2 CGE Modelling
Computable general equilibrium (CGE) modelling is an established method for studying the economy-wide impacts of economic policies. It has been used for economic policy analysis for several decades, and the concept of general equilibrium has been around for many more decades. CGE models are whole-of-economy models, so they automatically calculate the economy-wide effects of a policy change. They were first developed to study tax policies and trade policies including tariff reduction, and are also heavily used for climate change economic policy.
At their most basic, CGE models balance profit-maximising firms and utility-maximising households using a market that clears completely. They include the whole economy, and measure the changes in prices and quantities that a policy change produces. Because they include the whole economy, the economy-wide impacts - including all the flow-on effects - of an industry policy can be determined. Here, we will only consider static CGE models that compare the current, pre-policy market equilibrium with the new, post-policy market equilibrium. Dynamic models also exist that allow some transition effects to be studied, and can be particularly useful for studying the interaction between multiple policies introduced at different times. However, they are somewhat more complex than is necessary for the scenarios studied here.
CGE models model the economy by assuming that all players - productive firms, households, government, etc - maximise either their utility or their profits, and the market that matches buyers with sellers clears for all products. A very simple CGE model might have one representative household, and one or two productive sectors, as shown in Figure 1.
- Figure 1 - A very simple CGE model showing physical flows
The production sector or sectors will buy labour and any other inputs from the market, and will use these to produce goods and services that it sells to the market at prices that will maximise their profits. These inputs include both factors of production such as capital and land, and intermediate inputs – goods and services produced by that sector and other sectors that are used as inputs into production. The household sector will sell labour to the market to raise income and allow them to buy goods and services that maximise their utility and so their welfare. The market ensures that the prices and quantities are set at levels where there is no excess supply or demand for any good, service, or factor of production such as labour.
A more complex CGE model will have many more productive sectors. It will also have other parts of the economy that interact with the market, such as government and investment sectors. A government sector will get income from taxes on products, income, or other sources, which it can then spend on goods and services. An investment sector will use savings to buy capital goods. If the model is for a closed economy, there will be no imports or exports and the whole economy must be contained within the model - every good that is produced must be bought, every unit of labour sold must be used, everything is priced, and nothing can come from or vanish into thin air. An open economy model relaxes this constraint slightly, by allowing imports and exports from an outside source in a pre-determined way. A multi-region model describes that outside source (or sources) in a similar level of detail to the economy it is linking to. Many models also relax the constraints described above by including inventories or unemployment which allows for differences between supply and demand, but all the goods and labour must still be accounted for.
Static CGE models as used here are a scenario-based tool. They are designed to perform policy experiments to help understand the potential economic results of a particular policy change. They are not designed for forecasting, where many changes occur at once. Imagine throwing a handful of pebbles into a pond. The resulting pattern of ripples will be very complex, and it is difficult to know which pebble caused which ripple or effect. However, if just one pebble is dropped into a still pond, a very clear pattern of ripples emerges which can be directly attributed to that pebble. Similarly, (although multiple policy changes can be made in a static CGE model) studying one policy change at a time makes it easier to understand the effects of that specific change, and to know whether it is worthwhile. But it will not help you to forecast when the ripples will hit the shore when there are multiple changes (pebbles) happening.
Like all models, CGE models are limited by the data they use. This applies both to the quality of the data and the availability of the data. Generally, a CGE model needs values or quantities and prices of all goods, services, factors of production, and any other variables for the initial (unchanged) state of the economy; as well as elasticities describing how they respond to a change. These are used to calculate the remaining parameters, check the model design, and for comparing with the post-change results. Elasticities are usually parameters in a CGE model; the results of the model are the changes in prices and quantities and their effects on macro variables such as GDP. Data limitations are the main constraint on the number of sectors and the level of detail a CGE model can attain. Much of the data comes from either input-output tables or supply and use tables, which are published infrequently and often with several years' delay (as is the case in New Zealand). Fortunately, input-output tables and supply and use tables remain useful despite delayed releases unless there have been major structural shifts in the economy in the interim; and there also exist mathematical tools to update the tables where limited updated data is available if necessary.
