What is a CGE Model?

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What is a CGE
Model?
Miles K. Light, Ph.D.
University of Colorado
Armenian Ministry of Economy and
Trade
Yerevan, 2010
Basic Concepts:
What is a CGE Model?
A “Computable General Equilibrium” (CGE) model:
• is an economic model that combines the following:
• firms (factories,companies) that attempt to maximize profits
and minimize costs
• households who maximize “welfare” (consumption) by
choosing consumption goods according to price
• markets: where prices adjust until supply and demand is
equal
Basic Concepts:
When is a CGE model used?

Some Previous Uses:
 1997: Determine how Carbon-Limits would impact OECD
countries under the Kyoto Protocol

2002: Examine the economic effect of Free Trade with USA
would impact the economy in Peru, Colombia, and Ecuador.

2003: Assess how migration would impact the EU’s economy
with European enlargement

2004/2005: Consider the “total” economic impact of various taxreform packages in Jamaica and Mongolia
Basic Concepts:
Why are CGE Models Popular?

Main Strengths:



Combination of standard theory with detailed data
Optimization and “Micro-foundations”: An
improvement from Keynesian macroeconomic
models

Households respond to price changes

Firms change output and inputs when markets shift
Provides “evidence” to support claims:

Benefits and costs can be calculated, and used as evidence
to support particular policies

Trade-offs between policies can be quantified
Basic Concepts:
Partial Equilibrium:
Economic Theory + Data
Theory Only
Theory with: numbers
Basic Concepts:
Partial Equilibrium:
Economic Theory Only:
Effect of a Tax: Theoretical
Basic Concepts:
Impact using Numbers:
Effect of a Tax: With numbers
Basic Concepts:
Using the previous Partial Equilibrium
model, we can say:
Effect of a 100% tax:
• Output Declines:
• $2,000 to $1,000 (50% decline)
• Consumer prices rise:
• $20/each to $30/each (50% increase)
• Tax Revenues = $500
General Equilibrium:
All markets interacting
General Equilibrium:
• Multiple markets
• Multiple households
• Multiple firms
Typical Outputs
General Outputs:
• Production Levels
• New Price Levels & Inflation
• International Trade Volume (imports and exports)
• Welfare (Equivalent Variation)
• Factor Returns (Wages, Return to Capital)
Specialized Outputs: (if integrated)
• Productivity and Competition (for Increasing Returns to Scale Technology)
• Environmental Indicators (CO2, Pollutants) for energy-economy models
Example:
Simple 2 x 2 x 2 Model
- 2 Sectors
- 2 Factors
- 2 Goods
Example: 2 x 2 x 2 Model

An example Economy:

2 Production Sectors:



Each sector produces an output good:



“PX” is produced by the X Sector
“PY” is the output of the Y Sector
There are 2 “factors” of production:



X Sector (e.g., farming); and
Y Sector (e.g., industry)
Labor, which commands a price “PL”
Capital, which commands a price “PK”
One “Household” – Represents the average family or “national family”.
The household owns the factors of production, and purchases the
goods.
Example: 2 x 2 x 2 Model

Historical Data: Production and Consumption in 2007 for the
Example Economy

Output:



X Sector Output = 100 million USD ( 100 units at a price of 1.0 )
Y Sector Output = 100 million USD ( 100 units at a price of 1.0 )
Production Structure

X Sector Purchased:


Y Sector Purchased:



40 million USD in Labor (wages) / 60 million in capital expenses (rent/machines)
60 million USD in Labor (wages) / 40 million in capital expenses (rent/machines)
Total purchases of labor and capital: 200 million USD.
Consumption: The household purchased


100 million USD of good “PX”
100 million USD of good “PY”
Example: 2007 Data
The Social Accounting Matrix
Production Sectors
Consumers
Markets
|
X
Y
W
|
CONS
-----------------------------------------------------PX
| 100
-100
|
PY
|
100
-100
|
PW
|
200
|
-200
PL
| -40
-60
|
100
PK
| -60
-40
|
100
------------------------------------------------------
Example: Task: 50% Tax on X

Assignment: The government is considering a
50% tax on the production of the X Sector.
They want to know the following:

Tax Revenue Collections
 Change in Production for all Sectors
 Change in Employment & Return to Capital
 Overall impact upon consumption and prices (CPI)
Example: Task: 50% Tax on X

Now Build a CGE Model to Answer the
Questions.
Contact:
Miles K. Light, Ph.D.
[email protected]
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