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On the need to compensate the compensating variation in CGE modeling

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  • Ana-Isabel Guerra
  • Ferran Sancho

Abstract

The message of this research is that in the standard calibrated setting of Computational General Equilibrium (CGE) models, the welfare measures typically used to compare benchmark with counterfactuals are numéraire dependent. This evaluation bias affects the compensating variation and the Konüs index of cost of living. We show that the equivalent variation is neutral regarding the choice of value units in calibrated models but would be affected as well in uncalibrated CGE models. We illustrate with a simple example and propose an even simpler theoretical solution to overcome these biases; all that is required to have correct welfare estimates is to compensate normalizing with a suitable price index. This type of correction is necessary to overcome the sometimes blind implementation of welfare measures in numerical general equilibrium analysis. We show that the induced quantitative errors may be substantial providing biased welfare estimates and misleading results.

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  • Ana-Isabel Guerra & Ferran Sancho, 2018. "On the need to compensate the compensating variation in CGE modeling," Economic Systems Research, Taylor & Francis Journals, vol. 30(3), pages 313-322, July.
    • Handle: RePEc:taf:ecsysr:v:30:y:2018:i:3:p:313-322
    DOI: 10.1080/09535314.2017.1372371
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    Cited by:

    1. Ferran Sancho, 2021. "The mitigation potential of eco-taxation on carbon emissions: income effects under downward rigid wages," Environmental Economics and Policy Studies, Springer;Society for Environmental Economics and Policy Studies - SEEPS, vol. 23(1), pages 93-107, January.

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