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Basic concept for undersanding CGE

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Basic concept for undersanding CGE

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equilibrium modeling

1th Educational Workshop of the Simulation Lab

October,1 2015

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

primary factors of production factors

4 Literature

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

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

• 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.

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

• 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.

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

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

uninformative answers..

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

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

However,

simple.

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

However,

simple.

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

analytical way.

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

However,

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)

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

• CGE models provide a consistent framework to accommodate a

large number of structural model features & dimensions required

for a quantitative analysis of economic policy

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

• 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)

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

• 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

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

• 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.

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

For example...

• Evaluate the impacts on: macroeconomic variables,trade flows,

industrial activity, labor markets, factor prices, commodity prices,

and regional or household welfare

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

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

policy, and terms of trade.

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

Treatment of time

• Static

• Fake dynamics

• Recursive dynamcis

• Ramsey model:Steady state

• Overlapping generations

Regionalization

• Single country with closure rules

• Multi-regional model

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

following:

• Firms that attempt to maximize profits and minimize costs

• Households who maximize "welfare" (e.g., consumption) by

demanding commodities according to price

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

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)

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

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)

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

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

primary factors of production factors

4 Literature

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

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

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 commodities which can be produced using production

technologies X = F (K , L) and Y = G(K , L)

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 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

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 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)

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 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 )

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 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

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 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.

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

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),

those prices given the budget constraint (utility maximization),

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

supply (market clearance).

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

1 as an constrained optimization problem

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

1 as an constrained optimization problem

2 as a complementarity problem: square system of

equations/inequalities and unknowns

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

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 )

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

1 as an constrained optimization problem

2 as a complementarity problem: square system of

equations/inequalities and unknowns

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).

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.

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.

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).

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

economic models, including general equilibrium models, can be

cast as a mixed complementary problem.

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 models, including general equilibrium models, can be

cast as a mixed complementary problem.

• Mixed Complementarity Problem (MCP):

z ≥ 0, and z T F (z ) = 0.

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 models, including general equilibrium models, can be

cast as a mixed complementary problem.

• Mixed Complementarity Problem (MCP):

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).

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 models, including general equilibrium models, can be

cast as a mixed complementary problem.

• Mixed Complementarity Problem (MCP):

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.

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 models, including general equilibrium models, can be

cast as a mixed complementary problem.

• Mixed Complementarity Problem (MCP):

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.

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

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

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 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.

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

system of n equations/inequalities in n unknowns.

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

system of n equations/inequalities in n unknowns.

• Complementarity involves

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

system of n equations/inequalities in n unknowns.

• Complementarity involves

a. associating each equation with a particular variable, called the

complementary variable.

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

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.

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

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.

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

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.

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

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”?

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

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

firm’s optimization decision, equating price with marginal cost:

P = MC.

variable.

• Suppose that Cost = aX + (b/2)X 2 . Marginal cost is then given

by MC = a + bX .

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

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

income.

variable.

• We will suppress income and assume a simple function:

X = c + dP where c > 0, d < 0.

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

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.

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

Consumer behavior

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.

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

• Utility maximization problem:

max U (X , Y ) s.t. pX X + pY Y ≤ I

X ,Y

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

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 )

2 x 2 GE model Introduction to CGE modelling October,1 2015 27 / 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

Producer behavior

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.

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

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

• 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

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

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 )

2 x 2 GE model Introduction to CGE modelling October,1 2015 30 / 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

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 :

=: a i ,K (p K , p L)

∂pK

• Unit labor demand by sector i = X , Y :

=: 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

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

• 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.

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

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:

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

−(pX − CX (pK , pL )) ≥ 0 ⊥ X (1)

Non-positive profits for Y:

⊥ pX (4)

X − dX (pX , pY )W ≥ 0

⊥ pY (5)

Y − dY (pX , pY )W ≥ 0

2 x 2 GE model Introduction to CGE modelling October,1 2015 33 / 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

W − I/pW ≥ 0 ⊥ pW (6)

Income balance:

I = pK K + pL L . (9)

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

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.

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

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.

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Outline

1 Introduction

primary factors of production factors

4 Literature

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

GAMS

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

• 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)

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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

A stylized SAM

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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

• Production and utility activities are typically described by

constant-elasticity-of-substitution functions (CES) which have the

following form:

(10)

by σ = 1/(1 − ρ).

• The equivalent calibrated share form that is based on the observed

quantities, prices and budget shares from the data:

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)

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Calibration

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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Price normalization

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.

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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

2

6 g Goods /g1*g3/;

8 PARAMETER

9 theta(g,h) ’Share parameters’,

10 sigma(h) ’Substitution parameters’,

omega(g,h)

11

’Endowment parameters’;

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’;

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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 ;

);

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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Price normalization

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.

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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/;

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’;

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Model code

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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;

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

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;

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Model solution (output from 2_2GEmodel.lst)

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 .

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Exercise

increases by 20%. The following figure shows impacts for prices and

quantities (comparing the “new” vs. initial equilibrium).

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

Exercise

increases by 20%. The following figure shows impacts for prices and

quantities (comparing the “new” vs. initial equilibrium).

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE 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

Introduction 2 x 2 GE model 3. Steps in CGE, the 2 x 2 model Literature Steps in Developing and Applying a CGE Model

substitution between capital and labor in sector X

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

Outline

1 Introduction

primary factors of production factors

4 Literature

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

Books

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.

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

Articles

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)”.

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