Quantitative Tools for Microeconomic Conference Proceedings Policy Analysis Canberra, 17–18 November 2004 © Commonwealth of Australia 2005 ISBN 1 74037 184 4 This work is subject to copyright. Apart from any use as permitted under the Copyright Act 1968, the work may be reproduced in whole or in part for study or training purposes, subject to the inclusion of an acknowledgment of the source. Reproduction for commercial use or sale requires prior written permission from the Attorney-General’s Department. Requests and inquiries concerning reproduction and rights should be addressed to the Commonwealth Copyright Administration, Attorney-General’s Department, Robert Garran Offices, National Circuit, Canberra ACT 2600. This publication is available in hard copy or PDF format from the Productivity Commission website at www.pc.gov.au. If you require part or all of this publication in a different format, please contact Media and Publications (see below). Publications Inquiries: Media and Publications Productivity Commission Locked Bag 2 Collins Street East Melbourne VIC 8003 Tel: (03) 9653 2244 Fax: (03) 9653 2303 Email: [email protected] General Inquiries: Tel: (03) 9653 2100 or (02) 6240 3200 An appropriate citation for this paper is: Productivity Commission 2005, Quantitative Tools for Microeconomic Policy Analysis, Conference Proceedings, 17–18 November 2004, Canberra. JEL code: C, D, H The Productivity Commission The Productivity Commission, an independent agency, is the Australian Government’s principal review and advisory body on microeconomic policy and regulation. It conducts public inquiries and research into a broad range of economic and social issues affecting the welfare of Australians. The Commission’s independence is underpinned by an Act of Parliament. Its processes and outputs are open to public scrutiny and are driven by concern for the wellbeing of the community as a whole. Information on the Productivity Commission, its publications and its current work program can be found on the World Wide Web at www.pc.gov.au or by contacting Media and Publications on (03) 9653 2244. Foreword This publication contains the papers from a Productivity Commission conference on Quantitative Tools for Microeconomic Policy Analysis, held in November 2004 in Canberra. Policy modelling has played an important role in the work of the Productivity Commission and its predecessors over the years1. Reform can be disruptive and costly to some. Gaining some assurance that the beneficial impacts will justify such costs is critical to developing and selling proposals for policy change. Quantitative models cannot replicate reality, but they can provide us with a better understanding of the ramifications of policy changes. Over time, increased access to and understanding of sophisticated quantitative modelling have improved the basis for policy decisions. The objective of the conference was to provide an opportunity for the dissemination of new, data-related, modelling approaches, relevant to contemporary policy discussion. The invited audience was not confined to modellers, but also included policy analysts and advisors from government, universities and the private sector. Presentations at the conference were therefore not overly technical. However, the authors were invited to include necessary technical material in the versions of their papers contained in this volume. The Commission would like to thank the authors, who responded well to the invitation to make what is a technical subject accessible to a wider audience. Thanks are also due to all those who attended the conference, whose questions and discussions kept the focus on policy relevance. Last, but not least, thanks to Margaret Mead for organising the conference so well and assisting with the production of this volume. Gary Banks Chairman 1 For a history of the Commission’s activities over the last three decades see From Industry Assistance to Productivity: 30 Years of ‘the Commission’, Productivity Commission 2003. FOREWORD III IV FOREWORD Contents Foreword III Section 1 Estimating policy effects — computable general equilibrium models 1 1 Asset markets and financial flows in general equilibrium models 3 Warwick J McKibbin and Alison Stegman 2 Combining engineering-based water models with a CGE model 17 Peter B Dixon, Sergei Schreider and Glyn Wittwer Section 2 Labour markets and human capital — discrete choice models 31 3 Selectivity and two-part models 33 Tim R L Fry 4 The determinants of students’ tertiary academic success 45 Elisa Rose Birch and Paul W Miller Section 3 Evaluating microeconomic policies — experimental techniques 81 5 Experimental and quasi-experimental methods of microeconomic program and policy evaluation 83 Jeff Borland, Yi-Ping Tseng and Roger Wilkins 6 Discrete choice experiments in the analysis of health policy 119 Denzil G Fiebig and Jane Hall Section 4 Measuring productivity 137 7 A ‘model consistent’ approach to productivity measurement 139 Russel Cooper and Gary Madden 8 Environmental productivity accounting 171 C A Knox Lovell 9 Estimation of total factor productivity 195 Robert Breunig and Marn-Heong Wong CONTENTS V Section 5 Assessing health and ageing policies using microsimulations 215 10 The new frontier of health and aged care 217 Laurie Brown and Ann Harding 11 Behavioural microsimulation modelling with the Melbourne Institute Tax and Transfer Simulator (MITTS): uses and extensions 247 John Creedy and Guyonne Kalb Section 6 Trade and welfare 293 12 Extending CGE modelling to the liberalisation of services trade 295 Philippa Dee 13 Welfare analysis in an empirical trade model with oligopoly: the case of Australian non-durable goods imports 323 Harry Bloch and Han Hwee Chong VI CONTENTS VII 1 Asset markets and financial flows in general equilibrium models Warwick J. McKibbin Centre for Applied Macroeconomic Analysis and Economics Division, RSPAS, Australian National University and The Lowy Institute for International Policy and Alison Stegman Centre for Applied Macroeconomic Analysis and Economics Division, RSPAS, Australian National University Abstract This paper summarises the role of asset markets in general equilibrium models, focusing on the approach in the MSG and G-Cubed models. It is argued that asset markets play a critical role in macroeconomic dynamics and that ignoring this role is a weakness of many general equilibrium models that attempt to analyse dynamic adjustment. The important role of asset markets is highlighted in several applications of the G-Cubed and MSG models, including analysis of the North American Free Trade Agreement (NAFTA), trade policy reform, the Asian crisis and climate policy. 1.1 Introduction This paper discusses the importance of asset markets and financial flows in general equilibrium models. Asset markets and financial flows play an important role in adjustment to economic shocks and policy changes. If this role is not integrated into economic models, the dynamic story of adjustment will be incomplete and the usefulness of modelling results will be limited. The MSG and G-Cubed models are dynamic intertemporal general equilibrium models that combine the approaches of traditional computable general equilibrium (CGE) models,1 real business cycle 1 These are also referred to as applied general equilibrium (AGE) models. Hereafter, we use only the term ‘CGE models’. See Dervis, de Melo and Robinson (1982), de Melo (1988), Robinson ASSET MARKETS AND 3 FINANCIAL FLOWS IN GE MODELS models 2 and macroeconometric models.3 An explicit treatment of asset markets and financial flows allows the models to provide important insights into the adjustment process following economic shocks and policy changes.4 This paper provides a general outline of the MSG and G-Cubed approaches, focusing on the role of asset markets and financial flows. These models have been used extensively to analyse the impact of economic shocks and policy adjustments. A range of studies, where the models provide important insights into policy issues, are summarised. Policy issues covered in the studies include the impacts of the North American Free Trade Agreement (NAFTA), of trade policy reform and of alternative climate policy initiatives, as well as the causes and consequences of the Asian crisis. In each of these studies, the G-Cubed and MSG models provided insights that were difficult to explore in traditional CGE modelling analyses. 1.2 The MSG and G-Cubed models The MSG and G-Cubed set of models are dynamic intertemporal general equilibrium models that attempt to integrate the best features of traditional CGE models, real business cycle models and Keynesian macroeconometric models. The sectoral and country coverage of the models is flexible, and there are a range of alternative specifications. The original MSG model was developed by Warwick McKibbin and Jeffrey Sachs during the 1980s in response to the poor performance of existing macroeconometric models in understanding oil price shocks and macroeconomic imbalances, and the theoretical attack provided by the Lucas Critique (Lucas 1973). This early work, which was largely macroeconomics with rational expectations in several financial markets, evolved into the MSG2 model, documented in McKibbin and Sachs (1991), which is a single-sector (plus oil) (1989) and Shoven and Whalley (1984) for an overview of CGE models. This approach can be traced back to Johansen (1960) and, in the Australian context, see Dixon et al. (1982). 2 See Backus, Kehoe and Kydland (1992) for real business cycle models. 3 See