Final Demand in the UNI-CGE Model (12 minute read)


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Learning outcome: 

After completing this lesson, you will know how the demand behavior of households, government and investors is described in two stages in the UNI-CGE model. 

Demand Behavior by Domestic Agents

Domestic final demand is the demand for commodities by households, government, and investors.  In the UNI-CGE model, as in most CGE models, these agents are assumed to have different demand behavior.  

CGE models can draw on well-developed economic theory to describe households as utility maximizers, whose purchases are determined by their income, prices and preferences. In the UNI-CGE model, household demand is described by either a Cobb-Douglas utility function, or the Stone-Geary utility function with the LES system (Figure 1). You will learn more about these utility functions in the lesson on "Basics of Household Demand."  

Economic theory alone does not offer a sufficient guide on government spending, which is driven in large part by political considerations about how to spend tax revenue in ways that support a society's goals. Investment spending is influenced by financial conditions, such as interest rates and expectations, that are outside the scope of standard, static CGE models. Many models, including the UNI-CGE model, therefore define government and investment spending very simply, using fixed budget or fixed quantity shares. In the UNI-CGE model, government and investment spending maintains fixed quantity share of each commodity. This simple treatment has the advantage of capturing the initial, observed spending allocations by the government and investors, and making the transparent assumption that these consumption patterns will continue in the future.           

 Figure 1.  Domestic final demand behavior in the UNI-CGE model

Description of demand behavior:households follow LES, govt  and investors have fixed quantity shares in their baskets.

Two Stages of Final Demand

In most standard CGE models, final demand is described in stages. In the first stage, agents decide how much of each commodity they want to purchase in their total consumption basket.  For example, how much cheese or fruit does a consumer want to buy? At this stage, the commodities are "composites." They are a combination of the domestically-produced and imported varieties of the good.  

This decision on quantities of apples and cheese is illustrated in Figure 2. In the first stage of the demand decision, households, government and investors decide on how how much of each they want to buy. In this first stage, decision-making in the UNI-CGE model is described by the behaviors shown in Figure 1. Households maximize utility, described by the LES demand system in the UNI-CGE model. Government and investors purchases maintain the fixed quantity shares of cheese and fruit in their initial baskets.   

Figure 2.  Stages in Final Demand Decisions

 Stage one of domestic final demand is a choice of commodities.  Stage 2 is sourcing them from domestic supply or imports.

In the second stage, consumers decide on the sourcing of each commodity from domestic producers or from imports. This decision is referred to as an "Armington" import aggregation function, named after Paul Armington, who developed the idea that consumers differentiate among  varieties of the same commodity based on their sources.  This stage of decision-making, illustrated only for cheese, describes how much cheese to purchase from each source. (Import demand is explained in more detail in the Trade module.)

Some CGE models have a third stage of demand.  Once consumers decide on the quantity of the imported variety, they then decide on which country to source it from. The UNI-CGE model describes only the first and second stages of the demand decision. 

Sourcing Decision Made at the National Level

In some CGE models, including the UNI-CGE model, the allocation between domestic and import sourcing is done at the national level, shown in the rectangle in Figure 3.  First, each agent decides on the commodity composition of their basket. Next, demand for each commodity by all agents is combined. Then, the sourcing decision is made for the economy as a whole. That means the shares of imported and domestic varieties of a commodity are the same for all agents.  Some CGE models allow each agent to decide for itself on the share of domestic and imported goods in its consumption basket. 

 Figure 3.  Aggregate demand for imports in the UNI-CGE model

Schematic of domestic final demand in the UNI-CGE model, with equation descriptions. 

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Last modified: Tuesday, 16 April 2024, 9:39 PM