Economic Models, Economists' Toys

When an economist wants to study the economic behavior observed in the complex world around us, the first step is often to build an economic model. A model can focus an analysis by stripping down and simplifying real-world events into a representation of the motivations of the key players in any economic story. Some amount of context and interesting detail must be left out as the economist distills a model rich enough to explain events credibly and realistically but simple enough to put the spotlight on the essential actions in the story. When an economist succeeds in building a model, he or she now has a tool that can be manipulated. By playing with this “toy” representation of economic activity, the economist can learn more about the fundamentals behind an event and can study likely outcomes or possible solutions.

There are many kinds of economic models. The type of model that we will be studying is a computable general equilibrium (CGE) model. It is an “economy-wide” model because it describes the motivations and behavior of all producers and consumers in an economy and the linkages among them. It depicts firms that respond to demand by purchasing inputs, hiring workers, and using capital equipment. The income generated from sales of firms’ output ultimately accrues to households, who spend it on goods and services, taxes, and savings. Tax revenue funds government spending and savings lead to investor spending. The combined demand by private households, government, and investors is met by firms that, to complete the circular flow of income and spending, buy inputs and hire workers and capital used in their production processes. Such a comprehensive model may seem to be very complex, but we hope that its deconstruction in the following chapters will reveal it to be a relatively simple, “toy” representation of our complex world.

A computable general equilibrium (CGE) model is a system of mathematical equations that describes an economy as a whole and the interactions among its parts. A model this comprehensive is more complex than the bicycle industry model we built in Chapter 1, but it need not be a “black box.” In this chapter, our objective is to introduce, at a general level, the model's elements and mechanics. Even so, for many students, it may suffice to skim this chapter and return to it as needed as your modeling skills progress. For now, we also set aside any consideration of the economic theory that governs behavior in the model. Here, we do not consider how the model describes the motivations behind producers’ decisions about how much to produce or consumers’ decisions about how much to buy, or a nation's choice between consumption of its domestic production and imported goods. Of course, the economic properties of a CGE model are its real heart and soul, but they also present a much broader area of study; most of the other chapters in this book address this study.

In this chapter, we deconstruct the CGE model to describe its core elements. We show that a CGE model and the simple bicycle model share many features, such as exogenous and endogenous variables, market-clearing constraints, and identity and behavioral equations. We explain and compare linearized and nonlinear expressions of the behavioural equations in a CGE model. We describe how the price of a single good changes as it moves along the supply chain from producers to consumers and the implications for price transmission. We explain the practice of normalizing prices and the role of the price numeraire. We introduce model closure, which is the decision about which variables are exogenous and which are endogenous. We also describe how the CGE model runs by explaining the sequence of model calibration or consistency check, baseline model solution, and model experiment.

Types of Regulations

A vehicle tailpipe emissions standard was first enacted in the United States in 1970 and it has become more stringent over time. The intent of the regulation is to reduce harmful auto emissions, which contribute to today's higher incidence of asthma and other pulmonary health problems, and may be a factor in long-term global warming. According to an analysis of the newest emission standard, a reduction in emissions generates broad gains in the U.S. economy as a whole, not only by reducing health costs and improving the environment but also by increasing employment in industries that supply auto producers with low-emission inputs (U.S. EPA, 2012). Because regulations imposed on a single industry can have important economy-wide impacts, and may have spillover effects on other countries as well, CGE models have become a standard tool for their analysis.

Regulations are command-and-control policies. Unlike taxes, which create price incentives that influence economic choices, regulations are used by the government to directly mandate certain behavior. The mandates are usually negatively enforced with fines, imprisonment, or other undesirable outcomes. Regulations, like taxes, therefore have an impact on resource allocations by producers and consumers. But because regulations do not operate through price mechanisms, as taxes do, they are more challenging to represent in a CGE model, which is fundamentally based on observable market prices and quantities.

The database of a computable general equilibrium model has two components. One is the Social Accounting Matrix (SAM). The SAM database reports the value of all transactions in an economy over a specified period of time, usually a year. The SAM data are organized in a logical framework of rows and columns that provides a visual display of the transactions as a circular flow of national income and spending in an economy. The SAM that we use throughout this book, for demonstration, describes the economy of the United States in 2007. The second component of a CGE model database provides the elasticity parameters that describe producer and consumer responsiveness to changes in relative prices and income.

Until relatively recently, development of a database for a CGE model represented a time-intensive first step in a CGE-based analysis. Today, most CGE-based research draws at least in part on a global database of country SAMs and elasticity parameters that was developed and is regularly updated by the GTAP Center at Purdue University. The GTAP Center relies on individual researchers to contribute country data. The data are drawn from multiple sources, including national income and product accounts, international trade databases such as the United Nation's Comtrade, and other data sources that describe taxes, tariffs, and other government interventions. The GTAP Center then integrates and balances the country data contributions into a unified and internally consistent global database.

The large federal deficit in the United States has spurred intense debate on whether the sizeable tax cuts enacted by the previous administration should be maintained or allowed to lapse. The tax cuts were intended to spur consumer demand during the financial crisis. Economists argued that lower taxes would lead to increased consumer spending, thereby providing an economic stimulus as production and employment expanded to meet higher demand. Some economists also argued that lower tax rates motivate producers to invest and produce more, which also helps stimulate employment. Taxes influence the behavior of an economy's consumers and producers in important ways. CGE models have proven to be a valuable tool for researchers in empirically and comprehensively analyzing how taxes affect households’ and firms’ economic decisions about how much to consume, produce, and trade, and how these actions impact the economy as a whole.

Governments impose taxes for many reasons. Foremost is the need to raise revenue to support the provision of public goods such as national defense and education. Governments sometimes use taxes to redress market failures such as externalities. For example, the government may impose carbon taxes to reduce the harm to public health that is associated with air pollution by private industry.

Computable general equilibrium (CGE) models are sometimes criticized for being “black boxes” in which so many things are moving at once that results are difficult to explain and their credibility as a theoretically consistent, analytical tool is undermined. By deconstructing a standard CGE model with the aid of basic principles of economics, we hope to have dispelled some of their mystery and made them more comprehensible and useful to students and professional economists alike. Such an introductory study seems especially timely given the increased accessibility of CGE models and CGE model databases.

In this book, we studied the main components of a CGE model. We learned that producers in the model are assumed to maximize efficiency, and consumers are assumed to maximize utility. Their microeconomic behavior adds up to the macroeconomic performance of the economy. Our study of each component of the model – supply, demand, factor markets, trade, and taxes – emphasized the model's underlying economic theory and supplied practical examples from small-scale CGE models to illustrate these concepts.

We studied a “standard” CGE model that assumes a representative household consumer, a representative producer of each type of product, and uniquely determined solution values for prices and quantities. It is a static, or single-period, model that provides a before-and-after comparison of an economy after a shock, such as a new tax, but it does not describe the economy's adjustment path from the old to the new equilibrium. All of these features of our CGE model can at times represent shortcomings or constraints. The aggregation of all households, despite the great diversity in their income sources and tastes and preferences, into one representative household consumer is quite a strong assumption. Producers, too, may be diverse in ways that are important to an analysis, perhaps producing the same product using different types of technologies or facing very different transportation costs in different regions of a country. In addition, our world is characterized by some amount of randomness, like weather variability, and this stochasticity is not reflected in our deterministic CGE model. Static models also may not fully address the concerns of policymakers about the transition process, when there can be high unemployment or other types of dislocation as an economy adapts to shocks.

Introduction

The objective of these 11 model exercises is to provide you with step-by-step guidance in building a model, designing experiments, identifying relevant results, and interpreting findings.

The exercises are intended to:

1. • Engage your interest by showing the breadth of real-world problems that can be analyzed using a CGE model.

2. • Illustrate how to use economic theory to make predictions about and to interpret model results.

3. • Demonstrate how the design of model experiments is grounded in economic theory and background research.

4. • Introduce a broad sampling of methodological tools, including how to change elasticities and model closure, decompose shocks into subtotals, develop baseline scenarios, and run sensitivity analyses of assumptions about elasticity parameter values and shock sizes.

The case studies are suitable for use with many types of CGE models. However, the detailed instructions provided in the model exercises are designed for use with the Global Trade Analysis Project (GTAP) CGE model. The model, developed by Thomas Hertel and colleagues at Purdue University, is documented in Hertel and Tsigas (1997). Its user-friendly, menu-driven interface, RunGTAP, was developed by Mark Horridge (2001) and is ideal for use by novice and advanced modelers alike.

Model exercises 1–3 show you how to create a small, three-sector, three-factor database for the United States and an aggregated, rest-of-world region from the GTAP global database (Table ME Introduction 1). The instructions also guide you in setting up, running, and learning about the GTAP CGE model. You should complete these three exercises sequentially before doing the subsequent case studies. You can also use the model developed in these exercises to replicate the model results reported throughout the textbook chapters.

Model Exercises 4–11 provide case studies that complement and reinforce the concepts learned in the related chapters of the textbook. You can do all, or any one, of these exercises, and in any sequence. Model Exercises 9–11 present more challenging techniques for the advanced student. Model Exercises 4–11 are ideal for use as small, collaborative group projects. Each exercise poses questions about model results that can serve as a starting point for your exploration and study of your findings.

The U.S. economic stimulus package, implemented in the 2009 recession, was designed to increase government spending in order to compensate for sharp declines in spending by private households and investors, and in export sales. These four categories of demand – private households, investment, government, and exports – constitute the demand side of an economy. They are called components of final demand, since the goods and services that are consumed are in their end-use; they are not further combined or processed into other goods and services. An economy's structure can change when the categories of aggregate final demand change in relative size, because each type of final demand usually purchases different goods and services. For example, households purchase items like groceries and entertainment, whereas investors purchase mainly machinery and equipment, and governments mostly purchase services. The increased share of the government in U.S. final demand as a result of the stimulus program thus likely changed the types of goods demanded in the U.S. economy, at least in the short term.

In this chapter, we learn how the SAM's data describe each component of final demand. We then study how each final demand agent is assumed to behave in the CGE model. Our discussion in this chapter mostly focuses on commonalities among CGE models, including the concept of “commodities,” the two- (or three-)stage budgeting decision, and the measurement of national welfare. CGE models differ widely in their descriptions of private households’ consumption behavior, making it difficult to characterize a “standard” CGE model in this respect.

Since David Ricardo first developed the theory of comparative advantage, showing that nations gain from specializing in the goods that they produce at relatively lower cost, most students of economics have learned that all countries can gain from trade. Yet, many countries are reluctant to move too far or too fast toward free trade. Their reasoning is not inconsistent with Ricardo's theory. Trade and specialization lead to changes in a country's industry's structure and, in turn, to changes in the wages and rents of factors used in production. Therefore, although trade confers broad benefits on a country, it can also create winners and losers. Protecting, compensating, or managing the social and economic transition of those who lose has led many countries to qualify or delay their commitment to global free trade.

Since the early 1990s, CGE models have been widely used to analyze trade policy issues including unilateral trade liberalization, multilateral tariff reforms through the World Trade Organization (WTO), and preferential trade agreements such as the North American Free Trade Agreement (NAFTA) and the European Union's expansion. The contributions made by CGE models rest on their ability to identify which industries will grow or could contract with freer trade, to describe whether labor or capital will gain or could lose from trade reforms, and, perhaps most important, to measure welfare effects, which summarize the overall effects of changing trade policies on an economy's well-being.