On the need to compensate the compensating variation in CGE modeling

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.

KEYWORDS:

• Compensating variation
• equivalent variation
• computable general equilibrium

JEL CODES::

• D11
• D12
• D60

Acknowledgments

We appreciate the insightful comments of the referees for their contribution to improve the text. All remaining shortcomings are of course only our own.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 We thank one of the referees for this tip.

Additional information

Funding

Support from research project MICINN-ECO2014-52506R from the Ministry of Economy and Competitiveness and FEDER (EU) is gratefully acknowledged.