Computable General Equilibrium analysis in Agricultural Policy analysis

Dr. Sherko Soltanpanahi sherko2003@gmail.com

INTRODUCTION TO POLICY MODELS

WHAT IS ECONOMIC POLICY?

use of government actions designed to achieve specific goals

Deliberate

INTRODUCTION TO POLICY MODELS WHY UNDERTAKE POLICY ANALYSIS?

To advise policy makers Improve effectiveness of policies Choose between different paths to same objective Uncover unintended consequences of policies To understand policy as private agents Anticipate effects of public policies Design improved response strategies

INTRODUCTION TO POLICY MODELS POLICY AND POLITICS?

Policy is necessarily about politics Traditional Economic view:  economists provide technical analysis  politicians make political decisions Is separation possible? Whats the point if it is all politics? Is there still room for policy analysis?
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INTRODUCTION TO POLICY MODELS

We would argue, yes policy makers need guidance There is need for:

Qualitative policy analysis:

based on theoretical analysis general principles numerical assessment of specific impacts (direction) necessary to assess net impact
contradictory effects moving in opposite directions winners and losers => compensation

Quantitative policy analysis:

Policy makers will be unlikely to assess impacts Even if they have preconceived ideas

WHAT ARE MODELS?

Abstraction from reality
Reality is too complex Sets of assumptions

Focus on key aspects of problems

Allows to cut to the chase

Different models suit different purposes

Can reflect different points of view No right model As long as it:

 clarifies policy views  improves transparency of policy debate

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DIFFERENT TYPES OF MODELS

Theoretical vs applied models Theoretical: broad principals Applied: real life policy issues and data Partial vs general equilibrium/economy-wide Are feedback and linkages important? How important is the ceteris paribus? Econometric & Forecasting vs Single Point Parameter estimation : testing

ECONOMY-WIDE MODELS
Computable General Equilibrium Feedback through linkages is important Too complex to solve analytically . .so use (compute) numerical simulation Good for counterfactuals (scenarios) Degrees of complexity Simple linear: IO/SAM based 1st generation Complex nonlinear: 2nd generation
closer to economic theory (production / consumption)
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DIFFERENT TYPES OF CGE MODELS

Walrasian-Neoclassical Resource allocation issues Often takes form of template that fits all Have become more flexible Structuralist-Keynesian Adjustments in product and factor markets Role of institutions: identify crucial role players More ad hoc approach Dynamic vs static The notion of dynamic: Nature of intertemporal relationships Time horizon: short, medium, long

Walrasian general equilibrium  Walrasian general equilibrium prevails when supply and demand are equalized across all of the interconnected markets in the economy.

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Walrasian general equilibrium

 Computable general equilibrium (CGE) models are simulations that combine the abstract general equilibrium structure formalized by :  Arrow and Debreu with realistic economic data to solve numerically for the levels of supply, demand and price that support equilibrium across a specified set of markets.
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Foundations of CGE model  The fundamental conceptual starting point for a CGE model is the circular flow of commodities in a closed economy.

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Circular Flow of Income

Factor Costs

Factor Markets

Wages & Rents

Domestic Private Savings

Taxes Demand for Intermediate Inputs

Gov. Savings

Firms

Households
Private Consumption

Government
Transfers Government Expenditure

Saving/INV

Sales Revenues

Investment Expenditure

Product Markets
Import Payments Export Receipts

Domestic Demand for Final Goods Foreign Savings

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Rest of the World

Walrasian rules
 Walrasian general equilibrium rules are:

1. market clearance 2. zero profit 3. income balance

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Market clearance
1. for a given commodity the quantity produced must equal the sum of the quantities of that are demanded by the other firms and households in the economy.

2. for a given factor the quantities demanded by firms must completely exhaust the aggregate supply endowed to the households.
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zero profit
 the sum total of revenue from the production of goods must be allocated either to households as receipts for primary factors rentals, to other industries as payments for intermediate inputs, or to the government as taxes. The value of a unit of each commodity in the economy must then equal the sum of the values of all the inputs used to produce it: the cost of the inputs of intermediate materials as well as the payments to the primary factors employed in its production. The principle of conservation of value thus simultaneously reflects constancy of returns to scale in production and perfectly competitive markets for produced commodities.
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income balance
 the returns to households endowments of primary factors, that are associated with the value of factor rentals to producers, accrue to households as income that the households exhaust on goods purchases.  The fact that households factor endowments are fully employed, so that no amount of any factor is left idle, and that households exhaust their income on commodity purchases (some amount of which are for the purpose of saving), reflects the principle of balanced-budget accounting known as income balance. 17

Walrasian rules  The three conditions of : 1. market clearance 2. zero profit 3. and income balance are employed by CGE models to solve simultaneously for the set of prices and the allocation of goods and factors that support general equilibrium.
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General equilibrium theory

General equilibrium theory is a branch of theoretical
microeconomics.

 It seeks to explain production, consumption and prices

in a whole economy.

General equilibrium tries to give an understanding of the

whole economy using a bottom-up approach, starting with individual markets and agents.

Macroeconomics, as developed by so-called Keynesian

economists, uses a top-down approach where the analysis starts with larger aggregates.
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Source: World Bank Data, 2011

General equilibrium theory

 General equilibrium models typically model a multitude
of different goods markets.

 Modern general equilibrium models are typically

complex and require computers to help with numerical solutions.

Under capitalism (free market), the prices and

production of all goods are interrelated.

Calculating the equilibrium price of just one good, in

theory, requires an analysis that accounts for all of the millions of different goods that are available.!!!
Source: World Bank Data, 2011

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CGE models
 CGE models are a standard tool of empirical analysis, and are widely used to analyze the aggregate welfare distributional impacts of policies      Examples of their use may be found in areas: fiscal reform development planning international trade environmental regulation
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Partial &General equilibrium

In partial equilibrium analysis, the determination of the
price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant.

 The Marshallian theory of supply and demand is an

example of partial equilibrium analysis.

General equilibrium refers to the equilibrium in which

production, consumption, prices, and international trade are determined simultaneously for all goods produced and consumed in the economy.

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Assumptions of CGE
1. Economic agents, consumers, and producers- firmsexhibit rational behavior in the sense that given all the available information, consumers maximize utility from consumption, and firms try to maximize profits.

2. Consumers and producers when they make decisions

about consumption and production look at the real prices not the nominal prices.

We are assuming here agents base their decisions on relative prices not on nominal prices.
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Assumptions of CGE
3. In each country factors of production is fixed and the
level of technology in each country is constant.

4. Perfect competition prevails in each industries in each

country. There are no externalities.

5. Factors of production are perfectly mobile between the

industries within each country.

6. Community preferences in consumption can be

represented by a consistent set of community indifference curves.
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Dynamic General Equilibrium Model

Most of the empirical work in economics has relied on
partial equilibrium analysis.

This type of analysis concentrates on a single market and

quantifies the changes in supply, demand, prices, quantities and welfare brought about by exogenous shocks and/or parametric changes.

This approach is well suited to markets with limited size or

with weak linkages to other economic sectors.

Many economic problems do not fit easily into this

category, however.
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Dynamic General Equilibrium Model

The economic sector analyzed is often large, and
changes in that sector can have important repercussions economy-wide.

Such problems are more appropriately dealt with using

general equilibrium analysis in which all the sectors in the economy are seen as one linked system where changes in any part affect prices and output economy-wide.

Mathematically, an interlinked economy cannot be

described in one or two equations, but rather by a large system of simultaneous equations.
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Dynamic General Equilibrium Model

More precisely, in an economy with n markets, n-1
equations are required to solve for all of the prices and outputs in the system.

In a simple static model, the actual solution of a general

equilibrium problem requires that the modeler construct a social accounting matrix (SAM).

In the SAM, all production in all markets, all tax revenue
of the government and all consumption by all household for a specific base year has to be replicated exactly first.
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Dynamic General Equilibrium Model

The policies that have been analyzed through these
models include changes in various types of taxes and tariffs, technological change, natural resource policy, and employment policy.

Both efficiency and distribution impacts are

presented in these studies

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Why CGE Analysis of Agriculture?

why should we go to the trouble

of constructing an economy wide model to analyze policies in this sector?

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Benefits of AGE Analysis in agricultural policy analysis

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Benefits of CGE Analysis

1- Household focus: Traditional agricultural economic analysis has tended to focus
on commodities, and associated factor returns.

In contrast, CGE models begin with households as the primitive

concept.

Households supply factors of production and consume goods

and services.

Welfare in the model is computed directly in terms of

household utility and not some abstract summation of producer, consumer and taxpayer surplus.
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Benefits of CGE Analysis

2- Finite resources and accounting consistency: CGE models rely on social accounting matrices (SAMs) for their
empirical structure.

 These SAMs detail all the basic accounting identities which

must hold for the economy to be in equilibrium.

Those who work with CGE models quickly recognize that these
identities are as important as the behavioral assumptions.

The fact that households cannot spend more than they earn, or
that the same unit of labor, land or capital cannot be simultaneously employed in two different places, serves to tightly circumscribe the range of possible GE outcomes.

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Benefits of CGE Analysis

3-Second-best analysis: One of the distinguishing features of agricultural policy analysis is
the high degree of public intervention in the farm and food sector. This includes programs which:

(a) subsidize inputs such as credit, water, and fertilizer (b) restrict acreage planted to certain crops (c) intervene in output markets with subsidies or production
quotas (d) subsidize (or tax less) the consumption of food relative to other goods and services, (e) intervene at the border with export subsidies, import tariffs and quotas, etc.
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Benefits of CGE Analysis

This complex of policy interventions makes it very difficult to
anticipate the efficiency consequences of a marginal perturbation in, or reform of, farm and food policies.

In an CGE application focusing on US agriculture in the mid1980's, Hertel and Tsigas(1991), they demonstrate that the first-best alternative of removing all of the distortions would generate welfare gains an order of magnitude larger than the tradable quotas.

 In CGE models provide an excellent vehicle for conducting

welfare analysis in a second-best setting, and this makes them particularly well-suited for use in agricultural policy analysis.
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Benefits of CGE Analysis

4. Interindustry linkages: Often when one is conducting policy analysis in the farm
sector, it is difficult to know where to draw the line between the commodities and sectors affected by a given policy and the rest of the economy.

 More generally, distinguishing agriculture from non-agriculture

in the modern, industrialized economies has become quite difficult.

Increasingly, large, commercial farms contract out some of

their operations. The firms providing these services ranging from pesticide applications to financial services may not be exclusively tied to agriculture.

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Benefits of CGE Analysis

An important reason for capturing the non-farm linkages has to
do with the diversification of farm households earnings. They often have significant financial or wage earning interests in other sectors, so that their welfare depends on much more than the changes in agricultural activity.

 this distinguishing and linkages could be don in CGE analysis

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Benefits of CGE Analysis

5- Economywide Perspective: CGE analysis also provides a valuable tool for putting things in
an economy wide perspective.

 Microeconomic theory emphasizes the importance of relative,

as opposed to absolute, levels of economic variables.

Nowhere is the importance of relative vs. absolute

comparisons more evident than in international trade.

It is very common for agricultural economists to compare

production costs in different regions, and, when they are lower in one country than another, to conclude that country is more competitive.

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Hidden Challenges to CGE Analysis

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Hidden Challenges to CGE Analysis

1- Most of the early CGE models of developed market economics (DMEs) treated agriculture (possibly along with forestry and fisheries) as a single, aggregate sector, producing one homogeneous product.  This type of aggregation was essential in order to permit complete commodity coverage at a relatively uniform level of aggregation. Also, this is often the level of aggregation provided in published input-output tables which is not realistic.
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Hidden Challenges to CGE Analysis

2. A second important feature of general purpose models which has limited their applicability to agricultural issues is their failure to distinguish land from other capital inputs. Yet the presence of farm land in the agricultural production function is critical. It is perhaps the most distinguishing feature of this sector of the economy. Furthermore, land can also be an important instrument of public policy. Therefore land prices are potentially quite volatile. Since land usually represents the major form of wealth holding for the farm population, the impact of public policy on 40 farm prices and hence returns to landowners is of paramount importance to farmers and agricultural policymakers.

Hidden Challenges to CGE Analysis

3. A third critical limitation of the most common, CGE models s is their tendency to devote too little attention to the specification of key behavioral parameters in the farm and food system.  As a consequence, there is a wide gulf between the partial equilibrium models currently used in agricultural policy analysis, and the partial equilibrium behavior of their CGE counterparts. In some cases these discrepancies may be justified. However, in most instances the CGE models' parameters 41 simply lack sufficient empirical justification.  As a consequence, they often generate implausible results.

Indian Agricultural Policy: An Applied General Equilibrium Model

N.S.S. Narayana, K.S. Parikh, and T.N. Srinivasan, 1987

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Policy simulation
The analytical model is of the sequential applied general equilibrium (AGE) genre in which an equilibrium price vector is computed for each year in succession. a number of behavioral functions relating to demand and supply have been econometrically estimated with data mostly from the period 1950-51 to 1973-75. In the running of the model, for the period up to 1980
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The economy is divided into ten sectors, of which the first nine produce agricultural commodities and the tenth produces the only nonagricultural good.

Policy simulation
There are three sets of agents: producers, consumers, and government. Consumers are classified by their residence as rural or urban. Rural as well as urban consumers are divided into five expenditure classes each according to their monthly per capita household consumption expenditure. Means of production (capital), natural resources (land), human resources (labor), and livestock (draft and milk animals, poultry, etc.) generate income through production activities that is distributed to consumers.

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Policy simulation
behavior of producers (i.e., their production activities) determines commodity supplies and incomes. Consumer behavior generates commodity demands (and implicitly resource supplies). The government sets policies (e.g., investment targets, taxes, tariffs, quotas, rations, price supports and ceilings, etc.). Finally, equilibrium is achieved through exchange in 45 which domestic demands, together with export demand by the rest of the world for each sector's output, is equated to the sum of domestic supply and import supply.

RESULTS
Model simulations were carried out from 1980 to 2000. Policy changes are usually introduced in 1980, and the results of such a policy scenario are compared with those of a reference scenario. The first set of results compare public distribution policies with the reference run in which a basket of rice, wheat, and coarse grains (in fixed proportions), is distributed to all residents in each year at a subsidized price along with the purchase (or procurement) from 46 farmers of the needed grain at specified (below the market) prices.

RESULTS
Policy DP-0: at one extreme, abolishes both public distribution and procurement. FRFD-100W: at the other extreme, provides 100 kg. of wheat per year, free of cost, to all consumers, urban as well as rural, with the cost being financed by increasing the income tax levied on the two richest classes of urban consumers to the required extent. Policy FRFD-100W-X: on the other hand, keeps the income tax at its reference run level, and finances the food subsidy by reducing investment.
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RESULTS

"The expenditure classes are numbered in increasing order of real expenditure. P: the proportion of population E: average equivalent income per capita in each expenditure class.

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It turned out that to keep taxes fixed and distribute free food in all years from 1980, large reductions in investment and increases in imports were needed in the initial years. For this reason, in FRFD-100-X, taxes are kept at reference run levels only from 1986.

Impact of Redistributive Policies

REF Relative price of agriculture Tax rate % Average energy retake {kcal p.p) Net exports of cereals (109tonns) GDP (Rs. 109 at 1970 prices) GDP agriculture GDP non-agriculture Relative price of agriculture Tax rate % Average energy retake {kcal p.p) Net exports of cereals (109tonns) GDP (Rs. 109 at 1970 prices) GDP agriculture GDP non-agriculture 0. 925 2.3 21 62 -3.7 530 220 310 0.892 9.8 2569 8.7 1429 354 1075 DP-0 0.924 3.2 2171 -4.5 530 220 310 0.896 11.0 2581 7.3 1428 354 1075 FRFD-100W Year 1980 I.041 13.5 2241 -8.1 530 220 310 Year 2000 0.918 11.7 2610 7.2 1439 356 1085 FRFD-100W-X 1.096 6.0 2279 -8.8 530 220 310 0.931 9.8 2589 8.8 1295 345 950

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References
Lofgren, H., 2002, a Standard Computable General Equilibrium (CGE) Model in GAMS, International Food Policy Research Institute. Lofgren, H., 2003, the Agricultural Sector in the Analysis of the Poverty Impact of Macro Policies and Shocks: Issues and Technique, International Food Policy Research Institute. Minot, N., 2009, Using GAMS for Agricultural Policy Analysis, International Food Policy Research Institute. Moore, J. C., 2007, General equilibrium and welfare economy, Springer, New york, USA.
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Thank you

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