Factors, Factor Market Equilibrium, Factor Unemployment (15 minute read)
After completing this lesson, you will learn about factor supplies, understand the concept of factor market equilibrium, and learn how the choice of CGE model closure can describe either full employment or unemployment.
Factor Supplies
Factors are primary resources, sometimes called "endowments." In a single-period static CGE model like the UNI-CGI model, the supply of endowments is usually given and remains the same after experiments.
The land supply remains fixed because land cannot be manufactured or imported or exported. Labor cannot be manufactured either but some CGE models do allow change the labor supply to change if they allow migration. Capital equipment can be manufactured and traded, but its supply remains fixed because purchases of equipment do not increase the productive capital supply until a future period, when the equipment is installed in activities' production processes.
Over time, endowments of land, labor and capital will change. Land may become more or less usable, populations may grow or shrink, and investment spending on capital goods may change. These changes over time are described in multi-period dynamic CGE models.
Factor Market Equilibrium: Factor Demand = Factor Supply
It is a common assumption in CGE models that the national supply of a factor is 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 the wage or rent they are willing to pay. Factors will then move toward the highest-paying activities. These factor price and quantity adjustments will continue until wages and rents equalize across activities and 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 QFf,a is the quantity of demand (QF) for factor f by activity a. The sum of activities' demands for each factor must be equal to the total supply of that factor, QFSf. 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 FCLOSf. 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. If activities' demands for factors change, the supply of factors will adjust to equal the new level of demand. The change in the factor supply measures the change in the quantity of employment. If the factor supply has increased relative to the initial level it means that previously unemployed factors have been drawn into production. If the factor supply decreases relative to the initial level it means that some factors have become unemployed.
The factor market closure that allows quantities of a factor supply 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 labor unemployment. Note that there are no limits on the changes in factor supply in a standard CGE model like the UNI-CGE model. It is a good practice to review the unemployment or reemployment rates to see whether they are realistic.
Figure 2. Factor Market Closure
Larger version available HERE.
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