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 that we built in Chapter 1, but it need not be a “black box.” In this chapter, we deconstruct the CGE model and 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 describe how the price of a single commodity changes as the product moves along the supply chain from producers to consumers. 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, model solution, and model experiment.

In this chapter, our objective is to introduce, at a general level, the model's elements and mechanics.

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 “economywide” model because it describes the motivations and behavior of all producers and consumers in an economy and the linkages among them.

The large federal deficit in the United States in 2011 has spurred intense debate on whether the sizeable tax cuts enacted by the previous administration should be maintained or allowed to lapse. 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, and therefore 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.

In 2009, the United States government offered financial assistance to its auto manufacturers to help them survive a deep recession and a freefall in consumer demand for cars. The bailout was controversial in part because the government seemed to be choosing to support a particular manufacturing industry. The government response was that the aid package not only helped save the jobs of autoworkers but also preserved jobs in the many industries that supply parts to the automakers and that sell and service autos. This part of the U.S. economic stimulus program built on the idea that an injection of support into one part of the economy would move in a circular flow to the rest of the economy, starting with the strong interindustry linkages between automakers and other manufacturing and service sectors.

Objectives

This book will introduce you to computable general equilibrium (CGE) models. A CGE model is a powerful analytical tool that can help you to gain a better understanding of real-world economic issues. CGE models are a class of economic model that over the past twenty-five years has gained widespread use in the economics profession, particularly in government. Economists today are using these models to systematically analyze some of the most important policy challenges and economic “shocks” of the twentyfirst century, including global climate change, the spread of human diseases, and international labor migration.

Since the early 1990s, prominent CGE models have been built and maintained at the U.S. International Trade Commission, the Economic Research Service of the U.S. Department of Agriculture, the World Bank, and other national agencies and international organizations to provide ongoing economic analytical capability. These models have come to play an important part worldwide in government policy decisions. For example, the models' predictions about prices, wages, and incomes factored heavily in the debate about the terms of the North American Free Trade Agreement, the Kyoto Protocol, and China's entrance into the World Trade Organization.

Computable general equilibrium (CGE) models are sometimes criticized for being “black boxes” in which everything is moving at once. 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 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.

Factors of production are the labor, capital, land, and other primary resources that producers combine with intermediate inputs to make goods and services. A nation's factor endowment is its fundamental stock of wealth because factors represent its supply of productive resources. In Chapter 5, we considered production activities' demand for factors and how these adjust with changes in relative factor prices or output levels. Many other dimensions of factor markets in a CGE model also deserve study.

In the next sections, we describe factor markets in CGE models in detail, focusing on those aspects that are of greatest practical importance for CGE modelers. We begin by studying the factor market data in the SAM. Then we consider the behavior of factor markets in the CGE model. We explain factor mobility assumptions, which govern the readiness of factors to change their employment in response to changing wages and rents across industries.