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A New Foundation of Economic Theory and its Application to Trade Analysis

In the last two decades, a lot of models have been developed about the new trade theory. The work by Avinash Dixit and Joseph Stiglitz (1977) is often credited as the crucial innovation that made the new trade theory possible. In Dixit and Stiglitz (1977) and later works, models of production costs involve fixed costs and variable costs, which makes economy of scale easy to understand. In these models, fixed costs and variable costs are independent constants. Although it is intuitively clear that a production system with higher fixed cost generally have lower variable costs, a lack of analytical theories make it difficult to implement this intuition. In this chapter, we propose an economic theory based on the foundation of thermodynamics. From this new foundation, we develop an analytical theory to obtain a formula that explicitly representing the relation of fixed costs, variable costs and the uncertainty of the environment, which is the core concern in most economic decisions. It enables us to make detailed comparison of returns of systems with different fixed costs in different kinds of markets. It offers a clear understanding on why countries at different stages of development will adopt different trade policies. This understanding is highly consistent with the historical patterns that all latecomers that emerged into industrial powers, such as USA, adopted protectionist policies in the period of takeoff and shifted to free trade policy to access larger market for their products after their industries became highly competitive. This theory also shows that patterns in trade are intrinsically linked to migration restriction and explains why the current trade and migration system is not sustainable over the long term.