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# Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## Introduction to computable general

equilibrium modeling
1th Educational Workshop of the Simulation Lab

October,1 2015

## Dr. Renger van Nieuwkoop

Center for Energy Policy and Economics
Department of Management, Technology and Economics
ETH Zürich
Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

Content

1 Introduction

## 2 A simple general equilibrium model with two sectors and two

primary factors of production factors

4 Literature

## Introduction to CGE modelling October,1 2015 0 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## Introduction Introduction to CGE modelling October,1 2015 1 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Numerical simulation model based on general equilibrium theory.

• Elements of general equilibrium theory:
• Multiple interacting agents (firms, consumers, government).
• Individual behavior based on optimization
• Most agent interactions are mediated by markets and prices
• Equilibrium occurs when endogenous variables (e.g., prices) adjust
such that:
1 agents, subject to the constraints they face, cannot do better by
altering their behavior (taking prices as given)
2 markets (generally, not always) clear, for example, supply equals
demand in each market.

## Introduction Introduction to CGE modelling October,1 2015 1 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Numerical simulation model based on general equilibrium theory.

• Elements of general equilibrium theory:
• Multiple interacting agents (firms, consumers, government).
• Individual behavior based on optimization
• Most agent interactions are mediated by markets and prices
• Equilibrium occurs when endogenous variables (e.g., prices) adjust
such that:
1 agents, subject to the constraints they face, cannot do better by
altering their behavior (taking prices as given)
2 markets (generally, not always) clear, for example, supply equals
demand in each market.
• Computable: empirically calibrated to socioeconomic data,
elasticities, and policy.

## Introduction Introduction to CGE modelling October,1 2015 1 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## unearthing the features of CGE models that drive [their

results] is often a time consuming exercise. This is because
their sheer size, facilitated by advances in computer technology,
makes it difficult to pinpoint the precise source of a particular
results. They often remain a black box.
Indeed, frequently, authors are themselves unable to explain
their results intuitively and, when pressed, resort to

## — Panagariya and Duttagupta (2001), “The "gains" from preferential trade

liberalisation in the CGEs: where do they come from?”

## Introduction Introduction to CGE modelling October,1 2015 2 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

However,

simple.

## Introduction Introduction to CGE modelling October,1 2015 3 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

However,

## • Although model might be “huge”, the algebraic foundation is

simple.
• Often we use a model, because we can’t find the answer in an
analytical way.

## Introduction Introduction to CGE modelling October,1 2015 3 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

However,

## • Although model might be “huge”, the algebraic foundation is

simple.
• Often we use a model, because we can’t find the answer in an
analytical way.
• Models are to be used, not to be believed... (Henri Theil)

## Introduction Introduction to CGE modelling October,1 2015 3 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Combination of economic theory with data

• CGE models provide a consistent framework to accommodate a
large number of structural model features & dimensions required
for a quantitative analysis of economic policy

## Introduction Introduction to CGE modelling October,1 2015 4 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Combination of economic theory with data

• CGE models provide a consistent framework to accommodate a
large number of structural model features & dimensions required
for a quantitative analysis of economic policy
• Rigorous "micro-foundation" constitutes key improvement over
traditional Keynesian macroeconomic models and Input-Output
models (price-dependent economic behavior, "deep" behavioral
parameters)

## Introduction Introduction to CGE modelling October,1 2015 4 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Combination of economic theory with data

• CGE models provide a consistent framework to accommodate a
large number of structural model features & dimensions required for
a quantitative analysis of economic policy
• Rigorous "micro-foundation" constitutes key improvement over
traditional Keynesian macroeconomic models and Input-Output
models (price-dependent economic behavior, "deep" behavioral
parameters)
• General equilibrium perspective: interacting behavior of different
economic agents in different markets and respecting overall resource
constraints of the economy, scope of ceteris paribus assumptions

## Introduction Introduction to CGE modelling October,1 2015 4 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## • Combination of economic theory with data

• CGE models provide a consistent framework to accommodate a
large number of structural model features & dimensions required for
a quantitative analysis of economic policy
• Rigorous "micro-foundation" constitutes key improvement over
traditional Keynesian macroeconomic models and Input-Output
models (price-dependent economic behavior, "deep" behavioral
parameters)
• General equilibrium perspective: interacting behavior of different
economic agents in different markets and respecting overall resource
constraints of the economy, scope of ceteris paribus assumptions
CGE models are a useful tool to conduct cost-benefit analysis,
• investigate distributional implications, and quantify trade-offs
between economic policies.

## Introduction Introduction to CGE modelling October,1 2015 4 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## CGE models for energy and environmental policy do what?

For example...
• Evaluate the impacts on: macroeconomic variables,trade flows,
industrial activity, labor markets, factor prices, commodity prices,
and regional or household welfare

## Introduction Introduction to CGE modelling October,1 2015 5 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## CGE models for energy and environmental policy do what?

For example...
• Evaluate the impacts on: macroeconomic variables,trade flows,
industrial activity, labor markets, factor prices, commodity prices,
and regional or household welfare
• of changes in: carbon emission quota schemes, energy taxes,
technology subsidies, international terms of trade, energy pricing

## Introduction Introduction to CGE modelling October,1 2015 5 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## Types of CGE models

Treatment of time
• Static
• Fake dynamics
• Recursive dynamcis
• Overlapping generations
Regionalization
• Single country with closure rules
• Multi-regional model

## Introduction Introduction to CGE modelling October,1 2015 6 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## A CGE model is an economic model that typically combines the

following:
• Firms that attempt to maximize profits and minimize costs
• Households who maximize "welfare" (e.g., consumption) by
demanding commodities according to price

## Introduction Introduction to CGE modelling October,1 2015 7 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## A CGE model is an economic model that typically combines the

following:
• Firms that attempt to maximize profits and minimize costs
• Households who maximize "welfare" (e.g., consumption) by
demanding commodities according to price
• Markets that mediate behavior of economic agents (e.g., prices
adjust until supply and demand are equal)

## Introduction Introduction to CGE modelling October,1 2015 7 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## A CGE model is an economic model that typically combines the

following:
• Firms that attempt to maximize profits and minimize costs
• Households who maximize "welfare" (e.g., consumption) by
demanding commodities according to price
• Markets that mediate behavior of economic agents (e.g., prices
adjust until supply and demand are equal)
• Government that collects taxes and spends revenue on consumption
and transfer to households (government is usually represented as a
"passive" agent)

## Introduction Introduction to CGE modelling October,1 2015 7 / 61

1. Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature

## Introduction Introduction to CGE modelling October,1 2015 8 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Outline

1 Introduction

## 2 A simple general equilibrium model with two sectors and two

primary factors of production factors

4 Literature

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 9 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## A simple general equilibrium model with two sectors and

two primary factors of production factors (2 x 2 GE model)

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 10 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)
• F and G are homogenous of degree one (=exhibit constant
returns to scale) consistent with the assumption of perfect
competition

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)
• F and G are homogenous of degree one (=exhibit constant
returns to scale) consistent with the assumption of perfect
competition
• Production in each industry X and Y is represented by a profit-
maximizing firm (or a continuum of homogeneous firms)

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)
• F and G are homogenous of degree one (=exhibit constant
returns to scale) consistent with the assumption of perfect
competition
• Production in each industry X and Y is represented by a profit-
maximizing firm (or a continuum of homogeneous firms)
• A representative consumer/household earns income I from
supplying (inelastically) fixed endowments of K and L to firms
and demands commodities X and Y so as to maximize welfare
W = U(X , Y )

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)
• F and G are homogenous of degree one (=exhibit constant
returns to scale) consistent with the assumption of perfect
competition
• Production in each industry X and Y is represented by a profit-
maximizing firm (or a continuum of homogeneous firms)
• A representative consumer/household earns income I from
supplying (inelastically) fixed endowments of K and L to firms
and demands commodities X and Y so as to maximize welfare
W = U(X , Y )
• Let pX , pY , pK , pL and pW denote the price of X , Y , K , L and W ,
respectively

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Model description

## • 2 factors of production: capital (= K ) and labor (= L)

• 2 commodities which can be produced using production
technologies X = F (K , L) and Y = G(K , L)
• F and G are homogenous of degree one (=exhibit constant
returns to scale) consistent with the assumption of perfect
competition
• Production in each industry X and Y is represented by a profit-
maximizing firm (or a continuum of homogeneous firms)
• A representative consumer/household earns income I from
supplying (inelastically) fixed endowments of K and L to firms
and demands commodities X and Y so as to maximize welfare
W = U(X , Y )
• Let pX , pY , pK , pL and pW denote the price of X , Y , K , L and W ,
respectively
• Static model, closed economy, no government.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 11 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## A competitive equilibrium consists of a non-negative consumption

plan {CX ≥ 0, CY ≥ 0} for the representative consumer, a
non-negative production plan {KX , LX , X , KY , LY , Y } for each firm and
non-negative prices {pK , pL , pX , pY } such that:

1 for every firm the set of inputs used and outputs produced
maximize profit at those prices given the firms production
technology (profit maximization),

## 2 for each consumer the consumption bundle maximizes utility for

those prices given the budget constraint (utility maximization),

3 for each market (factors and goods), demand does not exceed
supply (market clearance).

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 12 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## Two ways of formulating economic models:

1 as an constrained optimization problem

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 13 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## Two ways of formulating economic models:

1 as an constrained optimization problem
2 as a complementarity problem: square system of
equations/inequalities and unknowns

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 13 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## Equilibrium of this economy can be described as solution to the

following constrained optimization problem:

max W = U(X , Y )
KX ,KY ,LX ,LY ,pK ,pL ,pX ,pY

s.t.

X = F (KX , LX )
Y = G(KY , LY )
K X + KY ≤ K
LX + LY ≤ L
pX X + pY Y ≤ pK (KX + KY ) + pL (LX + LY )

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 14 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## Two ways of formulating economic models:

1 as an constrained optimization problem
2 as a complementarity problem: square system of
equations/inequalities and unknowns

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 15 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

While solving economic equilibrium problems as constrained
optimization problems works for simple problems, the usefulness of
this approach breaks down quickly as the model becomes more
complicated:
• It is not always clear what to maximize/what objective function is
(e.g., multiple households, multiple countries).

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 16 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

While solving economic equilibrium problems as constrained
optimization problems works for simple problems, the usefulness of
this approach breaks down quickly as the model becomes more
complicated:
• It is not always clear what to maximize/what objective function is
(e.g., multiple households, multiple countries).
• Use of competitive market models can be based on optimization
approach but problematic if economy is not characterized by
perfect competition.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 16 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

While solving economic equilibrium problems as constrained
optimization problems works for simple problems, the usefulness of
this approach breaks down quickly as the model becomes more
complicated:
• It is not always clear what to maximize/what objective function is
(e.g., multiple households, multiple countries).
• Use of competitive market models can be based on optimization
approach but problematic if economy is not characterized by
perfect competition.
• Incorporation of “second-best” features (e.g., distortions due to
government interventions) is not straightforward with optimization
approach.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 16 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

While solving economic equilibrium problems as constrained
optimization problems works for simple problems, the usefulness of
this approach breaks down quickly as the model becomes more
complicated:
• It is not always clear what to maximize/what objective function is
(e.g., multiple households, multiple countries).
• Use of competitive market models can be based on optimization
approach but problematic if economy is not characterized by perfect
competition.
• Incorporation of “second-best” features (e.g., distortions due to
government interventions) is not straightforward with optimization
approach.
• Optimization cannot handle mixing of primal (e.g., physical
quantities such as power generation, gas flows) and dual
variables (e.g., prices).

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 16 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

While solving economic equilibrium problems as constrained
optimization problems works for simple problems, the usefulness of
this approach breaks down quickly as the model becomes more
complicated:
• It is not always clear what to maximize/what objective function is
(e.g., multiple households, multiple countries).
• Use of competitive market models can be based on optimization
approach but problematic if economy is not characterized by perfect
competition.
• Incorporation of “second-best” features (e.g., distortions due to
government interventions) is not straightforward with optimization
approach.
• Optimization cannot handle mixing of primal (e.g., physical
quantities such as power generation, gas flows) and dual
variables (e.g., prices).
• Can not easily incorporate corner solutions, i.e. price or
quantity=0.
2 x 2 GE model Introduction to CGE modelling October,1 2015 16 / 61
Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Rutherford (1995) and Mathiesen (1985) showed that many

economic models, including general equilibrium models, can be
cast as a mixed complementary problem.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 17 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Rutherford (1995) and Mathiesen (1985) showed that many

economic models, including general equilibrium models, can be
cast as a mixed complementary problem.
• Mixed Complementarity Problem (MCP):

## Given a function F: Rn −→ Rn , find z ∈ Rn such that F (z ) ≥ 0,

z ≥ 0, and z T F (z ) = 0.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 17 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Rutherford (1995) and Mathiesen (1985) showed that many

economic models, including general equilibrium models, can be
cast as a mixed complementary problem.
• Mixed Complementarity Problem (MCP):

## Given a function F: Rn −→ Rn , find z ∈ Rn such that F (z ) ≥ 0,

z ≥ 0, and z T F (z ) = 0.
• Example: x f (x ) = 0, x (5 − x) = 0. Solution: x = 0 (f (x ) = 0) or
x = 5 (f (x ) = 0).

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 17 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Rutherford (1995) and Mathiesen (1985) showed that many

economic models, including general equilibrium models, can be
cast as a mixed complementary problem.
• Mixed Complementarity Problem (MCP):

## Given a function F: Rn −→ Rn , find z ∈ Rn such that F (z ) ≥ 0,

z ≥ 0, and z T F (z ) = 0.
• Example: x f (x ) = 0, x (5 − x ) = 0. Solution: x = 0 (f (x) = 0) or
x = 5 (f (x ) = 0).
• “Mixed”: solution is a mix of equalities f (z ) = 0 and inequalities
f (z ) > 0.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 17 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Rutherford (1995) and Mathiesen (1985) showed that many

economic models, including general equilibrium models, can be
cast as a mixed complementary problem.
• Mixed Complementarity Problem (MCP):

## Given a function F: Rn −→ Rn , find z ∈ Rn such that F (z ) ≥ 0,

z ≥ 0, and z T F (z ) = 0.
• Example: x f (x ) = 0, x (5 − x ) = 0. Solution: x = 0 (f (x) = 0) or
x = 5 (f (x ) = 0).
• “Mixed”: solution is a mix of equalities f (z ) = 0 and inequalities
f (z ) > 0.
• “Complementarity”: z and f (z ) are a complementary pair. z is an
associated variable to a certain condition.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 17 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## An equilibrium in complementarity format is represented by a

non-negative vector of activity levels, a non-negative vector of prices,
and a non-negative vector of incomes such that:
1 Zero profit conditions (no production activity makes a positive
profit, output is an associated variable):
−profit ≥ 0, output ≥ 0, outputT (-profit) = 0
2 Market clearance conditions (excess supply (supply minus
demand) is non-negative for all goods and factors, price is an
associated variable):
supply − demand ≥ 0, price ≥ 0,
priceT (supply − demand) = 0
3 Income definition (expenditure equals income):
income = value of endowments

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 18 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Complementarity-based solution approach: Defines the

equilibrium as the solution to a (squared) system of equations.
• Two types of equations: zero profit conditions and market
clearance conditions.
• These can be formulated using optimal choice functions for
1 profits in production (= revenue/price minus costs)
2 excess demand (= demand minus supply)
that embody the underlying optimizing behavior of economic
agents.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 19 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.
• Complementarity involves

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.
• Complementarity involves
a. associating each equation with a particular variable, called the
complementary variable.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.
• Complementarity involves
a. associating each equation with a particular variable, called the
complementary variable.
b. if the variables are restricted to be non-negative (prices and
quantities), then the equations are written as weak inequalities.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.
• Complementarity involves
a. associating each equation with a particular variable, called the
complementary variable.
b. if the variables are restricted to be non-negative (prices and
quantities), then the equations are written as weak inequalities.
• if the equation holds as an equality in equilibrium, then the
complementary variable is generally strictly positive.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Economic equilibrium problems are thus represented as a

system of n equations/inequalities in n unknowns.
• Complementarity involves
a. associating each equation with a particular variable, called the
complementary variable.
b. if the variables are restricted to be non-negative (prices and
quantities), then the equations are written as weak inequalities.
• if the equation holds as an equality in equilibrium, then the
complementary variable is generally strictly positive.
• if the equation holds as a strict inequality in equilibrium, the
complementary variable is zero.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 20 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Exercise Complementarity

## We have a partial model with a linear supply and demand function.

1 Knowing that the marginal costs of the producer should be
greater/smaller (?) than the selling price and supply is
greater/smaller (?) than demand. Draw how an equilibrium might
look like (including corner solutions)
2 Write down the complementarity conditions.

Some help:
How do we know which inequality is associate with which variable and
the direction of the inequality? Economic theory tells you which
variable must be associated with which inequality and which way the
inequality goes.
a. ask the question whether or not a particular direction of the
inequality is consistent with economic equilibrium.
b. ask the question, “what must be true if the inequality is strict in
equilibrium”?

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 21 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

Solution
Three outcomes of partial equilibrium example

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 22 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Supply of good X with price P . The supply curve exploits the

firm’s optimization decision, equating price with marginal cost:
P = MC.

## • Note that the price equation is complementary with a quantity

variable.
• Suppose that Cost = aX + (b/2)X 2 . Marginal cost is then given
by MC = a + bX .

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 23 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • Optimizing consumer utility for a given income and prices will

yield a demand function of the form X = D(P , M) where M is
income.

## • Note that the quantity equation is complementary with a price

variable.
• We will suppress income and assume a simple function:
X = c + dP where c > 0, d < 0.

## 2 x 2 GE model Introduction to CGE modelling October,1 2015 24 / 61

Introduction 2. 2 x 2 GE model Steps in CGE, the 2 x 2 model Literature A simple general equilibrium model with two sectors and two primary factors of

## • MC < P cannot be an equilibrium, there is a profit opportunity

and more of the good will be produced.
• MC > P can be an equilibrium: the good is unprofitable and is
not produced. Thus X is complementary with the supply equation.
X < D(P , M) cannot be an equilibrium, excess demand will
• cause the price to rise and more will be supplied.
X > D(P , M) can be an equilibrium, this must mean that the
• good is free, and P = 0. Thus P is complementary with the
demand equation.

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Consumer behavior

## • Standard microeconomic model of consumer choice describes a

world inhabited by many rational individuals (consumers).
• These individuals are capable of making consistent decisions
about all kinds of issues, and act independently of all others.
• Preferences of a given individual are assumed to be described by
a utility function.
• Consumers are price-takers, no strategic interaction.
• They maximize utility subject to an individual budget constraint.
• The result of their optimization can be expressed as a set of
demand functions, which completely characterize the
preferences.

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## Optimal behavior of consumers

• Utility maximization problem:
max U (X , Y ) s.t. pX X + pY Y ≤ I
X ,Y

## • At the optimum (ignoring corner solutions), the marginal rate of

substitution, i.e., the rate that the consumer is willing to trade good Y for
good X, holding utility constant, must equal the ratio of the prices of the
two goods:
∂U(X,Y )/∂X p
= X for X , Y > 0 .
∂U (X , Y )/∂Y pY
| {z }
MRS
• Dual expenditure minimization problem:
min pX X + pY Y s.t. U (X , Y ) = 1
X ,Y

## • Solution to this problem is known as the Hicksian compensated demand

function: HX (pX , pY ) , HY (pX , pY )
• Value function for this optimization problem is the unit expenditure
function (minimum expenditure necessary to achieve one unit of utility,
given goods prices):
E(pX , pY ) ≡ pX HX (pX , pY ) + pY HY (pX , pY )
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Producer behavior

## • Firms are characterized by technology: way of converting inputs

into outputs.
• Technology of a firm is represented by a production function.
• Firms have to choose both the amount of inputs and the amount
of outputs, in order to maximize profits.
• Firms use factor inputs.
• Factors are owned by the households and are in fixed supply.
• Firms are price-takers, no strategic interaction.

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## Optimal behavior of firms

• Objective of the firm is to maximize profits:
max pX X − (pL LX + pK KX ) s.t. G (K , L) ≥ X .
K ≥0,L≥0 |{z } | {z }
revenue costs

## • At the optimum (ignoring corner solutions), marginal rate of technical

substitution, i.e., the amount by which input K should be decreased in
order to keep output constant following an increase in input L, must equal
the ratio of the two input prices:
∂G(K ,L)/∂K pK
= for K, L > 0 .
∂G(K , L)/∂L pL
| {z }
MRTS

## • Dual cost minimization problem:

min pK K + pL L s.t. G(K , L) = 1
K ,L
• Solution to this problem is known as the conditional factor demand
function: ZX (pK , pL ), ZY (pK , pL )
• Value function for this optimization problem is the unit cost function
(minimum costs to produce one unit of output X , given input prices):
CX (pK , pL ) ≡ pK ZX (pK , pL ) + pL ZY (pK , pL )
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## • Applying the envelope theorem the partial derivatives of the

value functions for firms and households, i.e., the unit cost and
unit expenditure functions, deliver the optimal reaction of the
respective choice variable to a change in prices.
• Unit capital demand by sector i = X , Y :

## ∂Ci (pK ,pL )

=: a i ,K (p K , p L)
∂pK
• Unit labor demand by sector i = X , Y :

## ∂Ci (pK ,pL )

=: a i ,L (p K , p L)
∂pL
• Consumer demand for good i = X , Y per unit of utility:

∂E (pX ,pY )
=: d (p
i X, p )
∂pi Y

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## • Decisions by consumers and firms are linked through:

• factor markets: firms buy production factors from consumers
• product markets: consumers buy goods & services from firms
• GE model tracks origination and spending of income
• Firms receive income by providing goods & services.
• Consumers get income by providing factor service to the firms.
• arising from optimizing, price-dependent, and mutually
consistent decisions of economic agents on markets.

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## Equilibrium conditions for the 2 x 2 model (I)

Following the three types of equilibrium conditions, the solution of the simple
2 x 2 GE model is given by the following square system of equations:

## Non-positive profits for X:

−(pX − CX (pK , pL )) ≥ 0, X ≥ 0, X (−(pX − CX (pK , pL ))) = 0

## write shorthand for this:

−(pX − CX (pK , pL )) ≥ 0 ⊥ X (1)
Non-positive profits for Y:

## Market clearing for X:

⊥ pX (4)
X − dX (pX , pY )W ≥ 0

## Market clearing for Y:

⊥ pY (5)
Y − dY (pX , pY )W ≥ 0
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## Market clearing for W:

W − I/pW ≥ 0 ⊥ pW (6)

## L − (aX ,L (pK , pL )X + aY ,L (pK , pL )Y ) ≥ 0 ⊥ pL (8)

Income balance:
I = pK K + pL L . (9)

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## • Solving the system of weak inequalities (1)–(9) for the unknowns

X , Y , W , pX , pY , pK , pL , pW , I yields the general equilibrium of
the model
• There are “off-the-shelf” algorithms for solving complementarity
problems (e.g. GAMS/MILES and GAMS/PATH solver)
• If a zero profit condition holds as a strict inequality in equilibrium,
i.e. profits for that activity are negative, that activity will not used.
If a zero profit conditions holds with equality, its associated activity
level is positive.
• If a market-clearing condition holds as a strict inequality, supply
exceeds demand for that good or factor in equilibrium so its price
must be zero. If a market-clearing condition holds with equality, the
price of the associated good is strictly positive.

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Price normalization

• Equilibrium determines only relative prices but not absolute price level.
• If all prices are multiplied by the same scalar, consumption choices do not
change: demand function is homogeneous of degree zero. (this follows
from continuity and monotonicity assumptions on consumers’
preferences).

• Problem: Prices are only defined up to scalar, i.e. there are infinitely
many prices that solve the system of equations (system is
over-identified).

• We need one more equation to fix the absolute price level. This
equation defines the units of account, or the numeraire price.
But then we have more equations than unknowns. Thus, one of the

equations can be dropped and we end up with an exactly identified
system.
Solution: Walras’ law.

• Consumer fully expends his wealth.
• Implication: If all markets but one are cleared, then the remaining
market must also be cleared.

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Outline

1 Introduction

## 2 A simple general equilibrium model with two sectors and two

primary factors of production factors

4 Literature

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GAMS

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## Calibration of a CGE model and SAM

• Calibration of a CGE model is the process of selecting parameters
values such that the model endogenously reproduces a benchmark
dataset, typically in the form of a Social Accounting Matrix (SAM)
starting from the Input Output Table (IOT)
• A SAM represents data on flows of all economic transactions that take
place within an economy (including external sector transactions)

## • Numbers in a SAM represent the values (price times quantity) of

economic transactions at a point in time (within a given period of time,
i.e. a year). Normalization of prices and quantities.
Theoretically, a SAM always balances, i.e it is micro-consistent

representing an equilibrium (zero profit, market clearance and income
balance conditions imply that row sums and column sums are equal to
zero)
Empirically, matrix balancing methods have to be applied to obtain a
• micro-consistent SAM which can be used for model calibration
Specification of “free” parameters, i.e., parameters which are not calibrated
• to reproduce the benchmark dataset, typically draws on other “appropriate”
sources

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A stylized SAM

## • For the example of the simple 2 x 2 model, we represent the

initial data by a SAM which consists of:
• Columns corresponding to the production sectors in the model (X ,
Y , W ) and the representative consumer CONS
• Rows corresponding to markets with prices pX , pY , pK , pL and pW
as complementary variables .
• The SAM:

X Y W K L CONS rowsum
X (pX ) 100 100
Y (pY ) 100 100
W (pW ) 200 200
L(pL ) 25 75 100
K (pK ) 75 25 100
CONS (Inc) 100 100 200
colsum 100 100 200 100 100 200

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## CES and calibrated share form

• Production and utility activities are typically described by
constant-elasticity-of-substitution functions (CES) which have the
following form:

(10)

## where x1 , . . . , xn denote inputs and the elasticity of substitution is given

by σ = 1/(1 − ρ).
• The equivalent calibrated share form that is based on the observed
quantities, prices and budget shares from the data:

## where , denotes the benchmark value share of input i

in total production value given input prices pi . Benchmark quantities and
prices are denoted with a bar.
• The associated cost / expenditure function is given by:

(11)

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## Suppose we want to calibrate a technology that combines inputs X and Y to

produce W = f (X , Y ).
• Observed benchmark data available as an input for calibration:
1 quantities of inputs and output
2 prices of inputs and output

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Calibration

## A firm produces output y with factor inputs x i at factor prices p i . What

values of αi are consistent with this information, taking ρ (σ) as given?

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Price normalization

## • Equilibrium determines only relative prices but not absolute price

level.
• If all prices are multiplied by the same scalar, consumption
choices do not change: demand function is homogeneous of
degree zero. (this follows from continuity and monotonicity
assumptions on consumers’ preferences).
• Problem: Prices are only defined up to scalar, i.e. there are
infinitely many prices that solve the system of equations (system is
over-identified).
• We need one more equation to fix the absolute price level. This
equation defines the units of account, or the numeraire price.
• But then we have more equations than unknowns. Thus, one of
the equations can be dropped and we end up with an exactly
identified system.

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## General equilibrium exchange model (I)

1 \$title General equilibrium exchange model with alternative choice of numeraire
2

## 5 SET h Households /h1*h3/

6 g Goods /g1*g3/;

8 PARAMETER
9 theta(g,h) ’Share parameters’,
10 sigma(h) ’Substitution parameters’,
omega(g,h)
11
’Endowment parameters’;

## 13 * Generate arbitrary data:

15 theta(g,h) = uniform(0,1);
16 alias (g,gg);
17
theta(g,h) = theta(g,h)/sum(gg,theta(gg,h));
18 sigma(h) = uniform(0,3);
19
omega(g,h) = uniform(0,1);

22 VARIABLE
23 P(g) Y(h) ’Market price for goodg’,
24 C(h) ’Household income’,
D(g,h)
25
XI(g) ’Unit cost of consumption’,
26
’Uncompensated demand’
27
’Market excess demand’;

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## General equilibrium exchange model (II)

1 EQUATION
2 income(h) ’Income definition’
3 cost(h) ’Unit expenditure function’
4 demand(g,h) ’Uncompensated demand function’
5
market(g), ’Market excess demand’
6
equil(g) ’Equilibrium condition (excess demand=0)’;

9 ;

);

## 21 * Fix one price index as numeraire. For example, good "g1":

23 P.FX("g1") = 1;

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Price normalization

## • Absolute equilibrium prices for alternative numeraires (based on model

walras.gms):

• As illustrated in the left side of the table, when the exchange model is properly
specified, the same relative equilibrium prices are returned irrespective of the
numeraire specification.
• Likewise the “Walras check”, the imbalance in the omitted numeraire market
clearance condition is zero.
• Conversely, when an imbalance is introduced in the model, both absolute and
relative prices depend on the numeraire choice and the “Walras check” is
nonzero, as indicted on the right side of the table.

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## The 2 x 2 GE model in GAMS (I)

1 * Declare elasticity parameters:

3 PARAMETER
4 S "Elasticity of substitution between capital and labor (X
sigma_x
sector)" /.5/
5 sigma_y "Elasticity of substitution between capital and labor (Y
sector)" /.5/
6 sigma_w "Elasticity of substitution between X and Y (W sector)" /.5/ "Labor endowment
7 lendow multiplier" /1/;

## 9 * Declare variables and equations for the 2x2 model:

11 POSITIVE VARIABLES
12 X ’X sector output index’
13 Y ’Y sector output index’
W
14
’Welfare index’
15 PX
PY ’Price index for commodity X’
16
PL ’Price index for commodity Y’
17
18
PK ’Price index for primaryfactor L’
19
P ’Price index for primaryfactor K’
W ’Price index for welfare’
20
H
H ’Household income and expenditure’;

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Model code

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## The 2 x 2 GE model in GAMS (III)

Model code
1 * Zeroprofit conditions:
2 PRF_X.. (25/100)*PL**(1-sigma_x) + (75/100)*PK**(1-sigma_x)
3 =G= PX**(1-sigma_x);
4 PRF_Y.. (75/100)*PL**(1-sigma_y) + (25/100)*PK**(1-sigma_y)
5 =G= PY**(1-sigma_y);
6
PRF_W.. (100/200)*PX**(1-sigma_w) + (100/200)*PY**(1-sigma_w)
7 =G= PW**(1-sigma_w);

9 * Marketclearing conditions:
10 MKT_X.. 100 *X =E= 0.5*(PW/PX)**sigma_w W*200;
*
11 MKT_Y.. 100 *Y =E= 0.5*(PW/PY)**sigma_w W*200;
*
12 MKT_W.. 200 *W =E= HH / PW;
13 MKT_L..
100 *lendow =G= 0.25*100*X*(PX/PL)**sigma_x
14
+ 0.75*100*Y*(PY/PL)**sigma_y;
15
MKT_K.. 100 =E= 0.75*100*X*(PX/PK)**sigma_x
16
+ 0.25*100*Y*(PY/PK)**sigma_y;

18 * Income definition:
19 I_HH.. HH =E= 100*lendow*PL + 100*PK;

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## The 2 x 2 GE model in GAMS (IV)

Model code
1 * Define model equations and assign variables to equations:
2 MODEL SIMPLE_MCP /PRF_X.X, PRF_Y.Y, PRF_W.W, MKT_X.PX, MKT_Y.PY, MKT_L.PL,
3 MKT_K.PK, MKT_W.PW, I_HH.HH /;

5 * Initialize variables:

7 X.L=1;Y.L=1;W.L=1;PW.l=1;PX.L=1;PY.L=1;PK.L=1;PL.L=1;PW.L=1;HH.L=200;

9 * Set a "numeraire":

11 PW.FX = 1;

13 * Solve statement:

15 SIMPLE_MCP.ITERLIM = 0;
16 SOLVE SIMPLE_MCP USING MCP;

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## The 2 x 2 GE model in GAMS (V)

Model solution (output from 2_2GEmodel.lst)

## 2 LOWER LEVEL UPPER

MARGINA
L
4 ---- VAR X . 1.0000 +INF .
5 ---- VAR Y . 1.0000 +INF .
6
---- VAR W . 1.0000 +INF .
7
---- VAR PX 1.000000E-10 1.0000 +INF .
8
---- VAR PY 1.000000E-10 1.0000 +INF .
9
10
---- VAR PL 1.000000E-10 1.0000 +INF .
11
---- VAR PK 1.000000E-10 1.0000 +INF .
---- VAR PW 1.0000 1.0000 1.0000
EPS
12
---- VAR HH . 200.0000 +INF .

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Exercise

## Suppose the labor productivity (or size of workforce) in the economy

increases by 20%. The following figure shows impacts for prices and
quantities (comparing the “new” vs. initial equilibrium).

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Exercise

## Suppose the labor productivity (or size of workforce) in the economy

increases by 20%. The following figure shows impacts for prices and
quantities (comparing the “new” vs. initial equilibrium).

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## 20% increase in labor endowment: Output from GAMS model

1 LOWE LEVEL UPPER
R
3 ---- VAR X . 1.0435 +INF .
4 ---- VAR Y . 1.1429 +INF .
5
---- VAR W . 1.0909 +INF .
6
---- VAR PX . 1.0930 +INF .
7
---- VAR PY . 0.9112 +INF .
8
9
---- VAR PL . 0.8264 +INF .
10
---- VAR PK . 1.1901 +INF .
---- VAR PW 1.0000 1.0000 1.0000 7.413234
E-10
11 . 218.1818 +INF .
---- VAR HH

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## 20% increase in labor endowment: sensitivity with respect to elasticity of

substitution between capital and labor in sector X

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Outline

1 Introduction

## 2 A simple general equilibrium model with two sectors and two

primary factors of production factors

4 Literature

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Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model 4. Literature

Books

## Bewley, Truman F. (2007). General equilibrium, overlapping

generations models and optimal growth theory. Harvard University
Press.
Ginsburgh, Victor A. and Michiel Keyzer (1997). The Structure of
Applied General Equilibrium Models. Cambridge MIT Press.
Hosoe, Nobuhiro, Kensi Gasawa, and Hideo Hashimoto (2010).
Textbook of General Equilibrium Modeling. Palgrave Macmillan.

## Literature Introduction to CGE modelling October,1 2015 60 / 61

Introduction 2 x 2 GE model Steps in CGE, the 2 x 2 model 4. Literature

Articles

## Devarajan, Shantayanan and Delfin S Go (1998). “The Simplest

Dynamic General-Equilibrium Model of an Open Economy”. In:
Journal of Policy Modeling 29.6, pp. 677–714.
Devarajan, S. et al. (1997). “Simple General Equilibrium Modeling”.
In: Applied Methods for Trade Policy Analysis - A Handbook. Ed. by
J.P. Francois and K.A. Reiner. Cambridge University Press.
Chap. Simple general equilibrium modeling.
Löfgren, Hans, Rebecca Lee Harris, and Sherman Robinson (2001). A
standard computable general equilibrium (CGE) model in Gams. TMD
Disccusion paper 75. Washington DC: Trade and Macroeconomics
Division International Food Policy Research Institute.
Wing, Ian Sue (2004). “Computable General Equilibrium Models and
their Use in Ecomomy-WIde Policy Analysis: Everything You Ever
Wanted to Know (But Were Afraid to Ask)”.