Incomplete Contracts and the Product Cycle

I present a model in which the incomplete nature of contracts governing international transactions limits the extent to which the production process can be fragmented across borders. Because of contractual frictions, goods are initially manufactured in the same country where product development takes place. Only when the good becomes sufficiently standardized is the manufacturing stage of production shifted to a low-wage foreign location. Solving for the optimal organizational structure, I develop a new version of the product cycle hypothesis in which manufacturing is shifted abroad first within firm boundaries, and only at a later stage to independent foreign firms. (JEL D23, F12, F14, F21, F23, L22, L33) In an enormously influential article, Raymond Vernon (1966) described a natural life cycle for the typical commodity. Most new goods, he argued, are initially manufactured in the country where they are first developed, with the bulk of innovations occurring in the industrialized North. Only when the appropriate designs have been worked out and the production techniques have been standardized is the locus of production shifted to the less developed South, where wages are lower. Vernon emphasized the role of multinational firms in the international transfer of technology. In his formulation of a product’s life cycle, the shift of production to the South is a profit-maximizing decision from the point of view of the innovating firm. The “product cycle hypothesis” soon gave rise to an extensive empirical literature that searched for evidence of the patterns suggested by Vernon.1 The picture emerging from this literature turned out to be much richer than Vernon originally envisioned. The evidence indeed supports the existence of product cycles, but it has become clear that foreign direct investment by multinational firms is not the only vehicle of production transfer to the South. The literature has identified several instances See William Gruber et al. (1967), Seev Hirsch (1967), Louis T. Wells, Jr. (1969), and Thomas G. Parry (1975) for early tests of the theory.