Unit 4 Product Life Cycle and Other Theories of International Business

International Business Management Unit 4
Sikkim Manipal University Page No. 86

Unit 4 Product Life Cycle and Other
Theories of International Business
Structure
4.1 Introduction
Objectives
4.2 Product Life Cycle Theory
4.3 The Five- Element Product Wave
4.4 Heckscher-Ohlin Trade Model
4.4.1 Eli Heckscher (1879 - 1952)
4.4.2 Bertil Ohlin (1899-1979)
4.4.3 Factor Price Equation Theorem
4.4.4 Factor Price Equalization Theorem
4.4.5 FPE is not observed in the real world. What does this mean?
4.4.6 A Chill Wind Blows from the East
Self Assessment Questions
4.5 Summary
4.6 Terminal Questions
4.7 Answers to SAQs and TQs
4.1 Introduction
Long term patterns of international trade are influenced by product
innovation and subsequent diffusion. A country that produces technically
superior goods will sell these first to its domestic market, then to other
technically advanced countries. In time, developing countries will import and
later manufacture these goods, by which stage the original innovator will
have produced new products.
Recently developed theories of endogenous trade policy formation have
attempted to explain tariffs as the result of economic interest seeking by
individuals or groups. This Unit demonstrates that tariffs will not emerge as
a policy choice if income is redistributed solely through trade
policy-induced factor price changes. A production tax cum subsidy will be
adopted as both gainers and losers are better off than with a tariff. This unit
will deal with such policies that drive the international trade.
On a smaller scale, individual products pass through distinct phases: after a
period of research and development, and trial manufacture, there is a period
of introduction characterized by slow growth and high development costs.
This is followed by a period of growth as sales and profits rise. A phase of
maturity and saturation is then experienced as sales level off and the first
signs of decline occur. The final phase is decline, characterized by lower
sales and reduced profits, and perhaps final disappearance from the market.
The duration of each stage of the cycle varies with the product and the type
of management supporting it.
The product life cycle (PLC) has represented a central element of marketing
theory for four decades. Following its development in the 1950s, and its
subsequent popularization in the 1960s, it has remained a stable feature of
marketing teaching; despite evidence of its limited applicability and the
growing awareness, amongst leading academics at least, of its flawed
nature.
Objectives
After studying this unit, the students would be able to:
o Understand the 'life cycle' of the brand leaders position as a theory that
has general practical applicability across the whole field of marketing.
o The Potentialities of the various product life cycle patterns globally
accorded and used.
4.2 Product Life Cycle Theory
Life cycle theory has been used since the 1970s to describe the behaviour
of a product or service from design to obsolescence.
The typical pattern of a product is represented by a curve divided into four
distinct phases: introduction, growth, maturity, and decline. Recent research
in the area has focused on its use in decision making in areas ranging from
those as broad as overall strategy to those as narrow as equipment
replacement.
But does the product life cycle, or PLC, really tell the entire story? Consider
the Ford Mustang. Since its 1964 introduction, the automobile has
undergone several changes. Performance was increased with the addition
of the 428 CobraJet in 1968 and Mach I styling in 1969. Another substantial
change took place in 1971 with the introduction of the high-performance
Boss 351. Then a true muscle car, the Mustang was detuned in 1974, when
oil prices forced a more fuel-efficient redesign, called Mustang II. The fourth
generation Mustang, introduced as the 1994 model, has been further refined
and is more aerodynamic than its immediate predecessor. Yet it still shares
roots with earlier models. A 302 V-8 is still offered, the wheelbase is similar,
and if one looks closely enough, one can see its genesis in the 1964 model.
The pattern evidenced by the life of the Mustang, then, is several curves of
introduction, growth, maturity, and decline.
Another intriguing example is the C-130 Hercules aircraft manufactured by
Lockheed. The company recently announced the sale of 25 "J" models to
the Royal Air Force, which is the fifth version of the Hercules originally
produced in the 1950s. Although the aircraft resembles its older relatives,
the new model features a totally different electronics package and more
powerful engines. Here again, the Hercules PLC shows a curve with five
local maximum points (swells of activity, in effect), rather than the traditional,
single maximum point, PLC curve.
The examples above suggest a PLC model represented by waves of
product introductions, growth, maturity, and decline. Design engineering,
process engineering, product marketing, production, and end-of-life
decisions are key elements within the system. Each has its own cycle
consisting of varying levels of activity. The waves are triggered by critical
decision points during the life of a product, when production, operations, and
marketing managers must optimize their collective efforts.
Conventional Life Cycle Theory
As shown in Figure 4.1, conventional theory suggests that a product or
service goes through four distinct stages. The objective is to maximize the
product's value and profitability at each stage. In the introductory phase,
sales are slow. The strategy is to create widespread awareness. Costs are
incurred in building distribution and increasing awareness through heavy
promotion. It is hoped that the investments made in new product
introduction pay off and the product or service moves to the growth phase.
The firm may either build market share or profitability in the growth phase.
Strategies here are to make differential changes that add value to the
product and to target new markets. Marketing moves away from promotion
through personal selling toward more mass media advertising. Just as
predators react to attractive targets, competition begins to build as
awareness increases and sales momentum builds. Unit manufacturing costs
begin to fall as fixed costs are spread over more production units and
workers move down the learning curve. The firm attempts to stay in the
growth stage as long as possible.
Sales growth slows at maturity and the firm moves to defend market
position. This is where marketing managers must pay the most attention.
Promotion costs increase significantly. Cost reduction is crucial as
competitors begin to lower prices and introduce improved versions of the
product. With the lower prices come lower profits, and competitors begin to
drop out. This is typically the longest lasting stage, with some market
leaders holding their position over several decades.
The final stage is decline. Here the firm may continue to market the product
hoping that competitors will discontinue their products. Other strategies are
to maximize profit by eliminating as many product costs as possible as sales
slow, or else to eliminate the product altogether.
Life Cycle Elements
Design engineering, process engineering, product marketing, and
production have been recurring elements in each stage of the product life
cycle. In addition, end-of-life (EOL) issues must be addressed when the
product approaches obsolescence. These elements vary in importance as
the product or service moves through its life, thus creating waves of activity.
The fact that they change in importance and magnitude requires that they
be closely managed. Let's begin our discussion of the individual elements
with design engineering.
Design Engineering
The typical design engineering curve (see Figure 4.2) shows two peaks.
One occurs during the introduction of the new product and the other during
a redesign that takes place during the maturity phase of the life cycle.
Design engineering is involved in the five phases of the new product
introduction (NPI) process. Idea validation is first. Engineers take informal
ideas and study the market for needs that are not being met by products
currently being offered or planned. Technology, manufacturing capabilities,
competition, and potential revenues are analyzed in the review.
The second phase is conceptual design. Here, ideas begin to take shape as
product specifications are identified. Initial investigations are made into
product pricing, performance, and styling in a feasibility analysis. Design
and manufacturing engineers may work as part of a concurrent team to
develop specifications and resolve technical aspects of how the product will
be produced.
Specification and design are third. This is the phase in which design
engineering plays a large role. The goal is design release. Final decisions
are made as to how the product will work and look.
The objective of prototype production and testing is to provide assurances
that the design is sound and the need for subsequent changes will be small.
The product is tested under a pilot run simulation to see how well it meets
specifications and quality objectives. Manufacturing capabilities are also
checked. Engineers may solicit customer reactions to the product in this
phase.
The final traditional phase of NPI is manufacturing ramp up, or
commercialization. The chief concern is obtaining the desired level of
manufacturing capacity as soon as possible while meeting quality
specifications. Design engineers provide solutions to problems with product
reliability and variability in this stage. They also participate in any resulting
manufacturing process changes.
The goal of any new product introduction is to place a quality product in the
market, in desired amounts, at the producing firm's lowest possible cost.
Design engineering's integral role in this process results in the introduction
of the initial version of the product. We call this the "A" model designation,
meaning that this is the first model in a potential series.
The second design engineering activity spike occurs when the cumulative
effect of implemented or contemplated product changes results in a
substantially new product. If the product needs a major face lift to attract
new users, the resulting peak in activity level may be higher than that for the
previous model. Changes made to the product here typically result in
markedly higher quality, new features that increase the product's utility
value, and/or improvements in the attractiveness of the product through
styling. This second, updated model is the "B" version. An example is
Caterpillar's high-drive crawler tractors, which were given an entirely new
series designation ("H") upon their introduction in the 1980s. The
high-drive bulldozers, on which the track resembles a skewed pyramid,
represented a substantial departure from conventional tracked tractors
with their oval tracks. In fact, they have redefined the industry.
Process Engineering
The process engineering function is responsible for the production system.
To that end, process engineers specify the type of system, equipment,
tooling, layout, and flow used in manufacturing or service operations. Their
task is to ensure the efficient production of each part or component.
Traditionally, the first step is a review of the end item bill of materials, which
identifies all the separate parts that make up the product or service to be
produced in, or to flow through, the operation area. Once the bill of materials
analysis is completed, the problem of which type of production system to
employ may be tackled.
Laufer (1975) identifies three basic types of process structures used in
manufacturing (which could easily be used by service entities as well):
intermittent, batch, and continuous. Typically, the type of product offered by
the firm defines which structure will be employed. Intermittent operations are
usually found in custom firms or job shops in which end item or service
specifications are provided by the customer. The product or service is made
as ordered, so production tends to be either infrequent or one time only.
Production run lengths are often small. Output is more standardized in the
batch operation and is produced in higher quantities. The plant is used to
process a product run over a given period of time, after which a different
item or goods may be produced. Finally, production in continuous
operations is highly standardized, variety is limited, and output is high.
When considering the type of process to employ, a production layout that
facilitates the product movement through the plant must be chosen.
Questions to consider include: Is the product suited to an assembly line
layout, in which work stations are linked by some type of material handling
device? Is production more efficient in a cellular layout, in which groupings
of dissimilar machines work on components that have similar processing
requirements? Should the firm employ a just-in-time layout and pull the
product through the plant?
In conjunction with selecting the process layout, manufacturing decisions
must be made as to the level of automation used within the plant. For
example, will the firm feature a flexible manufacturing system and group
numerically controlled machines throughout the different manufacturing
areas? Finally, maintenance and repair decisions must be made--no small
chore. Less frequent maintenance may allow for higher use of equipment
and tooling. Eventually, however, this may be offset by more frequent (and
more expensive) catastrophic failures.
The process engineering curve shadows that of design engineering in
Figure 2, with its two peaks. Activity begins just after receipt of the bill of
materials. The initial system is designed, equipment and tooling are
purchased, maintenance programs are put in place, and flows are decided.
The first peak is reached after design and process changes stabilize. Again,
this is the "A" model. The second begins to build with the development of
the "B" version, and peaks just before the system stabilizes, as equipment,
tooling, and flow are adjusted to optimize production.
Production
Production activity follows demand for the product or service; both are linked
by manufacturing planning and control systems. Activity begins in earnest
during production ramp-up. Equipment processes, and trained production
personnel must be in place. Targets for product cost, conformance to
specification, and overall quality must be met. As customer sales begin to
speed up production, overhead per-unit costs decrease and direct costs
increase.
Manufacturing activity ramps up during initial production, leaps through
growth, and peaks near the point at which customer demand is highest. The
shape of the curve, then, is similar to the traditional PLC shown in Figure 1.
Potts (1988) suggests that demand for service parts shadows the installed
base and also shows one peak, albeit lagging somewhat behind product
sales.
Relationships
Design engineering, process engineering, and production are all related.
The purpose of presenting the traditional relationship here is to facilitate
later comparisons with the five-element wave. The model is illustrated in
Figure 3, which shows that traditional product engineering follows a linear
path. The first step is design engineering, in which the good or service is
taken from concept and detail design to prototyping. The product moves to
process engineering, where technologies and production methods are
evaluated as a system is set into motion. Finally, the product flows to
production, where down-stream manufacturing activities, such as production
planning and scheduling, take place. This is known as the over-the-wall
method of product design and development, with each stage separate from
the next.
Product Marketing
New products are usually supported with high advertising budgets to build
awareness and encourage an initial purchase. If the target is the entire
market, a typical first strategy is to attack it with one theme. When resources
are relatively limited, the business may choose to identify smaller, more
homogenous concentrations within the market and tailor the advertising to
those groups. Once the product becomes established, fewer advertising
dollars per sales unit are required to encourage demand.
Sales promotion is another tool used to stimulate immediate demand.
Emphasis on sales promotion is highest at new product introduction, falls
during product growth, and increases as the good or service becomes more
of a commodity after competitors and the market adjust. Sales promotion
effects tend to be short term. According to Kotler and Armstrong (1991),
"Sales promotion consists of short-term incentives to encourage purchase or
sales of a product or service. Whereas advertising offers reasons to buy a
product or service, sales promotion offers reason to buy now." Examples of
these promotions are free samples, rebates on purchases, and the
ubiquitous newspaper coupon.
There are two occurrences of particularly high activity or expenditure in
marketing a product or service. The first peak occurs during introduction-the
"A" version where plans are created and first put into action. During
growth, marketing activity begins to fall as the product begins to generate its
own demand. The second flurry of activity occurs after demand growth
flattens and the product becomes somewhat of a commodity, when the
product is modified and results in a new and improved "B" version. Finally,
once the firm decides to allow the good to gracefully exit the market as it
moves towards obsolescence, advertising and promotion activity levels
naturally fall to zero.
End of Life
This element considers what happens when sales decline to the point at
which revenues drop to a level that supposedly precludes continued
production of a good by the firm. One strategy is to cease production and
allow inventory levels to drop to zero. An alternative tactic is to attempt to
give new life to the product and risk succumbing to what is known as "The
Thomas Lawson Syndrome." Harari (1994) provides this summary:
Even before it sank, the sailing ship Thomas Lawson had become obsolete
as steam-powered vessels emerged. Its saga symbolizes the fatal tendency
of organizations to cling to old beliefs and outmoded technologies.
In other words, the firm ignores the technological warnings of the industry
and continues to make the product at the expense of future success. This is
analogous to the ostrich that sticks its head in the sand when approached
by a hungry lion. The bird (firm) expects that it cannot be hurt by what it
cannot see, while the lion (the competitor) sees nothing but an easy meal.
How big a problem is EOL decision making? It may be immense,
considering that the largest firms in the U.S. have many products in the late
mature stage. Most technological changes occurred in a 20 year period
after World War II. Markets boomed, owing to large population increases
and repressed demand during the Depression and the ensuing war years.
The market's hangover began in the 1970s. Product break-through were
expensive and few. Companies began to cut R&D expenditures, and
population growth slowed. Businesses that made names for themselves in
the post-war boom had begun to feel invincible. They relied on dated
products, ignored potential new products that could result from research and
development, and created businesses filled with hierarchical practices rather
than the flexibility required for growth.
Where should a firm position itself? A product should continue to be
marketed as long as it provides a return that minimizes opportunity cost.
The key is to recognize that EOL decisions are important and should be
driven by a combination of customer expectation and marketplace realities.
EOL activities should consider profitability measures and a program in which
a manufacturer enters into an agreement with an EOL company.
According to Emehiser (1991):
An EOL program is a unique opportunity for a manufacturer to sell the legal
obligation of supporting a product that is no longer in manufacture. All or
part of product support may be assumed, dependent on the amount of
finished product in use, anticipated life of the product, spares available, and
other considerations. Product support can include parts distribution, service,
technical support, quality assurance, and/or continuation engineering.
In effect, the EOL Company assumes responsibility for supporting the
product or service, which the original manufacturer no longer produces. The
former therefore becomes the manufacturer and has its own single-peaked
manufacturing cycle.
In summary, then, each of the five elements of the product life cycle system
has its own cycles. These cycles, or waves, are formed by product decisions
that result in varying activity levels among the five elements. Figure 4
provides an initial comparison between the traditional product life cycle and
the five-element wave.
4.3 The Five-Element Product Wave
As illustrated in Figure 4.5, the wave model employs design engineering,
process engineering, product marketing, production, and end-of-life
activities as elements. The first wave is associated with the "A" version of a
product or service, and survives through the traditional PLC introduction and
growth phases. A second wave begins with the "B" version, the markedly
improved second model. It starts just before the traditional life cycle maturity
stage and lives until sales decline to a point at which an EOL decision must
be made.
Note that design engineering has a peak of activity level at each upgrade.
Process engineering activity shadows that of design engineering, as system
changes will be contemplated and made to facilitate the changes made in
the product or service. Product marketing also has activity level spikes that
closely match engineering design activity, lagged somewhat for product
introduction. Production has one activity peak that results from demand
management and production planning through master production
scheduling.
Finally, the EOL curve peaks at each redesign. The last wave begins shortly
before original production ceases and ends when the product is no longer
manufactured or supported by the EOL Company or division. The EOL
element requires that a decision be made about the preceding version at
each major redesign: continue production, make a short-term run of spares,
keep blueprints active so that parts can be made as ordered, enter into a
manufacturing and support agreement with another entity, or discontinue
production.
For the sake of parsimony, Figure 4.5 shows only a two-product model ("A"
and "B" versions). In reality, there may be hundreds of significant redesigns.
The wave effect comes from the fact that the process repeats for the
successful firm, forming swells in design engineering, process engineering,
product marketing, and manufacturing curves before the final crest at EOL
activity.
The five-element product wave, or FPW, uses trigger points, rather than
time, as the horizon over which the element curves vary. Changes in
magnitude, represented by the vertical axis, result from differing activity
levels within the five elements. Simple changes in levels of dollar or unit
product sales, in and of themselves, do not necessarily determine the trigger
points. Rather, the varying activity levels are a direct result of product
introductions and redesigns that, from the outset, must take into account
company strategy, core capabilities, and the state of the competitive
environment. For example, a product with strong sales may be redesigned
in a preemptive strike against competitors, further distancing that product
from the competition, such as with Caterpillar's innovative high-drive
bulldozers.
That the five-element wave is grounded in reality becomes apparent when
considering the recent research that suggests product introduction cycles
are being compressed. Bayus (1994) claims that knowledge is being applied
faster, resulting in increasing levels of new product introductions. Yet since
product removals are not keeping pace with introductions, there are an
increasing number of product variations on the market. Slater (1993)
observes that product life cycles are growing shorter and shorter. Vesey
(1992) reports that the strategy for the 1990s is speed to market and
discusses the pressures the market is exerting to shorten product
introduction lead times.
Regardless of whether life cycles are actually being compressed or
knowledge is simply being applied faster, it is apparent that firms are
increasing the speed with which they bring their products to market. The
effect of this is a compression of the design engineering, process
engineering, production, and product marketing elements of the wave
model. (The EOL curve may remain unchanged because accelerated
introductions do not necessarily affect EOL efforts.) The five-element wave
clearly shows the inefficiency of traditional "over-the-wall" systems as speed
to market increases. As the elements compress, more and more information
is thrown over the wall. Recipients find themselves with less and less time to
take action. Taken to the extreme, in-baskets, phone lines, conference
rooms, desks, and floors are soon gridlocked and littered with unanswered
correspondence and things to do. Forget quality; production itself grinds to a
halt.
The solution is to maximize the advantage of the relationships within the
five-element wave and work in concurrent teams, as illustrated in Figure 6.
That way, responsibility is shared throughout the system. Members from
each discipline optimize the system. The method tears down barriers
between departments and speeds the introduction process, thus decreasing
costs. The focal point becomes the customer, rather than the task. The
system is totally interactive and bound together. Each element is connected
to all of the others and is focused on the customer. (Note that the authors
have taken a great deal of artistic license here! No meaning should be
attached to the actual measure of overlap area in Figure 4.6.)
What is the recent experience with teams? There is evidence that using
concurrent design teams speeds the product to market and provides
substantial savings. Boeing expects that concurrent design will save some
$4 billion in the development of its 777 airliner. Westinghouse recently
suggested that concurrent engineering would eliminate 200 duplicate
processes in a project that consisted of 600 using traditional over-the-wall
approaches. Ford's Team Taurus was able to cut a full year out of model
turnaround. In addition, design changes required after initial production
began were reduced by some 76 percent.
The strength of the five-element product wave is the fact that it illuminates
critical decision points in the life of a product or service. The
interrelationships of the elements clearly illustrate the benefit of working
product introductions, design changes, and end-of-life decisions in teams.
This is particularly true in today's rapidly compressing environment of
speeding products to market. Furthermore, the model is flexible and may be
expanded or contracted to include those functional areas relevant to the
production team. Thus, whether a given firm's product is a service or a
manufactured good, the five-element wave is a powerful tool that can be
deployed to accelerate effective decision making in markets demanding
ever-increasing levels of speed and agility.
4.4 Heckscher-Ohlin Trade Model
The Heckscher-Ohlin (HO hereafter) model was first conceived by two
Swedish economists, Eli Heckscher (1919) and Bertil Ohlin. Rudimentary
concepts were further developed and added later by Paul Samuelson and
Ronald Jones among others. There are four major components of the HO
model:
1. Factor Price Equalization Theorem,
2. Stolper-Samuelson Theorem,
3. Rybczynski Theorem, and
4. Heckscher-Ohlin Trade Theorem.
Due to the difficulty of predicting the goods trade pattern in a world of many
goods, instead of the Heckscher-Ohlin Theorem, the Heckscher-Ohlin-
Vanek Theorem that predicts the factor content of trade received attention in
recent years.
4.4.1 Eli Heckscher (1879 - 1952)
Heckscher was a Swedish economist. He is probably best known for his
book "Mercantilist." Although his major interest was in studying economic
history, he also developed the essentials of the factor endowment theory of
international trade in a short article in Swedish in 1919. It was translated into
English thirty years later.
4.4.2 Bertil Ohlin (1899-1979)
Heckscher's student, Bertil Ohlin developed and elaborated the factor
endowment theory. He was not only a professor of economics at Stockholm,
but also a major political figure in Sweden. He served in Riksdag (Swedish
Parliament), was the head of liberal party for almost a 1/4 of a century. He
was Minister of Trade during World War II. In 1979 Ohlin was awarded a
Nobel prize jointly with James Meade for his work in international trade
theory.
HO Model = 2 2 2 model (2 countries, 2 commodities, 2 factors)
For example, there are two countries (America and Britain); each country is
endowed with 2 homogeneous factors (labour and capital) and produces 2
commodities.
This is the smallest case of "even" model, i.e., the number of commodities is
equal to that of factors. Extending the model to a more general case is not
easy. In fact, the results obtained from a more general model do not have
the clear, common sense interpretations which the simple HO model enjoys.
4.4.3 Factor Price Equation Theorem
Among the four main results of the HO theory, FPE is the most fragile
theorem. If any of the eight assumptions are violated, it will not hold.
However, this is one of the most powerful findings, if not the most important
one, in trade theory, as it shows how trade affects the income distribution of
a trading country.
Of course, the assumptions are somewhat unrealistic in the sense that they
are not likely to be observed in the real world. However, even if some of the
assumptions are violated, international trade has a tendency to equalize
factor prices; it will remove the wage gaps between countries, despite the
constraint that trading countries impose on the movement of factors, in
particular, on the movement of workers.
Assumptions
1. No barriers to trade
World trade is assumed to be free from any impediments, such as tariffs,
quotas, voluntary export restraints, and exchange control.
2. No transportation cost
After the industrial revolution in the
mid 1800s, major cities were
connected by railroads, reducing the
transportation costs further.
Lawrence of Arabia helped the Arabs
to recapture Arabia from the Turks.
Arabs eventually ousted Turks from
the region now known as Saudi
Arabia. As a result, Israel gained its
independence in 1948.
Procession of Horsemen and
Chariots, Eastern Han, 25 220
AD.
Romans built good roads such as Via
Appia and Via Ignatia, connecting
various parts of the Empire, reducing
the transportation costs. Good roads
made it possible for the Romans and
the Chinese to utilize horse drawn
chariots for fast communication and
transportation. There were bandits in
various regions and pirates in the
ocean, but the Romans made it
sufficiently safe for ordinary people to
travel.
Luke 15:13 "Not long after that,
the younger son got together all
he had, set off for a distant
country and there squandered
his wealth in wild living. 14 After
The Prodigal Son by Pierre puvis de
Chavannes (Washington National
Gallery). This parable suggests that
people were able to travel easily to
foreign countries during the time of
Jesus. Travel was relatively safe and
affordable by the emerging middle
class.
he had spent everything, there
was a severe famine in that
whole country, and he began to
be in need. So he went and hired
himself out to a citizen of that
country, who sent him to his
fields to feed pigs.
Transportation costs are assumed to be zero.
In reality, transportation costs are a significant portion of the marketing
costs of most traded goods, especially in agricultural products.
Remark: This is unrealistic. However, it is not a bad assumption,
because transportation costs inhibit and reduce trade volume; it does
not reverse the trade pattern between the countries.
3. Perfect Competition (PC) + Full Employment (FE)
PC prevails in both product and factor markets. This assumption rules
out monopolistic and oligopolistic market structures. It also rules out
price and wage rigidities. In a perfectly competitive market all buyers
and sellers are price takers, i.e., each one is too small to exert market
power and influence market prices. All factors are fully employed.
4. Factors are mobile in each country but are immobile across
national borders.
Like Ricardo, HO model draws a sharp distinction between domestic
and external factor mobility. The maximum degree of factor mobility is
permitted between industries within the same country (internal factor
mobility). But neither capital nor labour can cross national borders
(international factor immobility).
IFM insures that workers move from a low wage region to a high wage
region, and capital moves from a low interest country to a high interest
region. The net effect is that all factor prices are the same within a
country.
IFI implies that Mexican workers are not allowed to work or migrate to
the US.
5. No specialization
After the introduction of free trade, neither country specializes in one
commodity, as in Ricardian model. Each country produces both goods.
6. Production functions exhibit constant returns to scale (CRS) and
differ among industries:
Such a production function is sometimes said to be homogeneous of
degree 1 - HD(1) for short here.
CRS means that a proportionate increase in all inputs increases the
output by the same percentage.
Specifically, CRS means:
If y = F (L, K), then y' = F (2L, 2K) = 2y.
7. Identical technology between trading countries:
Production functions are the same in America and Britain. The HO
model is a long run model. Ohlin argued that "the physical conditions of
production are everywhere the same." Some countries may be slow to
adopt new technology. With the development of modern
telecommunications, information travels fast. This is a result of declining
transportation and communication costs.
The first page of Analects of Confucius
contains two verses in bold: The Master
said, "Is it not a pleasure to learn
something and practice it often?
"Is it not a joy to have friends visiting you
from far away quarters? (Characters in
regular font are the commentaries like
those of Bible interpreters.)
This book written by Confucius (551 -
473 BC) before Plato and Socrates
includes Zhu Xi's commentaries. This
edition was printed in Japan before Meiji
Restoration. Trade spreads technologies.
Paper was invented by Cai Lun in AD
105. Printing with carved wood blocks
appeared during the Tang dynasty.
Movable type was invented during Song
dynasty (c. 1050 AD) long before the
Gutenberg printing press.
8. No factor intensity reversal:
Remark: The implication of (1) and (2) is that commodity trade equalizes
commodity prices between countries. That is, Americans and Britons
pay the same prices for same commodities.
Will commodity price equalization result in factor price equalization?
Julius Caesar's tomb in
Palatino Hill, Rome (May
2003)
An Italian inscription which explains that the
body of an ancient ruler, Caesar, was
deposited here. Julius Caesar laid the
cornerstone of the Roman Empire (27 BC
476 AD).
By conquering neighbouring countries,
Roman government also provided police
function and ensured safety of travellers. For
example, Praetorian Guard and Roman
legions stationed in various outposts
provided peace and maintained law and
order throughout the Roman Empire. As a
result, international trade flourished on an
unprecedented scale. Licinius Crassus
crushed the Spartacus rebellion (71 BC).
Unit Value Isoquants
A unit value isoquant is a locus of input combinations that yield $1 worth of
output.
1) Among many isoquants choose the one for which p*
2
y
2
= 1, or y
2
= 1/p*
2
.
Figure 4.1, Unit value isoquant
Figure 4.1
2) Different production functions yield different isoquants:
Two different UVIs intersect each other.
Figure 4.2
In Figure 2, industry 2 is more capital intensive than industry 1.
3) Choose y
2
, L
2
, and K
2
to
maximize = p*
2
y
2
- wL
2
- rK
2
Subject to y
2
= F
2
(L
2
,K
2
).
Once the desired output is chosen, the cost must be minimized. The
equilibrium condition is:
MRTS = w/r
Figure 4.3, Implication of cost minimization
Figure 4.3
4) "No specialization" implies that a common isocost curve must be tangent
to both unit value isoquants. Suppose not.
Arbitrary factor prices (w, r) results in specialization in one commodity.
Figure 4.4
An arbitrary pair of factor prices (w ,r) cannot prevail, because it causes the
economy to specialize in one good. For instance, given the factor prices
represented by the slopes of the two isocost curves, industry 2 survives at
point A (p
2
y
2
= c
2
) the tangency points (both A and B) yield exactly $1
revenue. But the production costs at points 1 and 2 will differ. For example,
C
1
> C
2
= 1. Thus, firms will produce only commodity 2, which costs less but
yields the same revenue. That is, the country specializes in good 2 in the
above example.
Thus, for a given pair of output prices (p
1
, p2), there exists a unique pair of
factor prices (w,r). This implies that a pair of output prices completely
determines a pair of factor prices. Within a country, (p*
1
,p*
2
) <=> (w ,r).
Figure 4.5: Common Isocost Curve
4.4.4 Factor Price Equalization Theorem
Given assumptions 1 - 8, factor prices will be equalized between countries.
That is,
w = w*, r = r*.
Woman ironing, Edgar Degas. How will her wage be affected by free trade?
Proof
1. PC in factor markets + No specialization imply
w = p
1
MP
L1
= P
2
MP
L2
r = p
1
MP
K1
= P
2
MP
K2
w/r = MP
L1
/MP
K1
= MRTS
1
= the slope of UVI: y
1
= 1/p
1
.
= MP
L2
/MP
K2
= MRTS
2
= the slope of UVI: y
2
= 1/p
2
.
Thus, in the Home country, a common isocost curve is tangent to both
UVIs.
2. The same is true in the foreign country. w* = p*
1
MP*
L1
= p*
2
MP*
L2
r* = p*
1
MP*
K1
= p*
2
MP*
K2
3. No Barriers to Trade + No Transportation Costs imply
p*
1
= p
1
and p*
2
= p
2
. (Free trade implies output price equalization)
Thus, w* = p*
1
MP*
L1
= p
1
MP*
L1
. But will marginal products of labor in any
industry be the same in the two countries?
4. Identical Technologies
o IT: both countries have the same isoquant maps. This and (3) imply
that HC and FC have the same set of unit value isoquants.
o No FIR implies that expansion paths are unique in each country, and
the two countries have the same expansion paths, as shown in
Figure 6.
(k
1
= k*
1
, k
2
= k*
2
).
Figure 4.6. Effects of CRS on marginal products.
Figure 4.6
o HD(1) or CRS: Expansion paths are rays from the origin, along
which MPs remain constant. Each country chooses an input
allocation along each expansion path, depending on its resource
endowment. However, regardless of their locations, A = (L
1
,K
1
) and
B = (L*
1
,K*
1
), marginal product of each input does not depend on the
output level; it depends only on the capital-labor ratios. In Figure 5a,
CRS implies that marginal products remain constant along each
expansion path, regardless of the output levels. Thus,
MP*
Li
= MP
Li
, MP*
Ki
= MP
Ki
.
5. w* = p*
i
MP*
Li
= p
i
MP
Li
= w, (wage equalization)
r* = p*
i
MP*
Ki
= p
i
MP
Ki
= r. (interest rate equalization)
4.4.5 FPE is not observed in the real world. What does this mean?
1. It could mean that the Heckscher-Ohlin model does not apply to all trade
patterns. It applies to industries in which factor proportions are
important, e.g., agriculture and manufacture.
2. In practice, transportation costs are not negligible. Free trade does not
equalize output prices or wipe out factor price differentials completely,
but will reduce the gap in factor prices between countries.
3. Capital is more mobile than labour. If FPE does not hold, both factors
have incentives to move across national boundaries. If stringent
restrictions are imposed on migration, it is the capital that will move in
search of lower labour costs. This means outsourcing and a huge job
loss in high wage countries. Capital mobility further reinforces the effect
of free trade to equalize factor prices.
Convergence of Long run Income
National income is written as wL+ rK.
wL + rK = (w + rK/L)L = (w + rS/L)L.
Since w and r are equalized in the world market, there are two elements
that determine long run national income.
Population or labor force (L) and the savings rate (S/L).
Per capita income is (w+rS/L).
Beyond a certain threshold level of income, per capita savings rate is a
decreasing function of per capita income or wage. For example, China's
household savings rate is over 20%, but it is expected to decline. Due to
its high savings rate, China was able to maintain the growth rate of 9%
over the last 25 years. As the savings rate declines with the rise in per
capita income, per capita income approaches a limit that is attained by
high income. Eventually, in a stationary state, a nation's economic power
is measured by its population. In the short run, its wage also matters.
However, population growth also stops once the wage reaches a
threshold level.
Business Week, September 1, 2003, page 44.
4.4.6 A Chill Wind Blows from the East
At first glance, IBM's computer disk drive factory in Szekesfehervar,
Hungary, doesn't look the picture of industrial decline. Built just eight years
ago, its bright facade still glows from a hillside overlooking a bustling
shopping plaza. But a closer look reveals an unnatural stillness. Loading
docks that once were piled high with components lie empty. Turnstiles that
admitted 3,700 workers a day are chained.
IBM shut the plant last November, moving the work to China, where wages
are 75% cheaper. Dutch electronics maker Royal Philips Electronics and
Singapore contract manufacturer Flextronics International Ltd. has moved
an additional 1,500 Hungarian jobs to China in the past 18 months.
Flextronics also has closed a 1,000 worker plant in the Czech Republic.
The closings are sending shudders across eight formerly communist
countries just as they are gearing up to celebrate their entry into the
European Union on May 1.
The labor markets of Asia, especially China, are beginning to pull away
industrial investments that helped this region rebuild after communism's
collapse. "Their whole goal has been to join the EU," says Humphrey W.
Porter, president of Flextronics Europe. "The risk is that they don't realize
this is a rat race. And it's just the beginning, not the end."
But Eastern Europe's cost advantage is shrinking by the day. In the past two
years, real wages have risen by 20% in Hungary and 11.5% in the Czech
Republic, according to Vienna-based Erste Bank. Despite the runup, wages
in Eastern Europe's most dynamic economies are still 25% lower than those
in Western Europe. But the gap is widening with China, where wages have
stayed at about $100 per month for unskilled factory workers. Even Eastern
European companies, such as Hungary's Karsai Plastics Holding, are
opening plants in China.
Self Assessment Questions
a. What are the elements of Product Life Cycle?
b. How do you determine the life cycle of a product
c. How does the marginal utility effect the business platforms
4.5 Summary
The waves of activity in marketing, engineering, and production are being
compressed by a proliferation of new product introductions and shorter life
cycles. In turn, as the marketplace forces firms to react faster, these
functions must gather, share, and analyze information with increasing
speed. This requires that the firm abandon over the wall forms of
organization and, in their place, use cross functional teams, which feature
short lines of communication and an ability to make decisions quickly.
4.6 Terminal Questions
1. What is the 5 Wave model?
2. Compare the Product life cycle theory with the Hecksher Ohlin Theory
3. What are the implications of these theories on the Asian markets?
4.7 Answers to SAQs and TQs
SAQs
a. Refer to 4.2
b. Refer to 4.5.3
c. Refer to 4.5.2
TQs
1. Refer to 4.3
2. Refer to 4.2 and 4.4
3. Refer to 4.5.5

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International Business Management Unit 4

Sikkim Manipal University Page No. 86

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