No. 3 - Department of Treasury - The Western Australian Government

Western Australian Economic Summary2006 No.3This distinction becomes difficult for a piece of infrastructure (e.g. a waterpipeline) that could potentially service both social interests and achieveeconomic development objectives. There may be scope for a combinedapproach, but the costs and benefits from each approach may not becomparable for purposes of analysis. This is a key area of future research.Modelling IssuesJustify a Market FailureMany past proposals to the Western Australian Government for projectassistance supported by CGE analyses have stated that a project will“increase Gross State Product by $XX million a year” or “add $YY million ayear to economic activity”.However, before generating any figures from a model, the modeller mustask why they need to add this project to the economy, rather than itoccurring with no government interference. That is, why is it not in ourmodelling ‘base case’?Some form of market failure must be demonstrated before a project ismodelled in the context of an assistance proposal. Government support for aproject cannot increase economic welfare unless there is some form ofmarket failure that causes the project not to proceed. Unless market failurecan be found, the failure of a particular project to locate in Western Australiais a case of market reality, and government intervention cannot reverse thiswithout a subsidy so large that it will reduce economic welfare.The identification of market failure is probably the single biggestimprovement that could be generally applied across the CGE analyses thathave supported project assistance requests presented to theWestern Australian Government over the past few years.Justify the Assumptions UsedThese rival assumptions are not right or wrong, but they illustrate how farthe results of CGE models flow from the presuppositions of their authors.Most empirical exercises confront theory with numbers—they test theoriesagainst the data; sometimes they even reject them. CGE models, by contrast,put numbers to theory. If the modeller believes that trade raises productivityand growth, for example, then the model's results will mechanically confirmthis. They cannot do otherwise. In another context, Robert Solow, a Nobelprize-winner, has noted the tendency of economists to congratulatethemselves for retrieving juicy plums that they themselves planted in thepudding.The Economist, 2006, p. 61The above comment by The Economist magazine exposes a common fallacy inCGE modelling – that the act of modelling itself justifies the assumptionsused in the model. Too often CGE modelling results are presented withoutdiscussion of the critical assumptions that drive the results – policy makersare expected to believe that a project is worthwhile just because a CGEmodel says so. This treats a CGE model as an all-knowing ‘black box’.78 Department of Treasury and Finance