Economic Modeling

Economic models can be viewed as paper laboratories economists can use to conduct gedanken experiments, since it is impossible to perform these experiments in real life. There exist several types of models that can be used for different types of analyses of economic character, including macroeconomic, input-output and general equilibrium models. The models all have different virtues and drawbacks that cannot be further examined here. For long-term forecasts of the allocation of resources, that is labor, and all kind of physical materials, capital and consumption goods, one often uses general equilibrium models. Therefore we will focus mainly on this type of model.

The idea of general equilibrium is a fundamental pillar in economic theory, and basically it assumes that all the markets that make up an economy either are in or tends towards a state of equilibrium. This means that for each market the supply of each good or service will equal the demand for that good or service. Adam Smith's notion about the invisible hand coordinating market clearance can be viewed as the starting point of the theory of general equilibrium (Smith 1993 [1776]), but the first to formally describe general equilibrium was Walras (1995 [1874]). The idea was developed over the years and can be said to have reached maturity in the work by Arrow and Debreu (1954). It is therefore often referred to as the Arrow-Debreu economy. Introduction to the formal theory of general equilibrium can be found in numerous economic textbooks; see, for example, Hildenbrand and Kirman (1988), Ellickson (1993) and Myles (1995).

By the development of computable (that is, numerical multisectoral) general equilibrium models (CGE models), the theory of general equilibrium became an operational tool in empirically oriented economic analysis. CGE models with realistic empirical representation of one or more countries are often called applied general equilibrium (AGE) models. The models consist of a set of aggregated economic agents, who demand or supply aggregated goods (consumption goods, services and production factors). The agents are supposed to be rational in the economic sense, meaning that consumers maximize their utility and producers maximize profit. The model endogenously determines quantities and relative prices, at a point in time, and thereby the resource allocation in the economy, such that all markets clear.

It is commonly agreed that CGE modeling began with the work of Johansen (1960), which was the starting point for the MSG (multisectoral growth) model, a model still being developed and refined at Statistics Norway and used by the Norwegian authorities. The two latest versions, MSG-5 and MSG-6, are documented in Holmoy (1992) and Holmoy and Hregeland (1997). The CGE model ORANI, developed for Australia, can be looked upon as an elaboration of the MSG model, see Dixon et al. (1982). Introduction to and surveys of the methods and theories developed in AGE and CGE modeling can be found in Fullerton et al. (1984), Shoven and Whalley (1984, 1992), Bovenberg (1985), Bergman (1990) and Dixon et al. (1992).

Of course there exists a lot of criticism of general equilibrium models, basically referring to the (lack of) realism in describing the functions of a society. The criticism ranges from the need to extend and further develop GE models, as in Walker (1997), to a more fundamental critique of the underlying theory, especially the lack of an endogenous theory of technological progress and the implausibility of growth in a state of static equilibrium. See, for example, Black (1995) and Ayres (2000).

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