The product cycle hypothesis: The role of quality upgrading and market size

•We develop a dynamic model to endogenously determine the timing of production relocation.•We investigate the interaction between the location of production and the rate of quality improvement.•The policy function for quality improvement is not monotonic in quality if the product cycle emerges.•The product cycle emerges within a region formed by coordination cost and relative marginal production cost.

We develop a dynamic model in which the timing of innovating firm to relocate the production of a new product from North to South is endogenously determined. The decision of whether to produce in the South involves a trade-off between marginal cost savings from lower wages against a fixed coordination cost. The innovating firm invests in R&D to improve the quality of a new product, which raises the size of the market and the cost savings from producing in the South. We demonstrate that a new product is initially produced in the North and its production location is shifted to the South when its quality is sufficiently improved. We also investigate the interaction between the location of production and the rate of quality improvement.