CHAPTER 2:

CLASSICAL COUNTRY-BASED THEORIES OF

INTERNATIONAL TRADE

Submitted by:

Agricula, Angela
Dalisay, Ashley Nicole
De Los Reyes, Queze Rose
Politico, Gerald
Ramos, Mikaela

International Business and Trade A.Y. 2025-2026| 1st Semester 1

Learning Outcomes:

At the end of the chapter, students are expected to:

1. Explain the meaning of international trade theories and discuss how trade affects nations;
2. Differentiate classical theories from modern theories and have an understanding of the different
classical country-based theories of international business and trade;
3. Discuss the meaning of mercantilism, explain the characteristics of mercantilism as posited by
Adam Smith, elucidate on the factors of production, discuss colonization as a process to increase
a nation's wealth, and explain the price-specie-flow mechanism advanced by David Hume;
4. Relate surplus value, capital accumulation, and expanded reproduction;
5. Elaborate on the tenets of mercantilism as advocated by Philipp Wilhelm von Hornick,
distinguish between protectionism and laissez faire policy, differentiate neo-mercantilism from
free trade, and explain who the physiocrats are;
6. Discuss the different proponents of mercantilism and their contributions;
7. Discuss the meaning of absolute advantage, elaborate on the theory of absolute advantage as
posited by Adam Smith, explain the meaning of capitalism, and discuss how division of labor leads
to specialization, efficiency, productivity, and economic development;
8. Explain how the theory of absolute advantage, theory of international trade, and theory of
economic development are linked;
9. Elucidate on the "vent for surplus" theory;
10. Explain the meaning of comparative advantage, discuss the theory of comparative advantage
as posited by David Ricardo, elaborate on the law of diminishing marginal returns, and discuss the
theory of monetarism;
11. Relate David Ricardo's theory of comparative advantage to Heckscher-Ohlin's factor
proportions theory, discuss the Heckscher-Ohlin theory, explain the law of supply and demand
relative to the factors of production, and elaborate on the effects of the Heckscher-Ohlin theory on
international trade;
12. Analyze the advantages and constraints of the classical theories;
13. Understand the concepts of the classical theories and analyze the criticisms of each theory; and
14. Appreciate how the classical theories work in the real world of business and trade.

Introduction

International trade plays a crucial role in the development of nations, shaping both their
economies and their political directions. The Philippines, as highlighted in the study An Analysis
of the History of Philippine Trade Policy (1950–2004) by Christian Laluna, Arnil Paras, and
Vanessa Soliva, has long been a country deeply engaged in trade. The presence of numerous
executive orders, Republic Acts, tariff and customs codes, and international treaties reflects how
central trade has been to national policy.

International Business and Trade A.Y. 2025-2026| 1st Semester 2

 However, the authors argue that the Philippines has not followed a consistent and
independent trade policy. Instead, the nation’s trade strategies have often shifted in response to
external shocks and local political interests. The 1949 currency crisis and the 1980s debt crisis are
two key examples of events that forced the government to adjust its trade policies. These
adjustments led to the rise of different business classes—first the traditional industrial elite after
1949, and later a globally oriented entrepreneurial class after the 1980s. Each of these groups
influenced the political economy and shaped trade policy outcomes.

The authors further conclude that liberalization has become embedded in Philippine trade
policy, not only because of government choices but also due to international commitments and
agreements. The emergence of a new business middle class that benefits from globalization has
ensured that there will always be political support for continued liberalization. This reflects a
broader truth about trade policy: nations must constantly balance the need to protect domestic
industries with the opportunities and obligations of participating in the global economy.
Ultimately, how protective or liberal a country chooses to be depends on the direction taken by its
government in pursuit of what it believes will benefit its people.

LESSON 2.1. International Trade Theories

International trade theories explain how and why nations engage in trade and what benefits
they derive from it. Trade is the exchange of goods and services between people or entities, and
when this exchange occurs between countries, it becomes international trade. Economists
developed theories to analyze trade patterns, determine which products should be exported or
imported, and explain how trade affects nations.

Classical Theories of International Trade

Classical theories were the earliest frameworks that explained trade. They were primarily
country-based and focused on how nations could increase their wealth and economic growth
through trade. According to Reyes (2012), the main points of classical trade theories are:

1. Trade as a Driver of Growth - Trade expands a country’s consumption capacities,

increases global output, and provides access to scarce resources and larger markets. Poorer
nations, without trade, would struggle to grow.
2. Promotes Equality - Trade tends to balance factor prices internationally, raising incomes
in labor-abundant countries and lowering them in labor-scarce ones. This leads to a more
efficient use of global resources.
3. Comparative Advantage - Countries develop by focusing on industries where they have
comparative advantage, whether in labor efficiency or factor endowments.

International Business and Trade A.Y. 2025-2026| 1st Semester 3

 4. Free Trade Principle - In a free trade system, international prices and production costs
dictate how much a nation should trade to maximize welfare. Governments should avoid
excessive interference.
5. Outward-Looking Policy - Participation in international trade is more beneficial than
isolation or self-reliance. Nations prosper more by integrating into the global economy.

Classical theories emphasized free trade, comparative advantage, and the role of trade in
stimulating economic growth and equality.

Limitations of Classical Theories

While useful, classical theories were based on assumptions that did not always align with
reality. They often ignored non-competitive pricing, government policies, and unequal distribution
of resources among countries. In practice, many developed and developing nations did not
experience trade as simply as the theories suggested.

Modern Theories of International Trade

By the mid-20th century, economists shifted from country-based theories to firm-based

(company-based) theories. These modern theories recognized that businesses, not just nations,
were key players in trade.

● Focus: Modern theories analyze how firms compete internationally, choose markets to
expand into, and produce goods more efficiently than rivals.
● Application: They are practical for businesses seeking to expand globally and consider
more factors than classical theories, including technology, branding, and firm strategies.

Realities of International Trade

In practice, no single theory fully explains global trade. Factors of production land, labor,
capital, and entrepreneurship are not equally distributed across countries.

● Example: Countries like the U.S. and Russia have vast arable land but are not primarily
agricultural economies. Instead, they are industrialized because of their access to capital
and educated labor.
● Wealthy Nations as Importers: Richer countries often import heavily because their citizens
have complex demands. At the same time, they invest in factories and subsidiaries in
developing countries to take advantage of cheap labor and raw materials.
● Developing Countries’ Role: Less industrialized nations create comparative advantages by
offering cheaper factors of production.

Thus, governments and businesses today apply a mix of classical and modern theories when
shaping policies and strategies.

International Business and Trade A.Y. 2025-2026| 1st Semester 4

 International trade theories provide frameworks for understanding global trade, but in reality,
nations and firms adapt strategies depending on their unique resources and goals. While classical
theories emphasized comparative advantage and free trade, modern theories focus on firms and
competitiveness. Together, these theories help explain the complexities of global trade and remain
vital for economic policy and business decision-making.

LESSON 2.2 Mercantilism

The Commercial Revolution (1450–1750)

The Commercial Revolution, which lasted roughly from 1450 to 1750, transformed Europe’s
economic structure. This period witnessed the decline of feudalism and the rise of capitalism.
Local economies became integrated into national economies, and trade expanded from small-scale
exchanges to global commercial networks. The revolution was driven by exploration, colonization,
and the emergence of financial institutions that supported large-scale trade. This period set the
foundation for the modern global economy.

Transition from Feudalism to Capitalism

One of the defining aspects of the Commercial Revolution was the transition from feudalism
to capitalism. Under feudalism, wealth and power were tied to land ownership, while trade
remained localized. Capitalism, however, emphasized private ownership of resources and profit-

International Business and Trade A.Y. 2025-2026| 1st Semester 5

making through commerce. This new system encouraged innovation, competition, and
international exchange, laying the groundwork for a globalized economy.

Rise of National Economies

During this period, Europe moved away from fragmented local economies toward
centralized national economies. Monarchs and emerging nation-states consolidated power and
recognized that wealth accumulation strengthened their military and political influence. As a
result, states supported merchants, created trade regulations, and expanded colonial empires to
enrich their nations.

Mercantilism (Bullionism)

The Commercial Revolution gave birth to the doctrine of mercantilism, often referred to as
bullionism. Mercantilists argued that the wealth of a nation was determined by the amount of
precious metals, particularly gold and silver, that it possessed. To increase their holdings, countries
pursued a trade surplus, exporting more goods than they imported. Exports brought in gold, while
imports drained it, making mercantilist policies heavily focused on restricting imports and
encouraging exports.

Protectionism

A key feature of mercantilism was protectionism. Governments actively intervened in the

economy by imposing tariffs, quotas, and restrictions on imports to protect domestic industries.
They granted monopolistic privileges to certain companies, subsidized export industries, and
provided tax exemptions to strengthen national production. While these measures benefitted
selected industries, they often harmed consumers by raising prices on foreign goods.

Colonization

Colonization was an important tool for mercantilist states. European powers such as Spain,
Portugal, France, England, and the Netherlands expanded their empires overseas. Colonies
provided raw materials such as silver, gold, and agricultural products, while also serving as captive
markets for finished goods from the mother country. This system ensured a continuous inflow of
wealth and strengthened European economies, though it exploited colonial regions.

Factors of Production

Mercantilism emphasized the importance of the factors of production: labor, land (natural
resources), capital, and entrepreneurship. Labor was considered the most essential, as workers
transformed raw materials into valuable goods. Natural resources, including land, trees, and mines,
provided inputs for production. Capital goods represented the tools and equipment necessary for

International Business and Trade A.Y. 2025-2026| 1st Semester 6

production, while capital referred to the funds used to purchase them. Finally, entrepreneurship
was recognized as the factor that combined all resources efficiently to generate profit.

Adam Smith and Free Trade

Scottish economist Adam Smith challenged mercantilism in his work The Wealth of
Nations (1776). Smith argued that a nation’s true wealth did not lie in the accumulation of gold
and silver but in the productivity of its labor and industries. He promoted free trade, where goods
and services could move without restrictions such as tariffs and quotas. According to Smith, free
trade allowed nations to benefit mutually and achieve sustainable growth.

Laissez-Faire Economics

Closely tied to Adam Smith’s ideas was the doctrine of laissez-faire economics, which
means “let it be.” This theory emphasized minimal government intervention in the economy,
allowing markets to regulate themselves. Smith believed that reducing government interference
encouraged competition, efficiency, and overall economic development.

Division of Labor and Specialization

Smith also introduced the principle of division of labor, which involves breaking down
production into smaller tasks. When workers specialized in specific tasks, they became more
skilled and efficient, leading to greater productivity. This specialization eventually gave rise to
economies of scale, where producing larger quantities of goods reduced the average cost of
production. Together, these ideas showed how efficiency and growth could be achieved in a free
market economy.

David Hume and the Price-Specie-Flow Mechanism

International Business and Trade A.Y. 2025-2026| 1st Semester 7

 Economist David Hume contributed to economic thought by explaining the price-specie-flow
mechanism. He argued that trade imbalances corrected themselves under the gold standard. For
example, when a country exported more goods, it received an inflow of gold, raising domestic
prices. Conversely, a trade deficit led to gold outflows and lower prices. These fluctuations
naturally balanced international trade without the need for heavy government regulation.

Jean-Baptiste Colbert and Colbertism

In France, Jean-Baptiste Colbert promoted a mercantilist system known as Colbertism. Serving

under King Louis XIV, Colbert emphasized state control of the economy. He encouraged
manufacturing, supported public works, raised tariffs, and established merchant fleets to boost
exports. His policies aimed to make France self-sufficient and economically powerful,
strengthening the state’s influence in Europe.

Contributions of Other Thinkers

Jean-Baptiste Colbert – He was the French finance minister under King Louis XIV who
developed a variation of mercantilism known as Colbertism. Colbert emphasized strong state
control of the economy. He encouraged industrial growth, expanded naval fleets, increased tariffs
on imports, and supported domestic manufacturing. His goal was to make France self-sufficient
and one of the most powerful economies in Europe.

Sir William Petty – An English economist, Petty believed that capital accumulation was central
to economic growth. He emphasized that wealth could expand through the productive use of
surplus, arguing that efficient use of resources led to stronger national economies.

Sir Thomas Mun – As director of the East India Company, Mun strongly defended foreign trade
as the key to national wealth. He argued that exporting more goods than importing was essential
to achieve a favorable balance of trade, making him one of the classic defenders of mercantilist
practices.

International Business and Trade A.Y. 2025-2026| 1st Semester 8

Richard Cantillon – An Irish-French economist, Cantillon is often regarded as one of the first
true theorists of economics. He introduced ideas on the circular flow of the economy, the role of
entrepreneurs, and the influence of supply and demand on prices. His works became a bridge
between mercantilist thought and classical economics.

Philipp Wilhelm von Hornick – A German economist, Hornick outlined a nine-point mercantilist
program in his book Austria Over All, If She Only Will (1684). His principles emphasized
maximizing the use of a nation’s land, encouraging domestic production, avoiding imports, and
promoting manufacturing.

Giovanni Botero – An Italian thinker, Botero believed that population growth and industrial
expansion contributed significantly to national wealth. He tied economic prosperity to state power
and moral responsibility.

Antonio Serra – Another Italian economist, Serra emphasized the importance of industrialization.
He argued that industries created increasing returns to scale, meaning that as production expanded,
efficiency and profits also increased.

Antoine de Montchrétien – A French writer and economist, Montchrétien is credited with coining
the term “political economy.” He stressed the role of agriculture in building wealth and believed
that self-sufficiency was crucial to strengthening the nation.

Neo-Mercantilism

Although mercantilism declined after the rise of free trade, some countries continue to
practice neo-mercantilism today. Nations such as China, Japan, Singapore, and Germany promote
export-led growth, restrict imports, and subsidize domestic industries. This modern version reflects
the enduring influence of mercantilist policies in shaping global trade.

Lesson 2.3 Theory of Absolute Advantage

Absolute Advantage means a producer, which could be a person, a group, a company, or a

country, can produce a good or service better, faster, more efficiently, at a greater volume, and
with fewer resources than others. It means that a producer can produce a good or services in greater
quantity for the same cost or the same quantity at a lower cost or the producer can produce the
same quantity of product/service for lesser quantity of inputs, and , therefore, lower marginal cost
than other producer without compromising the quality.

Example:

● For example, if Canada can produce 100 pounds of beef using two ranchers, while
Argentina need three ranchers to produce 100 pounds of beef, Canada has an absolute
advantage over

International Business and Trade A.Y. 2025-2026| 1st Semester 9

Argentina in beef production. Absolute advantage can be result of a country’s natural endowment.

Marginal Cost is the cost incurred in producing an additional unit of a product.

Example

● When a homeowner decides to buy a few extra cookies from the bakery; the marginal cost
is simply the price of those extra cookies, even if it differs from the price of the first batch.

Adam Smith is recognized as the founder of modern economics, hence, considered as the
father of economics. He is credited with using the word mercantilism first and that his book. The
Wealth of Nations, the birth of modern capitalism.

Capitalism, also called free market economy or free enterprise economy is an economic system,
where most means of production are privately owned and production is guided and income
distributed largely through the operation of market, which determine prices, product, and services
rather than the government.

Example

● Example could be a family run bakery, the owner have interested their own money to open
and run the business, and they make decision about production and pricing.

The Theory of Absolute Advantage believes that countries should produce and export such
products which they have an absolute advantage on and import those goods that they produce
relatively less efficiency and at a higher cost.

According to Smith, free trade promotes international division of labor through specialization
in the production and exchange of such commodities, in case of which they command some
absolute advantage

International Business and Trade A.Y. 2025-2026| 1st Semester 10

LESSON 2.4 Theory of Comparative Advantage

Comparative advantage means a producer can produce a good or service at a lower opportunity
cost than others. This is means a person, company, or country can produce a good or service at a
lower opportunity cost compared to others. This doesn’t mean they are the absolute best at making
it, but rather they give up less of other goods when producing it.

Example:
• Country A can produce 10 cars or 20 tons of rice.
• Country B can produce 8 cars or 40 tons of rice.
Even though Country B is better at producing both, Country A has a comparative advantage
in producing cars (because it sacrifices less rice to produce them).
Opportunity cost is what is lost or missed out on when choosing one possibility over another.
This is the value of the next best alternative that you give up when making a choice. Every decision
involves giving up something.

Example:
If you spend 2 hours studying, your opportunity cost might be the 2 hours you could have used to
work and earn money or relax with friends.

Adam Smith was among the first to put in writing the theory of comparative advantage, but the
theory of comparative advantage was formulated by David Ricardo. Smith introduced the idea of
specialization and trade in his book The Wealth of Nations. Later, David Ricardo improved the
idea with the theory of comparative advantage, showing mathematically why countries should
specialize and trade even if one is better at producing everything.

Example:

Smith said a pin factory is more efficient when workers specialize in tasks. Ricardo explained that
even if England was better at making both wine and cloth compared to Portugal, both countries
would still benefit by specializing England in cloth, Portugal in wine and trading.

For Smith, the specialization and division of labor provided the base for lowering labor costs,
which ensured comparative advantage for a country. Specialization means focusing on producing
one product or task instead of many. Division of labor breaks production into smaller tasks
assigned to different workers, which increases productivity and lowers costs.

International Business and Trade A.Y. 2025-2026| 1st Semester 11

Example:
In a shoe factory:
• One worker cuts leather,
• Another stitches,
• Another adds the sole.
This way, production is faster and cheaper compared to each worker making the whole shoe.

Industrial capitalism is an economic system in which trade, industry, and capital are privately
controlled and operated for profit. This is an economic system where private individuals or
companies own factories, machines, and businesses. The main goal is profit. This system
encourages innovation and efficiency but can also lead to inequality.

Example:
During the Industrial Revolution, private entrepreneurs built textile factories, railways, and steel
plants. They invested their own money to make profits, not for the benefit of the government.

Comparative advantage warranted complete specialization in the specific commodity with a

comparative advantage in terms of labor hours used per unit of output. It can be measured by
looking at how many labor hours are needed to produce one unit of a good. A country will
specialize in the product that requires fewer resources compared to other goods.

Example:
• If it takes 5 hours to make 1 shirt in Country A and 15 hours in Country B, then A has a
comparative advantage in shirts.

David Ricardo started out as a successful stockbroker, making $100 million in today’s dollars.
After reading Adam Smith’s The Wealth of Nations, he became an economist. He was originally
a wealthy stockbroker who earned a fortune. After being inspired by Adam Smith, he studied
economics and became one of the most influential classical economists, shaping theories of trade
and value

2.5. Heckscher- Ohlin Theory (H-O Theory)

1. David Ricardo’s Theory of Comparative Advantage

International Business and Trade A.Y. 2025-2026| 1st Semester 12

 David Ricardo explained that even if one country is more efficient in producing all goods
(absolute advantage), trade is still beneficial if each country specializes in producing the goods
where it has the greatest relative efficiency (comparative advantage).
The key factor is the relative abundance or scarcity of production resources (land, labor, capital).
Example:
•Suppose the Philippines has abundant labor but less capital. It will specialize in labor-intensive
goods like textiles, garments, or call center services.
•Meanwhile, Japan has more capital and advanced technology, so it will specialize in capital-
intensive goods like cars or electronics.
• By trading, both benefit Philippines imports cars and Japan imports clothes.
2. Heckscher & Ohlin’s Contribution
Eli Heckscher and Bertil Ohlin expanded Ricardo’s idea by focusing more on factors of production
(land, labor, and capital). They argued that a country gains comparative advantage by producing
goods that use its abundant resources.
Example:
•A country like Saudi Arabia, with abundant oil reserves (natural resource/land), specializes in
oil and petroleum exports.
•A country like India, with a large labor force, specializes in labor-intensive services like IT
support and customer service.
•A country like Germany, with more capital and technology, specializes in machinery and cars.
3. Heckscher-Ohlin Theory (H-O Theory)

The H-O theory focuses specifically on the relationship between a nation’s resources and its
trade patterns. It is sometimes called the factor proportions theory because trade patterns depend
on how much land, labor, and capital a country has relative to others.
Prices of goods are determined by supply and demand of these factors abundant factors are
cheaper, so countries use them more.
Example:
• If China has cheap and abundant labor, it will export labor-intensive goods (toys, clothing,
electronics assembly).
• If USA has abundant capital and technology, it will export capital-intensive goods (airplanes,
advanced medical equipment).
4. Paul Samuelson’s Contribution

International Business and Trade A.Y. 2025-2026| 1st Semester 13

 Paul Samuelson refined and elaborated the H-O model. Because of his influence, the extended
version is called the Heckscher-Ohlin-Samuelson (HOS) model. Samuelson helped formalize
the theory with mathematical models, making it more applicable to real-world trade analysis.
Example:
•He studied how changes in factor availability (like increase in skilled labor or capital) affect
wages, trade balance, and production.
•For instance, if a country trains more engineers (increasing skilled labor), it may shift from
exporting simple manufactured goods to more sophisticated products like software or electronics.
5. Jaroslav Vanek’s Contribution

Jaroslav Vanek extended the H-O-S model by considering multiple countries and multiple
goods, not just two. This made the theory more realistic for modern global trade where many
countries and goods interact simultaneously. His version is sometimes called the Heckscher-
Ohlin-Vanek (HOV) model.
Example:
• Instead of only analyzing trade between two countries (say, USA and China), Vanek’s model can
analyze trade among USA, China, India, and Brazil simultaneously.
• It helps explain why a country like Brazil exports agricultural products (land-intensive), India
exports IT services (labor-intensive), and Germany exports machinery (capital-intensive) all at
the same time.

International Business and Trade A.Y. 2025-2026| 1st Semester 14