Discuss the role of assumptions in economics. Use the first fundamental theorem of welfare economics to illustrate your point.

Assumptions are used to simplify the complex world and make it easier to understand. To study the effects of international trade, for example, we may assume that the world consists of only two countries and that each country produces only two goods. Of course, the real world consists of dozens of countries, each of which produces thousands of different types of goods. But by assuming two countries and two goods, we can focus our thinking on the essence of the problem. Once we understand international trade in an imaginary world with two countries and two goods, we are in a better position to understand international trade in the complex world in which we live. economists use different assumptions to answer different questions. Thus, assumptions are initial conditions made before a micro or macroeconomic analysis is built.

The first Fundamental theorem of Welfare Economics is based on two assumptions:

1. In the economy, all commodities are competitive. The equilibrium in the economy is Pareto efficient.
2. There is market for all commodities. Each commodity is produced in the economy and consumption of commodity ads to utility function.

In an economy, all markets are competitive. Consumers and producers believe that their decisions have no effect on prices. In order to reduce the complexities, we have assumed simple economy with two markets and two input markets. Each market has two demanders and one supplier. In both market prices of commodities is regarded as the parameter.

In both market, competition is possible. It is because of there are large numbers of traders of commodity from both sides of the market. Individual h gets income from selling input z_h. An individual’s own share in the profit of the two firms in the economy. It maximizes the utility function u_h (xh₁,xh₂, zh). It is subject to the budget constraint.