Nepalese economy: foreign trade and foreign employment of Nepal

Any two member countries of SAFTA are India and Nepal.

SAFTA (South Asian Free Trade Area) was formed in 2004 among the SAARC nations to reduce trade barriers; its members include Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka.

Readymade garments and woollen carpets.

Nepal exports readymade garments and woollen carpets (along with items like pulses, cardamom, tea, and handicrafts) to countries such as India, the USA, and Germany.

Access to international markets for Nepali goods and services on a most-favoured-nation basis, and technical assistance plus special treatment for least developed countries.

Two advantages Nepal gets from WTO membership:

1. Market access: As a WTO member, Nepal enjoys most-favoured-nation (MFN) treatment and reduced tariff barriers in member countries, which helps expand exports of goods such as garments, carpets, and tea.
2. Special treatment for LDCs: Being a least developed country member, Nepal receives technical assistance, capacity-building support, and preferential treatment (including duty-free, quota-free access under schemes like EBA), which supports trade and development.

Effects of Foreign Employment on Nepal's Long-term Economic Development

Introduction. Foreign employment has become a defining feature of the Nepali economy since the mid-1990s. Over 2.2 million Nepalis hold official labour permits (and many more are abroad unofficially), mostly in the Gulf States and Malaysia. Remittances now exceed Rs 1,200 billion a year, roughly a quarter of GDP — among the highest ratios in the world. Whether this flow builds the economy or hollows it out is the central question.

Positive effects

1. Foreign exchange and balance of payments. Remittances are the single largest source of foreign currency, covering a large part of the trade deficit and keeping foreign exchange reserves comfortable (over 12 months of imports).
2. Poverty reduction and living standards. Remittance-receiving households spend more on food, education and health. Remittances have been a major reason for the fall in the poverty headcount.
3. Relief to the labour market. Nepal's domestic economy cannot absorb the growing labour force; migration acts as a safety valve against open unemployment and underemployment.
4. Household capital formation. Remittances finance land, housing, small enterprises and children's education, and reduce dependence on local moneylenders.
5. Skill and exposure. A section of migrants returns with technical skills, work discipline and business ideas.

Negative effects

1. Brain drain and loss of productive labour. It is mostly young, able-bodied and semi-skilled workers who leave. Villages are left with the elderly, women and children, and farms are abandoned.
2. Remittance dependency, not development. Remittances are spent largely on consumption and imports rather than on productive investment. Nepal's growth has become consumption-driven, financed from outside, not by domestic production.
3. Import-led consumption and inflation. Remittance income raises demand for imported goods, widens the trade deficit and pushes up prices and wages at home.
4. Dutch disease and de-industrialisation. Large foreign exchange inflows appreciate the real exchange rate and make domestic manufacturing and agriculture less competitive, weakening the very sectors needed for long-term growth.
5. Weak capital formation and tax base. Since remittances come as private transfers, they add little to public revenue; the state cannot tax them and thus cannot invest in infrastructure and human capital.
6. Social costs. Family separation, rising divorce, neglected children, alcoholism and unsafe migration (deaths, exploitation by brokers) impose long-run social costs.
7. Vulnerability to external shocks. Dependence on Gulf labour markets means Nepal's economy is exposed to oil prices, pandemics, and policy changes in host countries.
8. No structural transformation. Migration has not shifted labour from agriculture to industry; it has only shifted it abroad. The economy remains remittance-supported rather than production-based.

Evaluation

In the short run, foreign employment has been beneficial — it has financed consumption, reduced poverty and kept the balance of payments stable. But for long-term economic development, its net effect is largely negative, because development requires productive investment, a diversified industrial base, a skilled labour force and a broad tax base — all of which migration erodes. Remittances have become a substitute for domestic production rather than a source of it.

Conclusion. Foreign employment should therefore be treated as a temporary safety valve, not a development strategy. Nepal must channel remittances into productive sectors through remittance bonds, concessional credit and rural enterprise schemes, expand skill-based and legal migration, and simultaneously build domestic employment through agriculture modernisation, industry and tourism — only then can remittances support rather than replace long-term growth.

The World Trade Organization (WTO) deals with the global rules of trade between nations. It was established on 1 January 1995 as the successor to GATT and provides a forum for negotiating trade agreements and settling trade disputes.

Foreign employment is useful for Nepal for the following five reasons:

1. Remittance inflow: Nepali migrant workers send home a large part of their earnings as remittances. This is the single largest source of foreign exchange for Nepal and helps finance imports and balance the balance of payments.

2. Reduction of unemployment and underemployment: Nepal's domestic economy cannot generate enough jobs for its growing labour force. Foreign employment absorbs a large number of surplus workers, reducing open unemployment and disguised unemployment in agriculture.

3. Increase in national income and savings: Remittances add to the disposable income of households, raising the country's gross national income. A part of this income is saved in banks, which increases the volume of investible funds in the economy.

4. Rise in the standard of living: Migrant households spend remittance income on better food, education, health care and housing. This improves the living standard of the workers' families and reduces poverty.

5. Development of skills and transfer of technology: Workers employed abroad learn new skills, work discipline and modern techniques. When they return, they can use these skills in their own enterprises or in the domestic labour market, contributing to economic development.

Besides these, foreign employment reduces pressure on land and other limited natural resources and helps earn foreign exchange that can be used to import capital goods. Thus, in the present context of Nepal, foreign employment acts as a safety valve for the economy.

Free Trade

Free trade is a system of international trade in which goods and services are exchanged between countries without any artificial barriers such as tariffs (customs duties), quotas, subsidies, or other restrictive trade measures. Under free trade, prices are determined purely by the forces of demand and supply in the world market, and each country specialises in producing goods in which it has a comparative advantage. It is promoted globally by the World Trade Organization (WTO), which works to reduce trade barriers among member nations.

Free trade is based on the principle of comparative advantage — each country gains by specialising in the production of those goods it can produce at a relatively lower opportunity cost and trading them for goods other countries produce more efficiently. In theory, this raises world output, lowers prices, widens consumer choice, and increases the welfare of all participating nations.

Why Developing Countries Are Not Always Benefited from the Expansion of Free Trade

Although free trade is theoretically beneficial to all, in practice developing countries do not always gain from its expansion. The main reasons are:

1. Unequal distribution of gains: The benefits of free trade are not shared equally. Developed countries, with their advanced technology, capital, and skilled labour, capture a larger share of the gains, while developing countries receive a smaller share. Thus the rich tend to become richer and the poor remain relatively poor.

2. Dependence on primary products: Developing countries mostly export primary products (raw materials, agricultural goods) and import manufactured goods. The terms of trade for primary products tend to deteriorate over time compared to manufactured goods (the Prebisch–Singer thesis). So developing countries must export more to buy the same amount of imports, reducing their gains.

3. Weak bargaining power: In international forums such as the WTO, developed countries dominate negotiations. They press developing countries to open their markets while continuing to protect their own agriculture and industries through subsidies and non-tariff barriers. This unequal bargaining position harms developing countries.

4. Infant industry problem: Newly established industries in developing countries cannot compete with the well-established, large-scale industries of developed countries. Under free trade, cheap imports may wipe out these infant industries, hindering industrialisation and long-run growth.

5. Loss of revenue and employment: Developing countries rely heavily on customs duties for government revenue. Free trade reduces this revenue. Also, cheap imports may displace domestic producers, causing unemployment and a decline in domestic output.

6. Brain drain and resource outflow: Free trade and globalisation encourage the migration of skilled labour and capital from developing to developed countries, depriving developing countries of their scarce human and physical resources.

7. Vulnerability to external shocks: Greater openness makes developing economies more exposed to fluctuations in world prices, demand, and financial crises in developed countries, which can destabilise their economies.

Conclusion: Free trade is not a guaranteed blessing for developing countries. Its benefits depend on the structure of their economies, their bargaining power, and the fairness of international trade rules. Therefore, developing countries need a gradual, strategic approach — protecting infant industries where necessary while integrating into the world economy — so that the gains from free trade are realised and equitably shared.

Causes of the Increasing Trade Deficit in Nepal

Introduction. A trade deficit means the value of a country's imports exceeds the value of its exports. Nepal's trade deficit has been widening continuously — imports of roughly Rs 1,600 billion against exports of only about Rs 150 billion in recent fiscal years, giving a deficit of over Rs 1,400 billion. The causes are both structural (supply-side) and demand-side.

1. Narrow and undiversified export base. Nepal exports only a few primary and low-value items — cardamom, tea, pulses, jute goods, carpets, readymade garments, handicrafts and some processed food. These are few in number, low in value addition, and subject to price and demand fluctuations abroad. Exports therefore cannot grow fast enough to pay for a rapidly rising import bill.

2. High and rising import propensity. Nepal imports petroleum products, machinery and spare parts, medicines, chemical fertilizers, electronics, gold, vehicles and large quantities of daily consumer goods. Most of these are essential or income-elastic, so imports rise automatically with population, urbanization and income. Petroleum products alone account for a very large share of the import bill.

3. Remittance-financed consumption rather than investment. Remittances of about Rs 1,360 billion a year raise household purchasing power, but a large part is spent on consumption of imported goods and on imported construction materials for housing. Since remittance is not channelled into productive investment that could substitute imports or expand exports, it directly feeds the deficit.

4. Weak industrial base and supply-side constraints. Nepali industry suffers from low capital formation, outdated technology, small market size, high cost of production, labour unrest, irregular power supply in the past, and shortage of skilled labour. Domestic output is thus unable to meet rising demand, and the gap is filled by imports. The economy has also experienced deindustrialization, with manufacturing contributing a declining share of GDP.

5. Liberal trade policy without export capability. After joining the WTO (2004) and under the Nepal–India Trade Treaty, tariffs were reduced and quantitative restrictions removed. This made imports cheap and easy, while Nepal's weak productive capacity prevented it from taking advantage of the export opportunities opened up. Trade liberalization therefore benefited imports more than exports.

6. Landlocked position and high transit costs. Being landlocked, Nepal must route most overseas trade through Kolkata/Haldia, paying high freight, insurance, handling and delay costs. This raises the price of Nepali exports and makes them uncompetitive, while adding to the cost of imports without reducing their volume.

7. Low productivity and poor quality standards. Low agricultural and industrial productivity, weak quality control, lack of testing laboratories and international certification mean Nepali goods often fail to meet foreign buyers' standards. Consumers also prefer imported goods for their perceived quality and brand value.

8. Over-dependence on India and narrow markets. About two-thirds of Nepal's trade is with India, where goods move freely across an open border. Nepal's exports are concentrated in a few markets and a few commodities, so any fall in demand or price there sharply reduces export earnings while imports continue.

9. Political instability and policy inconsistency. Frequent changes in government, strikes, blockades (such as the 2015 border blockade), and inconsistent industrial and trade policies discourage long-term investment in export industries and disrupt production and trade routes.

10. Inadequate infrastructure and institutional support. Poor roads, transport, storage, banking and insurance facilities, weak export promotion, ineffective export subsidies and cumbersome customs procedures all raise transaction costs and reduce export competitiveness.

Evaluation. These causes are closely interlinked and largely structural rather than temporary. The demand-side pull comes mainly from remittance-financed consumption and rising income, while the supply-side weakness lies in low productivity, a narrow export base and inadequate infrastructure. Price factors such as the rupee's peg with the Indian currency and high transit costs further worsen competitiveness. Because the deficit is structural, it cannot be corrected by exchange-rate adjustment or tariff changes alone; it requires industrialization, export diversification and value addition, productive use of remittances, improved infrastructure and a stable, consistent trade and investment policy.

Free trade allows goods to be imported and exported without any barriers, while protection trade restricts imports through tariffs, quotas and other barriers to shield domestic industries.

(1) Progressive elimination of tariffs and non-tariff barriers on trade among member states.
(2) Free movement of goods across the borders of member countries without discriminatory restrictions.

Two advantages of remittance in Nepal:

1. Increases foreign exchange reserves – Remittance is a major source of foreign currency, which helps maintain Nepal's balance of payments and strengthens the value of the Nepalese rupee.
2. Raises household income and reduces poverty – The money sent by migrant workers supports the daily living, education, and health expenses of their families, improving their standard of living.

Advantages and Disadvantages of Foreign Employment in Nepal

Foreign employment has become a major feature of the Nepalese economy. Every year a large number of Nepali youths migrate to countries such as Malaysia, Qatar, Saudi Arabia, the UAE and South Korea for work. This migration brings both benefits and serious costs to the nation.

Advantages

1. Source of foreign exchange (remittance): Nepali migrant workers send home large amounts of remittance. This is the single largest source of foreign currency for Nepal and helps finance imports and maintain the balance of payments.

2. Reduction of unemployment and underemployment: Nepal has limited job opportunities. Foreign employment absorbs a large number of unemployed and underemployed youths, reducing pressure on the domestic labour market.

3. Increase in national income and savings: Remittance increases the disposable income of households, raises the national income and adds to the country's savings and investment capacity.

4. Improvement in living standard: Migrant families are able to spend more on food, education, health and housing. Remittance has helped reduce the incidence of absolute poverty in many rural areas.

5. Transfer of skills and technology: Workers who return from abroad bring new skills, work discipline and technical knowledge, which can be used in domestic enterprises.

6. Increase in government revenue: The government earns revenue through passport fees, labour permits, visa charges and remittance-related service charges.

Disadvantages

1. Loss of active and skilled manpower (brain drain): Most migrants are young, energetic and skilled. Their departure deprives the country of productive manpower needed for development.

2. Negative effect on agriculture and industry: With young workers leaving villages, large areas of farmland remain fallow. Domestic industries also face a shortage of labour and rising wages.

3. Remittance-dependent economy: The economy has become heavily dependent on remittance. If remittance declines due to recession or policy changes in host countries, the whole economy is affected.

4. Low productive use of remittance: A large part of remittance is spent on consumption, land purchase and imported luxury goods rather than on productive investment. This creates inflation and import dependence.

5. Exploitation and poor working conditions: Many workers face long working hours, low wages, unsafe working conditions, delayed payment and denial of basic rights in foreign lands.

6. Social and family problems: Long separation from family leads to broken homes, neglect of children and elderly parents, and social problems such as alcoholism and gambling.

7. Risk to life and property: Workers face cheating by manpower agencies, health problems, accidents and even death abroad. Many families are left without support.

8. Drain of money through agencies: A large portion of income is spent on high recruitment fees charged by manpower companies, reducing the actual benefit of migration.

Conclusion

Foreign employment has provided relief to Nepal's unemployment problem and is the backbone of its remittance economy. However, excessive dependence on it, loss of skilled manpower and social costs have weakened its long-term benefit. Therefore, the government should create productive employment at home, regulate manpower agencies strictly and channel remittance into productive sectors so that foreign employment becomes a means of development rather than a permanent necessity.

Nepal's foreign trade has remained backward and structurally weak. Its major problems are as follows:

1. Huge and growing trade deficit Nepal's imports far exceed its exports. The value of imports is many times the value of exports, so the trade deficit is large and rising every year. This deficit has to be financed by remittances, foreign loans and grants, which creates dependence on foreign countries.

2. Narrow export base Nepal exports only a limited number of primary and semi-processed goods such as carpets, readymade garments, pulses, cardamom, tea, jute goods and handicrafts. There is little export of manufactured or high-value goods. Dependence on a few commodities makes export earnings unstable.

3. Dependence on a few markets Most of Nepal's trade is concentrated with India, and to a lesser extent with China and the USA. About two-thirds of total trade is with India alone. Such concentration makes Nepal vulnerable to the trade and economic policies of a few countries.

4. Landlocked geographical position Nepal is a landlocked country. It has no direct sea route, so goods must pass through India or China. This increases transport cost, causes delays and makes foreign trade dependent on the goodwill and transit facilities of neighbouring countries.

5. Low quality and high cost of production Nepalese goods are often of low quality and are produced at high cost due to lack of modern technology, skilled labour, capital and infrastructure. As a result, they cannot compete with cheap and quality goods of India, China and other countries in the international market.

6. Lack of export-oriented industries Most industries in Nepal are small-scale and produce for the domestic market. There are very few large, export-oriented industries. Weak industrial development limits the volume and variety of exports.

7. Inadequate infrastructure Poor roads, inadequate transport, irregular electricity, lack of cold storage and weak communication facilities raise the cost of production and make timely delivery of export goods difficult.

8. Bureaucratic and policy hurdles Complex customs procedures, weak trade policy, lack of export incentives, and political instability discourage exporters and foreign investors. Smuggling and informal (unrecorded) trade across the open border with India also distort official trade figures.

9. Low bargaining power Because Nepal's export volume is small and its markets are few, it has weak bargaining power in international trade negotiations and cannot secure favourable terms.

Conclusion Thus, Nepal's foreign trade suffers from a large trade deficit, narrow export base, dependence on a few markets, landlocked position, low competitiveness and weak infrastructure. Diversification of exports, industrial development, improvement in quality and infrastructure, and a stable trade policy are needed to solve these problems.

(1 mark)

Any two arguments in favour of free trade:

1. Comparative advantage and gains from trade — Free trade lets each country specialise in producing goods in which it has a lower opportunity cost and exchange them, so total world output rises and all trading nations can consume beyond their own production possibility frontier.

2. Lower prices and greater consumer choice — Removal of tariffs and quotas allows cheaper imported goods to enter the domestic market, so consumers pay lower prices and get a wider variety of goods and services.

A free trade agreement among SAARC member countries to reduce tariffs and promote trade in the region.

SAFTA is a free trade area formed by the SAARC countries (Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka), signed in 2004 and effective from 2006, under which member countries gradually reduce customs duties on goods traded among themselves to boost intra-regional trade.

Two importance of remittance in the Nepalese economy:

1. Source of foreign exchange: Remittance is the largest source of foreign currency earnings for Nepal, helping to finance imports and maintain the balance of payments.
2. Poverty reduction and household welfare: It raises the income of recipient households, enabling them to spend more on food, education, health and housing, thereby reducing poverty.

Direction and Problems of Nepalese Foreign Trade

Direction of Nepalese Foreign Trade

1. Direction of exports: Nepal's exports are heavily concentrated on India, which absorbs roughly two-thirds of total exports. Other major export destinations include the USA, Germany, the UK, China, and some Gulf countries. Exports to India consist mainly of primary and semi-processed goods — pulses, cardamom, ginger, jute goods, carpets, pashmina, and cement — while exports to third countries are dominated by readymade garments and woollen carpets. Thus Nepal's export trade is both narrow in range and heavily India-centric.

2. Direction of imports: Imports come mainly from India, followed by China, and then from other countries such as the UAE, Saudi Arabia, Malaysia, Singapore, and South Korea. From India, Nepal imports manufactured goods, machinery, chemicals, medicines, and food items; from China and third countries, it imports petroleum products, machinery, transport equipment, fertilisers, and gold. The direction of imports is therefore more diversified than exports, but still dominated by India.

3. Overall trade direction: Nepal trades with about 100 countries, yet India alone accounts for around 60–65 per cent of total trade. This shows that Nepal's foreign trade is excessively dependent on a single partner, making it vulnerable to India's trade policy changes.

Problems of Nepalese Foreign Trade

1. Huge and growing trade deficit: Nepal's imports far exceed its exports. The trade deficit has been widening every year (reaching over Rs 1,300 billion in recent years), which drains foreign exchange reserves and weakens the balance of payments.

2. Narrow export base: Exports are limited to a few primary and agricultural products such as cardamom, pulses, ginger, and jute. There is little export of high-value manufactured goods, so export earnings remain low and unstable.

3. Heavy dependence on India: With about two-thirds of trade tied to a single country, Nepal faces the risk of unilateral trade restrictions, border blockades (as in 2015), and price and policy shocks from India.

4. Low competitiveness: Nepalese goods are costly and of inferior quality compared to Indian and Chinese products due to high production costs, outdated technology, lack of modern machinery, and poor quality control. This makes it hard to compete in international markets.

5. Landlocked and transit problems: Being landlocked, Nepal depends on India and China for transit. Delays, high transit costs, and procedural hurdles at ports and customs raise the cost of trade and reduce export competitiveness.

6. Inadequate infrastructure: Poor roads, unreliable electricity, limited warehouse and cold-storage facilities, and weak transport links raise the cost of moving goods to borders and reduce the volume of trade.

7. Lack of export-oriented policy and promotion: Weak export promotion, insufficient export incentives, poor market information, and inadequate institutional support mean Nepal has not been able to diversify markets or products.

8. Dependence on imports for consumption and production: Even essential goods, petroleum products, raw materials, and capital goods are imported. This makes the economy dependent and vulnerable to external price rises.

9. Trade policy and structural weaknesses: Frequent changes in trade policy, bureaucratic hurdles, and lack of coordination among concerned agencies discourage exporters and investors.

10. Remittance-supported imports: Remittances finance a large part of imports rather than productive investment, so the trade imbalance persists instead of being corrected by export growth.

Conclusion

Nepal's foreign trade is characterised by a narrow, India-dominated export base and a wide, diversified import base, resulting in a chronic trade deficit. To correct this, Nepal needs to diversify both markets and products, modernise agriculture and industry, improve infrastructure and transit facilities, and pursue a stable, export-oriented trade policy.

Examine how foreign employment can contribute to the Nepalese economy. [8 marks]

Foreign employment has become a major pillar of the Nepalese economy. According to the Ministry of Labour, Employment and Social Security, more than five million Nepali migrant workers have gone abroad for work, and remittance has consistently remained around one-fourth of the country's GDP. Its contribution to the economy can be examined under the following points:

1. Source of foreign exchange and remittance: Migrant workers send home remittance, which is the single largest source of foreign currency for Nepal. In recent years remittance has exceeded Rs 1,000 billion annually. This helps maintain the balance of payments, strengthens the foreign exchange reserve, and supports the stability of the Nepalese rupee.

2. Increase in national income and GDP: Remittance is included in the national income as net factor income from abroad. It raises the Gross National Income (GNI) and enables the country to finance a large part of its import trade. Without remittance, the trade deficit would be far more difficult to manage.

3. Reduction of poverty and unemployment: Foreign employment absorbs a large number of unemployed and underemployed youths who cannot find work at home. The income earned raises the living standard of their families, enabling them to meet food, education, health, and housing expenses. Studies show that remittance-receiving households have a lower poverty rate than others.

4. Increase in consumption, saving and investment: Remittance increases household consumption, which raises aggregate demand and stimulates production and employment in trade, transport, construction and services. A part of the income is saved in banks and cooperatives, which increases the supply of loanable funds for investment. In many villages, remittance is used to buy land, build houses and start small enterprises.

5. Development of human capital: Workers going abroad gain technical skills, work discipline and experience in modern technology and management. When they return, this "returnee skill" can be used in domestic industry, agriculture and business, raising productivity.

6. Increase in government revenue: Foreign employment contributes to government revenue through passport and visa fees, labour permits, remittance service charges and taxes on the consumption financed by remittance. This helps the government finance development works.

7. Reduction of pressure on domestic labour market: By exporting surplus labour, foreign employment reduces competition for scarce jobs at home, keeps wages from falling too low, and reduces the problem of disguised unemployment in agriculture.

8. Promotion of foreign relations and technology transfer: Migrant workers build social and economic links with destination countries, which helps in the transfer of technology, ideas and business contacts, and promotes tourism and trade.

Negative aspects (to be examined): Foreign employment also has costs. It creates scarcity of labour in agriculture and industry, raises wages and production costs at home, causes brain drain of skilled manpower, breaks families, and makes the economy dependent on remittance. Much remittance is spent on unproductive consumption and imports rather than productive investment.

Conclusion: Foreign employment contributes significantly to Nepal's foreign exchange reserve, national income, employment, poverty reduction and government revenue. However, its benefit is greater when remittance is channelled into productive investment and when workers are sent with proper skill training. Therefore, foreign employment should be managed as a means of temporary income and skill generation rather than a permanent solution to unemployment.

Balance of trade records only the export and import of visible goods (merchandise), whereas balance of payment records all economic transactions of a country with the rest of the world, including goods, services, transfers and capital flows.

Two principles of WTO:

1. Non-discrimination (Most Favoured Nation): a trade advantage given to one member must be given to all members.
2. Freer and fair trade: member countries should gradually reduce tariffs and other trade barriers through negotiation.

Under a fixed exchange rate system, the exchange rate is fixed by the central bank (government), whereas under a flexible exchange rate system it is determined by the forces of demand and supply in the foreign exchange market.

Nepal became a member of the WTO on 23 April 2004, the first least developed country (LDC) to join through the full accession process.

Comparative Advantage Theory

The theory was propounded by David Ricardo in 1817 in Principles of Political Economy and Taxation. It states that international trade is beneficial to all countries even if one country has an absolute advantage in producing all goods. A country should specialise in the production of the good in which it has a comparative advantage, i.e. the good with lower opportunity cost, and import the good in which its opportunity cost is higher. Thus, a country imports a good if its domestic cost of production, measured as opportunity cost, is high.

Assumptions

1. Two countries and two goods.
2. Labour is the only factor of production and is homogeneous.
3. Labour is perfectly mobile within a country but immobile between countries.
4. Production costs are measured in labour hours.
5. Free trade, full employment, and no transport costs.
6. Technology is given and constant.

Example

Suppose two countries, Nepal and India, produce two goods, rice and cloth. Each country has 100 labour units.

India has an absolute advantage in both goods because it uses fewer labour hours for rice as well as cloth. But comparative advantage depends on opportunity cost.

Opportunity costs:

• Nepal: $1$ rice $= 10/20 = 0.5$ cloth; $1$ cloth $= 20/10 = 2$ rice.
• India: $1$ rice $= 5/15 = 0.33$ cloth; $1$ cloth $= 15/5 = 3$ rice.

Thus:

• India has comparative advantage in rice because $0.33 < 0.5$.
• Nepal has comparative advantage in cloth because $2 < 3$.

Specialisation and Trade

Nepal produces only cloth:

$100/20 = 5 \text{ cloth}$

India produces only rice:

$100/5 = 20 \text{ rice}$

Let the terms of trade be:

$1 \text{ cloth} = 2.5 \text{ rice}$

This lies between the two opportunity costs, $2$ and $3$.

• Nepal exports $2$ cloth and gets $2 \times 2.5 = 5$ rice.
  It consumes $3$ cloth $+ 5$ rice.

• India exports $5$ rice and gets $5/2.5 = 2$ cloth.
  It consumes $15$ rice $+ 2$ cloth.

Before Trade

Assuming each country divides its 100 labour units equally between rice and cloth:

• Nepal: $50/10 = 5$ rice and $50/20 = 2.5$ cloth.
• India: $50/5 = 10$ rice and $50/15 = 3.33$ cloth.

Gains from Trade

For India, $1.33$ cloth is worth $1.33 \times 2.5 = 3.33$ rice in trade. So the net gain is:

$5 - 3.33 = 1.67 \text{ rice}$

or equivalently $0.67$ cloth. Hence India also gains.

Conclusion

Both countries gain from specialisation and trade. Nepal imports rice because its domestic opportunity cost of rice is high, and India imports cloth because its domestic opportunity cost of cloth is high. This explains how comparative advantage creates the need for international trade.