1 MBA Evening, International Business, Instructor: Binod Lingden Subba

Unit -2
THEORIES OF INTERNATIONAL TRADE AND INVESTMENT

Chapter outlines
International Trade Theories
1. Mercantilism
2. Absolute Advantage Theory
3. Comparative Advantage Theory
4. Factor Endowment Theory
5. Product Life Cycle Theory
6. Competitive Advantage Theory
7. An overview of Nepal’s Foreign Trade

International Investment Theories

1. OLI Theory
2. Internationalization Theory
3. Contemporary issues in international trade and investment

THEORIES OF INTERNATIONAL TRADE

International trade theories are simply different models of international trade that have been developed to analyzed
the pattern of international trade and suggest ways to maximize the gains from trade. These theories explain the
diverse ideas of exchange of goods and services across the global boundaries. International trade theories suggest
explains the questions of:
a) Which product a country should import and export to gain from trade?
b) How much a country should trade to gain from trade?
c) With whom a country should trade to gain from trade?

Therefore, international trade theories help to answer these questions of which, how much, and with whom a country
should import and export to gain from trade. Different trade theories that have evolved over the past century those
are most relevant today. These theories attempt to analyze the pattern of international trade and suggest ways to
maximize the gains from trades.

Various international trade theories that evolved in various time frames are:
1. Mercantilism
2. Theory of absolute advantage
3. Theory of comparative advantage
4. Factor endowment theory
5. Product life cycle theory
6. National competitive advantage theory
2 MBA Evening, International Business, Instructor: Binod Lingden Subba

MERCANTILISM [1500 – 1700]

Mercantilism is an economic theory based on the premise that national wealth and power is best served by increasing
export and minimizing import. It considered precious metal such as gold and silver as wealth of a nation and should
be collected from foreign countries by exporting more commodities to gain from trade. The main goal of mercantilism
is to increase a nation‘s wealth by imposing government regulation to encourage export and discourage import
especially through the use of tariff barriers.

Mercantilism believes that precious metals, such as gold and silver, are deemed indispensable to a nation‘s wealth. If
a nation does not possess mines, precious metals should be obtained by trade. It is believed that trade balances must
be ―favourable,‖ meaning an excess of exports over imports. Colonial possessions should serve as markets for exports
and as suppliers of raw materials to the mother country. Manufacturing are forbidden in colonies, and all commerce
between colony and mother country is held to be a monopoly of the mother country.

Assumptions of mercantilism
a) There is a finite amount of wealth in the world.
b) A nation can only grow rich at the expense of other nations.
c) Therefore, a nation should try to achieve and maintain a favourable trade balance, exporting more than it imports.

History of mercantilism
Mercantilism was the dominant economic policy most associated with the Early Modern period of the 16th and 17th
centuries, based on the premise that national wealth and power were best served by increasing export and collecting
precious metals in return. During this era, the only true measure of a country‘s wealth and success was thought to be
the amount of gold and silver reserves that a nation possessed. In order to add precious metals to a nation‘s reserves,
it would seek to maximize its net exports and minimize its imports in order to secure its prosperity. Countries that
had more wealth could in turn raise and maintain stronger armies and navies, and thus be more powerful.
According to the doctrine of mercantilism, the gold and silver reserves in the world were thought to be limited.
Therefore, one‘s gain in precious metals would come at some other country‘s expense. Trade was a zero-sum
game. For example, the gain from trade for England, mercantilism taught, would be a loss for France or Spain. The
best way to ensure a nation‘s prosperity was by limiting imports and increasing exports, thereby generating a net
inflow of gold and silver, thus increasing the country‘s overall gold stocks. Every European nation was trying to find
a market for its exports to bring wealth while limiting imports, which would otherwise transfer wealth to others.

Mercantilism was an economic theory that governments applied many forms of protectionist policies in order to
promote efficient domestic consumption and maximize the export of surplus production. For example, according to
the famous British Navigation Act of 1651, all imports to England had to be carried to English ports on English ships.
Colonial exports to Europe had to first land at an English port before going any further. These laws sharply restricted
colonial trade with anyone else but England. With mercantilism, each country sought to export as much as possible
while preventing imports. As a result, the economic importance of colonies to the success of colonizing powers
became vital.

Colonies played a critical role for European countries. Colonies provided the precious metals and raw materials that
European countries needed but could not produce at home. They were also markets for finished goods. According to
mercantilism, colonies could only trade with their mother nation, and the direction of wealth should flow to the
mother nation. In order to protect colonial trade, each European nation developed powerful navies, which protected
its nation‘s trade routes. Democracy and free trade destroyed mercantilism in the late 1700s. American and French
revolutions formalized large nations ruled by democracy. They endorsed capitalism.
3 MBA Evening, International Business, Instructor: Binod Lingden Subba

THEORY OF ABSOLUTE ADVANTAGE [1776]

The theory of Absolute advantage was propounded by economist Adam Smith (1776) in his book ―An Inquiry into the
nature and cause of the Wealth of Nations‖. He argued that it was impossible for all nations to become rich
simultaneously by following mercantilist prescriptions because the export of one nation is another nation‘s import.
However, all nations would gain simultaneously if they practice free trade and specialized in accordance with their
absolute advantage. Therefore, this theory prescribes a country to specialize in those products in which it has an
absolute advantage.

Theory of Absolute advantage holds that different countries produce some goods more efficiently (at lower cost per
unit) than other countries. Hence, countries should specialize in the production of those goods for which they have
an absolute advantage and then trade these goods for the goods produced by other countries. In other words, each
country should produce goods in which it can do more efficiently than other country or countries and exchange these
goods with other country‘s or countries‘ goods in which they have absolute advantage.

A country is said to have an absolute advantage over another country in the production of goods if the country can
produce more output as compared to other countries by using same amount of input i.e. labor. For example, if Nepal
can produce 60 units/labor and Japan can produce 10 units/labor, Nepal has absolute advantage over Japan. According to this
theory, labor is the only true input and therefore used it for calculating productivity. Absolute advantage is
determined by a simple comparison of labor productivity across countries. As a result of more advanced division of
labor by specializing in the production of certain goods, more output can be produced with the same amount of
labour in a limited time.

According to this theory, each country has its own resources either natural (mines, climate, landscape, etc.) or acquired
(technology, innovation, etc.). Among these resources, which one is more efficient to specialize for production is
determined by the labors‘ productivity of that country as compared to other countries. This means, country should
focus on the production of those goods in which fewer labors can produce maximum outputs as compared to other
countries and subsequently other countries also should do the same. As a result, productivity increases, labor cost
decreases, and both countries gain from trade when exchanging their goods.

Assumptions of theory absolute advantage

 Trade between two countries take place on the basis of the barter system.
 There is free trade between the two countries, without trade barriers and restrictions.
 Labor is the only factor of production and its productivity remains the same.
 Labor was mobile within a country but immobile between countries.
 Assumes perfect competition i.e. no transportation cost, no restriction on the movement of goods between the two
countries (free trade).

Example of absolute advantage showing how countries can be benefited through trade
Suppose there are two countries (Nepal and Japan), producing two products (agriculture and manufacturing), and
using labour as the only input. Goods can be traded without costs and workers are immovable between two
countries, but movable between two sectors within a country. Table (2.1)

Table(2.1): Productivity before specialization

Country Output unit per Labour
Output of agricultural products Output of manufacturing products
Nepal 60 units/labour 40 units/labour
Japan 10 units/labour 50 units/labour
Total output before 70 units 90 units
specialisation

 In agriculture, one labour can produce 60 units in Nepal and 10 units in Japan. Absolute advantage to Nepal is in
agricultural products, because 60>10.
 In manufacturing, one labour can produce 40 units in Nepal and 50 units in Japan. Absolute advantage to Japan is in
manufacturing products, because 50>40.
4 MBA Evening, International Business, Instructor: Binod Lingden Subba

Specialisation is recommended in respective products, for instance, Nepal should specialize in agricultural products
and Japan in manufacturing products. Table (2.4)

Table(2.2): Productivity after specialization

Country Output unit per Labour
Output of agricultural products Output of manufacturing products
Nepal 60 units/labour 0 units
60 units/labour
Japan 0 units 50 units/labour
50 units/labour
Total output after 120 units 100 units
specialisation

The following illustration presents productivity after specialization as prescribed by Smith.

 Since Nepal is more efficient in agriculture; therefore, Nepal has an absolute advantage in the production of
agricultural products.
 Likewise Japan is more efficient in manufacturing; therefore, Japan has an absolute advantage in the production of
manufacturing products.

From the above table, it clearly presents the reasons for specialization and mutual gains can occur from barter system.
A country should specialize in production and export of goods which it produce most efficiently, that is with the
fewest labour hours
5 MBA Evening, International Business, Instructor: Binod Lingden Subba

THEORY OF COMPARATIVE ADVANTAGE [1817]

The Theory of Comparative Advantage explained by David Ricardo (1817) in his book ―On the Principles of Political
Economy and Taxation‖. This theory expanded and refines the theory of Absolute Advantage as Adam Smith fails to
explain why countries with an absolute disadvantage in all their products still engage in international trade or what if
a country has absolute advantage in producing both products?

For example, China has absolute advantage in almost all the goods than Nepal. But that does mean the China will only export?
What will it do with all its export earning if it does not import? It does not make sense for country to keep exporting without
importing. How can a less efficient country such as Nepal hope to compete with other countries in the world?

This type of questions was answered by Ricardo‘s Theory of Comparative Advantage. David Ricardo explored what
might happen when one country has an absolute advantage in the production of both goods.

According to the theory, a country which experiences absolute advantages in both of the commodities should
specialize in that production, which accrues it comparatively most efficient over the commodity, and should sacrifice
which accrues comparatively less efficient. This theory argues that a country must give up or sacrifice less efficient
output to produce more efficient output. Doing will get comparative advantage. According to this theory, labor
opportunity cost is used to compare between most and least efficient commodity. Opportunity cost is the benefit that
is missed or given up when a nation chooses one alternative over another.

For example, In China, it is possible to produce both agricultural products and manufacturing products with less labour than it
would take to produce the quantities in Nepal. It is cheaper to produce agricultural products in China than Nepal; it is cheaper
still for China to produce excess manufacturing products. However, China choose to specializes in manufacturing products which
it can produce more efficiently and trade that for Nepal’s agricultural products. Since both nations can benefit from specialization
and exchange. Such arrangement will increase total production.

Assumptions of comparative advantage theory

 There are only two countries and they produce two products.
 Labor is the only factor of production and cost of production is measured in terms of labor units.
 All units of labors are homogeneous.
 Production is subject to law of constant returns.
 Factors of production are perfectly mobile within the country but perfectly immobile between two countries.
 There is full employment in countries concerned.

Example of absolute advantage showing how countries can be benefited through trade
Suppose there are two countries two countries (Nepal and China), and two commodities (Agriculture and
manufacturing). In both commodities, China is more efficient to produce than Nepal. It is presented in the table (2.3):
Table(2.3): Comparative advantage before trade
Output per unit of labor
Country Manufacturing Agriculture
China 10 labors/unit 20 labors/unit
Nepal 60 labors/unit 30 labors/unit

In above table (2.3), China has absolute advantage in both manufacturing and agriculture.
China
 10 labors are required to produce 1 unit of manufacturing products.
 20 labors are required to produce 1 unit of agricultural products.
Nepal
 60 labors are required to produce 1 unit of manufacturing products.
 30 labors are required to produce 1 unit of agricultural products.
6 MBA Evening, International Business, Instructor: Binod Lingden Subba

A country has comparative advantage if it has a lower opportunity cost of producing goods than another country.
Opportunity costs measures the loss of output of a products brought out by an increase in the production of another
products. Table (2.4)
Table(2.4): Comparative advantage after trade
Opportunity cost
Country Manufacturing Agriculture
China 10/20 = 0.5 20/10 = 2
Nepal 60/30 = 2 30/60 = 0.5

Each country should specialize in the production for which it has less opportunity cost. From above table (2.4):
 China is more efficient in manufacturing than in agriculture because has less opportunity cost of manufacturing than
the opportunity cost of agriculture i.e. 0.5<2.
 Nepal is more efficient in agriculture than in manufacturing because it has less opportunity cost of agriculture than
the opportunity cost of manufacturing i.e. 0.5<2

Specialization is recommended for CHINA in manufacturing and Nepal in agriculture. It holds that trade is beneficial to
both participating countries.

Finally, Ricardo showed that every country has a comparative advantage, a good or service that they can produce at a
lower (opportunity) cost than any other country. As a result, production is maximized when each country specializes in
the good or service that they produce at lowest cost, that is in the goods in which they have a comparative advantage.
Since specialization in comparative advantage maximizes production, trade can make every country wealthier.

Difference between Absolute advantage and Comparative advantage

Table(2.5): Absolute advantage theory vs. comparative advantage theory
Absolute Advantage Comparative Advantage
It was Adam Smith who first described absolute advantage David Ricardo, who explained the concept in his book ‗On the
in the context of International trade. Principles of Political Economy and Taxation‘.
Absolute advantage describes the ability of a specific Comparative advantage describes the ability of a specific country to
country to produce goods at a lower cost per unit. produce goods at a lower opportunity cost.
Absolute advantage is focused on the advantage of cost. Comparative advantage is based on opportunity cost.
Absolute advantage is a condition where the trade is not Comparative advantage is a condition in which the trade is
mutually beneficial for two countries. mutually beneficial for two countries.
7 MBA Evening, International Business, Instructor: Binod Lingden Subba

FACTOR ENDOWMENT THEORY [1935]

Factor endowment theory was propounded Swedish economist Eli Heckscher in 1919 and later the work was
completed by his student Bertil Ohlin in 1935. Their combine work is popularly known as Heckscher-Ohlin theory (H-
O Theory), which is also called the factor proportions theory or Factor endowment theory.

Theory of Absolute advantage and Comparative advantage fail to explain in their international trade theory, ―Why
costs differ in the production of commodities among different nations?‖

This question was attempted to explain by Factor endowment theory. This theory gave two reasons for making
possible of comparative cost differences, which are as follow:
 Difference in factors combination required for the production of different commodities: Even if the production
purpose for a given product is same, irrespective of the country of production, the factor combination required for
them will differ. This means some of the product requires more of the labor in their production relative to capital,
where as another group of goods may require more of capital or land relative to labor. The difference in factor
combination thus classifies commodities in to labor intensive and capital intensive. For example, textile products are
labor intensive because it needs lots of employees and semi-conductor is capital intensive product.

 Relative differences in this factor endowment in different countries: It makes some countries rich in labor and other
in capital. Therefore it is this difference in relative factor endowment of countries, which explains international
differences in comparative cost of production. For example, India, Pakistan, and Bangladesh have abundant labors than
capital. Singapore, Japan, and Hong Kong have abundant capital but scarce labors.

Factor endowment

Labor Capital

H-O theory is based on country‘s production factors: labor and capital that a country has been endowed with by
Mother Nature. The theory holds that factors in relative abundance are cheaper than factor in relative scarcity. Factors
that are in great supply relative to demand will be cheaper and factors that are in great demand relative to supply will
be expensive. Therefore, country should produce and export those goods that require factors that are in great supply
in home country so that the production cost will be cheaper. In other words, country should specialize in and export
those products which have abundant factors of production in home country. Country should export those products
whose factors of production are abundant and import those products whose factors of production are scarce. It is also
called 2x2x2 model i.e. two countries, two commodities, and two factors (labor and capital).

A country with abundant labor has lower labor costs as compared to capital and if labors are scarce, labor cost will
be obviously be high against capital. For example, India and China have huge population and are home to cheap labor work
force. Therefore, these countries are becoming the optimal locations for labor intensive industries such as textiles and garments
industries.

A country with abundant capital than labor has lower capital costs as compared to labour and vice versa. For example,
technological products are much cheaper than agricultural products in Singapore, Dubai, Japan and Singapore.

Example, according to H-O theory, countries should focus on these sectors to gain from trade.

Country Labors Capital Specialization

Nepal Abundant Scarce Hospitality

Singapore Scarce Abundant Technology

In a nutshell, Heckscher-Ohlin theory suggests that a country should specialize in the production and export of goods
whose production requires a relatively large amount of the factor with which the country is relatively well endowed.
In other words, countries produce and export goods that require resources (factors) that are abundant and import
goods that require resources in short supply.
8 MBA Evening, International Business, Instructor: Binod Lingden Subba

Assumptions of factor endowment theory

 Two countries.
 Two commodities.
 Two factors (labor and capital).
 Perfect competition exists in all markets.
 Each country‘s endowment of factors is fixed.
 Factors are mobile internally, but immobile internationally.

PRODUCT LIFE CYCLE THEORY [1966]

Harvard Business School Professor, Raymond Vernon (1966) developed product life cycle theory in response to the
failure of the Hecksher-Ohlin model to explain the observed patter of international trade.

This theory suggested that the location of production depends on the stages of product life cycle. Production of new
product (Introduction stage) always occurs in the area where it was invented (home country). After the product
becomes adopted and used in the world markets, production gradually shift away from the point of origin to foreign
locations, especially, to developing nations as the product reaches the stage of maturity and declines. In some
situations, the product becomes an item that is imported by its original country of invention. Thus, a product that
begins as a nation‘s export item eventually becomes its import.

Raymond Vernon‘s product life cycle passes through four distinct stages and location of production depends on the
stage of the cycle: Introduction, Growth, Maturity, and Decline.

Maturity
Sales Growth
Decline
Introduction

Time

1. Introduction: The product is developed and introduced in advanced nation where research and development are
highly concentrated. Most sales are domestic and export is limited. To some degree, the product is experimental.
Customer acceptance is uncertain and some features of products are not yet completely identified. Production
remains on a limited scale and price is high.

Example: Apple Company launched its product in U.S and marketed only in its country of innovation namely CHINA

2. Growth: This is the stage of customer acceptance where they are aware and understand the benefit of product. The
product demand grows substantially both in domestic and foreign markets. Firm might set up production facilities in
those advanced countries where demand is growing. In this stage, competitors begin to copy the products and sell
domestically. Competitors may also branch out and begin exporting. Consequently, production within other
advanced countries begins to limit the potential for exports from the country of innovation. The growth stage is
marked by an emerging product standard based on mass production.
9 MBA Evening, International Business, Instructor: Binod Lingden Subba

Example: Apple Company targets its market in advance nations such as Japan, UK, Germany, Canada, and South Korea. These
advance nations gradually start to produce same types of product and limit the potential for export from CHINA such that they
become the ultimate competitors.

3. Maturity: In this stage, global marketplace becomes saturated, meaning everyone bought the product, either from the
innovating company or one of its competitors. Firm compete for the remaining consumers through lowered prices.
The price becomes main competitive weapons. The number of producing firms multiplies and competition becomes
very vigorous. This result to the establishment of foreign operations in advanced nations where labor costs are lower
than in the country of innovation in order to remain competitive.

Example: To have competitive price advantage, Apple Company shifts their production locations in advance nations (Spain,
Finland) where labor costs are lower. In addition because of market places are saturated in advance nations, Apple Company
targets its market in developing nations.

4. Decline: This is the stage where cost pressure is extremely high because of multiple producers involved in the
market. To adjust this situation, company further shifts its production location to the developing countries where
cheap labour forces are available. The innovators may move production into these developing countries in an effort to
boost sales and keep costs low. Over time, the country of innovator switches from being an exporter of the product to
an importer of the product as production becomes concentrated in lower-cost foreign locations.

Example: Apple Company shifts its production location to the developing nations such as China, Taiwan, and Indonesia where
labor costs are low. CHINA, the country of innovator which initially was exporter now imports the product from these developing
countries.

Assumptions of product life cycle theory

Regions may be available for the production of a particular product based on its life-cycle and that during the cycle
the production will be transferred to regions with best conditions for production.
10 MBA Evening, International Business, Instructor: Binod Lingden Subba

THEORY OF NATIONAL COMPETITIVE ADVANTAGE: PORTER’S DIAMOND [1990]

Michael Porter developed a model in 1990 A.D. that allow examining why some nations are more competitive and
why some industries within nations are more competitive than others are, in his book The Competitive Advantage of a
Nations. This model of determining factors of national advantage is known as Porter‘s diamond or Theory of National
Competitive advantage.

Example: Why some nations are more competitive such as France for wine, Japan for automobiles, Switzerland for luxuries
watches, United States for Chemical. And why some industries within nations are more competitive such as Wai Wai is more
popular among other noodles in Nepal.

Porter tried to answer these questions by identifying the determinants of national competitive advantage. Porter used
a diamond shaped diagram as the basis of a framework to illustrate the determinants of national advantage.

As per this theory, there are four determinants that always shape the environment in which local industries compete.
These determinants are the competitive advantage of an industry in particular country and it can realize competitive
advantage of a nation in global competition. These determinants are: Factor condition, Demand condition, Factor
endowment, Related and supporting industries, and Firm strategy, structure and rivalry.
Porter’s diamond

Firm‘s strategy, structure and

rivalry

Factor Demand
Condition Condition

Related and supporting

industries

1. Factor condition (resources): Porter proposes that an organization with endowed or acquired factors of production
has competitive advantage to succeed in foreign markets and created factors conditions are more important than
inherited factor conditions.

Factor condition can be either inherited or created:

 Inherited factor condition: It refers to the naturally inherited resource such as land, water, raw materials, climate, etc.
 Created factor condition: It refers to the created resources such as skilled human resources, advanced technology,
good infrastructure, investment, and scientific knowledge base (research).

Porter argues that ‗created‘ factor conditions are more important in determining an organization or country‘s
competitive advantage than ‗natural‘ factor conditions that are already present. It is important that these created factor
conditions are continuously upgraded through the development of skills and the creation of new
knowledge. Competitive advantage results from the presence of world-class institutions that first create specialized
factors and then continually work to upgrade them. Nations thus succeed in industries where they are particularly
good at factor creation.

For example, automotive industry in Japan is known as the leading and prominent industry in the world. For that, it has all
created factor condition such as technology, skilled human resources, and imported raw materials for car production.

2. Home country demand condition: Porter proposes that an organization with the presence of demand conditions
from local customers pushes to grow, innovate, and improve quality which ultimately helps to gain competitive
advantage in foreign markets.

Porter argued that demand of products in a home country is important. Home demand provides clearer and earlier
signal of demand trend in the global market. Demand conditions are pressures to create products according to
11 MBA Evening, International Business, Instructor: Binod Lingden Subba

buyers‘ requirement in terms of quality, price, and service in a particular industry. When an industry creates products
according to the requirements of home demand, they will gain competitive advantage in that country and eventually
in foreign markets. Demand condition influences on the pace and direction of innovation and product development.

For example, Japanese customers preferred car with higher quality that put pressure on Japanese car makers to develop standard
quality cars if car makers have to survive in the home market. This in turn makes car industries to compete internationally.

3. Firm’s related and supporting industries: Porter proposes that an organization with the presence of home based
related and supporting industries that are internationally competent has competitive advantages in foreign markets.
The success of one industry is dependent on the related and supporting industries.

Porter argues that the continuous supplies of required components for production by associated industries or
suppliers have competitive advantage in foreign markets. Associated industries or related and supporting industries
include suppliers that supply raw materials regularly, parts of product suppliers, HR agency that supplies
competence manpower, financial institutions that provides loan at lower interest rate, transporters that assists in
moving goods to end-users, advertising agencies that promotes products, distribution channels that continuously
push products to end-users. These industries help in innovation that helps organization under them to produce at
low cost.

For example, Sweden's global superiority in its pulp and paper industries is supported by a network of related industries
including packaging, chemicals, wood-processing, conveyor systems and truck manufacture.

4. Firm’s strategy, structure and rivalry: Porter proposes that an organization with best strategy, good style of
management, and strong competition in domestic market helps to gain competitive advantage in foreign markets.

Porter argues that the ways in which firms are established and managed, set goals, and level of competition in
domestic market is critical to success in international markets.
 Strategy and structure: Strategy implemented by a firm will determine the success in foreign markets. Firm‘s strategy
can be international (selling standard products without lowering price), multi-domestic (selling modified products
without lowering price), global (selling standard products by lowering price), and transnational (selling modified
products by lowering price) strategy.

The types of organizational structure or management style should be according to the strategy adopted by the firm to
have competitive advantage in foreign markets. Management styles can be ethnocentric, polycentric, regiocentric, and
geocentric. Firm with international strategy adopts ethnocentric, multi-domestic adopts polycentric, global adopts
regiocentric, and transnational adopts geocentric management style. There should be matching between strategy and
structure of a firm to have competitive advantage in foreign markets.

 Rivalry: Firms that face strong domestic competition will be better to face competitors in foreign markets. Strong
domestic rivalries pressurized to create innovative products with best quality in advanced upgraded technology at
lower costs.
12 MBA Evening, International Business, Instructor: Binod Lingden Subba

AN OVERVIEW OF NEPAL’S FOREIGN TRADE

As a matter of fact, the Nepalese government is showing a special interest in establishing an export-oriented
economy. However, there are major barriers to the development of trade. Nepal is facing a problem of ever increasing
trade deficit. Import is rapidly increasing but the increase in export is very low. Nepal is facing trouble to take the
advantage of globalization in trade.

Following points are presented to know about the present condition of Nepal‘s foreign trade:
1. Country overview
2. Major trading partners
3. Major export products
4. Major imports
5. Foreign trade balance
6. Opportunities and challenges of Nepal’s foreign trade
7. Guidelines for foreign trade in Nepal

1. Country overview
 In ancient times, barter trade prevailed at domestic and border trade.
 The international trade was limited to Tibet and East India Company. Nepal provided transit passes between India
and Tibet during the medieval times in history (treaty of peace and commerce was signed with Tibet during the time
of Pratap Malla).
 India occupied 95 percent of Nepalese trade during the Rana period.
 The First Trade Policy introduced in 1983 with the slogan of "Exports for Development"
 Following the wave of economic liberalization and Structural Adjustment Program, Nepal introduced its first Liberal
Trade Policy in 1992. Trade Policy 1992 removed most of the trade barriers such as eliminating licensing for import
and export, establishing industry etc.
 Given the changed context GON introduced Trade Policy, 2009. Considering the dynamism in the trade sector and
addressing alarming trade deficit, the Government introduced new Trade Policy, 2015
 To integrate Nepalese economy with global economy through trade, Nepal joined WTO and became the 147th
member of the WTO in April 2004.
 In February 2004, Nepal became a member of the BIMSTEC. BIMSTEC seeks to establish a more comprehensive free-
trade area through deeper and more substantial sector coverage of services and an open and competitive investment
regime.
 Nepal has signed bilateral trade treaties with seventeen countries, including the United States, United Kingdom,
Yugoslavia, India, Russia, South Korea, North Korea, Egypt, Bangladesh, Sri Lanka, Bulgaria, China, Czech Republic,
Pakistan, Romania, Mongolia, and Poland.
 Nepal recorded a trade deficit of 127338.30 Million NPR in June of 2018. Balance of Trade in Nepal averaged -31721.70
Million NPR from 2001 until 2018, reaching an all time high of -3913.30 Million NPR in October of 2001 and a record
low of -127338.30 Million NPR in June of 2018.

2. Major trading partners of Nepal

In 2018, Nepal has 121 trade partners in the world. The major partners are:
 Export partners: The major trade partners of Nepal are India, USA, Turkey, Germany, UK, China, France,
Bangladesh, and Japan.
 Import partners: India, China, UAE, France, Argentina, Indonesia, Thailand, South Korea, Vietnam, and Saudi
Arabia. Refers to table (2.6):
Table (2.6): Major trading partners of Nepal
S. Export [in US $ million] S. Import [in US $ million]
N. Country Value % N. Country Value %
1 India 418.52 56.5 1 India 6561.8 65.2
2 USA 82.80 11.2 2 China 1271.4 12.6
3 Turkey 47.63 6.4 3 U.A.E. 174.26 1.7
4 Germany 29.21 3.9 4 France 152.61 1.5
5 UK 25.46 3.4 5 Argentina 133.92 1.3
6 China 22.42 3 6 Indonesia 121.36 1.2
7 Italy 12.09 1.6 7 Thailand 108.07 1.1
8 France 11.08 1.5 8 South Korea 93.17 0.9
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9 Bangladesh 9.84 1.3 9 Vietnam 91.40 0.9

10 Japan 9.70 1.3 10 SaudiArabia 88.75 0.9
Others 71.41 9.9 Others 1273.05 12.7
Total 740.16 100% Total 10,069.8 100%
Source: TEPC, Export Import data bank
3. Major export products of Nepal
About 300 product items are exported from Nepal. The most popular export product items of Nepal are woolen
carpets, Pashmina, leather, pulses, and handicraft products. This is presented in table (2.7):
Table (2.7): major export products from Nepal
S.N Products S.N Products
1 Woolen Carpets 6 Floricultural products
2 Pashmina products 7 Jewelries
3 Leather and leather 8 Spices (dry and fresh ginger, cardamom,
products turmeric, cinnamon chilies etc)
4 Pulses 9 Medicinal herbs
5 Handicraft products 10 Tea and coffee

4. Major import products of Nepal

About 3000 product items are imported by Nepal. The most popular import product items of Nepal are petroleum
products, gold, cement, machineries, and vehicles and so on. This is presented in table (2.8):

Table (2.7): major import products by Nepal

S.N Products S.N Products
1 Petroleum products 7 gold – semi-manufactured form
2 Iron, steels 8 Cereals
3 Machineries 9 Cement
4 Vehicles 10 Iron and steel
5 Cereals 11 Electrical appliances
6 Clothes 12 Pharmaceutical products

5. Foreign trade balance of Nepal

Nepalese foreign trade performance has so far been poor. Several factors seem to be responsible, and of these, its
landlockedness is one of the major causes for Nepal's weak production base, which is eventually linked with the
growth of exports and imports of technology and raw material. The foreign trade status of Nepal in 2017 is presented
in the table (2.8):

Table (2.8): Nepal’s foreign trade status [in US $ million]

Year Export Import Balance
2008 904 3694 -2790
2009 884 4390 -3506
2010 875 5114 -4239
2011 907 5922 -5015
2012 895 6515 -5620
2013 891 6826 -5935
2014 926 7910 -6984
2015 739 6639 -5900
2016 694 8899 -8205
2017 740 1007 -9330
Source: TEPC, Export Import data bank
14 MBA Evening, International Business, Instructor: Binod Lingden Subba

6. Guidelines for trading in Nepal

Here are some guidelines to trade in Nepal (source: export.gov):

Guidelines for trading in Nepal

Standard Import tariff

Documenta
tion
Market
entry Ecommerce
Trade Payment
Strategy method
barriers

 Market entry strategy: To access the local market, foreign companies generally should use local representatives or
agents. Supplying government projects offers opportunities for large volume sales, but requires an authorized local
representative or agent. A number of business services/programs, some fee-based, are provided under this Partner
Post arrangement, including connecting foreign businesses to local companies of interest that could include buyers,
agents, distributors, sales representatives, and other strategic business partners.

 Trade requirement and documentation: Documents required for shipment to Nepal include a commercial invoice, a
customs declaration form (CDF), clearly marked and labeled packaging, and a certificate of origin. Similarly,
exported items sent by air require a CDF, a copy of the export license (if applicable), a commercial invoice, a
certificate of origin, a copy of the letter of credit or advance payment statement from a bank, a foreign exchange
declaration form, a packing list, a photocopy of the income tax registration certificate, an airway bill, and an
authorization letter.
 Importers do not require a license except for banned or quantitatively restricted items
 Exporter need to show their general export/import permits and taxpayer‘s certificate to import goods.

 Nepal’s trade standard: Nepal generally follows internationally recognized standards; it does not follow the ISO 9000
series. Institutions charged with establishing standards include the Nepal Bureau of Standards and Metrology and
the Department of Drug Administration.
 The Nepal Bureau of Standards and Metrology (NBSM) is the only agency authorized to develop technical standards
for different products. NBSM is currently working on developing standards and labeling programs for electrical
appliances.
 The Department of Drug Administration regulates the consumption and quantification of modern drugs for human
use in Nepal.

 Payment method: The only readily available method of financing trade transactions in Nepal is a letter of credit (LC),
an instrument made by most commercial bank.

 Import tariff: Import tariffs are generally assessed on an ad valorem basis. Nepal uses the Harmonized Tariff System
(HTS) for classification purposes. Import duty rates vary from zero to 80 percent.

 Trade barriers: Technical standard barriers are applied to a small number of manufactured products, such as vehicles
and refrigerators. Vehicles imported into Nepal must qualify under the Euro I standard, and refrigerators must be
chlorofluorocarbon (CFC) gas-free. Nepal does not allow the import of used items, the definition of which is often
interpreted to include refurbished products (with the exception of refurbished aircrafts).

 E-commerce: E-Commerce is still in its infancy in Nepal. The country‘s challenging terrain and lack of street
addresses make deliveries a challenge. Credit card transfers and transfers from e-banking websites are sometimes
accepted, but Nepalese who do not have a dollar account cannot make payments using foreign currency.

7. Opportunities and challenges of Nepalese trade

The opportunities of challenges of Nepalese foreign trade discussed below:
15 MBA Evening, International Business, Instructor: Binod Lingden Subba

Opportunities of Nepalese foreign trade

 Nepal is strategically located between two growing giant economies of the world, India and China. In view of the
huge potentials of these burgeoning markets, the prospect of doing business in Nepal is tremendous.
 Nepal has enormous natural resource such as water, beautiful landscape, land suitable for agricultural. Therefore,
country has lot of potential to export hydroelectricity, medicinal herbs, agricultural products, and manufacturing
products.
 Nepal is a member of the WTO, BIMSTEC and a founding member of SAARC. This will provide additional
opportunities for the traders in Nepal.
 Nepal has made a conditional commitment to open up sectors like legal service, engineering, architecture, Research
and Development, advertising, market research, courier, telecom, musical products, higher education, financial
service, hotels and restaurants. Foreign investment in these above specified areas is safe, secure and most profitable in
Nepal.
 Scope of transit trade via Nepal is high and should be encouraged through transport, transit, and infrastructural
linkages.

Challenges of Nepalese trade

 Nepal has Being landlocked country, Nepal if deprived of cheapest and most widely used system of transport for
international trade. This has resulted to the higher price of the products.
 Being poor country, Nepal lacked lots of infrastructures required for trade. Problems of transportations, electricity,
machineries, technologies etc. have made difficulties to conduct the trade.
 Nepal has lots of labors but they are unskilled. They are manual workers lacking with technical, managerial, multi-
cultural, and communication skills.
 The roots of corruption in public organizations are so deep that traders have no confidence on accomplishing bigger
goals that are connected with international trade.
 There is poor preparatory efforts and inefficiency in trade diplomacy and negotiations.
 There is no any proper policies regarding foreign trade and therefore investors are insecure about investment
environment.
16 MBA Evening, International Business, Instructor: Binod Lingden Subba

THEORY OF INTERNATIONAL INVESTMENT

International investment theory explains the flow of investment capital into and out of a country by investors
who want to maximize the return on their investments.

In general, it is helpful to look at FDI theories as an attempt to answer the "who, what, when, where, why and
how" of a particular investment, and to determine whether the economic factors involved justify making foreign
investment. To understand FDI, it may help to first seek to understand why an investor would choose t o invest
abroad rather than either outsourcing production to an existing firm.

To answer the questions of FDI, various international investment theories are presented below:
1. OLI model
2. Internationalization theory

OLI THEORY OF INTERNATIONAL INVESTMENT

Take a quick inventory of the things around you. It is likely that most of these things were made by multinational
firms: I am typing on a Microsoft computer; I drove a Seema to work today; I brushed my teeth this morning with
Crest toothpaste (a Proctor and Gamble brand) after drinking Starbucks coffee; and my mobile phone is made by
Samsung. Given the ubiquity of multinational firm products, it might seem obvious that multinational firms should
exist, but, as in most things economic, there is an important underlying tension between costs and benefits.

The costs of going multinational

Compared to a domestic firm — one that only operates in one country — a multinational firm faces extra costs and
difficulties. A multinational firm has to manage operations in another country, which may involve a different
working language, a different (and possibly worse) legal structure, differences in time zones, costly long-distance
communication, the cost of internationally shipping inputs and outputs, and the extra costs of expatriate personnel. If,
compared to a domestic firm, a multinational firm faces extra costs, then there must be advantages to multinational
production that — at least in some cases —outweigh the extra costs. Otherwise, why would multinational firms exist?

The benefits of going multinational

The ownership-location-internalization (OLI) model is a simple ―big picture‖ framework for organizing our thoughts
about the benefits of multinational production. We discuss each component of the framework below

The ownership-location-internalization (OLI) model is a simple ―big picture‖ framework for organizing our thoughts
about the benefits of multinational production. We discuss each component of the framework below.

1. Ownership: The ownership condition says that the firm must own some asset that generates enough value to make it
worth the extra costs of multinational production. This asset might be a blueprint, a patent, or copyright. A
pharmaceutical company, for example, may own a patent on a cholesterol drug. This patent gives the firm market
power (since other firms cannot produce this drug) which increases the firm‘s profits. Other kinds of assets include
things such as managerial talent, a brand‘s reputation, or some other intangible capital owned by the firm. Note that
some of these assets are explicit and legally protected (e.g., Pfizer‘s patent on Lipitor) while others are not (e.g.,
Google‘s work culture).

2. Location: A multinational firm, by definition, operates in more than one country. To make this worthwhile, there
must be some advantage from operating in that location. One type of location advantage is a saving in transportation
and tariff costs. This kind of advantage is most important for goods that are expensive to ship abroad (i.e., to export).
It would be very expensive, for example, for McDonald‘s to ship hot Big Macs to Canada for sale, so McDonald‘s
produces Big Macs in Canada to sell to the Canadian market. This type of arrangement is often called horizontal
foreign direct investment.

3. Internalization: The internalization advantage says that there must be a gain from keeping the international
expansion within the firm. One way an internalization advantage arises is when the firm‘s assets (its ownership
advantage) are easy to copy. Producing within the firm, rather than licensing to an outside firm, may make it easier
for a firm to protect its assets.
17 MBA Evening, International Business, Instructor: Binod Lingden Subba

THEORY OF INTERNATIONALIZATION
Theory of internationalization is based on the premise that investing in a foreign subsidiary (daughter company)
rather than licensing, the company is able to transfer knowledge across borders while maintaining it within the firm,
where it presumably yields a better return on the investment made to produce it. This means, company should
establish its own subsidiary in foreign countries rather than licensing because there will be no misuse or copying
intangible assets (patent, managerial skills, good will, technical knowhow) by rivals in foreign markets when these
assets are within the control of foreign subsidiary as compared to licensing.

This theory assumes that multinational should expand in foreign market through investment along with intangible
assets. These intangible assets include:
o Technological know-how
o Marketing strategy
o Consumer goodwill
o Effective and dedicated management
o Research and Development (R&D)
o Patent

These intangible assets put additional values in foreign market. For that, a MNC must internalize (establishing its
own subsidiary in foreign market) the market for them. Therefore, establishing subsidiary i.e. investing for plant in
foreign country and transferring intangible assets from home country helps to gain from FDI rather than licensing.
There is less chance of disclosing information of intangible assets in foreign subsidiary while licensing has more
chance of disclosing intangible assets‘ information that may lead to business failure.
18 MBA Evening, International Business, Instructor: Binod Lingden Subba

CONTEMPORARY ISSUES IN INTERNATIONAL TRADE AND INVESTMENT

International trade and investment are vital drivers of participating countries‘ economic growth. However, when
transactions cross the borders of nations, exogenous environmental factors affect the business. These factors include
dumping, regulatory measures, lop sided development of developing countries, frequent market change, language
barriers, difficulties in payment, political risk, and economic risk. These factors are contemporary issues of
international trade and investment because these factors are uncontrollable to businessmen, differs from country to
country, and affects the movement of businesses in foreign markets.

1. Issues of dumping: When a company or country sells its products at lower price in foreign markets than the
prevailing price in the domestic market then it is called dumping. The objective of dumping is to sell products at
lower price so that market share will increase and thereby create monopoly in foreign markets.

This is the most important issue because such trend can put domestic businesses at a significant disadvantage because
they can‘t offer a competitive price. Dumping has given a space for unfair trade competition, threats to domestic
businesses, and may lead to trade war. For example, China is dumping products in Nepal.

2. Issues of regulatory measures: Every country want to protect its economy and tries to export its surplus natural
resources, agricultural products, and manufacturing goods and import only those goods and services which are not
available in the domestic market. For this purpose, regulatory measures such as tariff barriers (custom duties) and
non-tariff barriers (quotas, local content requirement, embargoes, import deposits, etc.) are introduced.

3. Issues of lop sided development of developing countries: Developed countries are equipped with sophisticated
technologies capable of transforming raw materials into finished goods on a large scale. While developing countries
on the other hand lack technological knowledge and latest equipment. It leads to lop sided development in the
international trade and investment.

4. Issues of frequent market change: It is difficult to anticipate changes in demand and supply conditions in
international markets because of frequent changes in price, changes in buyer‘s preferences, changes in import duties
and freight rates, fluctuations in foreign exchange rates, etc. This issue has created international markets
unpredictable.

5. Issues of language barriers: The international language barriers can pose significant challenges to the international
trade, investment, and MNCs. Price lists, catalogues, advertisement, and correspondence are often to be done in
foreign languages. Businesses wishing to trade abroad must know the foreign language or employ somebody who
knows that language. If not handled this issue correctly, businesses can lose their opportunity to establish a credible
brand image.

6. Issues of difficulties in payment method: The proliferation of international e-commerce websites has made selling
goods overseas easier and more affordable for businesses and consumers. However, payment methods that are
commonly accepted in the home market might be unavailable in host countries. Similarly, remittance of money for
payment in foreign trade often involves much time and expense. Therefore, determining acceptable payment
methods and ensuring secure processing are central issue for businesses who seeks to trade internationally.

7. Issues of political risk: There are countries and emerging markets those offer considerable opportunities for
expanding international business. However, these countries and markets sometimes pose challenges. Issues such as
ill-defined or unstable policies and corrupt practices are huge problematic in emerging markets. Similarly, changes in
policy, regulations, and interest rates can impact to international trade and investment. A growing trend towards
economic nationalism also makes the current global political landscape potentially hostile towards international trade
and investment.

8. Issues of economic risk: When a company begins to trade outside its home country, it assumes economic risk, which
is the possibility that changes in the economy of the country where it does business will cause financial or other harm.
Issues such as the inflation rate, availability of financial resources, market price, taxes, minimum wages, interest rate,
cost of materials, etc. are common problems of today‘s international trade and investment that impacts on profits.