MODELS

The GEM-E3 Model and its extensions.

Prof. P. CaprosICCS/NTUA

March 2007 2

Objectives

To install operational versions of GEM-E3 on the computer system of the European Commission for in house use.

To support a series of policy applications with GEM-E3 on issues related to the Lisbon agenda and the assessment of impacts from regulation and legislative initiatives of the Commission.

To improve the GEM-E3 computable general equilibrium model.

March 2007 3

The GEM-E3 model.

GEM-E3 is a multi-region Computable General Equilibrium model built to evaluate the economic impacts of structural policies.

GEM-E3 provides the user with many modelling options: a European model, a World model, and a series of different model closures.

GEM-E3 is developed using GAMS and uses MS-Excel for the data and the results.

A non-developer user may run GEM-E3 after a short training, example IPTS of EC/JRC.

March 2007 4

Model Extensions

Internal Market under imperfect competition and economies of scale.

Bottom up energy sub-model and depletable energy resources mechanism.

Endogenous technical progress. Imperfect markets for labour and

capital.

March 2007 5

Model versions delivered to Commission

Models source code and manuals delivered to Commission for in house

use.

1st p

hase

GEM-E3 core version + Imperfect Markets + Energy Environment Module + Unemployment (i.e. Wage Curve)

2nd p

hase

ICT version + Endogenous technology progress.

ICT version + Disaggregated and improved labour, capital, skills and households.

GEM-E3 v. ICT

GEM-E3 v. EGICT

GEM-E3 v. SICT

GEM-E3 v. EGSICT

March 2007 6

“Internal market, competition and trade” (GEME3 v. ICT).

This version will serve as the basis for all model developments.

Standard version featuring:- Market integration and trade with imperfect

competition and economies of scale- Energy and environmental module- Option for unemployment (wage curve

introduction).

March 2007 7

“Endogenous Growth, Internal Market, Competition and Trade”

(GEME3 – v. EGICT).

• Model with endogenous technical change.• Combines the advanced trade model version with

endogenous growth driven by technology progress and innovation.

• The EGICT version will be used to study:- the knowledge society, - the internal market, - the business climate and the environmental

sustainability aspects of the Lisbon strategy

March 2007 8

“Social structures, Internal market, Competition and Trade” ”

(GEME3 – v. SICT).

SICT version features:- disaggregated and improved labour, capital, skills

and households - improved representation of the services sector and

the trade for services in the Internal Market. SICT model version enables to study:- Distributional and social impacts on employment.- Advanced analysis on double dividend issues

(employment and environment).

March 2007 9

Links between model versions and Lisbon policy agenda.

Policy AgendaPolicy Agenda The model extensionsThe model extensions

1. The Knowledge

Society

2. The Internal Market

3. The Business Climate

4. The Labour Market

5. Environmental

Sustainability

1. Endogenous Technical Progress

2. Market Integration under imperfect competition and product varieties

3. Capital market and investment flows

4. Labour market under imperfect competition

5. Energy-Environment sustainability driving innovation, demand for equipment goods and exports

March 2007 10

Schedule

Phase A

The GEM-E3 team will: • Perform the necessary updates, • Check the operation of the model, • Improve the user interface• Provide the user manual and• Install the ICT GEM-E3 version at

the Commission.

Phase B

• Install EGCT and SICT versions at the Commission

• Finalisation of user interface• User manual provision• Provide support in designing and

implementing the policy scenarios

Timeline

Month 5 : Installation of improved model version (ICT) to the Commission .

Month 17: Policy applications as per Phase A.

Month 19: Installation of final model versions to the Commission.

Month 35: End of policy applications as per Phase B.

GEM-E3

Regional and sectoral coverage

(current and proposed)

March 2007 12

GEM-E3 Data BasesThe European version of GEM-E3 is

entirely based on Eurostat statistics. The World version of GEM-E3 is

based on the GTAP-6 database which covers the whole world aggregated in 87 regions and 57 sectors (base year 2001).

March 2007 13

GEM-E3 Regional aggregation.

Current:

1. Oceania

2. Japan

3. East Asia

4. China

5. India

6. Rest of Asia

7. U.S.A.

8. Canada

9. Mexico & Venezuela

10. Latin America

11. E.U. 27

12. Other Europe

13. C.I.S.

14. Middle East

15. Mediterranean

16. South Africa

17. Rest of Africa

Proposed:

• E.U. 27 (separately)• Rest of Europe• North America• Latin America and Mexico• Rest of OECD• C.I.S.• Rest of Asia• Africa Sub Sahara• Middle East and N. Africa

March 2007 14

GEM-E3 Sectoral aggregation

Current 1. AGRICULTURE

2. COAL

3. OIL

4. GAS

5. ELECTRICITY

6. NON FERROUS METALS

7. FERROUS METALS

8. CHEMICAL PRODUCTS

9. OTHER ENERGY INTENSIVE

10. ELECTRONIC EQUIPMENT

11. TRANSPORT EQUIPMENT

12. OTHER EQUIPMENT GOODS

13. OTHER MANUFACTURING PRODUCTS

14. CONSTRUCTION

15. FOOD INDUSTRY

16. TRADE AND TRANSPORT

17. TEXTILE INDUSTRY

18. OTHER MARKET SERVICES

19. NON MARKET SERVICES

Proposed1. AGRICULTURE

2. COAL

3. OIL

4. GAS

5. ELECTRICITY

6. NON FERROUS METALS

7. FERROUS METALS8. CHEMICAL PRODUCTS

9. OTHER ENERGY INTENSIVE

10. ELECTRONIC EQUIPMENT

11. TRANSPORT EQUIPMENT

12. OTHER EQUIPMENT GOODS

13. OTHER MANUFACTURING PRODUCTS

14. CONSTRUCTION

15. FOOD INDUSTRY

16. TRADE AND TRANSPORT

17. TEXTILE INDUSTRY

18. COMMUNICATIONS

19. FINANCIAL SERVICES

20. INSURANCE

21. BUSINESS SERVICES NEC

22. RECREATIONAL AND OTHER SERVICES

23. PUBLIC ADMINISTRATION, DEFENSE, EDUCATION, HEALTH

WP 2.1: Internal Market and world trade under imperfect competition

and economies of scale

Extension of GEM-E3

March 2007 16

Basic modelling idea Goods are differentiated by origin (Armington

assumption) Differentiation by consumers is reflected through

the form of the demand nesting hierarchy. The selling price of a good is a function of an

endogenous mark-up and the eventual barriers to trade.

The mark-ups reduce when enlarging the marketwhen enlarging the market, as a result of more intensive competition.

March 2007 17

Supply Technologies

Calibration Minimum Efficient Scale Cost Gradient (engineering studies) Number of equivalent equal size

firms from Herfindahl index Calibration of mark-up

Entry/exit of firms Symmetric firms Number of firms endogenous To ensure zero profits or non-zero

profits (optional) Endogenous mark-ups

Depending on concentration Depending on average cost

Scale

MES

Average cost curve

Marginal cost curve

Cost

Initialfirm

Firm inthe

enlargedmarket

ProductionUnit_var FixedCost

March 2007 18

Demand nesting hierarchy

Structural changes such as the EU Internal Market

MARKET SEGMENTATIONDomestic Consumers (final and

intermediate)

demand for goods and services

Domestically producedgoods

Imported goods fromEU or RW

Goods from EU Goods from RW

Domestic firms Other EU firms RW firms

Split in EU countries

MARKET INTEGRATIONDomestic Consumers (final and

intermediate)

demand for goods and services

Goods from EU andDomestic

Imported goods fromRW

Goods from EU

Domestic firms Other EU firms RW firms

Split in EU countries

Goods fromDomestic

March 2007 19

The love of variety effect Hypothesis about horizontal product differentiation

between firms within the same sector and country

When varieties increase, the consumer obtains the same aggregate quantity more efficiently (i.e. with lower quantities hence lower cost)

This relaxes short-term supply constraints, leading to lower market prices and magnifies the effect of market enlargement

The number of varieties increase with more intensive competition as the effect from the market enlargement dominates over the effect from market concentration.

March 2007 20

Imperfect competition Various modelling options (Cournot, monopolistic

competition, Ramsey-Boiteux pricing, etc.) In any case the market price depends on costs and an

endogenous mark-up:

Under free entry/exit of firms, the number of firms adjusts in a sector, depending also on the efficient size of company as related to the market size.

Enlargement leads to increase of number of firms hence varieties and a reduction of the mark-ups

111

cm pp

WP 2.2: Engineering economic model integration for the energy

and environment systems

Extensions of GEM-E3:

- Engineering oriented energy sub-model- Depletable energy resources- Endogenous energy efficiency and savings- Environmental impact sub-model- Sub-model for cost-benefit environmental assessment- Double dividend analysis: environment and employment

March 2007 22

Basic modelling idea The core GEM-E3 already covers energy issues and the

interactions with the environment Linkage to a detailed environmental sub-model Calibration to energy projections by PRIMES and

POLES.

However, the core model lacks Discrete representation of power producing technologies. Non-linear (decreasing return to scale) mechanism for

the supply of energy resources, such as the depletable fossil fuels.

March 2007 23

Bottom-up for power generation Explicitly represents a variety of old and new

technologies of power generation. Endogenous investment into new power generation

plants. Energy investment is linked to the demand for

equipment goods. Technology progress incorporated through the capital

vintages. Emissions from power generation linked to the

environmental sub-model and policy instruments influence power sector decisions.

March 2007 24

Bottom-up for power generation

Dispatching under capacity constraintsDispatching under capacity constraints Investment in new power plantsInvestment in new power plants

on volume dependingon accumulati

forward timea asrisk and learning

estechnologi

,,ostlifetime_c

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mequilibriugeneralthefromas

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risklearningf

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INV

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Price of electricity – optionsPrice of electricity – options• Mark-up (under IC)• Ramsey-Boiteux to recover fixed

costsInfluenced byInfluenced by• Fuel and technology costs• Environmental policies

March 2007 25

Depletable energy resources The price of energy resources become a function of

The rate of extraction from proven reserves and the rate of discovery of new reserves.

The accumulated use of the resources The reserves are introduced as a separate production

factor. In the presence of climate change policies, abatement

costs increase as a result of lower fossil fuel prices related to lower demand; opposite effects in case of dash for gas.

March 2007 26

Endogenous energy savings Endogenous decision to invest in energy saving

equipment. Production and consumption functions are extended with

the energy saving considered as an additional factor Energy saving draws from a limited potential for savings

per sector, hence follows decreasing return to scale Investment in energy saving induces expenses taken

into account in the least cost decision of the agent. The purchase of goods to implement energy saving

influences total demand for goods and services

WP 2.3: Endogenous Growth through technology and

innovation

Extension of GEM-E3

March 2007 28

Basic modelling idea Combination of two

production functions: Knowledge production Knowledge production

functionfunction: generation of new innovation

Output production functionOutput production function: standard KLEM function extended to account for the impact of endogenous technology innovation

MELKAY

LAA R

,,,;

,

March 2007 29

Endogenous innovation: supplyMain modelling hypothesis:

R&D investment of firms show decreasing return to scale with accumulated knowledge

Spillovers represented as positive externality leading to higher productivity of R&D expenditure

The combination determines the supply function of innovations (price and quantity locus)

Public R&D subsidies support innovation but are subject to the effects from GE budget constraint

March 2007 30

Endogenous Innovation: demand

Decision of a firm to purchase innovation: Endogenous, positively affects

productivity of factors but induces expenditure

Applies to the new capital vintage Simultaneously with the demand for

all production factors (L,E,M) and productive investment, so as to maximise expected net present value of the firm

In the model dynamics depends on firm sales expectations and the unit costs of factors

Sub Package 2.4: Model improvement of labour market, households sector and capital

market

Extensions of GEM-E3 :

- Improvement of the formulation of labour markets.- Inclusion of multiple household classes.- Improvement of capital market and capital mobility.

March 2007 32

Capital and labour formulation of standard GEM-E3 Labour supply is derived from consumption-leisure-savings choice,

labour demand depends on the KLEM optimisation Capital demand is derived from investment function, capital supply

depends on general equilibrium closure (Walras law) Current modelling options for labour market:

Wages determined from equilibrium of supply-demand Current modelling options for capital market:

Rate of return on capital derived from national budget equilibrium, a reduced form reflecting differentiated interest rates and risk premia

Rate of return on capital derived from multinational income-savings closure

March 2007 33

Labour market extension Categories of households are introduced with

different patterns about consumption and savings

Skills of labour are introduced. Skills are linked with household categories and

the mechanism of income distribution Each market is imperfect, reflecting negotiation

power of unions and the influence of unemployment

Labour is imperfectly mobile across countries.

March 2007 34

Capital market extension Capital flows financing investment are

differentiated per origin and destination in the presence of differentiated rates of return and risk premia

Capital is imperfectly mobile across regions and market clearing is imperfectly coordinated

This extension allows to understand the adjustments to the global economy when structural policies, such trade liberalization, environmental sustainability etc. are undertaken.