Devarajan et al.: Policy Lessons from Trade-Focused, Two-Sector Models

Devarajan, S., Lewis, J. & Robinson, S., 1990. Policy Lessons from Trade-Focused, Two-Sector Models. Journal of Policy Modeling, 12(4), 625-657.

These authors create a one country, two-sector, three good CGE trade model that is designed to be simple, or, in their words, minimalist. The benefits to this are clear: the CGE becomes much less of a black box. They call it the 1-2-3 model.

“The model has three actors: a producer, a household, and the rest of the world” (627).

“The 1-2-3 model is different from the standard neoclassical trade model with all goods tradable and all tradables perfect substitutes with domestic goods. The standard model, long a staple of trade theory, yields wildly implausible results in empirical applications” (630). One way to work around this is building on the word of Salter (1959) and Swan (1960) that separates tradables from non-tradables.

They claim that their 1-2-3 model is Walrasian, even though there are macro-level closures. “The additions of government, savings-investment, and the balance of trade are done in ways that retain the notion of flow equilibrium and do not strain the Walrasian paradigm” (642). They also highlight two different approaches on “macro closures”: in the first approach, macro-level factors are exogenous. “In the second approach, the CGE model is extended to include variables typically found in macro models…and to expand the notion of equilibrium to incorporate asset markets and expectations. The intent is to build CGE models that move beyond the Walrasian paradigm and directly incorporate macro phenomena” (642).

The started with the 1-2-3 model, then added macro-level factors like tariffs, subsidies, taxes, savings and investment. The addition of savings and investment brought up the need to discuss closure rules. Thus, a minimalist CGE model is built upon to make it more realistic.