Around the same time, the growing importance of FDI was becoming evident. According to the US Tariff Commission (1973: p.322), in 1970 multinationals accounted for 62% of US exports ($22 billion from a total of $35 billion) and 34% of imports ($10.5 billion from a total of $31 billion). A theory of international trade in which the multinational played no role therefore no longer squared well with reality. In an influential paper, Vernon (1966) sought to address this omission by putting “less emphasis upon comparative cost doctrine and more upon the timing of innovation, the effects of scale economies, and the role of ignorance and uncertainty in influencing trade patterns” (p. 190).
Vernon began with the assumption that enterprises in any one of the advanced countries are not distinguishably different from those in any other advanced country, in terms of
their ability to access and comprehend scientific knowledge. However, this does not necessarily imply that all enterprises have the same capacity to exploit scientific knowledge in the generation of new products. Vernon considered there to be a large gap between the knowledge of a scientific principle and the embodiment of that principle in a marketable product, and that entrepreneurs were required to shoulder the risks involved in testing whether the gap could be bridged. Furthermore, Vernon posited that “the entrepreneur’s consciousness of and responsiveness to opportunity are a function o f ease of communication; and further, that ease of communication is a function of geographical proximity” (p. 192). Therefore, Vernon abandoned the simplifying assumption of knowledge as a universal free good and instead introduced it as a determinant in the decision to trade or to invest.
Given the assumption that domestic producers have greater knowledge about their home market (the opportunities it offers as well as the risks involved) than do foreign producers, Vernon considered US firms to hold a number of advantages over their foreign rivals. At the time of writing, the US enjoyed GDP per capita that was considerably higher than any of its rivals (twice as high as that of Western Europe), and was also characterised by high unit labour costs and relatively unrationed capital compared with other markets. Vernon therefore concluded that whenever there was a chance to develop a new product that was either responsive to wants at high levels of income, or addressed the need to conserve labour, this opportunity would first be apparent to US firms (as they were in the best position to observe the US market).
for new products, Vernon further assumes that “the evidence of an unfilled need and the hope of some kind of monopoly windfall for the early starter both are sufficiently strong to justify the initial investment that is usually involved in converting an abstract idea into a marketable product” (p. 193). We therefore arrive at the prediction that US firms will spend more on ‘product development’ than their foreign rivals5.
However, Vernon’s theory goes far beyond the prediction o f higher product-development investment, to make inferences about the location o f production during a product’s life6. Vernon identified three distinct stages: new product; maturing product; and standardised product. During the new product stage, producers are concerned with the degree of freedom they have in modifying their factor inputs, and the need for swift and effective communication between producer, customer, and supplier (and even competitor). As the first-mover, a firm will enjoy some degree o f monopoly power and therefore face a low price elasticity of demand. Taken together, these considerations should encourage the firm to opt for domestic production during the new product stage7. To the extent that there is overseas demand for the new product, the firm will supply via exports at this early stage.
As the product matures and demand grows (both at home and abroad), a certain degree of standardisation takes place. Vernon is at pains to point out that this does not mean that
5 Vernon notes that this prediction is consistent with the “pioneer appearance” in the US of products such as the sewing machine, typewriter, and tractor etc.
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Hence the name given to his theory, the ‘product life-cycle’.
7 In other words: “the producer who sees a market for some new product in the United States may be led to select a United States location for production on the basis of national locational considerations which extend well beyond simple factor cost analysis plus transport considerations” (Vemon, 1966: p. 196).
product differentiation ceases to occur (on the contrary, differentiation may intensify as rival firms attempt to gain some degree of market power), but rather that industry (and consumer) acceptance o f certain general standards (and features) is likely. This has implications for the location of production, as producers become less concerned about input flexibility and market communication, and more concerned with production cost and market share. Vernon seems to envision an evolution in the mode of foreign market supply (overseas production replacing exports) during this stage, although he is less than clear about the timing, or specific determinants, of such a transition. He observes that “as long as the marginal production cost plus the transport cost of the goods exported from the United States is lower than the average cost of prospective production in the market of import, United States producers will presumably prefer to avoid an [overseas] investment” (p. 197). However, he notes that this calculation will be subject to considerable uncertainty (particularly with respect to the prospective overseas-production cost), and that firms will often be motivated by other factors, such as the threat of new competition in the foreign market, the anticipation of future tariff levels, or the prevailing political situation. Furthermore, he argues that a threat is a stronger motivator than an opportunity, with firms often quick to react when they perceive that the status quo is under threat.
Finally, we enter the standardised product phase in which the specification of the product is well defined and demand has become more geographically dispersed (so that US domestic demand is not as important as it was in the earlier stages). It is interesting that a reading of the product life-cycle from a modem textbook will typically tell you that this is the stage at which production moves almost completely overseas and US demand is met
by imports from overseas affiliates. However, Vernon actually centres discussion of this stage around the possibility of production moving to less-developed countries (LDCs). The main thrust of his argument is that if LDCs were to be involved in export-led production, standardised products would be the most suitable, given that they are well- defined, have a well-established market, and tend to sell on the basis of price8. While this argument may be logical, it fails to convince. As a product becomes highly standardised it seems likely that production and market access costs will become increasingly important, with other factors such as first-mover advantages and market power from product differentiation becoming less so. Firms are therefore looking for the least cost location overall, and while this may certainly be a less-developed country is some cases, more often than not it will be one of the industrialised nations.
We have discussed the work o f Vernon in some detail because it heralded the introduction of the multinational enterprise in international trade theory and the beginning of a move away from classical comparative advantage trade theory. Perhaps because it was in some respects a ‘ground-breaking’ paper, and also being typical of the style of academic papers of that time, the paper lacks rigour and is perhaps overly descriptive. Also, as Vernon is quick to observe, the discussion relates only to innovation in certain kinds of products, and consequently the theory says nothing about industrial innovation in general. Regardless o f this, the paper introduces a number of important new ideas, many of which have gone on to be applied more generally by other authors. Indeed, we go on to discuss more recent, formal models of international trade and the multinational enterprise, the
Vernon also suggests that “industries which produce a standardized product are in the best position to avoid the problem [of significant local supply chain requirements], by producing on a vertically-integrated self-sustaining basis.” Such industries should prove most suitable for less-developed countries.
seed o f which can clearly be found in Vernon’s work.