The product cycle revisited: Knowledge intensity and firm internationalization

vol. 46, 2006/5, pp. 1 – 22

vol. 46, 2006/5 1

Tamar Almor/Niron Hashai/Seev Hirsch

The Product Cycle Revisited: KnowledgeIntensity and Firm Internationalization

Abstract

■ This paper presents an expanded version of the product cycle framework, whichillustrates how the role of R&D, production and marketing activities, as a salientdeterminant of competitive advantage, evolves along the product cycle. The frame-work considers the implications of these changes for the internationalization offirms marketing products belonging to the different phases of the cycle.

Key Results

■ The paper shows how changes in “knowledge-intensity” of products along theproduct cycle are interrelated with changes in “service-intensity” and “distancepremium” and thus enable to predict the sequence in which low knowledge inten-sive and high knowledge intensive firms internationalize R&D, production andmarketing activities.

Authors

Dr. Tamar Almor, Senior Lecturer, School of Business Administration, College of Management, TelAviv University, Rishon LeZion, Israel.Dr. Niron Hashai, Lecturer, Jerusalem School of Business Administration, The Hebrew University,Mount Scopus, Israel.Seev Hirsch, Emeritus Professor, Faculty of Management, Tel Aviv University, Rishon LeZion, Israel.

Manuscript received April 2005, revised December 2005, final revision received March 2006.


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Introduction

Firm-specific knowledge has been traditionally regarded as the single most impor-tant determinant of competitive advantage in the international market place. Tocompete internationally, firms must possess idiosyncratic assets, which compensatefor the “liability of foreignness” (Hymer 1976) that penalizes firms engaging incross-border transactions, relative to their indigenous competitors. Firm specificknowledge has two important characteristics, it can be withheld from competitors,and its transfer across national borders entails significant costs (Teece 1977). Alarge body of literature exists that examines the relationship between firm specificknowledge and the preferred foreign market servicing mode (e.g., Kogut/Zander1993, Martin/Salomon 2003). In addition, extensive literature can be found on theinternationalization of knowledge creation activities (e.g. Cantwell 1995, Niosi1997, Patel/Pavitt 1991, Patel/Vega 1999, Papanastassiou/Pearce 1996, 1999),usually referred to as the internationalization of Research & Development (R&D)activities. The present paper adopts a different approach: it examines the relation-ship between the level of firm specific knowledge (hereinafter: knowledge-inten-sity) and the internationalization process of firms. More specifically, we pose thefollowing research question: How do changes in the knowledge-intensity of firmsaffect the sequence and configuration of the internationalization process of theirresearch & development, production and marketing activities?

This research question was motivated by our observations regarding the inter-nationalization modes adopted by a sample of 75 Israeli firms, all heavily engagedin international transactions1. Our empirical data showed a relationship betweenthe knowledge-intensity of firms and their internationalization modes, as detailedin Table 1. Table 1 presents data relating to foreign subsidiaries, categorized by themajor function these subsidiaries performed: R&D (representing knowledge cre-ation activities), production or marketing. The sample was divided into two groups– 47 firms characterized by high knowledge intensity (HK firms) and the remaining28 firms, characterized by low knowledge intensity (LK firms)2.

Table 1. Foreign Subsidiaries Distribution of Israeli HK and LK firms (1999)

Analysis of the two groups by the functions of their subsidiaries reveals sig-nificant differences: overall, HK firms have a much higher propensity than LK firmsto engage in cross-border investment. Moreover, LK firms hardly engage in cross-border investments in R&D, and the share of LK firms with marketing subsidiariesis lower than that of HK firms. The propensity of the two groups to invest in pro-duction is about the same.

These internationalization patterns of knowledge creation, production and mar-keting activities of LK and HK firms seem to make intuitive sense, and it is quiteprobable, that when a similar analysis is performed on firms from other countries,the distribution of their cross-border activities will not be too different from thatshown in Table 1. However, a review of international business literature presentedbelow indicates that existing models do not explicitly deal with the interface betweenknowledge intensity and the sequence in which firms internationalize their valueadding functions.

In this paper we develop a dynamic framework, which predicts the relationshipbetween firm-specific knowledge intensity and the internationalization of firms’functions. We posit that a reformulation of the product cycle model (Hirsch 1965,1967, Vernon 1966) can provide the basis for such a framework. We further contendthat differences between the internationalization patterns of LK and HK firms canbe explained by the composition of their output portfolio. Specifically, we showthat LK firms behave as if mature products dominate their product portfolio, whileHK firms behave as if their output portfolio is dominated by products in the intro-ductory and growth phases of the product cycle.

We start with a brief review of the relevant international business literature, deal-ing with the sequence of entry and configuration of cross-border operations by firmsengaged in internationalization. In the following sections we present an expandedversion of the product cycle framework, which was originally formulated to describethe evolution of individual products or industries. Our version adapts the frameworkto the analysis of the internationalization patterns of firms. A number of buildingblocks, used in the construction of the framework are specified. These include theconcepts of knowledge-intensity, service-intensity and distance premium. We followby expanding the product cycle framework to contain a set of decisions, which mustbe made by firms competing internationally and predict the propensity of firms tointernationalize their value adding functions. This dynamic internationalizationframework traces the steps, which innovating firms follow, as their products movealong the typical growth trajectory from introduction to maturity. Next, we outlinea number of testable propositions derived from our framework and show prelimi-nary findings based on data collected from a sample of Israeli industrial firms. Inthe concluding section we discuss the theoretical contribution of the framework, re-late it to our empirical findings and suggest avenues for further research.

The Product Cycle Revisited

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Internationalization: A Brief Literature Review

The product cycle framework is one of the pioneering models relating to the inter-nationalization of firms (Hirsch 1965, 1967, Vernon 1966). The framework statesthat products typically pass through the phases of introduction, growth and matu-rity. The location of new products’ production is influenced by the proximity of in-novators to their home country customers. In the introductory phase, when productsare not yet standardized, innovators locate production activities at home, where“communication between the market and the executives…is swift and easy, and inwhich a wide variety of potential types of inputs... are easily come by” (Vernon1966). During the growth phase the demand for products expands into additionalmarkets, and over time the innovators locate production activities in proximity toconsumers in these countries. As products mature, they become more and morestandardized. First mover advantages are gradually dissipating and production costconsiderations become critical. During the maturity phase production will be locatedin countries that enjoy cost advantages. This may imply transfer of production abroadwhen the home country location suffers from location disadvantage.

The product cycle model was rightly criticized for its limited applicability andfor being too deterministic. Moreover, it applied to individual products and even toindustries but only marginally to firms. Two alternative schools of thought havebecome the received theories of internationalization, the ‘behavioral school’ andthe ‘economic school’.

The ‘behavioral school’ focuses on the firm. It views internationalization asan evolutionary process, during which the firm increases its international involve-ment as a function of heightened knowledge and market commitment (Aharoni 1966,Johanson/Wiedersheim-Paul 1975, Johanson/Vahlne 1977, 1990, Welch/Luostarinen1988).

This approach also referred to as the Uppsala model, postulates that firms in-ternationalize through sequential stages, commencing with sales in the home mar-ket and irregular exports. This is followed by regular exporting via independentagents and subsequently by the establishment of sales subsidiaries. At a later stage,firms engage in cross-border production. Internationalization starts by using arm’slength transactions in ‘psychically’ close markets. Foreign market commitment andmarket knowledge increases over time, leading to further commitments in morepsychically distant markets.

This view is supported by scholars such as Reid (1981), Czinkota (1982) andCavusgil (1984), who claim that managers, who have little or no experience ininternational markets, will initially expand their businesses into psychically closemarkets. Once successful, firms will pursue active expansion into more challeng-ing and unknown markets and become increasingly committed to internationalgrowth.


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The ‘economic school’ views internationalization as engagement in cross bor-der activities motivated by rational economic considerations (e.g., Buckley/Casson1976, 1998, Dunning 1977, 1988, Hirsch 1976, Rugman 1981, 1986). Firms choosetheir foreign market-servicing modes by evaluating economic costs of differenttransactions and selecting the mode that minimizes overall costs.

Within the ‘economic school’, the OLI Paradigm (Dunning 1977, 1988) specifiesthe conditions, which must be satisfied for firms to engage in cross-border pro-duction. These conditions are associated with three types of advantages: ownershipadvantage, location advantage and internalization advantage.

Ownership advantage is a firm characteristic. It is manifested by firm specific,technological, marketing or managerial knowledge and/or by control over other rentproducing assets, such as privileged access to markets or resources not available tocompetitors. Location advantage is a country characteristic. Conceptually it is sim-ilar to that of comparative advantage, familiar from international trade theory.Location advantage is represented by the comparative cost of materials, laborand natural resources accessible by enterprises operating within their nationalborders as well as the relative geographic proximity of the home country to poten-tial markets and suppliers. The factors that constitute location advantage are coun-try specific phenomena and are location bound – they are internationally immobile.Internalization advantage applies to modes of engagement in international businesstransactions. When a firm prefers to exploit its ownership advantage internally,rather than by licensing or use of other modes of externalization, Foreign DirectInvestment (FDI) is said to be motivated by internalization advantage (Buckley/Casson 1976, 1998, Kogut/Zander 1993, Martin/Salomon 2003, Rugman 1981,1986).

Essentially, the ‘behavioral school’ offers a dynamic view of internationaliza-tion, based on behavior and learning concepts (Forsgren 2002), whereas the morestatic ‘economic school’ (Melin 1992) builds on economic reasoning to explain thechoice between foreign market servicing modes. Moreover, with a few exceptions(e.g., Buckley/Casson 1998, Buckley/Hashai 2004, 2005), the ‘economic school’treats the firm as a ‘black box’ and does not differentiate between the motivationsto internationalize different functions of the firm.

In the following sections we return to the underlying logic of the product cycleframework and develop a dynamic view of the internationalization process of firmsbased on economic reasoning. Our framework posits that the internationalizationof specific value adding functions is triggered by the knowledge intensity of firmsoffering products belonging to the different phases of the product cycle. While theinternationalization of knowledge creation (represented by R&D) activities is in-creasingly receiving more attention (e.g., Cantwell 1995, Niosi 1997, Patel/Pavitt1991, Patel/Vega 1999, Papanastassiou/Pearce 1996, 1999) the impact of knowledgeintensity on the internationalization process of the firm as a whole has been virtu-ally ignored. Our proposed framework aims to fill this gap.


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Building Blocks of the Expanded Product Cycle Framework

Our point of departure is the distinction between different functions undertakenby the firm. Following Buckley and Casson (1976, 1998), Buckley and Hashai(2004, 2005), Hirsch (1976), Casson (2000) and others, we view the firm as anorganism, performing three semi autonomous functions: R&D, production andmarketing.

R&D activities relate to the creation and absorption of proprietary knowledgethrough firm (rather than country) specific activities, which contribute to the for-mation of ownership advantage (Dunning 1977, 1988). This firm specific knowl-edge can be withheld from other firms and is transferable between different geo-graphic locations at the firm’s discretion.

In the analysis that follows we distinguish between products on the basis oftheir knowledge-intensity (KI), which is formally defined below:

(1)

CM denotes the cost of manufacturing a given product, while CRD denotes the aver-age cost of firm specific knowledge contained in each unit of output. Knowledge-intensity is the ratio of CR&D to CM. When KI exceeds a certain level, say 0.10, theproduct is considered knowledge–intensive.

Production (P) involves the transformation of inputs into outputs. Unskilled andskilled labor, raw materials, intermediate inputs and equipment are employed toproduce outputs of goods, services or combinations of the two. Since the costs ofthese inputs vary between countries, production costs may be associated with lo-cation advantage (Dunning 1977, 1988).

The term marketing is employed in this paper in a special sense. It denotes thoseactivities, which require interactions between the firm and its customers. These in-teractions facilitate bilateral information flows between the firm and its customersand the provision of appropriate pre- and post-sales services. The marketing function(M) requires further elaboration because of its close relationship with differentmodes of internationalization. To explain this relationship we introduce the conceptof service-intensity.

Service Intensity

Following Hill (1977) a service is defined as the intangible output of a productiveprocess, involving interactions between providers and users of the service. It followsfrom this definition that the production and consumption of services cannot takeplace simultaneously (Bhagwati 1986, Hirsch 1989, Sampson/Snape 1985).


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Intangible services must accompany any tangible good before the latter can beused or consumed. Transportation illustrates this point. Tangible goods can be usefulto the customer only if they are accompanied by transportation services. Other com-monly used services include communication, insurance, finance, warehousing, pack-aging, etc. We label these services, which are commonly provided by specializedfirms – “universal”. Other services are “firm specific”. They tend to be associatedwith new and complex products. Firm-specific services may be further divided in-to “pre-” and “post-sales” services. Pre-sale services include various sales promo-tion activities (e.g., presentations in exhibitions, advertisement, direct meetingswith potential customers) in order to create awareness of the product, demonstrateits attributes and when necessary, ‘tailor’ the product to specific customer require-ments. Post-sale services may include training, installation, running in, maintenanceand repairs. Provision of firm specific services is based on knowledge generated bythe manufacturer of the associated products (Hirsch 1989, Almor/Hirsch 1995).Firm specific services tend to become universal over the product cycle, as the firmspecific knowledge required for their provision gets diffused.

Figure 1 illustrates the concept of service-intensity as applied to transactionsinvolving goods and associated services. Total service costs are measured by thedifference between total costs of the transaction (denoted by CT) and the manufac-turing costs (denoted by CM). Services costs represent the difference between thetwo and are measured by (CT – CM). Denoting manufacturing cost plus the cost ofrequired firm specific services by CFS we divide service costs into two parts: thecost of universal services – denoted by (CT – CFS) and the cost of firm specific ser-vices, denoted by (CFS – CM). As shown in expression (2) below, service-intensity(SI) is defined as the ratio of firm-specific services costs to unit manufacturing costs.When firm-specific services account for a high proportion of the total transactioncosts the product under consideration is labeled service-intensive.

(2)

Noting that the technical complexity of knowledge-intensive products requires fre-quent interactions with the customers (Hirsch 1989, Almor/Hirsch 1995), we positthat service and knowledge intensities are positively correlated. An empirical testof this crucial proposition in discussed in the following section.


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Figure 1. Service-Intensity (SI)

The Cost of Cross-Border Interactions: Distance Premium

In the course of the internationalization process firms engage in both intra- andinter- firm interactions. Intra-firm interactions are required to facilitate bilateralinformation and knowledge flows between R&D, P and M. Such flows may includedata on product specifications, manufacturing instructions, feedback regardingproduct design and so forth (Casson 2000, Kogut/Zander 1993). The nature of in-teraction between the firm and its customers was discussed in detail earlier in con-nection with the concept of service intensity.

The difference between domestic and international interactions has thus far beenignored. To incorporate international interactions into our analysis we introduce theconcept of distance premium. The cost of interaction between the firm’s functionsis higher when they are located in different countries (Kogut/Zander 1993, Teece,1977). The cost of interaction with customers similarly rises with distance and withthe time it takes to provide the relevant firm specific services. This is particularlyrelevant to international interactions where additional costs associated with distanceare incurred due to the need to communicate in two or more languages, use multiplecurrencies, and accommodate different legal systems as well as tax and regulatoryregimes (Contractor 1990, Hirsch 1976, Hymer 1976, Kogut/Singh 1988, Kogut/Zander 1993, Rangan/Adner 2001). Distance premium thus has geographic, eco-nomic and cultural components (Hirsch/Hashai 2000, Hofstede 1980, Johanson/Vahlne 1977, 1990). Moreover, the cost of interaction between the firm and itscustomers is expected to increase with service-intensity.

The distance premium (denoted by DP) is formally defined below as the excesscost of cross-border over domestic interactions:

(3)

Where: IR denotes international interaction costsIH denotes domestic interaction costs.IR is larger than IH, e.g. DP is positive.

DP can be quite high relative to total costs associated with a given transaction. Infact, until recently it tended to render many functions domestic and many servicesand service-intensive goods non-tradable. Technological developments in trans-portation, the telecommunication revolution, the development of the Internet andof other communication technologies, have had a combined effect that brought abouta dramatic reduction in DP in recent years. These changes in turn, have been in-strumental in increasing both international trade and international investments inservices and in service-intensive goods in recent years.3 Noting, however, that DPhas not been entirely eliminated, we employ this concept to predict the interna-tionalization process of firms’ value adding functions.


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An Expanded Product Cycle Framework

Having defined the value adding functions of knowledge creation, production andmarketing (R&D, P and M) and the concepts of service-intensity and distance pre-mium, we consider the relationships between changes in product characteristicsover the product cycle and the internationalization patterns of R&D, P and M byfirms engaged in cross-border interactions.

Dominant Determinants of Competitive Advantage over the Product Cycle

We posit that the relative importance of R&D, P and M in determining competitiveadvantage, varies across the three phases of the cycle: introduction, growth andmaturity. This view is illustrated in Figure 2, which shows that firm specific knowl-edge is the primary determinant of competitive advantage during the introductoryphase of the cycle, marketing is the prime determinant during the growth phase andproduction assumes primacy during the maturity phase.

During the introductory phase, when investment in R&D peaks, technologicalsuperiority has a major impact on competitive advantage, and may even grant in-novating firms a monopolistic position. Production and marketing are of secondaryimportance in shaping the competitive position during this phase.

During the growth phase, as technology gradually diffuses first mover advan-tages of innovating firms are eroded. At this stage, the firm’s competitive positiondepends more and more on its ability to provide pre- and post-sales services effi-ciently. Hence the marketing function becomes the major determinant of the firm’scompetitive position.


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Figure 2. The Phases of the Product Cycle and the Determinants of Competitive Advantage

Production takes over as the prime determinant of competitive advantage whenmaturity is reached, growth slackens and unit production costs account for a growingpercentage of total costs (Klepper 1996). When a product is standardized, productioncost considerations, rather than technological superiority or improved servicing,become the major determinants of competitive advantage.

Turning again to the notion of distance premium, we posit that DP diminishesover the product cycle. As products become less knowledge-intensive and morestandardized, the complexity and frequency of information and knowledge flowsdecline (Melin 1992, Vernon 1979). DP further diminishes over the cycle becauseof its close association with service intensity, which peaks at the early phase of thecycle, and declines over the following phases.

The Internationalization of the Firm’s Value Adding Functions

Next, we consider the location of the firm’s functions. In line with the basic premiseof the ‘economic school’ we assume that the location of functions will be chosenso as to minimize overall costs. Assuming that demand and supply capacities areindependent of the chosen location of specific value adding activities, costs min-imisation is strictly equivalent to profit maximization of internationalising firms.(Buckley/Casson 1976, 1998, Dunning 1993, Hirsch 1976, Martin/Salmon 2003,Rugman 1981).

Consider a world consisting of two countries: H (the home country) and R (therest of the world). An innovative firm, located in country H seeks to sell its newproduct in R. Where will this firm locate its value adding functions as its productprogresses along the cycle?

Separation between R&D, P and M during the introductory phase is very cost-ly due to a high DP. Note, however, that the fact that DP peaks during this phasecreates pressures to locate M abroad, close to country R’s customers, to minimizethe cost of interaction with them. We assert that the dominance of R&D in deter-mining the innovator’s competitive advantage during this phase favors the locationof all three value adding functions in H where the product originates. Furthermore,the innovating firm is likely to enjoy a monopolistic position during the early phaseof the cycle, which implies that the supply of competing products is limited, thusreducing the need to move M to country R. Thus, we expect R&D, P and M to bekept together in country H during the introductory phase and we anticipate that theinnovating firm will serve its foreign markets through exports.

As the product moves to the growth phase, technology diffuses internationally,and first mover advantage gets eroded. The H based innovative firm loses its monopo-listic position, and faces increasing competition from R based firms. Once the own-ership advantage starts to diffuse internationally and the relative dominance of the in-novating firm’s ownership advantage declines (Buckley 1983), DP creates the forces


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that drive the innovating firm to internationalize marketing activities, in order to over-come the inherent location advantage enjoyed by indigenous firms from country R.

During the growth phase marketing becomes the dominant determinant of com-petitive advantage. The decline of DP in comparison with the introductory phasereduces the cost of separation between R&D, P and M. On the other hand, thedominance of M in determining the firm’s competitive position during this phaseimplies that the importance of interactions with customers increases. Firms locatedin R benefit from lower costs of serving their home market and enjoy an inherentcost advantage relative to those incurred by H firms. To counteract this cost disad-vantage the H-based firm needs to relocate its marketing activities to R. Hence,marketing activities, driven by ‘market seeking’ considerations (Dunning 1988,1993), dominates internationalization activities undertaken during the growth phase.

Ownership advantage, which peaks during the introductory and growth phasesof the product cycle, counterbalances the economic pressures for relocation ofproduction activities. As the product matures, these economic pressures increase,whereas the impact of DP decreases. During the maturity phase production becomesthe dominant determinant of the firm’s competitive advantage. In those cases wherecountry H is characterized by “location advantage”, production remains in H. Pro-duction may be transferred to country R when the home country is characterizedby “location disadvantage”. This analysis leads to the expectation that internation-alization of marketing precedes that of production.

Note, however, that this expectation applies only to initial foreign market entry.When subsequent products are introduced, the firm may already possess foreign-based marketing and production affiliates, which can be used to accommodate thenew products. Looked at differently, we may say that foreign entry diminishes theimpact of DP by transforming the distance premium into a sunk cost.

Moreover, the diminution of DP affects not only the internationalization of pro-duction and marketing, it has a similar impact on the internationalization of R&DAs depicted in Figure 2, the introduction of new products implies that R&D be-comes yet again a major determinant of the firm’s competitive advantage. If the H-based, innovating firm has already internationalized M and P, internationalizationof R&D will essentially reduce the firm’s internal DP by locating R&D in proximityto M and/or P. Once M and P are internationalized, it is easier for the innovatingfirm to locate R&D in “centers of excellence” abroad (Cantwell 1995), to reducedistance costs between P and M and R&D (Patel/Vega 1999).

A number of testable propositions concerning the sequence of international-ization are suggested by our analysis:

1) Exports precede the location of marketing activities abroad. 2) Internationalization of marketing activities precedes internationalization of pro-

duction activities. 3) Internationalization of R&D activities follows that of marketing and production.


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Our framework can also be used to predict the extent of internationalization of R&D,P and M. We expect internationalization of P to be undertaken primarily by firmswhose products are characterized by location disadvantage in H. On the other hand,firms whose products are characterized by location advantage will tend to exploittheir ownership advantage by exporting. Note, however, that internationalizationof M activities is motivated by the need to overcome those negative effects of DP,which are unrelated to the location advantage of the home country. Ceteris paribus,we expect a higher proportion of firms to internationalize M than P activities. In asimilar vein, we conclude that R&D is likely to be internationalized only when in-novation of new products continues. We consequently expect a higher proportionof firms to internationalize M than R&D activities.

Preliminary Empirical Testing

Before discussing our empirical investigation a note on methodology is in order.We use the ratio of R&D to manufacturing costs (hereinafter – R&D ratio) as aproxy for product maturity, a choice which is far from obvious and requires an ex-planation. This ratio represents the level of firm specific knowledge. Use of theR&D ratio is based on the assumption that the level of a firm’s knowledge acquiredthrough investments in R&D is positively correlated with the maturity of its productportfolio. The output of firms characterized by a high R&D ratio is assumed to con-sist of a high proportion of products belonging to the early phases of the productcycle. The output of firms characterized by a low R&D ratio is assumed to consistof a high proportion of mature products. This seemingly heroic assumption aboutthe relationship between R&D intensity of firms and the maturity of their productsis based on the basic premise of the product cycle framework which asserts, as notedabove, that R&D declines over the phases of the cycle. Acceptance of this assump-tion allows us to use firm related data (R&D intensity) as a proxy for maturity andto use cross section data to test hypotheses concerning the product cycle, which isa dynamic phenomenon. We return to this issue in the concluding section.

Our database, briefly mentioned earlier, consists of 75 Israeli firms. These firmswere selected from a list of Israel’s 150 largest industrial firms, published annually(Dun & Bradstreet 2000), which in 1999, accounted for about 80 percent of thecountry’s industrial exports. Only firms whose international sales accounted for 25percent or more of total sales were included in the sample. The threshold of 25 per-cent international sales was selected in order to focus on firms that are interna-tionally oriented, rather than firms that mainly target the Israeli market. After elim-inating foreign affiliates, holding companies and firms that were privately held, wewere left with a sample of 101 firms.


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These firms were asked to take part in a structured in-depth interview docu-menting, among other things, financial data and information about their cross-border activities, including the number of subsidiaries, engaged in marketing (M),production (P) and R&D in 1995 and 1999. The final sample consisted of 75 firmsthat agreed to take part in the interviews and provided useable information. Com-parisons between the 75 participating firms and the 26 non-participating firms didnot show evidence of any response bias in terms of firm sales, number of employ-ees, age, industrial classification and percentage of foreign sales.

We used the information provided by the firms to divide them into the follow-ing eight groups (1999 data):

1. R&D0P0M0 – Firms with no subsidiaries.2. R&D0P0M1 – Firms with only M subsidiaries 3. R&D0P1M0 – Firms with only P subsidiaries4. R&D0P1M1 – Firms with no R&D subsidiaries, but with P and M subsidiaries 5. R&D1P0M0 – Firms with only R&D subsidiaries 6. R&D1P0M1 – Firms with R&D and M subsidiaries, but no P subsidiaries 7. R&D1P1M0 – Firms with R&D and P subsidiaries, but no marketing subsidiaries8. R&D1P1M1 – Firms with R&D, P and M subsidiaries.

Next, we divided the firms into two groups:

1. Firms belonging to industries characterized by a high R&D ratio – HK firms.2. Firms belonging to industries characterized by a low R&D ratio – LK firms.

The 47 HK firms belonged to the following industries: electronics, software, telecoms,pharmaceuticals and biotechnology. The 28 firms belonging to the chemicals, food& drink, metal & steel, rubber, plastics, wood, paper, textiles and apparel industrieswere classified as LK firms.4

Validation of propositions derived from the product cycle framework must bepreceded by empirical confirmation of our assertion that knowledge and service in-tensities are positively correlated. Only if such a correlation is found to exist arewe justified in hypothesizing that HK and LK firms adopt different international-ization strategies.

Taking the ratio of marketing costs to cost of goods sold (COGS) as a proxy forservice intensity and the ratio of R&D expenses to COGS as a proxy for knowledgeintensity, the positive relation between service and knowledge intensities is empir-ically supported. The correlation between the two proxies is 0.958 (p=0.000, n=56).Moreover, comparison between the two groups shows that the service intensity ofthe HK firms (1.455) is significantly higher than that of the LK group (0.099)5.Having confirmed that firm specific knowledge and service intensities are highlycorrelated and that HK firms spend significantly more on marketing than LK firms,we proceed with the interpretation of the data in Table 2, which shows the distrib-ution of the sampled firms into the eight groups outlined above.


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Tab

le 2

.F

orei

gn S

ubsi

diar

y G

roup

s of

Isr

aeli

HK

and

LK

firm

s (1

999)

Table 2 shows that only two thirds of the 75 firms included in the sample ownedforeign affiliates in 1999. The remainder relied on independent agents to sell anddistribute their products in the international markets. Turning next to those firms,which did engage in cross border operations, we note that every firm in this grouppossessed marketing subsidiaries. It follows that only firms with marketing sub-sidiaries did engage in additional forms of internationalization, such as productionor R&D facilities. These figures confirm that cross-border investment in market-ing was the major vehicle of internationalization. In fact, in accordance with ourexpectations, the number of marketing subsidiaries was significantly larger than thenumber of either production subsidiaries (T-value =5.393, df=74, p≤ 0.000) or R&Dsubsidiaries (T-value =4.866, df=74, p≤ 0.000). Additional confirmation is offeredby the finding that three of the eight groups listed in Table 2 are empty: R&D0P1M0,R&D1P0M0 and R&D1P1M 0 – in other words, as predicted by our framework, firmswithout marketing subsidiaries do not engage in production or in R&D abroad. Onthe other hand, R&D0P0M1, R&D0P1M1, R&D1P0M1, and R&D1P1M1 are not emptygroups; firms which invest abroad may engage only in marketing, combine pro-duction with marketing, marketing with R&D or combine all three functions.

Division of the sample into HK and LK firms shows that relatively more LK

firms engage in cross-border production while relatively more HK firms combinemarketing with R&D. As noted earlier HK firms clearly dominate cross border in-vestment in R&D, always in combination with other activities.

HK firms dominate three groups: R&D0P0M1, R&D1P0M1 and R&D1P1M1. Allthree cases are consistent with expectations derived from the expanded productcycle framework namely, that high DP causes HK firms (manufacturers of productsbelonging to early phases of the cycle) to have a higher propensity than LK firms(producers of mature products) to invest in cross border M activities. As arguedabove, internationalized firms, which continue to introduce new products, are likelyto internationalize their R&D activities. Thus, HK firms, originating in countriescharacterized by location advantage are expected to dominate the R&D1P0M1 group.On the other hand, HK firms from countries lacking location advantage are expectedto internationalize P in addition to M and R&D, thus dominating the R&D1P1M1

group6. The domination of the R&D1P1M1 group by HK firms has its mirror image in

the R&D0P0M0 group, which has only LK firms. This distribution is consistent withthe proposition that low DP, associated with mature products, reduces the pressureto internationalize by cross border investment, and facilitates servicing of foreignmarkets by exporting. Domination of the R&D0P1M1 group by LK firms is explainedby the proposition that producers of mature products maintain their competitiveadvantage by internationalizing their production activities, when the home countrysuffers from location disadvantage.

Using a K means cluster analysis we were able to further support the notion thatHK firms dominate several groups while LK firms dominate others. This procedure


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attempts to identify relatively homogeneous groups of cases based on selectedcharacteristics and presents for each characteristic its “cluster center”, using analgorithm that requires specifying the number of clusters (two in our case). The re-sults of the K means cluster analysis show that for five of the eight groups detailedin Table 2 a higher proportion of firms belongs either to the LK firms cluster (clus-ter 1) or to the HK firms cluster (cluster 2). The results, presented in Table 3, areconsistent with our expectations and are statistically significant in all, but one case.

While we did not have data that allows us to analyze the internationalization pat-terns over long time periods, we did obtain data on the distribution of foreign sub-sidiaries in 1995. This information enabled us to cross check whether the changes infirms’ classification into the eight groups detailed above between 1995 and 1999 con-form to our hypotheses. This was done by using the z-statistic as an equality test ofthe sampling distribution in order to measure the difference between two proportions.As indicated in Table 4 the probability for firms to move from exports in 1995(R&D0P0M0) to internationalization of marketing activities in 1999 (R&D0P0M1)was statistically significant. The probability of transition from internationalizationof marketing in 1995 to internationalization of both marketing and production in 1999(R&D0P1M1) was not statistically significant. In this case most of the firms remainedin the R&D0P0M1 group also in 1999. However, most of the firms that changed toanother group moved to the R&D0P1M1 group. Finally, the probability of movingfrom internationalization of marketing and production to internationalization of allvalue activities (R&D1P1M1) was also statistically significance. As expected onlyHK firms performed the latter transition. Hence, overall our preliminary empiricaltesting supports the hypotheses suggested by our framework.


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Table 3. K-means Cluster Analysis of Foreign Subsidiary Groups (1999)

Discussion

This paper presents a framework of internationalization, which is viewed as a dy-namic process, triggered by the interaction between two forces: firm specific knowl-edge intensity and distance.

To describe this process we employ an expanded version of the product cycleframework, whose original formulation focused on the evolution of individual prod-ucts and industries from the introductory phase through growth, to maturity. Weadapt the framework to the analysis of the behavior of firms that are portrayed aseconomic entities, engaged in three types of value adding activities: creation of pro-prietary firm specific knowledge, production, and marketing.

Firm specific knowledge constitutes the basis of the firm’s competitive advan-tage. It is generated by investment in R&D and other elements of proprietary in-formation, which can be withheld from outsiders. Firm specific knowledge can beregarded as an intangible asset, which is dissipated over time through depreciation,diffusion and obsolescence. Consequently, R&D is said to be the major determinantof competitive advantage, during the introductory and early growth phases of theproduct cycle. Marketing takes over as the major determinant of competitive ad-vantage during the growth phase. Production becomes the major determinant as theproduct reaches maturity.

Distance is introduced into the framework as a factor that affects cross-borderinteractions. The cost of interactions with suppliers, customers, agents and sub-sidiaries rises as a function of geographic, cultural, legal and other components ofeconomic distance. “Distance Premium”, e.g. the difference between domestic andforeign costs of market servicing and other interactions, also varies over the prod-uct cycle. Being strongly correlated with both service-intensity and knowledge-intensity, which peak during the early phase of the cycle, and decline as the prod-uct approaches maturity, the distance premium is a significant component of the“liability of foreignness”, affecting the modes as well a the sequence of interna-tionalization.


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Table 4. Mode of Internationalization Sequence (1995-1999)

The evolving interaction over the product cycle between product characteris-tics and the distance premium suggests a number of testable propositions regardingthe sequence of foreign entry and operating modes associated with the internation-alization of the marketing, production and R&D functions.

Our framework suggests that ownership advantage, which is essentially repre-sented by firm specific knowledge, declines over the cycle. By contrast, locationadvantage, which is a country characteristic, does not change systematically withproduct maturity. It follows that the relative importance of ownership to locationadvantage declines over the cycle. Thus, the declining dominance of ownershipover location advantage, combined with the reduction in distance premium over theproduct cycle, determines the level and sequence of cross border investments inmarketing, production and R&D. Marketing is expected to be the most interna-tionalized activity and the first one to be internationalized. The internationalizationof production is expected to follow that of marketing. R&D is the last activity tobe internationalized, most frequently by HK firms.

While our framework adds a dynamic dimension to the ‘economic school’ ofinternationalization, it also enriches the predictions of the ‘behavioral school’ ofinternationalization, by focusing on the economic forces that shape the interna-tionalization process. While our predictions are consistent with those of the stagesmodel, the differences between the two approaches are not trivial. The “triggers”of the stages model approach are the accumulated experience of doing businessabroad, and the associated reduction of risk. Moreover, the stages model appearsto assume that internationalization of production activities is the “natural” outcomeof the internationalization process. The twin triggers of accumulated experienceand risk reduction lower the barriers, which prevented the firm from international-izing its functions, in the first place. The stages model does not, however, explainwhy internationalization of production is inherently superior to other modes ofinternationalization. Neither does it explain the shift between different modes offoreign market servicing (Andersen 1993, 1997).

Our framework answers these questions: It identifies knowledge intensity asthe major trigger of internationalization, contending that proprietary knowledge,dissipates with product maturity, as the relevant information spreads, and ceasesbeing proprietary. Internationalization, according to this approach, is a mechanismemployed to overcome the progressive erosion of proprietary knowledge. This ero-sion is counteracted first by the internationalization of the marketing function, wherethe diffusion of proprietary knowledge obliges the original innovators to establishmarketing outlets in the target markets, and to provide the required firm specificservices. Subsequently, the erosion may continue. To counteract this process theinnovators may internationalize their production activities.

Moreover, our framework suggests that this outcome is not inevitable. Interna-tionalization of marketing activities may be sufficient in those cases where locationadvantage resides in the innovators home country. In certain cases the internation-


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alization of R&D activities is also required in order to augment the firm’s compet-itive advantage (Cantwell 1995, Patel/Vega 1999, Pearce/Papanastassiou 1996,1999, Vernon 1979). Reduction of the distance premium due to past investments inmarketing and production makes this possible.

We also contend that internationalization of marketing activities will be moreprevalent and may even be more risky than the internationalization of production.When pre- and post-sales firm specific services account for a high proportion of to-tal product costs, commitment of resources to service and support activities may beextremely large and highly risky. Consequently, assessment of the level of a firm’sinternationalization should be based on the share of total resources committed tooperations outside the home country, and not merely on the internationalization ofproduction activities.

Two major avenues for future research based on the framework developed inthis paper, are suggested. First, a more detailed empirical validation of our frame-work is obviously called for. While the sample we have studied, accounts for a highproportion of Israel’s exports, it may well have some idiosyncratic characteristics,which may not apply to other environments. Additional longitudinal evidence aswell as evidence derived from additional countries is therefore needed. Second,since internalization decisions have long been the focal point of internationalbusiness research (e.g., Andersen/Gatignon 1986, Buckley/Casson 1976, 1998,Dunning 1977, 1988, 1993, Rugman 1981, 1986), future extensions of the productcycle framework could well benefit from addressing the issue of internalization.Further examination of the interplay between fixed and variable costs seems apromising direction of investigation in this respect.

Finally, we present a note on model building and empirical validation. The factthat the empirical findings are consistent with our propositions does not in itselfvalidate the product cycle framework, which was originally formulated to describethe evolution of individual products and industries from introduction throughgrowth to maturity. Direct validation of the framework requires the use of case stud-ies based on historical data. In the present case we used the R&D ratio as a proxyfor maturity. This ratio represents, at best, the level of firm specific knowledge. Itis not a legitimate indicator of the level of maturity of the firm’s products. Indi-vidual products (and industries) inevitably move along the cycle from introductionthrough growth to maturity. The erosion of firm specific knowledge can be slowed,prevented or even reversed, by sustained investment in R&D and other mechanismsof knowledge acquisition. These investments are, in turn, used to support additionalgenerations of new products. The interpretation of the empirical findings must con-sequently be modified. These findings do not in themselves validate the proposedproduct cycle framework. They are, however, consistent with the view that firmspecific knowledge intensity, proxied by the R&D ratio, is a reasonable predictorof the sequence and mode of firms’ internationalization. Moreover, if one acceptsthe notion that the R&D ratio constitutes a plausible representation of the average


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maturity of the firm’s product portfolio, it may indeed be claimed that the interna-tionalization patterns exhibited by the firms in our sample accord with the predic-tions derived from our expanded product cycle framework.

Acknowlegdements

We wish to thank two anonymous mir reviewers as well as The Israel Institute of Business Researchat Tel Aviv University, The Research Unit of the School of Business Administration at the Collegeof Management and The Asper Center at the Hebrew University for their financial support.


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Endnotes

1 At least 25 percent of their output was exported.2 A detailed specification of the two groupings appears later in the paper. 3 The ratio of services exports to overall goods and services exports has increased from 15.1 percent

in 1980 to 18.6 percent in 2000 (WTO 2002).4 Ideally we should have used firm R&D data as a basis for classification. However, this would have

obliged us to drop from the sample 19 firms which failed to supply the figures. The R&D ratios ofthe 47 HK firms and the 28 LK firms for which we had data were 0.229 for HK firms and 0.025for LK firms. This difference is statistically significant (T-value = 2.746, df = 54, p ≤ 0.009). Com-parisons between HK and LK firms did not show evidence of any bias in terms of firm sales, num-ber of employees and percentage of international sales.

5 T-value = 1.771, df = 69, p <0.084 6 Overall, the HK firms in our sample had significantly more R&D subsidiaries than production ones

(T-value =1.953, df = 46, p ≤ 0.057).

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The product cycle revisited: Knowledge intensity and firm internationalization

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