SGS takes economic impact modelling to the next level!

Introduction

Proponents of development projects and the government agencies that are charged with assessing them are universally interested in understanding the degree to which the project will lift economic activity levels. This lift can be manifested in a variety of ways but is most often estimated in terms of increased:

  • Gross regional product (GRP)
  • Regional employment
  • Regional investment, and
  • Regional exports.

When undertaking these assessments, the project is generally described in terms of its construction and operating phases. The ‘direct’ regional impacts of each phase are assessed, with the aim of this process to identify the degree to which a project’s economic activity is ‘new’ to a region, as opposed to being a transfer of regional economic activity that would have otherwise occurred.[1]

Subsequent modelling efforts use economic models to estimate the degree to which a project’s ‘direct’ impacts trigger ‘indirect’ activity given the multiple rounds of buyer/supplier transactions that are unleashed in the regional economy.

Previously SGS has relied on input-output (I-O) based models to estimate these indirect impacts, but the inherent limitations of this approach have caused increasing concern, both for us and our clients (figure 1).

Figure 1: Limitations of input-output modelling approaches

The advantage of the I-O technique is its ease of use and transparency. However, as a methodology for undertaking economic impact analysis, the ease of use comes at a cost. In particular, the I-O model is easy to use because of a number of limiting and unrealistic assumptions.

One major limitation of the I-O model is the use of fixed coefficients; implying that a region’s industrial structure remains unchanged by the project being assessed. In addition, these fixed coefficients imply that the marginal response of industries, as a result of the project, is equivalent to the average relationship observed in the base year (from which the coefficients are derived). In other words, one of the biggest limitations of the use of input output modelling is that it assumes that the ratio of labour, capital and raw materials are fixed and, in turn, impervious to either price increases or real resource constraints.

Another major limitation of the I-O model is its lack of supply side constraints. Constraints on the availability of inputs in the real world, such as skilled labour, drive price changes (e.g. wages in mining boom areas) that act as signals that induce changes in the consumption patterns of producers and consumers. In I-O analysis, where all adjustments take place on the quantity side, this type of rationing response cannot occur. Consequently, the technique often results in a significant overstatement of the impacts on employment and Gross Regional Product (GRP).

These and other limitations lead the Australian Bureau of Statistics to conclude that IO modelling overstates project impacts, particularly when large changes in demand and production are involved.

SGS’s new CGE capacities

To ensure our clients get the best advice we can offer, SGS has developed the capacity to perform computable general equilibrium (CGE) modelling, which overcomes the limitations of I-O modelling. In turn, CGE modelling is the preferred economic impact modelling of all Australian treasuries.

SGS has developed this capacity in partnership with Cadence Economics. Under this partnership, SGS economists:

  • Have been trained to use the Cadence Economics model, and
  • Use Cadence Economics to peer review the inputs, outputs and interpretation of the CGE modelling results.

This partnership allows SGS to truly cost effectively service its clients, particularly when rigorous economic impact estimates need to be relied upon. In addition, the partnership and the modelling technology employed allows SGS to undertake CGE modelling in timeframes usually associated with I-O analysis, shortening project delivery timelines. This partnership also provides a strong complement to our financial and economic appraisal (i.e. cost benefit or cost effectiveness analysis) services, which we currently employ when preparing business cases for our clients.

In terms of the CGE model details, the Cadence Model (CEGEM) is described in Figure 2. Additional information is available via SGS.

Figure 2: The workings of CEGEM

CEGEM is a multi-commodity, multi-region, dynamic model of the world economy. Like all economic models, CEGEM is based on a range of assumptions, parameters and data that constitute an approximation to the working structure of an economy. Its construction has drawn on the key features of other economic models such as the global economic framework underpinning models such as GTAP and GTEM, with state and regional modelling frameworks such as Monash-MMRF and TERM.

Labour, capital, land and a natural resource comprise the four factors of production. On a year-by-year basis, capital and labour are mobile between sectors, while land is mobile across agriculture. The natural resource is specific to mining and is not mobile. A representative household in each region owns all factors of production. This representative household receives all factor payments, tax revenue and interregional transfers. The household also determines the allocation of income between household consumption, government consumption and savings.

Capital in each region of the model accumulates by investment less depreciation in each period. Capital is mobile internationally in CEGEM where global investment equals global savings. Global savings are made available to invest across regions. Rates of return can differ to reflect region specific differences in risk premiums.

The model assumes labour markets operate in a manner where employment and wages adjust each year so that, for example, in the case of an increase in the demand for labour, the real wage rate increases in proportion to the increase in employment from its base case forecast level. CEGEM determines regional supplies and demands of commodities through optimising behaviour of agents in perfectly competitive markets using constant returns to scale technologies. Under these assumptions, prices are set to cover costs and firms earn zero pure profits, with all returns paid to primary factors. This implies that changes in output prices are determined by changes in input prices of materials and primary factors.

Conclusion

The CEGEM model that SGS is now equipped to use is well grounded in economic theory and is accepted as being credible by all levels of government. By partnering with Cadence Economics, SGS can now provide our clients better value for money by generating more rigorous and defensible results, i.e. cost competitively and in a timely manner.


[1] For example, a new hotel may target a previously unserved market in a region, thereby attracting new visitors to the region. Alternatively, a new hotel may simply compete for the region’s existing visitor market, rendering its patronage as a transfer of regional economic activity.