Learning Outcome:  

After completing this lesson, you will understand the concept of factor market equilibrium, and how the choice of CGE model closure can describe either full employment or unemployment.

Factor Market Equilibrium:  Factor Demand = Factor Supply 

It is a common assumption in CGE models that the national supply of a factor is fixed and fully employed. Full employment describes an equilibrium in which the sum of activities' demands for a factor is equal to the national supply of that factor. 

Factor Market Equilibrium in the UNI-CGE Model

How does a CGE model ensure factor market equilibrium? Following a model shock, wages and rents change, sending price signals to producers and factors. Activities may change their demands for factors and factors will move toward the highest-paying activities. These factor price and quantity adjustments will continue until a full employment equilibrium is reestablished.  

As an example, what if a positive demand shock for computers motivates producers to increase their computer output, which increases their need for engineers? The computer industry must compete for the fixed national supply of engineers.  It will raise wages to attract engineers from other industries, such as aerospace. As engineers move into computer jobs, the aerospace industry will also have to increase their wages in order to hold onto its workers. Engineers will continue to move to computer companies until wages in both industries are equal and total demand for engineers is equal to the supply.   

In the UNI-CGE model, factor market equilibrium is imposed by an equation (Figure 1).Variable QF_f,a is the quantity of demand for factor f by activity a. The sum of activities' demands for each factor must be equal to the total supply of that factor, QFS_f.  After a model shock, wages and rents will adjust until they equalize across production activities and supply and demand for each factor is again in equilibrium.

Figure 1.  Factor Market Equilibrium

Larger version available HERE.

Factor Market Closure and Unemployment 

Unemployment is a structural problem in many countries. To depict these economies realistically, modelers may want to change the full employment assumption and, instead, allow for factor unemployment. 

The UNI-CGE model includes a factor market closure that allows a choice between the assumptions of full employment and unemployment. The choice of closure is defined by a parameter FCLOS_f. It is a FLAG that signals the employment assumption for each factor in the model (Figure 2). 

When FCLOS has a value of one, factor markets are constrained to be in a full employment, supply-demand equilibrium, and wage and rents will adjust to achieve it.  When FCLOS has a value of 2, wages or rents are fixed.  Demand for factors is still equal to supply but the supply of factors will adjust up or down in response to a model shock.  

The factor market closure that allows quantities of factor to adjust is typically used for labor.  If the national supply of labor expands after a shock, it is interpreted as pulling in previously unemployed workers.  When the national labor supply contracts, it is interpreted as an increase in unemployment. 

Figure 2.  Factor Market Closure

Larger version available HERE.

Copyright:  Cornerstone CGE CC 4.0 BY-NC-SA