wealth and scale of the US market provided great incentives for enterprises to create cost-cutting process innovations. Vernon said that most new products were created in the United States. Given the unpredictability and dangers associated with introducing new products, the pioneering firms believed it was better to keep production facilities close to the market and the firm’s centre of decision-making. Additionally, non-price factors will be what drive demand for the majority of new products. As a result, corporations can charge relatively high prices for new items, eliminating the need to hunt for low-cost manufacturing facilities in other nations.

Vernon explained that, early in the life cycle of a typical new product, while demand in the United States is quickly increasing, demand in other industrialised countries is limited to high-income groups. The low initial demand in other advanced countries makes it unprofitable for enterprises to begin producing the new product. Still, it does necessitate some exports from the US to those countries.

Demand for the new product gradually increases in other advanced countries (e.g., Great Britain, France, Germany and Japan). For foreign producers, it becomes profitable to begin manufacturing for their native markets. Furthermore, US corporations may establish manufacturing operations in advanced countries with increasing demand.

If cost constraints grow too great, the process may not end there. As developing countries (e.g., Thailand) gain a production edge over advanced countries, the cycle through which the United States lost its advantage to other advanced countries may be repeated. As a result, the focus of global manufacturing shifts from the United States to other industrialised countries and subsequently from those countries to poor ones.

As a result of these tendencies, the United States gradually shifts from being a producer exporter to an importer of the product as production shifts to lower-cost overseas locales and subsequently emerging countries.

5.6.1 Product Life Cycle Stages The product cycle is divided into three segments.

The First Stage: The New Product

Innovation necessitates highly trained labour as well as substantial amounts of resources for research and development. Because of the requirement for closeness, knowledge, and communication, in addition to the many diverse skilled-labor components necessary, the product is usually most successfully conceived and initially built near the parent firm, and therefore in a highly industrialised market.

The product is non-standardized throughout the development stage. The manufacturing process necessitates high adaptability (meaning continued use of highly skilled labour). As a result, production costs are relatively high. At this stage, the innovator is a monopolist and thus enjoys all of the benefits of monopolistic power, including the huge profit margins required to cover the high development expenses and expensive manufacturing process. At this point, the price elasticity of demand is minimal; high-income people buy it regardless of cost.

Stage 2: The Developing Product

As production grows in size, the process becomes more standardised. As the requirement for flexibility in design and manufacturing decreases, so does the necessity for highly skilled labour. The innovative country expands its exports to other countries. Competitors with minor differences emerge, placing downward pressure on prices and profit margins. Production expenses are becoming a growing source of worry.

As competitors increase price pressures, the inventive firm must make key decisions about how to keep market share. Vernon contends that at this point, the firm must choose between losing market share to foreign-based manufacturers using cheaper labour or maintaining market share by capitalising on comparative advantages in factor costs by investing in other nations. This is one of the first theoretical explanations for how commerce and investment are becoming more interwoven.

The standardized product is the third stage.

In this final step, the product’s manufacturing is standardised. As a result of having access to capital in global capital markets, the country of production is simply the one with the lowest unskilled labour. Profit margins are razor-thin, and competition is ferocious. The product has run its course in profitability for the pioneering firm.

As the technology of the product’s manufacture matures, the country’s comparative advantage shifts. The same product’s manufacturing site changes. The country manufacturing the product during such a period benefits from net trade surpluses. However, any benefits, according to Vernon, are transitory. As knowledge and technology evolve, so does the producer country’s comparative advantage.

5.6.2 Product Cycle Theory’s Trade Implications

Product cycle theory describes how specific products were manufactured and exported from one country but transferred their production and export locations to other countries over time due to product and competitive evolution. Figure 5.4 depicts the trade patterns visualised by Vernon as a result of the maturing stages of a given product cycle. The countries of production and export of the product shift as the product and the market for the product mature and change.

The product was designed and manufactured in the United States at first. The United States is the only country manufacturing and consuming the product in its early stages (from time t0 to time t1). At the moment, production is very capital-intensive and labour-intensive. The United States began exporting the product to other advanced countries at time t1. These countries have the financial means to purchase the product in its raw form. New Product Stage, where it is relatively expensive. These other advanced countries also begin their own manufacturing at time t1 but remain net importers. However, a few shipments do make their way to less developed countries at this period.

As the product progresses to the second stage, the Maturing Product Stage, production capability in the other advanced countries rapidly expands. Competitive variations (products) emerge as the product’s core technology becomes more widely understood and the necessity for skilled labour in its manufacture decreases. Near the end of the stage, some countries also become net product exporters (time t3). Less developed countries develop their own production at time t2, although net imports remain. Meanwhile, the lower manufacturing costs of these emerging competitors cause the United States to become a net importer by time t4. Currently, the competitive advantage for production and exports is shifting across countries.

In the third and final stage, Standardized Product Stage, the comparative advantage of production and exports shifts to less developed countries. The product is reasonably mass-produced and can be manufactured with less-skilled labour. The US continues to cut domestic output while increasing imports. The other advanced countries continue to produce and export, although exports remain high as less developed countries boost production and become net exporters. When time t5 arrives, the product has completed its course or life cycle.

The product life cycle hypothesis has historically been used to explain international trade patterns. Take photocopiers as an example; Xerox produced them in the US in the early 1960s and initially sold them to Americans. Xerox exported photocopiers from the United States, particularly to Japan and advanced Western European countries. As demand grew in those nations, Xerox formed joint ventures to establish production in Japan (Fuji-Xerox) and the United Kingdom (Rank Xerox). Furthermore, as Xerox’s patents on the photocopier process expired, additional international competitors entered the market (e.g., Canon in Japan, Olivetti in Italy).

As a result, US exports fell, and US customers began to purchase some of their photocopiers from lower-cost overseas sources, mainly Japan. Recently, Japanese corporations have discovered that manufacturing photocopiers in their home country is prohibitively expensive. Therefore, they have begun to shift production to emerging countries such as Singapore and Thailand. As a result, the United States and several other advanced countries have shifted from being photocopier exporters to importers. This international photocopier trade pattern shift corresponds to the product life cycle theory predictions. The idea explains clearly why mature businesses are migrating out of the United States to low-cost assembly areas.

5.6.3 Product Life Cycle Theory’s Limitations

This idea has been critiqued for the following flaws:

1. Applicable to technological products:

Technology-based goods typically undergo modifications in the manufacturing process as they grow and mature. Other products, such as resource-based (minerals) or services that use capital in the form of human capital, are difficult to categorise using the phases of maturity.

2. The majority of new items are not created and launched in the United States:

Although most new items were indeed introduced in the United States between 1945 and 1975, there have always been notable exceptions. In recent years, many innovative items have been introduced in Japan, the United States, and advanced European nations (laptops, computers, compact discs and electronic cameras).

As seen from the foregoing, Vernon’s theory may be useful for describing the pattern of international trade during America’s brief period of global supremacy; nevertheless, its application in the present world is limited.