Computable General Equilibrium Analysis in Agricultural Policy Analysis

8/3/2019 Computable General Equilibrium Analysis in Agricultural Policy Analysis

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Computable General Equilibriumanalysis in Agricultural Policy analysis

Dr. Sherko Soltanpanahi

[email protected]


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WHAT IS ECONOMIC POLICY?

Deliberate use of governmentactions designed to achieve specificgoals

INTRODUCTION TO POLICY MODELS


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WHY UNDERTAKE POLICY ANALYSIS?

To advise policymakers

Improveeffectiveness of policiesChoosebetween different paths to sameobjectiveUncover unintended consequences ofpolicies

To understand policyas privateagentsAnticipateeffects of public policiesDesignimproved response strategies



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POLICY AND POLITICS?

Policyis necessarilyabout politicsTraditional Economic view:

economists providetechnicalanalysis politicians make political decisions

Is separation possible?

Whats the pointif itis all politics?Is there stillroom for policyanalysis?



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Wewould argue,yes policymakers need guidanceThereis need for:

Qualitative policyanalysis:based ontheoreticalanalysis

general principles

Quantitative policyanalysis:numericalassessment of specificimpacts (directionnecessaryto assess netimpact

contradictoryeffects moving in opposite directionswinners and losers => compensation

Policymakers willbe unlikelyto assess impactsEvenif theyhave preconceived ideas



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WHAT ARE MODELS?

Abstraction fromrealityRealityis too complexSets of assumptions

Focus onkeyaspects of problemsAllows to cutto thechase

Differentmodels suit different purposesCanreflect different points of view

No rightmodelAs long as it:

clarifies policy views improves transparency of policy debate


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DIFFERENT TYPES OF MODELS

Theoretical vs applied modelsTheoretical:broad principalsApplied:reallife policyissues and data

Partial vs generalequilibrium/economy-wideAre feedbackand linkages important?Howimportantis theceteris paribus?

Econometric & Forecasting vs Single PointParameterestimation: testing


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ECONOMY-WIDE MODELS

Computable General EquilibriumFeedbackthroughlinkages is importantToo complexto solveanalytically .

.so use (compute)numerical simulationGood for counterfactuals (scenarios)

Degrees of complexity

Simplelinear: IO/SAM based 1st generationComplexnonlinear: 2nd generation

closerto economictheory (production/consumption)


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DIFFERENT TYPES OF CGE MODELS

Walrasian-NeoclassicalResourceallocationissuesOftentakes form of templatethat fits allHavebecomemore flexible

Structuralist-KeynesianAdjustments in productand factormarketsRole of institutions:identifycrucialrole playersMoread hocapproach

Dynamic vs staticThenotion of dynamic:

Nature of intertemporal relationshipsTimehorizon: short,medium,long


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Walrasian generalequilibrium

Walrasian generalequilibrium prevails

when supplyand demand are

equalized across all of theinterconnected markets inthe

economy.


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Walrasian generalequilibrium

Computable generalequilibrium (CGE)models are simulations thatcombinetheabstract generalequilibrium structure

formalized by:

Arrowand Debreu withrealisticeconomicdatato solvenumerically forthelevels of

supply, demand and pricethat supportequilibriumacross a specified set of markets.


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Foundations of CGE model

The fundamentalconceptual starting

point fora CGE modelis thecircular

flow of commodities inaclosedeconomy.


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FirmsFirms

Product

Markets

Factor

Markets

Rest of the

World

HouseholdsHouseholds GovernmentGovernment Saving/INVSaving/INV

Factor

Costs

Wages

& Rents

Demand for

IntermediateInputs

Sales

Revenues

Private

Consumption

Taxes

Domestic Private Savings

Government

Expenditure

Gov. Savings

Investment

Expenditure

Import Payments

Export Receipts Foreign Savings

Domestic Demand for Final Goods

Transfers

Circular Flow of Income


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Walrasian rules

Walrasian generalequilibriumrules are:

1. marketclearance

2. zero profit

3. incomebalance


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Marketclearance

1. fora givencommoditythequantity producedmustequalthe sum of thequantities of thatare demanded bythe other firms andhouseholds intheeconomy.

2. fora given factorthequantities demandedby firms mustcompletelyexhaustthe

aggregate supplyendowed to thehouseholds.


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zero profit

the sumtotal of revenue fromthe production of goodsmustbeallocated eitherto households as receipts for

primary factors rentals,to otherindustries as payments for

intermediateinputs, orto the governmentas taxes.

The value of a unit of eachcommodityintheeconomymustthenequalthe sum of the values of alltheinputsused to produceit:thecost of theinputs of intermediate

materials as wellas the payments to the primary factorsemployed inits production.

The principle of conservation of valuethus simultaneously

reflects constancy of returns to scalein productionandperfectlycompetitivemarkets for produced commodities.


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incomebalance

thereturns to householdsendowments of primaryfactors,thatareassociated withthe value of factorrentals to producers,accrueto households as

incomethatthehouseholds exhaust on goodspurchases.

The factthathouseholds factorendowments are fullyemployed, so thatno amount of any factoris leftidle,

and thathouseholds exhausttheirincome on

commodity purchases (someamount of whichareforthe purpose of saving),reflects the principle ofbalanced-budgetaccounting knownas incomebalance.


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Walrasian rules

Thethreeconditions of :1. marketclearance

2. zero profit

3. and incomebalanceareemployed by CGE models to solve

simultaneously forthe set of prices and

theallocation of goods and factors thatsupport generalequilibrium.


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Generalequilibriumtheoryis abranch of theoreticalmicroeconomics.

It seeks to explain production,consumptionand prices

inawholeeconomy.

Generalequilibriumtries to givean understanding of thewholeeconomy using a bottom-up approach, starting with

individualmarkets and agents.

Macroeconomics,as developed by so-called Keynesian

economists, uses a top-downapproachwheretheanalysis

starts withlargeraggregates.

Source: World BankData, 2011

Generalequilibriumtheory


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Generalequilibriummodels typicallymodelamultitudeof different goods markets.

Modern generalequilibriummodels aretypically

complexand requirecomputers to help withnumericalsolutions.

Undercapitalism (freemarket),the prices and

production of all goods areinterrelated.

Calculating theequilibrium price of just one good,intheory,requires ananalysis thataccounts forall of the

millions of different goods thatareavailable.!!!

Source: World BankData, 2011

Generalequilibriumtheory


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CGE models

CGE models area standard tool of empiricalanalysis,and arewidely used to analyzetheaggregatewelfare distributionalimpacts ofpolicies

Examples of their usemaybe found inareas: fiscalreformdevelopment planning

internationaltradeenvironmentalregulation


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In partialequilibriumanalysis,the determination of the

price of a good is simplified byjustlooking atthe price of

one good,and assuming thatthe prices of all other goods

remainconstant.

The Marshallian theory of supplyand demand is an

example of partialequilibriumanalysis.

Generalequilibriumrefers to theequilibriuminwhichproduction,consumption, prices,and internationaltrade

are determined simultaneously forall goods producedand consumed intheeconomy.

Partial &Generalequilibrium


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Assumptions of CGE

1. Economicagents,consumers,and producers- firms-exhibitrationalbehaviorinthe sensethat givenallthe

availableinformation,consumers maximize utilityfrom

consumption,and firms tryto maximize profits.

2. Consumers and producers whentheymake decisionsaboutconsumptionand productionlookatthereal

prices notthenominal prices.

Weareassuming hereagents basetheir decisions onrelative prices not onnominal prices.


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Assumptions of CGE

3. Ineachcountry factors of productionis fixed and thelevel of technologyineachcountryis constant.

4. Perfectcompetition prevails ineachindustries ineach

country. Thereareno externalities.

5. Factors of productionare perfectlymobilebetweentheindustries withineachcountry.

6. Community preferences inconsumptioncanberepresented byaconsistent set of communityindifferencecurves.


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Dynamic General Equilibrium Model

Most of theempiricalworkineconomics has relied onpartialequilibriumanalysis.

This type of analysis concentrates ona singlemarketand

quantifies thechanges in supply, demand, prices,

quantities and welfarebroughtaboutbyexogenous shocksand/or parametricchanges.

This approachis well suited to markets withlimited size orwithweaklinkages to othereconomic sectors.

Manyeconomic problems do not fiteasilyinto this

category,however.


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Theeconomic sectoranalyzed is oftenlarge,andchanges inthat sectorcanhaveimportantrepercussions

economy-wide.

Such problems aremoreappropriately dealtwith usinggeneralequilibriumanalysis inwhichallthe sectors inthe

economyare seenas onelinked systemwherechanges inany partaffect prices and outputeconomy-wide.

Mathematically,aninterlinked economycannotbedescribed in one ortwo equations,butratherbyalarge

system of simultaneous equations.


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More precisely,inaneconomywithnmarkets,n-1equations arerequired to solve forall of the prices and

outputs inthe system.

Ina simple staticmodel,theactual solution of a generalequilibrium problemrequires thatthemodelerconstructa

socialaccounting matrix (SAM).

Inthe SAM,all productioninallmarkets,alltaxrevenueof the governmentand allconsumptionbyallhousehold

fora specificbaseyearhas to bereplicated exactly first.



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The policies thathavebeenanalyzed throughthese

models includechanges in various types of taxes andtariffs,technologicalchange,naturalresource policy,and employment policy.

Bothefficiencyand distributionimpacts are

presented inthese studies



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Why CGE Analysis of Agriculture?

why should we go to thetrouble

of constructing aneconomywidemodelto analyze policies inthis

sector?


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Benefits of AGE

Analysis inagricultural policy

analysis


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1- Household focus:

Traditionalagriculturaleconomicanalysis has tended to focusoncommodities,and associated factorreturns.

Incontrast, CGE models beginwithhouseholds as the primitiveconcept.

Households supply factors of productionand consume goodsand services.

Welfareinthemodelis computed directlyinterms ofhousehold utilityand not someabstract summation of producer,consumerand taxpayer surplus.

Benefits of CGE Analysis


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2- Finiteresources and accounting consistency:

CGE models rely on socialaccounting matrices (SAMs) fortheirempirical structure.

These SAMs detailallthebasicaccounting identities whichmusthold fortheeconomyto beinequilibrium.

Thosewho workwith CGE models quicklyrecognizethattheseidentities areas importantas thebehavioralassumptions.

The factthathouseholds cannot spend morethantheyearn, orthatthe same unit of labor,land orcapitalcannotbesimultaneouslyemployed intwo different places, serves to tightlycircumscribetherange of possible GE outcomes.



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3-Second-bestanalysis:

One of the distinguishing features of agricultural policyanalysis isthehigh degree of publicinterventioninthe farmand food sector.This includes programs which:

(a) subsidizeinputs suchas credit,water,and fertilizer(b)restrictacreage planted to certaincrops(c)intervenein outputmarkets with subsidies or productionquotas(d) subsidize (ortaxless)theconsumption of food relativeto

other goods and services,(e)interveneattheborderwithexport subsidies,importtariffs andquotas,etc.



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This complex of policyinterventions makes it very difficulttoanticipatetheefficiencyconsequences of amarginal perturbationin, orreform of, farmand food policies.

Inan CGE application focusing onUS agricultureinthemid-

1980's, Hertel and Tsigas(1991),they demonstratethatthe first-bestalternative of removing all of the distortions would generatewelfare gains an order of magnitudelargerthanthetradablequotas.

In CGE models provideanexcellent vehicle forconductingwelfareanalysis ina second-best setting,and this makes them

particularlywell-suited for useinagricultural policyanalysis.



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4. Interindustry linkages:

Oftenwhen oneis conducting policyanalysis inthe farmsector,itis difficultto knowwhereto drawthelinebetweenthecommodities and sectors affected bya given policyand therest

of theeconomy.

More generally, distinguishing agriculture fromnon-agricultureinthemodern,industrialized economies has becomequitedifficult.

Increasingly,large,commercial farms contract out some oftheir operations. The firms providing these services rangingfrom pesticideapplications to financial services maynotbeexclusivelytied to agriculture.



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Animportantreason forcapturing thenon-farmlinkages has todo withthe diversification of farmhouseholdsearnings. Theyoftenhave significant financial orwageearning interests in othersectors, so thattheirwelfare depends onmuchmorethanthechanges inagriculturalactivity.

this distinguishing and linkages could be donin CGE analysis



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5- Economywide Perspective:

CGE analysis also provides a valuabletool for putting things inaneconomywide perspective.

Microeconomictheoryemphasizes theimportance of relative,as opposed to absolute,levels of economic variables.

Nowhereis theimportance of relative vs. absolutecomparisons moreevidentthanininternationaltrade.

Itis verycommon foragriculturaleconomists to compareproductioncosts in differentregions,and,whentheyarelowerinonecountrythananother,to concludethatcountryis morecompetitive.



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Hidden Challenges toCGE Analysis

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1- Most of theearly CGE models of developed marketeconomics (DMEs)treated agriculture (possiblyalong with

forestryand fisheries)as a single,aggregate sector,producing onehomogeneous product.

This type ofaggregation wasessentialin orderto permitcompletecommoditycoverageatarelatively uniform

level of aggregation. Also,this is oftenthelevel ofaggregation provided in published input-outputtableswhichis notrealistic.

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Hidden Challenges to CGE Analysis


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2. A second important feature of general purposemodels whichhas limited theirapplicabilityto agricultural

issues is their failureto distinguishland from othercapital

inputs.

Yetthe presence of farmland intheagricultural

production functionis critical. Itis perhaps themostdistinguishing feature of this sector of theeconomy.Furthermore,land canalso beanimportantinstrument of

public policy.

Thereforeland prices are potentiallyquite volatile. Sinceland usuallyrepresents themajor form of wealthholding

forthe farm population,theimpact of public policy onfarm prices and hencereturns to landowners is of

paramountimportanceto farmers and agricultural

policymakers.

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3. A third criticallimitation of themostcommon, CGEmodels s is theirtendencyto devotetoo littleattentiontothe specification of keybehavioral parameters inthe farm

and food system.

As aconsequence,thereis awide gulf betweenthepartialequilibriummodels currently used inagricultural

policyanalysis,and the partialequilibriumbehavior oftheir CGE counterparts.

In somecases these discrepancies maybejustified.However,inmostinstances the CGE models' parameterssimplylacksufficientempiricaljustification.

As aconsequence,they often generateimplausible

results.

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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

Theanalytical modelis of thesequentialappliedgeneralequilibrium (AGE) genrein whichan

equilibrium price vectoriscomputed foreachyear

insuccession.

anumberof behavioral functionsrelating todemand and supplyhave beeneconometrically

estimated with data mostly from the period 1950-51

to 1973-75.In therunning of the model, for the

period up to 1980

Theeconomyis divided into tensectors, of whichthe firstnine produceagriculturalcommoditiesand

the tenth produces the onlynonagriculturalgood.


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Policy simulation

Thereare t

hreesets ofagents: producers,consumers,and government.

Consumersareclassified by theirresidenceasruralorurban. Ruralas wellas urbanconsumersare

divided into fiveexpenditureclasseseachaccording to theirmonthly percapitahouseholdconsumptionexpenditure.

Means of production (capital),naturalresources(land),humanresources (labor),and livestock(draft

and milkanimals, poultry,etc.) generateincomethrough productionactivities thatis distributed toconsumers.


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Policy simulation

behaviorof producers (i

.e., t

heirproductionactivities)determinescommoditysuppliesand incomes.

Consumer behavior generates commodity demands(and implicitlyresource supplies).

The government sets policies (e.g.,investmenttargets,taxes,tariffs,quotas,rations, price supports and ceilings,etc.).

Finally,equilibriumis achieved throughexchangein

which domestic demands,togetherwithexport demandbytherest of theworld foreach sector's output,isequated to the sum of domestic supplyand import

supply.


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RESULTS

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Model simulations werecarried out from 1980 to 2000.

Policychanges are usuallyintroduced in 1980,and

theresults of sucha policy scenario arecompared withthose of areference scenario.

The first set of results compare public distributionpolicies withthereferenceruninwhichabasket of rice,

wheat,and coarse grains (in fixed proportions),is

distributed to allresidents ineachyearata subsidizedpricealong withthe purchase (or procurement) fromfarmers of theneeded grainat specified (belowthemarket) prices.


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RESULTS

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PolicyDP-0:at oneextreme,abolishes both public distributionandprocurement.

FRFD-100W:atthe otherextreme, provides 100 kg. of wheat peryear, free of

cost,to allconsumers, urbanas wellas rural,withthecostbeingfinanced byincreasing theincometaxlevied onthetwo richestclasses of urbanconsumers to therequired extent.

Policy FRFD-100W-X:

onthe otherhand,keeps theincometaxatits referencerunlevel,and finances the food subsidybyreducing investment.


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RESULTS

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"Theexpenditureclasses arenumbered inincreasing order of realexpenditure. P:the proportion of population

E:averageequivalentincome percapitaineachexpenditureclass.

Itturned outthatto keep taxes fixed and distribute free food inallyears from 1980,largereductions ininvestmentand increases inimports wereneeded intheinitialyears. For

this reason,in FRFD-100-X,taxes arekeptatreferencerunlevels only from 1986.


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Impact of Redistributive Policies

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REF DP-0 FRFD-100W FRFD-100W-X

Year 1980

Relative price of agriculture 0. 925 0.924 I.041 1.096

Tax rate % 2.3 3.2 13.5 6.0

Average energy retake {kcal p.p) 21 62 2171 2241 2279

Net exports of cereals (109

tonns) -3.7 -4.5 -8.1 -8.8GDP (Rs. 109 at 1970 prices) 530 530 530 530

GDP agriculture 220 220 220 220

GDP non-agriculture 310 310 310 310

Year 2000

Relative price of agriculture 0.892 0.896 0.918 0.931

Tax rate % 9.8 11.0 11.7 9.8Average energy retake {kcal p.p) 2569 2581 2610 2589

Net exports of cereals (109tonns) 8.7 7.3 7.2 8.8

GDP (Rs. 109 at 1970 prices) 1429 1428 1439 1295

GDP agriculture 354 354 356 345

GDP non-agriculture 1075 1075 1085 950


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References

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Lofgren, H., 2002,a Standard Computable GeneralEquilibrium (CGE) Modelin GAMS, International FoodPolicy Research Institute.

Lofgren, H., 2003,the Agricultural Sectorinthe Analysisof the Poverty Impact of Macro Policies and Shocks:

Issues and Technique, International Food PolicyResearch Institute.

Minot, N., 2009,Using GAMS for Agricultural Policy

Analysis, International Food Policy Research Institute.

Moore, J. C., 2007, Generalequilibriumand welfareeconomy, Springer, Newyork,USA.


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Computable General Equilibrium Analysis in Agricultural Policy Analysis