International Business Chapter 6 Notes Part 2

The Product Life-Cycle Theory - Proposed by Raymond Vernon in the mid 1960s - Vernon’s theory was based on the observation that, for most of the twentieth century, a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semiconductor chips) - Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products - In addition, the high cost of U.S. labor gave U.S. firms an incentive to develop cost-saving process innovations - Vernon argued that most new products were initially produced in America - Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks inherent in introducing new products - Also, the demand for most new products tends to be based on non price factors Consequently, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries - Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups - The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries - Demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States - As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries Product Life-Cycle Theory In the 21st Century - The product life-cycle theory seems to be an accurate explanation of international trade - Consider photocopiers: patterns - The product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries of western Europe. - As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). - In addition, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). - As a consequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-cost foreign sources, particularly Japan. - More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch production to developing countries such as Thailand. - Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. - This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory that mature industries tend to go out of the United States and into low-cost assembly locations - Many new products are now first introduced in Japan (e.g., video-game consoles) or - Moreover, with the increased globalization and integration of the world economy an South Korea (e.g., Samsung smartphones) increasing number of new products (e.g., tablet computers, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations - This may be accompanied by globally dispersed production, with particular components of a new product being produced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage) - Vernon’s theory may be useful for explaining the pattern of international trade during the period of American global dominance, its relevance in the modern world seems more limited New Trade Theory - The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade - Economies of scale : are unit cost reductions associated w/ large scale of output - Have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment - New trade theory makes two important points: 1. through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods 2. those industries in which the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises - World trade in certain products may be dominated by countries whose firms were first movers in their production Increasing Product Variety and Reducing Costs - In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market - If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products - those products may not be produced, thereby limiting the variety of products available to consumers - Alternatively, they may be produced but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized - Individual national markets are combined into a larger world market - As the size of the market expands due to trade, individual firms may be able to better attain economies of scale - Implications w/ new trade theory : - Is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods; thus, trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology - EXAMPLE : - There are two countries, each with an annual market for 1 million automobiles - By trading with each other, these countries can create a combined market for 2 million cars - In this combined market, due to the ability to better realize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies - Similarly, demand for a minivan may be 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. - Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained - - Once the two countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. - The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. - Consumers in this case benefit from having access to a product (sports cars) that was not available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices Economies of scale, First-Mover Advantage, and the pattern of trade - A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages - First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry. - The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage - New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match - Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage Implications of New Trade Theory - The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology - Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products - By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services - - - The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry First-movers’ ability to benefit from increasing returns creates a barrier to entry business historian Alfred Chandler suggests the existence of first-mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries Most contentious implication : Is the argument that it generates for gov’t intervention and strategic policy New trade theories suggest the role of luck, entrepreneurship, and innovation in giving a firm first-mover advantage National Competitive Adv : Porter’s Diamond - Michael Porter, the famous Harvard strategy professor, has also written extensively on international trade - Porter and his team looked at 100 industries in 10 nations - Porter’s work was driven by a belief that existing theories of international trade told only part of the story - The essential task was to explain why a nation achieves international success in a particular industry - Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage . - These attributes are : ● Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry. ● Demand conditions—the nature of home-country demand for the industry’s product or service. ● Related and supporting industries—the presence or absence of supplier industries and related industries that are internationally competitive. ● Firm strategy, structure, and rivalry—the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry - - Porter speaks of these four attributes as constituting the diamond He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable - the diamond is a mutually reinforcing system - The effect of one attribute is contingent on the state of others Porter maintains that two additional variables can influence the national diamond in important ways: chance and government - Chance events, such as major innovations, can reshape industry structure and provide the opportunity for one nation’s firms to supplant another’s Government, by its choice of policies, can detract from or improve national advantage Factor Endowments - lie at the center of the Heckscher–Ohlin theory - He recognizes hierarchies among factors - Basic factors (e.g., natural resources, climate, location, and demographics) - Advanced factors (e.g., communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how) - Advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, companies, and governments - Gov’t investments in basic and higher education, by improving the general skill and knowledge level of the population and by stimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors - Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors - Conversely, disadvantages in basic factors can create pressures to invest in advanced factors Demand Conditions - Emphasizes the role home demand plays in upgrading competitive advantage - Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding - Such consumers pressure local firms to meet high standards of product quality and to produce innovative products Related and Supporting Industries - Broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive - The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally - One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries - Clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster - Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regular conferences or workshops Firm Strategy, Structure, and Rivalry - Two important points here : 1. Different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage 2. That there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry - Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors - Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors - All this helps create world-class competitors Evaluating Porter’s Theory - Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry - The presence of all four components is usually required for this diamond to boost competitive performance (although there are exceptions) - Porter also contends that government can influence each of the four components of the diamond—either positively or negatively - Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and so on - Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs - Government policy can influence supporting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws Managerial Implications : Location, First-Mover Adv, Gov’t Policy, Investments, & Strategy Locations - From a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently - The result is a global web of productive activities, with different activities being performed in different locations around the globe depending on considerations of comparative advantage, factor endowments, and the like - If the firm does not do this, it may find itself at a competitive disadvantage relative to firms that do First-Mover Adv - This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commitments may also seem to be important in less concentrated industries - For the individual firm, the clear message is that it pays to invest substantial financial resources in trying to build a first-mover advantage, even if that means several years of losses before a new venture becomes profitable Gov’t Policy - Business firms produce exports, and business firms import the products of other countries - Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions - The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm - Many firms recognize this and lobby for open markets - - - EXAMPLE : - The U.S. government announced its intention to place a tariff on Japanese imports of liquid crystal display (LCD) screens in the 1990s, and IBM and Apple Computer protested strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers; and (3) the proposed tariff, by increasing the cost of LCD screens, would increase the cost of laptop computers produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture Porter’s theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production (e.g., to invest in better training for its employees) and to increase its commitment to research and development It is also in the best interests of business to lobby the government to adopt policies that have a favorable impact on each component of the national diamond Businesses should urge government to increase investment in education, infrastructure, and basic research (because all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (because this makes firms stronger international competitors Changes in Gov’t Policy, Investments, and Business Strategy - - - The world’s nations have worked toward lowering barriers to cross-border trade in goods and services. These shared goals and acceptance of the prevailing rules-based order have created a predictable environment that has made cross-border business investments less risky The election of Donald Trump to the presidency of the United States, and the shift in trade policy that he has initiated, has driven a freight train through the established order - The environment is no longer predictable - Business investments made today may become unprofitable tomorrow if trade barriers are suddenly erected The change in trade policy has created major uncertainty about the future, which raises the risks of cross-border investments to support international trade The value of an investment made a few years ago may now be significantly reduced That when investment risks increase, businesses typically do three things: 1. They reduce their investments in risky projects, which in this context would probably mean lower investments in countries involved in a trade war 2. They hedge their bets. Hedging bets might require a firm like Apple to source a component from several different locations and to assemble in multiple locations so that if a trade dispute and higher tariff barriers make one location less economical, the firm can shift some of its production to another location a. Hedging bets might also require the firm to increase its domestic production, even if doing so raises costs. It should be noted that reducing investments risks, and hedging by sourcing from multiple locations, will reduce the efficiency of resource allocation in the global economy, depress and/or distort trade flows, and lower economic growth rates going forward 3. To counteract all of this, business can and will lobby governments to encourage them to resolve disputes and create a more stable and predictable environment