Theoretical Foundation of Economic Development Based on Networking Decisions in the Competitive Market

In the paper, an analytical framework with both increasing returns and transaction costs is developed to investigate the general equilibrium with endogenous specialization and division of labor. In this framework, each individual’s optimum decision in choosing her pattern of specialization is always a corner solution and general equilibrium network of division of labor is based on one of myriad combinations of corner solutions. We establish the existence and efficiency theorems of the general equilibrium for large economies. But for a finite economy, the general equilibrium may fail to exist. It is shown that the function of the market is not only to allocate resources for a given network structure of division of labor, but also to coordinate all individuals’ decisions in choosing their patterns of specialization to utilize positive network effects of division of labor net of transaction costs. With the analytical framework, the spirit of classical mainstream economics can be resurrected in a modern body of mathematical formalism.