Assumptions are used to simplify and make the complicated world more understandable. For the purposes of studying the consequences of international trade, we can imagine that the world consists of only two countries, each of which produces only two items. The real world is made up of numerous countries, all of which manufacture hundreds of distinct products. However, by assuming two countries and two items, we may focus on the problem’s core. We will have a better understanding of international trade in our complicated world if we understand international trade in an imaginary universe better with two countries and two goods. To answer various questions, economists make various assumptions. As a result, assumptions are the first conditions that must be met before a microeconomic or macroeconomic analysis can be developed.
Two assumptions determine the first Fundamental theorem of Welfare Economics which are:
- All commodities are competitive in the economy. The economy’s equilibrium is Pareto efficient.
- There is a market for everything. Each item is manufactured in the economy, and its consumption adds to the utility function.
All markets in an economy are competitive. Consumers and manufacturers believe that their actions have no impact on price. We imagined a simple economy with two marketplaces and two input markets to reduce the complications. There are two demanders and one provider in each market. Both market prices of goods are used as a parameter.
Competition is inevitable in both markets. It’s because a commodity has a large number of merchants on both sides of the market. Individual h earns money from the sale of input z. An individual’s portion of the profits of the economy’s two enterprises. It optimizes the utility function, to put it another way (xh1,xh2, zh). It is constrained by financial constraints.