Wing: CGEs

Wing, I., 2004. Computable General Equilibrium Models and their use in economy-wide policy analysis: everything you ever wanted to know (but were afraid to ask). Center for Energy & Environmental Studies and Department of Geography & Environment. Boston University and Joint Program on the Science & Policy of Global Change, MIT.

This article explores the foundation of CGE models, beginning with their micro-economic roots. It then builds upon this to highlight how these models can utilize SAMs for further elaboration and forecasting of economic data. It then looks at how these models relate to equilibrium seeking behavior, as well as how distortions to market activity can be introduced to examine the possible effects of policy interventions.

“Computable general equilibrium…models are simulations that combine the abstract general equilibrium structure formalized by Arrow and Debreu with realistic economic data to solve numerically for the levels of supply, demand and price that support equilibrium across a specified set of markets” (1).

Though they are widely used, GGE models are seen by some policy makers to be a black-box, where causal linkages can not be established. Partially, this is because typical CGE models are so large that causal linkages are difficult to see. Another reason is that the models are so complex that most users have a difficult time understanding the wide variety of linkages that may or may not be present: many models rely on a wide range of expertise, and synthesizing all of it becomes quite complex. The overarching goal of this paper is to provide a framework for explicating what many view as being obscure. This article attempts to clear up some of the suspicion surrounding CGE models.

“The fundamental conceptual starting point for a CGE model is the circular flow of commodities in a closed economy…” (5). This flow takes place amongst different agents and classes: households, firms, governments, etc. These flows act are inherently bestowed with equilibrating effects, essentially creating a balance of payments over the running of the model. Firms produce goods that are consumed by households who provide the primary factors for the firms to produce goods. The quantity produced equals the quantity demanded. The equilibrium occurs when the market clears because supply and demand cross to provide a socially optimum price. Value is also distributed and balanced as either rent payments back to households, or reinvestment in firms. This redistribution of value implies that firms make no profit. Additionally, households are forced to balance their income by, after having employed all of their factors of production, they either consume or save all of their income, both of which are seen as a type of consumption.

To explain the algebra of CGE models, Wing deploys an economy with three assumptions: no tax, subsidy or trade restriction; households are represented singularly as someone who rents out factors to industry for money that is then used to satisfy demand, and that each industry is a representative that buys the factors from the households in order to produce the goods demanded by the households. These interactions can then be placed into an input-output matrix.

As noted in the previous paragraph, the nature of the results of this computation are well situated to be displayed in an input-output matrix. A more complex I-O matrix can be deployed to track domestic and intra-state flows. This is the Social Accounting Matrix (SAM). “The structure the [sic] SAM reflects the principle of double-entry book-keeping, which requires that for each account, total revenue--the row total--must equal total expenditure—the column total” (10).

The next aspect of CGE modeling that is considered by the author is the Cobb-Douglas production function. Households are seen as autonomous agents that make decisions to consume or save based on their income constraints compared to the prices for the specific good in question. This is how product demand is created. Firms also produce based on an equation that takes into consideration their inputs, factors, output and the constraint of current productive technology.

“In the C-D economy the conditions for general equilibrium are as follows. Market clearance implies that the quantity of each commodity produced must equal the sum of the quantities of that commodity demanded by the j producers in the economy as an intermediate input to production, and by the representative agent as an input to consumption and savings activities” (14). Eventually, the CGE market clears by adhering to Walras’ Law: “…the sum of the values of market demands equal to the sum of the values of market supplies” (17). This then must be plugged into a SAM for the purposes of establishing an accounting equilibrium.

The remainder of the paper deals with exogenous distortions on models.

Tax distortions can be illustrative of the effects of certain kinds of policy interventions when they are imposed on a CGE model. However, Wing is quick to point out that many believe that CGE models act similarly to “crystal balls”, where a certain policy can be imposed on the model and the result coming from the black box demonstrates the policy’s relative effects. This, however, is not the strength of the CGE. “…the CGE models’ usefulness in policy analysis owes less to their predictive accuracy, and more to their ability to shed light on the economic mechanisms through which price and quantity adjustments are transmitted among markets” (25-6).

The exploration of the effects of exogenous distortions on CGEs is then taken to a real world example: a carbon tax.