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

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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
2006 No.3 Western Australian Economic SummaryHowever, it is well known that any problem inputted into the model wouldhave a response consistent with the shock applied to the economic theoryand assumptions on which such models are based. For example, basicmicroeconomic analysis proves that imposing a tariff on imported goodsimposes welfare losses on consumers. A CGE model based on neoclassicaleconomic theory can only quantify this, never prove or disprove it 1 .If a proposed project is modelled by placing a large lump of new capital in aregional economy without modelling the true cost of that project togovernment, allowing free labour market migration, there should be nosurprise that the size of the regional economy expands. In such cases amodeller is, as Solow said, just finding the juicy plums that they planted inthe pudding.In terms of the practical modelling of a project, modellers must understandand justify the assumptions that they are making, both implicit and explicit.This is because they could be determining the outcome of a simulationbefore they even run the model. The justification for assumptions must begrounded in sound logic and/or empirical evidence.Additionally, it is critical for modellers to detail their assumptions in thewrite up of their analysis, and highlight the ones that underpin the majorresults. CGE modelling is perhaps as close as an applied economist will everget to undertake a controlled experiment and, as such, leaving a trail forfuture researchers to repeat an analysis is a critical part of a modeller’s task.Present a Measure of Economic WelfareWelfare analysis, not economic impact analysis, is required toassess the merit of a proposalThe task of governments is to improve the lives of citizens in their respectivejurisdictions. They can do this through a variety of means, from providingthe rule of law, provision of public goods such as health and educationservices, or possibly through economic development activities such asassisting major projects 2 .Economists use the Pareto Improvement Criterion to decide whether acertain action is worth pursuing. A government action leads to a Paretoimprovement if it makes at least one person better off and no one worse off(Sugden and Williams, 1978, p. 89). This form of analysis is called welfareanalysis.1 CGE models are very good at valuing competing alternative, such as the rise inother taxes required to offset the loss in tariff revenue, such as in IC (1997, p. N23).2 Governments can also improve different types of welfare. They can increaseeconomic welfare (e.g. increased incomes or consumption), social welfare (e.g. byconstructing community infrastructure) or environmental welfare (e.g. by rehabilitatinga sensitive area). This paper concentrates on economic welfare, not because othertypes of welfare are unimportant, but simply because there are issues with economicwelfare that need to be resolved.Department of Treasury and Finance 79
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No. 3 - Department of Treasury - The Western Australian Government

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