Ninth INFORUM World Conference th th September 2001 Gerzensee (Switzerland) The analysis of welfare effects in INTIMO Rossella Bardazzi

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1 Nnth INFORUM World Conference th th 9-16 September 2001 Gerzensee (Swtzerland) The analyss of welfare effects n INTIMO Rossella Bardazz Ths paper deals wth the analyss of welfare effects for an EU member state brought by the Eastern enlargement of the EU. We wll try to answer the tradtonal mcroeconomc queston: what amount of compensaton would the consumers requre n order to forego the change brought by the enlargement? (...) The assessment of ths pont provded by our multsectoral model INTIMO s very detaled because t produces both the sectoral prce ndexes, the composton of personal consumpton and the dstrbuton of personal ncome. However, the quanttatve analyss of the welfare ssue wth ths tool rases some problems descrbed n the followng paragraphs. A soluton s proposed and an estmaton of welfare effects for some polcy scenaros s presented. The ssue When we approached the problem from a practcal pont of vew, we found that the soluton was not so straghtforward as we thought. In fact, t was somethng that we had never studed before wth our model. 1 In the basc lterature of welfare economcs, we found dfferent ways to deal wth ths ssue. The answer to the queston asked above ( what amount of compensaton would the consumers requre n order to forego the change brought by the enlargement? ) mples the computaton of equvalent varaton (EV). Ths measure uses the base year prces and asks what ncome change at these prces would be equvalent to the proposed change n terms of ts mpact on utlty. Equvalently, t can be thought as the mnmum amount of ncome the consumer would be wllng to accept n order to forgo the move from stuaton 1 to stuaton 2. An alternatve welfare measure s the compensatng varaton (CV). It uses the new (smulated) prces as the base and asks what ncome change would be necessary to compensate the consumer for the prce change (compensaton take place after some change, so the compensatng varaton uses the after-change prces). Both of these numbers are reasonable measures of the welfare effect of a prce change. Ther magntude wll generally dffer because t wll depend on what the relevant prces are, but ther sgn wll always be the same. Whch measure s the most approprate depends on what queston we are tryng to answer. If we are smply tryng to get a reasonable measure of wllngness to pay, the equvalent varaton s probably better for two reasons. Frst, the EV measures the ncome change at current prces, and t s much easer to judge the value of money at current prces than at some hypothetcal prces. Second, f we are comparng more than one proposed polcy scenaro, the 1 Ths secton s based upon the analyss of welfare measures presented by Boadway and Bruce (1984).

2 compensatng varaton uses dfferent base prces for each new scenaro whle the equvalent varatons keeps the base prces fxed at the status quo. Thus the EV s more sutable for comparsons among a varety of scenaros (see Varan, 1992). Dffcultes may arse n the practcal applcaton of these measures. Frst of all, the nformaton requred to obtan exact measures of welfare change, such as CV or EV, s very demandng. Hence t s often necessary to resort to emprcal approxmatons n appled work. Moreover, these are measures of the change n the well-beng for an ndvdual household between two stuatons where, for smplcty, the two stuatons refer to dfferent bundles of commodtes consumed. The adaptaton of welfare change measures for a sngle household to welfare change measures for the economy as a whole requres both some approxmatons to make the measures emprcally applcable, and some value judgments to enable one to go from snglehousehold measures to many-household aggregates. As for the frst knd of problem, a common procedure to construct approxmatons to EV or CV s to compute quantty ndces. Quantty ndces are ntended to ndcate n one summary measure how much the quanttes consumed have changed between the two stuatons. The two methods commonly used are the Laspeyres quantty ndex Q L and the Paasche quantty ndex Q P, defned as follows: Q L j p 1 x 2 j p 1 x 1 Q P j p 2 x 2 j p 2 x 1 The Laspeyres quantty ndex s the weghted rato of quanttes consumed n the two perods, where the weghts are the ntal prces. The Paasche quantty ndex uses the new prces. An alternatve way of lookng these ndces s to wrte them n the followng level form: j p 1 x 2 & j p 1 x 1 j p 1 )x. EV j p 2 x 2 & j p 2 x 1 j p 2 )x. CV In the level form these ndces are frst order approxmatons of Equvalent Varaton (EQ) and 2 1 Compensatng Varaton (CV). If we thnk of the true quantty ndex at the prces p as beng EV n rato form, the Laspeyres quantty ndex s an overestmate of the true ndex. Smlarly, the true quantty ndex usng the new prces can be thought of as CV n rato form and the Paasche ndex s an underestmate of the true ndex. 2 See Boadway and Bruce, 1984, p.213.

3 If Q p>1 so Gp x >Gp x, ths ndcates that the ncome avalable n the new stuaton s more 1 than enough to be able to purchase the old set of goods at the new prces. In other words, x was 2 1 nsde the budget constrant n stuaton 2. Snce x was purchased when x could have been, ths mples that x s preferred to x. Moreover, x could not have been purchased when x was, therefore Gp x >Gp x, or Q L>1. So far we have consdered the welfare change resultng from changes n the quanttes of goods consumed by a household. Income has been taken as exogenously gven. In practce, at least part of a household s s obtaned from the sale of factors of producton. Such factors may nclude the supply of labour, rsk, and savngs (or forgone consumpton). Increases or decreases n the supply of these factors wll nfluence the utlty level of the household, and t may be useful to develop welfare change measures whch account for them. The welfare change measures developed so far were constructed on the assumpton that we could aggregate all consumers nto a sngle representatve consumer for welfare measurement purposes. Treatng a many-person economy as f t were a sngle-person economy mples frst of all that aggregate demand functons have the same propertes as ndvdual demand functons. That s the aggregate demand functon represents an aggregate preference orderng, or a set of socal ndfference curves. Aggregate welfare change measure has normatve sgnfcance f we assume a Socal Welfare Functon to choose both the optmal quantty for each prce ether the optmal dstrbuton of ncome. Alternatvely, we regard the aggregate demand as representatve of the sum of ndvdual demands f we assume that ndvdual preferences are dentcal and homothetc for all persons. 3 Nonetheless, most practtoners of appled welfare economcs proceed to measure welfare change by smply aggregatng CVs (EVs) over ndvduals. The usual argument s that ths measure should not be nterpreted as measurng socal welfare n the sense that f aggregate CV (EV) rses socety must be better off but, rather, t should be nterpreted as ndcatng whether or not there has been a potental Pareto mprovement n socal welfare (the ganers from the change could hypothetcally compensate the losers from the change). However, the use of the unweghted sum of household compensatng or equvalent varatons as a necessary and suffcent ndcator of potental Pareto mprovement s full of dffcultes. At best such measures can be used as a prelmnary attempt ro rank socal states. By usng ndvdual data the welfare varatons could be calculated for homogenous groups of ndvduals and aggregated wth specfc Socal Welfare Functons (SWF). In partcular, dsaggregated data on household consumpton should be used to estmate demand functon for groups of households wth smlar characterstcs. Then, CVs (EVs) could be computed and aggregated by usng an addtve SWF to sum the varatons for homogenous groups of households attachng to the CVs dstrbutonal weghts. In partcular, weghts reflect the proporton of each class of goods on total expendture for households of dfferent types. 3 A second measure could be estmated by usng not only the varatons of prces and quanttes but also the substtuton effects. Demand functons for dfferent goods and Slutsky matrces of substtuton effects should be estmated. Ths term should be added to the orgnal formulas of the ndces n the level form compute a second order approxmaton of EV and CV.

4 What have we done? From what we have studed, t was clear that a serous analyss of welfare effects could only be done wth ndvdual data and estmaton of demand functon for homogenous groups of households. Ths s not somethng that was avalable n our model. Wth our data, we could compute a frst order approxmaton of welfare varatons by assumng all the restrctve hypotheses we have lsted above (representatve consumer, dentcal and homothetc preferences, and so on) or, at best, a second order approxmaton by usng the estmated substtuton effects for the demand system. We reckoned that the latter was not worth the effort requred: n my opnon, the addtonal nformaton obtaned by ths step was not very nterestng. I personally would have lked to use ndvdual data to make a defnte step forward. Therefore, what we have done s smply the computaton of Laspeyres and Paasche ndces as measures of welfare changes n dfferent scenaros. We thnk that the nformaton contaned n these ndces, although very lmted, has ts own merts. In fact, we should remnd that n INFORUM models, nterrelatons among real and nomnal varables are a unque feature that s reflected also n the estmaton of the household consumpton. The smultanety of model soluton produces mpacts on household consumpton due to changes not only n prces, but also n dsposable ncome, labour market, nvestments, nternatonal trade flows and so on. Wth the structure of the model n mnd, we proceed to the analyss of our results. The estmated welfare effects of EU enlargement We estmated the welfare effects through the quantty ndces descrbed above. The tme horzon s up to 2010 wth four alternatves: a baselne scenaro, wthout the enlargement and wth the CEEC5 countres GNP rates of growth assumed to be followng the average rate of growth of other countres n the system; a frst scenaro (Italy/CEEC5 countres vs-à-vs) consderng the nteracton between the Italan economy and the CEEC5 countres. In ths scenaro we assume that CEEC5 GNP s gong to grow faster of about 2% wth respect to the baselne. On the sde of resources, we assume that mports wll grow as faster as the GNP so that the resource structure does not change. Hgher CEEC5 mports wll turn out to be hgher exports for the countres n the model system. Ths scenaro consders the effect of CEEC5 mports ncrease only over Italan exports. In other words, gven the ncrease n Italan exports due to the ncrease n CEEC5 demand, the Italan model s run alone; a second scenaro (EU/CEEC5 countres va-à-vs) consderng the mpact of the CEEC mports ncrease over the export structure of all the models n the system through the BTM model and the countres models. We assume a growth rate of CEEC5 GNP as n the prevous scenaro. However, n ths case, the effect of the exports ncrease generated by the accelerated growth of CEEC5 GNP wll nvolve every model n the system and, n turn, each country wll be affected by the modfcatons of every country resource structure. In ths case, Italan exports wll be determned by changes n demand of mports by all the countres n the system. a thrd scenaro (Specalzng CEEC5) where the growth rate of CEEC5 GNP wll be 2% hgher than n the baselne, as n scenaros 1 and 2, but the growth of ther mports wll

5 not be evenly dstrbuted among sectors. Instead, the overall growth rate wll be obtaned by a specalzaton of mports n the followng commodtes: a) furnture, medcal and surgcal furnture, b) artcles of apparel and clothng accessores, c) wood and artcles from wood, d) mneral fuels, mneral ols and products of ther dstllaton. In fact, these are the tems where CEEC5 mport flows have beng concentratng n the last decade. In ths scenaro, INTIMO s run wth the system of models as n the prevous scenaro. So far, the smulaton scenaro do not nclude any change of prces due to the reducton of tarffs. Therefore, the economc effects are due to changes n the demand. In fact, an ncrease of the CEEC5 mports turns out to be an ncrease of Italan exports. Whatever wll the sectoral output (or GNP) ncreases be, the magntude of the mpact on domestc prces s expected to be neglgble because a) the CEEC5 prces do not change n any scenaro and b) the ncrease n fnal demand wll be expected to be modest and plausbly t wll not sensbly affect the productvty whch s - n ths case - the man lever nfluencng the prce formaton. The welfare effects resultng from changes n household consumpton are presented n Tables 1 and 2. In these tables Laspeyres and Paasche ndces are presented for all scenaros. We remnd that these welfare measures are ndces (1.0 at the base year) and only ther level form s an approxmaton of EV and CV, respectvely. We regard the eastern enlargement as welfare ncreasng f the dfferences between the smulaton scenaro and the baselne - the last three columns of the tables - are postve for each year. In fact, f these dfferences are postve t means that quanttes consumed n the case of enlargement are larger then those consumed wthout ths event. INTIMO provdes data on prces and consumpton for about forty categores of goods. Household consumpton s estmated wth PADS and a demographc projecton model produces populaton 4 projectons for the demand system. In these equatons, household dsposable ncome and a prce term are the most mportant ndependent varables. Household dsposable ncome s modelled n the accountant as the sum of Resources (such as compensaton of employees, property ncome and transfer payments) mnus Uses (such as taxes, socal securty contrbutons and transfers to others) of the Income Dstrbuton Account for Households. For example, f exports ncrease then employment wll rse and so wages. Therefore, personal consumpton expendture wll be hgher. On the other hand, a prce ncrease wll reduce consumpton, but ths effect s expected to be very low n these smulatons, as explaned above. Results suggest that eastern enlargement s welfare ncreasng for the Italan economy. Laspeyres and Paasche quantty ndces for the base smulaton, compared wth smlar ndces for the smulaton scenaros wth the EU enlargement are always lower. The man reason of the welfare mprovement s that personal consumpton ncreases for almost all tems. In all enlargement scenaros the aggregate household consumpton rate of growth s hgher than n the baselne. Welfare ncreases through the scenaros: the most welfare mprovng scenaro s the one wth specalzaton n CEEC5 mports (see column (3)of both tables), but also the second scenaro shows dfferences wth the baselne that are approxmately twce as large as the dfferences between the frst scenaro and the baselne (compare the fgures n columns (2) and (1)). The reason s that the 4 At present, nsde DPM we have not assumed any mpact n net mmgraton due to EU enlargement.

6 ncrease n foregn demand for the Italan economy s larger n scenaros 2 and 3. In both these scenaros (EU/CEEC5 countres va-à-vs and Specalzng CEEC5), Italan exports ncrease not only because of CEEC5 mports but also for the demand of other EU members: ntegraton mples an expansonary effect for all Europe and Italy s drectly and ndrectly affected through nternatonal trade flows. Moreover, when CEEC5 mports growth s smulated n some specalzed commodty groups, the effect on Italan exports s hgher because some of these are leadng Italan exportng sectors (textles, wood, apparels). For the macroeconomc results of all scenaros, see Table 3 at the end of ths paper. Fgures 1 and 2 show the growth rates of our quantty ndces n all scenaros. The growth rates present the same pattern: they are n the range from 1.4 to 1.9 percentage ponts, wth a peak around the year 2003, then a slow down to the lowest value after 2006, and an upturn at the end of the perod. Ths pattern s explaned manly by the behavour of nvestments (see Table 3). In most cases, the lnes do not cross and the rankng s the same as that we have seen n the Tables: the slowest growth of welfare ndces s n the baselne, the fastest n the thrd scenaro. References: Varan H. (1992), Mcroeconomc Analyss, Thrd Edton. Boadway R.W., Bruce N. (1984), Welfare Economcs, Blackwell.

7 Table 1 - Laspeyres ndces for all scenaros ( ) and dfferences from the baselne scenaro Laspeyres Indces for the baselne and the smulaton Dfferences from the baselne scenaros scenaro (%) (*) QL(0) QL(1) QL(2) QL(3) (1) (2) (3) Note: (0) Baselne Scenaro (1) Italy/CEEC5 vs-à-vs Scenaro (2) EU/CEEC5 vs-à-vs Scenaro (3) Specalzng CEEC5 Scenaro (*) 100*(QL (scenaro)-ql (0))/QL (0) t t t Table 1 - Paasche ndces for all scenaros ( ) and dfferences from the baselne scenaro Paasche Indces for the baselne and the smulaton scenaros Dfferences from the baselne scenaro (%) (*) QL(0) QL(1) QL(2) QL(3) (1) (2) (3) Note: (0) Baselne Scenaro (1) Italy/CEEC5 vs-à-vs Scenaro (2) EU/CEEC5 vs-à-vs Scenaro (3) Specalzng CEEC5 Scenaro (*) 100*(QP (scenaro)-qp (0))/QP (0) t t t

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9 Fgure 1 - Laspeyres Indces (EV) Annual Growth Rates (%) for the Baselne and the Smulaton Scenaros Legenda: plus lne: Baselne Scenaro square lne: Italy/CEEC5 vs-à-vs Scenaro cross lne: EU/CEEC5 vs-à-vs Scenaro damond lne: Specalzng CEEC5 Scenaro F I A R B S S 2.40 gure 2 - Paasche ndces (CV) nnual Growth ates (%) for the aselne and the mulaton cenaros

10 Legenda: plus lne: Baselne Scenaro square lne: Italy/CEEC5 vs-à-vs Scenaro cross lne: EU/CEEC5 vs-à-vs Scenaro damond lne: Specalzng CEEC5 Scenaro

11 Table 3 Lne 1: Baselne Lne 2: Italy and CEEC5 vs-a'-vs - dfference from base Lne 3: Italy-EU and CEEC5 vs-a'-vs - dfference from base Lne 4: Specalsng CEEC5 - dfference from base Alternatves are shown n devatons from base values. RATES OF GROWTH PRODUCT ACCOUNT RESOURCES Gross Natonal Product Imports USES Consumpton Household consumpton Government expendture Prvate collectve consumpton Fxed captal formaton Changes n nventores Exports

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