Vernon’s product life-cycle
Introduction
The underlying principles in Vernon’s Product Life Cycle (1966) are quite straight forward.
These are; a) Introduction b) growth c) Maturity and d) Decline. The area or location of the
production depends entirely on the current stage of the life cycle. This theory relies on the real
experiences of the then US market. Vernon at that time observed that most of the world’s new
products were imported from the US. The United States of America was the initiators of almost
all the latest new technologically driven products. The US extra time had grown and actually
started importing some products that it had originally exported. Vernon’s international product
life cycle (1966) tries to explain exactly why it happened.
Please explain Vernon’s product life-cycle theory of FDI. What are the strength and
weakness of the theory?
In the first stage of the Vernon’s life cycle, the products are not standardized and the goods have
some implications i.e. price elasticity, communication in the entire distribution chain is wanting
and the location of the actual product itself. As the product matures, conditions start changing
and some degree of standardization sets in and it starts to attract some demand both at home and
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abroad. (Vernon, 1966) As the demand grows, the countries abroad begin to produce their own
products at a lower cost of labor and ultimately the overall product cost also lowers its cost. To
counter these developments, the US companies may eventually decide to also set up similar
production operations in these countries that have developed economies which also limit the
exports to from the US. (Noorzoy, 1980)
As the US markets and others from developed countries mature the resulting products become
more standardized. The conditions once again are changing within the life circle. The increased
demand and cheap labor costs from countries abroad makes pricing the critical component in the
international market and the product cost becomes an issue in the production process. The MNCs
based in advanced countries get a chance to export back their products to the US. This may lead
the less developed and the underdeveloped countries providing competitive locations for
production that ultimately will lead them to be exporters. (Stevens and Lipsey, 1992)
This evidence provides the concept that the more standardized a product is the more its location
will change. It also provides evidence that the less standardized or the more unstandardised
products are the more they will remain in one location in phosphorus locations.
One of the strengths of Vernon’s theory provides that as time elapses the major exporters may
change places with the importers and these may lead low cost producers to become exporters.
These frequent changes across different barriers and trade practices may lead to the sharing of
the technological skills among the technologically advanced countries with the LDC’s that may
lead to healthy and fair competition among them. The theory also provides an explanation of the
historical developments of the FDI.
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The other weaknesses of the Vernon’s theory are that his view is actually ethnocentric. It’s
currently obvious that a lot of new products are actually produced in other advanced economies
like Japan. The realities of globalization mean that there is more dispersed production to utilize
comparative advantage. (Eurostat, 1998)
The Vernon theory was undertaken in the 1960’s. Over the years the trading patterns have,
especially in the export and import market have drastically changed.
Why do you think the host country tends to resist cross-border acquisitions, rather than
Greenfield investments?
The host country views most green field investments favorably as opening new markets and also
creating other new production opportunities, facilities and new jobs. Cross-border company
acquisitions are unfavorable as they are viewed mostly as foreign takeovers of potential domestic
companies that have interest in the local communities or creating job opportunities. Their major
objectives are basically to improve production and increase their profits. (Markusen, 1995)
How would you incorporate political risk into the capital budgeting process of foreign
investment projects?
One way is to adjust the estimated cost of capital relatively upwards to reflect the nature of
political risk and later discount at a higher rate the expected future cash inflows or cash flows.
Insurance premiums can also be deducted to provide a provision for political risks from the
future cash flows and also utilize the cost of capital for other domestic capital budgeting
expenditures. (Caves, 1996)
Please discuss and compare forward vs. backward internalization.
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Forward internalization refers to a situation where the Multi-national Corporations with huge
intangible assets utilizing the Foreign Direct Investment (FDI) in order to make use of the assets
on a greater scale and subsequently internalize any reasonable externalities that has been
generated by the assets. Backward internalization refers to a situation when Multi-national
Corporations (MNC) acquire external foreign firms so as to gain access to the basic intangible
assets that are within the foreign firms and similarly internalize any of the externalities produced
by the assets. (UNCTAD, 1996)
Discuss how you would incorporate currency exchange risk into the capital budgeting
process of foreign investment.
Applying net present value to get the future cash flows, the discounting rate should be adjusted
to reflect also the effects of the currency exchange. The other way is to adjust the estimated cost
of capital relatively upwards to reflect the nature of currency exchange risk and later discount at
a higher rate the expected future cash inflows or cash flows. Insurance premiums can also be
deducted to provide a provision for the currency exchange from the future cash flows and also
utilize the cost of capital for other domestic capital budgeting expenditures.
To conclude, the once popular US MNE models are fading. Globalization, the new technical
changes and the emerging economies that have come of age have greatly facilitated the rise of
new types of MNC’s that are driven by new innovations and better ways of accessing the
markets unlike the earlier MNC’s that were driven by exploitative tendencies and blatant
incompetence. However, the decline of the US MNE’s does not mean that the existing theories
that were once based on the US models have failed. The basic explanation is that the existence of
MNE largely depends on the capabilities that allow them to expand internationally.
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Reference
Vernon, R. (1966), ‘International Investment and International Trade in the Product Cycle’,
Quarterly Journal of Economics May.
Caves, R. (1996), Multinational Enterprises and Economic Analysis, Cambridge: Cambridge
University Press.
Eurostat (1998), Globalization Through Trade and Foreign Direct Investment’, Luxemburg:
European Communities.
Markusen, J. (1995), ‘The Boundaries of Multinational Enterprises and the Theory of
International Trade’, Journal of Economic Perspectives, Vol. 9, pp. 169-189.
Noorzoy, M.S. (1980), ‘Flows of Direct Investment and Their Effects on US Domestic
Investment’, Economic Letters, Vol. 5, pp. 311-317.
Stevens, G. and Lipsey, R. (1992), ‘Interactions Between Domestic and Foreign Investment’,
Journal of International Money and Finance, pp. 40-62.
UNCTAD (1996), World Investment Report: Investment, Trade and International Policy
Arrangements, New York/Geneva: United Nations.
