SIMULATING THE EFFECTS OF THE EUROPEAN SINGLE MARKET: A CGE ANALYSIS FOR SPAIN

SIMULATING THE EFFECTS OF THE EUROPEAN SINGLE MARKET: A CGE ANALYSIS FOR SPAIN Oscar Bajo Antono Gómez D.T.2005/03

SIMULATING THE EFFECTS OF THE EUROPEAN SINGLE MARKET: A CGE ANALYSIS FOR SPAIN * Oscar Bajo-Rubo (Unversdad de Castlla-La Mancha and Insttuto de Estudos Fscales) Antono G. Gómez-Plana (Unversdad Públca de Navarra) Abstract In ths paper we provde an emprcal assessment of two of the measures proposed n the context of the European Sngle Market, namely, easng the provson of domestc and foregn servces, and modfyng the rules of publc procurement, for the case of Span. We buld and smulate a computable general equlbrum (CGE) model, whch ncorporates three partcular features: () ncreasng returns to scale and a noncompettve prce rule; () sectoral export demand functons; and () equlbrum unemployment accordng to a matchng functon approach. Key words: Computable general equlbrum, European Sngle Market, Spansh economy JEL classfcaton: D58, F15, F17 * The authors wsh to thank Javer Ferr and Ezequel Urel for helpful comments and suggestons on the data used n the paper. Fnancal support from the Spansh Insttute for Fscal Studes, Fundacón BBVA, Goberno de Navarra, and the Spansh Mnstry of Scence and Technology (through the projects SEC2002-01892 and BEC2002-00954), s also gratefully acknowledged.

1. Introducton In the md-1980s the European Communtes (now European Unon, EU) launched the so called Sngle Market Programme (SMP henceforth), wth the am of elmnatng any exstng barrers to the moblty of goods, servces, labour, and captal (Commsson of the European Communtes, 1985). The Programme, to be completed by January 1st, 1993, envsaged the elmnaton of those trade barrers stll remanng despte the completon of the customs unon:.e., fscal barrers, quanttatve barrers, market access restrctons drected at frms from other member countres (and, n partcular, publc procurement), customs formaltes, techncal regulatons, etc. The SMP also contemplated some measures amed to promote an ncreased competton. An overvew of the SMP can be seen n Flam (1992). Despte the mportant progress attaned, after ten years there stll reman several restrctons, whch put a lmt to the full operaton of a common market for goods and factors wthn the EU. In general, the areas where the SMP rules have not been entrely fulflled are those related to techncal barrers to the exchange of goods, restrctons n publc procurement, and obstacles to the free movement of servces (European Commsson, 2003). Hence, snce barrers to a full common market n the EU stll reman, some new drectves amed to mplement the prncples of the SMP are currently beng developed. Accordngly, the need for further assessments of the SMP s stll n order, whch would be partcularly relevant n some areas such as the sngle market for servces, or the regulaton of publc procurement. In addton, there are no many assessments avalable of these ssues n the context of the SMP; we just can quote Copenhagen Economcs (2005) and Kox et al. (2004) on trade servces lberalzaton, and COWI (2003) on publc procurement. On the other hand, the Spansh economy can represent an nterestng case of study for the effects of the SMP, due to several reasons. Frst, Span can be consdered a medum-sze economy, gven the sze of her man macroeconomc varables, whch has experenced a process of rapd growth n the last forty years, startng from a relatvely weak poston as compared to the rest of Western European countres. Ths has been partcularly true after her accesson to the EU n 1986, allowng her an even deeper ntegraton wth other more advanced economes, so Span has been able to jon the Economc and Monetary Unon from ts start. Further on, a new assessment of the SMP effects would have an addtonal nterest n the Spansh case, snce Span would be one of the four more restrctve EU members regardng nternatonal trade n servces (Kox et al., 2004). In sum, the Spansh experence could be of nterest for other medum-sze economes expected to follow a process of ntegraton wth other relatvely more advanced countres. In ths paper we provde an emprcal assessment of two of the measures proposed n the context of the SMP, namely, easng the provson of domestc and foregn servces, and modfyng the rules of publc procurement, for the case of Span. As mentoned above, these are probably the areas where further advancements n the mplementaton of the SMP are stll needed (European Commsson, 2002, 2004). We do ths by means of a computable general equlbrum (CGE) model smulated for the Spansh economy, whch provdes a more complete analyss, as compared to partal equlbrum models; see Shoven and Whalley (1992) for a survey of ths knd of models. Ths methodology, on the other hand, has not been appled before to assess the effects of the SMP on the Spansh economy, wth the only excepton of Gómez-Plana (1998) 1

and Bajo-Rubo and Gómez-Plana (2000), who focus nstead on the measures mplemented n the frst stage of the SMP (.e., removal of trade barrers, decrease n transport costs, and harmonzaton of techncal barrers). We wll buld a CGE model, whch s an extenson of Gómez-Plana (1998) and Bajo-Rubo and Gómez-Plana (2000, 2004), and ncorporates three partcular features: () ncreasng returns to scale and a non-compettve prce rule; () sectoral export demand functons; and () equlbrum unemployment accordng to a matchng functon approach. Notce that these assumptons would be justfed from recent emprcal work on the Spansh economy. So, for nstance, Sots (2003) estmates sectoral markups for a large frm-level data set encompassng all sectors of economc actvty apart from fnancal nsttutons, and fnds sgnfcant values n most cases. On the other hand, Moreno (1997) estmates export demand functons for a set of Spansh manufacturng sectors, obtanng evdence aganst the small country assumpton for four of them: Energy, Chemcals and non-metallc mneral products, Metal products (ncludng machnery and equpment), and Other manufactures. Fnally, assumng full employment would be qute unrealstc for the Spansh economy, and the matchng functon approach seems to work reasonably well n the smulatons of Bajo-Rubo and Gómez-Plana (2004). The rest of the paper s organzed as follows. The setup of the model s presented n secton 2, the emprcal analyss and results are dscussed n secton 3, and secton 4 concludes. 2. The model The model of ths paper s statc, and descrbes a sngle open economy, dsaggregated n thrteen producton sectors, wth fourteen consumpton goods, a sngle representatve consumer, a publc sector, and a rest of the world. The equlbrum of the economy nvolves three condtons smultaneously: zero-proft n all actvtes; market-clearng n goods and captal markets; and some constrants related to the macroeconomc closure, dsposable ncome, and unemployment. In ths secton we present a bref descrpton of the model; the full set of equatons can be seen n the Appendx. 2. 1. Producton Producton s based on a nested technology of ntermedate nputs, captal, and labour. The frm s problem conssts of maxmzng profts (or, alternatvely, mnmzng costs, n the dual approach) subject to the technology constrant. The unt cost functons are obtaned from ths frm s problem, and are then used n the zero-proft condtons. In turn, the demands for factors and ntermedate nputs come from the applcaton of Shepard s lemma on cost functons, and are later used n the goods and factors marketclearng equatons. There are many well-known approaches to modellng competton among frms n CGE models, n addton to the more common assumpton of perfect competton; see, e.g., Francos and Roland-Holst (1997), Hoffmann (2002) or Wllenbockel (2004). However, a trade-off between theoretcal complexty and emprcal data avalablty s always present, snce the lack of data usually prevents mplementng many mperfect competton specfcatons, or forces oneself to usng nadequate data (such as aggregated fgures, old data, or from other countres), whch has been a common 2

crtque to determnstc CGE models. For these reasons, we have opted for representng competton among frms n the followng way. The model ncorporates ncreasng returns to scale and a non-compettve prcng rule, due to the exstence of some fxed costs on both labour and captal. The presence of fxed costs means that average costs are hgher than margnal costs, so that frms set prces by chargng a markup on margnal costs. Ths prcng rule s based on the assumpton that frms face demand functons wth negatve slopes, and compete à la Cournot. There s free entry and ext of frms n each sector, so that n equlbrum frms just break even. The non-compettve prcng rule s obtaned from the frst-order condton of the frm s problem descrbed above, leadng to a markup descrbed by the Lerner ndex. The calbrated markup for sector s: Ω MARKUP = N ELAS where the prce-cost margn MARKUP depends on: () the conjectural varatons parameter, Ω ; () the share of a typcal frm n sector s output, equal to the nverse of the number of frms n each sector, N ; and () the perceved elastcty of demand faced by sector, ELAS. In the emprcal applcaton, Ω = 1, snce frms compete à la Cournot; N s proxed by the Herfndahl ndex on concentraton, under the assumpton A A σ + 1 σ θ, where of symmetrcal frms (see secton 3.1); and ELAS s proxed by ( ) A σ s the Armngton elastcty, and θ s the output share of sector on total output (Wllenbockel, 2004). 2. 2. Consumpton There s a representatve household behavng as a ratonal consumer. The level of consumer s wealth s determned by the endowments of captal and labour, jontly wth exogenous net transfers pad by the publc sector. The fxed endowment of labour should be nterpreted as a maxmum supply of labour snce lesure and unemployment are assumed to be endogenous. Hence, labour supply would be elastc up to the endowment constrant. The household s decson problem conssts of choosng her optmal consumpton bundle, by maxmzng a nested utlty functon subject to a budget constrant. Preferences are represented by a nested utlty functon on savngs, lesure, and (consumpton of) goods. Notce that, gven our statc approach, we consder a unt elastcty of substtuton between (consumpton of) goods and savngs (Howe, 1975), so that savngs can be nterpreted as the purchase of bonds for future consumpton. The budget constrant ncludes total factor rents jontly wth exogenous net transfers pad by the publc sector, less exogenous ncome taxes. Demand functons for savngs, lesure, and goods, are derved from the frst-order condtons, and are ncluded n the goods and labour market-clearng condtons, as well as n the macroeconomc closure for savngs. 2. 3. Publc sector The role of the publc sector n the model s twofold,.e., owner of resources (e.g. from captal endowment and tax revenue), and purchaser of certan goods; n addton, t also determnes the polcy rules. As a resources owner, ts wealth ncludes ncome from captal rents, net transfers pad to the representatve household and receved from the 3

rest of the world, and tax revenues. Taxes consst of socal contrbutons pad by employers and employees, value added taxes, other net ndrect taxes, and ncome taxes. All taxes are modelled as effectve ad valorem rates calbrated from benchmark data, except for ncome taxes that are taken as an exogenous fxed amount. In order to solate any bas from the publc sector on results, ad valorem tax rates are allowed to change endogenously under the equal yeld assumpton. The publc sector also enters the model as a purchaser. The publc sector expendture ncludes both market (.e., output that s dsposed of n the market at economcally sgnfcant prces) and non-market goods (.e., output that s provded at prces that are not economcally sgnfcant). 2. 4. Foregn sector The model ncorporates the large open economy assumpton for the exports of the manufacturng sectors, and the small open economy assumpton for the exports of the remanng sectors, as well as for mports. On the one hand, some market power would appear for certan manufacturng goods sold to the rest of the world, for whch the country would behave as a prce-setter, and ths has been mplemented by ncludng export demand functons. On the other hand, the economy would face a perfectly elastc export supply functon (.e., exogenous world prces) for the rest of sectors, where a constant elastcty of transformaton functon between domestc and foregn sales s used. Regardng mports, we assume that goods are dfferentated accordng to ther orgn (.e., domestc or foregn), followng Armngton s assumpton (Armngton, 1969), whch allows for the possblty of ntra-ndustry trade despte the assumpton of exogenous world prces. The foregn sector s closed by assumng that the dfference between recepts and payments from the rest of the world s exogenous. Ths restrcton would avod, e.g., a permanent ncrease n exports wth no change n mports, an unlkely scenaro snce t would nvolve an unlmted captal nflow to the country. 2. 5. Factor markets Two factors enter nto the model: captal and labour. Wth respect to captal, both the representatve household and the publc sector own fxed endowments. The captal rents adjust to clear the domestc captal market, under the assumptons of captal nternatonal mmoblty and perfect moblty across domestc sectors. The only owner of labour s the representatve household. As explaned n secton 2.2, the demand for lesure s derved from the household s problem. Hence, labour supply (.e., the labour endowment less the demand for lesure) would be elastc up to the fxed amount of labour. In the same way as captal, labour s assumed to be nternatonal mmoble, but moble wthn the country. We assume the presence of equlbrum unemployment along wth a matchng functon approach, followng Pssardes (2000) and Balstrer (2002). A matchng rule gves the number of jobs as a functon of the number of workers lookng for a job (.e., the unemployed), and the number of frms lookng for workers (.e., the vacances). Frms and workers are assumed to spend some resources before job creaton and producton take place. Therefore, real wages net of taxes (W) nclude a premum (1/H) on reservaton wages (W 0 ) that represents search costs: 4

1 W = W0 H In turn, the H-functons (.e., the nverse of the premum) have propertes smlar to those of the matchng functons: ( 1 U ) LD U H = LD U where a bar denotes the benchmark value for the referred varable, U s the unemployment rate, LD s the aggregate demand for labour, η 0 s the elastcty wth respect to labour demand (measurng the postve externalty from frms to workers), and η 1 s the elastcty wth respect to unemployment (measurng the postve externalty from workers to frms). Labour demand s used as a proxy for vacances, as n Balstrer (2002). 2. 6. Macroeconomc closure for nvestment and savngs Followng Dervs et al. (1981), total nvestment s splt nto sectoral gross captal formaton usng a fxed-coeffcents Leontef structure. Notce that, n our statc framework, nvestment shows ts nfluence on the economy as a component of fnal demand. The model embodes a macroeconomc closure equaton statng that nvestment and (prvate, publc, and foregn) savngs are equal. 2. 7. Equlbrum condtons The equlbrum of the economy s a set of prces and an allocaton of goods and factors that solves smultaneously three sets of equatons: Zero-proft condtons for all sectors. Market-clearng n goods and factor markets. Constrants on dsposable ncome (that must equal expendtures for all agents), equlbrum unemployment, and macroeconomc closure of the model. Fnally, the model s solved usng Rutherford s (1999) method, based on Mathesen (1985), whch treats general equlbrum models as mxed complementarty problems, and s mplemented n the emprcal applcaton usng GAMS/MPSGE. A descrpton of the calbraton procedure can be found n Dawkns et al. (2001). η0 η1 3. Emprcal analyss and results 3. 1. Calbraton and data The model presented n the prevous secton has been calbrated usng Spansh data. The man data set s the Spansh Socal Accountng Matrx (SAM), elaborated by Urel et al. (2005) from the Spansh Natonal Accounts and Household Budget Survey, and reshaped to ft our model followng the methodology explaned n Gómez-Plana (2001). Elastctes are taken from econometrc evdence: elastctes of substtuton between labour and captal, and Armngton elastctes come from GTAP (Hertel, 1997); elastctes of transformaton come from de Melo and Tarr (1992); and the elastcty of substtuton between lesure and consumpton has been obtaned usng the procedure of Ballard et al. (1985), from the uncompensated elastcty of labour supply estmated by García and Molna (1998). Fnally, the elastctes of the matchng functon are taken from Burda and Wyplosz (1994), the elastctes of the export demand functon from Moreno (1997), and the Herfndahl ndces on concentraton from Bajo-Rubo and Salas (1998). We use the Consumer Prce Index (CPI) as numerare. 5

3. 2. Scenaros and smulatons As mentoned n the Introducton, we wll smulate n our CGE model the effects of two of the measures proposed n the context of the SMP, namely, easng the provson of domestc and foregn servces, and modfyng the rules of publc procurement. Recall that these are probably the areas where further advancements n the mplementaton of the SMP are stll needed. It s mportant to notce that we are not tryng to quantfy exactly the effects of the partcular polcy measures consdered, on the performance of the Spansh economy. More precsely, our objectve wll be tryng to dentfy the man trends followed by some relevant varables after the polcy shock, together wth the major mechansms nfluencng them. Concernng the removal of barrers on servces, the European Commsson has proposed n 2004 a Drectve to ease the freedom of establshment for servce provders and the free movement of servces wthn the EU. Accordng to Copenhagen Economcs (2005), ths Drectve would reduce the exstng barrers to the provson of servces by more than 50%. Three sectors (Busness servces, Communcaton servces, and Wholesale and retal trade; SMP sectors henceforth) would be explctly under the rules of the Drectve. In Copenhagen Economcs (2005), tarff equvalents (.e., the percentage mpacts on prces) are estmated for these three sectors, for two types of barrers: rent-creatng barrers, whch reduce competton on rasng prces above margnal costs, and so generatng rents to the ncumbent frms; and cost-creatng barrers, whch ncrease the use of real resources. These tarff equvalents, both at ts benchmark level and a post-drectve smulaton, are shown n Table 1. In the emprcal applcaton below, barrers on servces have been modelled as ad valorem tarff equvalents (see Table 1). Then, the removal of these barrers has been smulated n the followng way: through an exogenous fall n the markup over costs,.e., the wedge between producer prces and producer costs, n the case of rent-creatng barrers; and through an exogenous ncrease n productvty, n the sense that a greater amount of output can be produced usng the same amount of nputs, n the case of costcreatng barrers. On the other hand, accordng to European Commsson (2004), publc procurement prces pad by publc authortes would be lower when the EU drectves were appled. In partcular, the smulatons performed n COWI (2003) show that the prce of those purchases where drectves on publc procurement were not appled, would have been around 40% hgher than otherwse. We have smulated a quanttatve equvalent expendture cut n publc procurement, when purchasng the same physcal amount of goods and servces, usng as benchmark the fgures on publc expendture shown n the Spansh SAM of Urel et al. (2005). Summarzng, our smulaton of the above SMP polces wll be presented n three scenaros: - Scenaro RCB: Change n rent-creatng barrers n SMP sectors (from benchmark to post-drectve tarff equvalents, accordng to Table 1). - Scenaro CCB: Change n cost-creatng barrers n SMP sectors (from benchmark to post-drectve tarff equvalents, accordng to Table 1). 6

- Scenaro PPR: Savngs n publc procurement, wth an exogenous decrease n the prces pad, when purchasng the same physcal amount of goods and servces. 3. 3. Smulaton results The results from the above smulatons on the man macroeconomc varables appear n Table 2. As can be seen, all the three smulated polces lead to sgnfcant ncreases n both Gross Domestc Product (GDP) and welfare (measured as Hcksan equvalent varatons) 1. Snce prces would fall, both the real wage and real captal rental rates would ncrease, lowerng employment and rasng lesure, whch would slghtly ncrease the rate of unemployment. Fnally, both exports and mports would ncrease n the RCB and PPR scenaros, and decrease n the CCB scenaro. Overall, the trade balance would mprove n the three scenaros. Next, we present n tables 3 through 6 the results across sectors for some relevant varables. Regardng prces (Table 3), they would strongly decrease for the SMP sectors (especally Busness servces) n the RCB scenaro, wth small changes n the rest of sectors; smlar but weaker effects would appear n the CCB scenaro. In turn, the PPR scenaro would show small decreases n prces for most sectors, hgher n general for the SMP sectors. The effects on sectoral output are shown n Table 4. In the RCB scenaro, there would appear a fall n output for the SMP sectors (mostly occurrng n Busness servces and, to a lower extent, n Wholesale and retal trade), coupled wth a rase n output n the rest of sectors. On the contrary, the other two scenaros would regster a generalzed ncrease n output for all sectors, wth the only excepton of Agrculture and, especally, Other servces, n the CCB and PPR scenaros, respectvely. Table 5 shows the changes n relatve factor ntensty, as measured by the captal/labour rato. In the RCB scenaro, all sectors would experence an ncrease n ther relatve captal ntensty (wth the only exceptons of Metal and machnery, and Energy and water), an effect that would be stronger n general for the SMP sectors. Conversely, n the CCB scenaro the captal/labour rato would fall n all sectors, except for the large ncrease n Busness servces and, much more slghtly, n Wholesale and retal trade (.e., two of the SMP sectors). In turn, n the PPR scenaro the captal/labour rato would experence a generalzed fall n all sectors. Fnally, accordng to the results n Table 6, fnal consumpton would rase n nearly all sectors, n the RCB and CCB scenaros. However, the stuaton would be very dfferent n the PPR scenaro, wth fnal consumpton experencng sgnfcant decreases n some sectors, n partcular Health, Educaton, Socal work, and Communty servces. In the rest of ths secton we wll sketch the man mechansms drvng the above results. Begnnng wth the RCB scenaro, the decrease n rent-creatng barrers would mean ntally an exogenous relatve decrease n the prces of the goods from SMP 1 Notce that the welfare result for the PPR scenaro should be nterpreted wth cauton, gven that the sze of the publc sector has changed. 7

sectors, so that, ceters parbus, the real rents of the productve factors would also fall. Accordngly, the SMP sectors would reduce ther demand for both labour and captal. Snce these sectors would be relatvely captal-ntensve (see the frst column n Table 5), and captal s fully employed, the rest of sectors would absorb the surplus of the prmary factors, whch would nvolve an ncrease n the relatve prce of labour (.e., a Stolper-Samuelson effect). So, captal would be relatvely cheaper, and most of the sectors would become more captal-ntensve, whch, ceters parbus, would ncrease the output of non-smp sectors and reduce that of SMP sectors. In turn, n the CCB scenaro the decrease n the cost-creatng barrers for the SMP sectors s modelled as an ncrease n labour productvty for these sectors. Ths greater labour productvty n the SMP sectors (n fact, only remarkable n Busness servces and, to a lower extent, n Wholesale and retal trade) represents a labour-savng techncal change, whch would ncrease ther captal/labour rato. Ths effect would lower the relatve prce of labour, so the captal/labour rato of the non-smp sectors would fall. On the other hand, the ncrease n labour productvty n any partcular sector would lead, ceters parbus, to a rse n total labour productvty that would translate nto a based expanson of the fronter of possbltes of producton towards labour-ntensve goods. If the goods relatve prces would reman unchanged, the output of labour-ntensve goods would ncrease, due the Rybczynsk effect. However, as captal becomes relatvely more expensve than labour, captal-ntensve goods would become also relatvely more expensve, so the rse n output would be less based to labour-ntensve goods (.e., those from the non-smp sectors). Lastly, n the PPR scenaro publc expendture would be reduced. Fnal consumpton would fall for some goods closely related to publc sector actvtes (such as Communty, Educaton, Health, and Socal work servces), whch would be reflected n the performance of the related producton sectors. Ths s the case of Other Servces, a sector strongly lnked wth the goods purchased by the publc sector, whch would experence a sgnfcant fall n output. 3. 4. Senstvty analyss To conclude, we present a senstvty analyss of the above results. Accordngly, we focus on the three man assumptons of the model: the matchng unemployment rule, the large open economy assumpton, and ncreasng returns to scale wth a non-compettve prce rule. In partcular, we have tested a perfectly compettve labour market, the small open economy framework has been assumed for all sectors, and the productve sector has been modelled as perfectly compettve wth a producton technology of constant returns to scale. The effects on macroeconomc varables from changes n these three assumptons are shown n Table 7, as scenaros LAB, SOE and CRTS, respectvely 2. Though most of the results would be unchanged, n the LAB scenaro there would be no unemployment, whch gves a hgher rse n welfare. In turn, n the SOE scenaro both exports and mports would show hgher ncreases n the RCB and PPR scenaros; whereas n the case of the CCB scenaro exports would ncrease nstead of decreasng, and the decrease n mports would be hgher. Fnally, the results from the CRTS scenaro do not prove to be too dfferent from those n Table 2, except for mports n the CCB scenaro, whch would be roughly unchanged nstead of decreasng. Therefore, when analyzng the effects on partcular varables from polces such as those ncluded 2 The results n terms of sectoral varables are avalable from the authors upon request. 8

nto the SMP, researchers and polcymakers should be aware of the relevance of some other assumptons, n addton to those drectly related to the foregn sector, such as the modellng of the labour market; the assumpton of mperfect competton, however, does not seem to be so relevant for the fnal results. 4. Conclusons The SMP was launched n the md-1980s n order to elmnate any barrers stll remanng wthn the EU, to the moblty of goods, servces, labour, and captal. However, ten years after ts envsaged completon, several restrctons stll reman, n partcular regardng trade servces lberalzaton and the regulaton of publc procurement. In ths paper we have provded an emprcal assessment of two of the measures proposed n the areas where further advancements n the mplementaton of the SMP are stll needed, namely, easng the provson of domestc and foregn servces, and modfyng the rules of publc procurement, for the case of Span. More specfcally, three alternatve polces have been smulated: n the case of servces, an exogenous fall n the markup over costs (removal of rent-creatng barrers), and an exogenous ncrease n productvty (removal of cost-creatng barrers), for three partcular sectors (whch we termed SMP sectors); and, n the case of publc procurement, an exogenous cut n publc expendture. To ths end, we have bult and smulated a CGE model, whch ncorporates three partcular features: () ncreasng returns to scale and a noncompettve prce rule; () sectoral export demand functons; and () equlbrum unemployment accordng to a matchng functon approach. In any case, our objectve was not tryng to quantfy exactly the effects of these partcular polcy measures on the performance of the Spansh economy, but rather tryng to dentfy the man trends followed by some relevant varables and the major mechansms nfluencng them. In general, the three polcy shocks smulated n the model represented an mprovement n resource allocaton, leadng to sgnfcant ncreases n GDP and aggregate welfare, wth a postve effect on the trade balance. Prces would fall n most sectors, especally n the SMP sectors, so that both the real wage and real captal rental rates would ncrease. However, even though output would rse n most sectors, some of the sectors concerned (such as Busness servces or Other servces) would experence a fall n output n some of the smulatons. In addton, aggregate employment would fall, and lesure would rse, so slghtly ncreasng the rate of unemployment. To conclude, notce that, despte the favourable outcomes of the polcy measures analyzed n ths paper, n terms of lower prces, and hgher GDP and welfare, some negatve effects could appear n those sectors more partcularly concerned, even leadng to harmful consequences n terms of unemployment. Therefore, some accompanyng polces addressed to support those sectors and groups losng from these polces, would be n order. 9

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Table 1. Tarff equvalents for rent- and cost-creatng barrers: Span and EU-25 Busness servces Communcaton servces Wholesale and retal trade Rent-creatng barrers Cost-creatng barrers Domestc frms Foregn frms Domestc frms Benchmark Post- Drectve Benchmark Post- Drectve Benchmark Post- Drectve 7.11 0.2 11.14 0.9 14.48 2.4 (5.5) (0.2) (11.0) (0.7) (9.3) (3.0) 0.21 0.0 0.73 0.1 1.79 1.7 (0.2) (0.0) (0.9) (0.1) (1.3) (1.2) 2.2 0.6 2.0 0.3 1.1 0.4 (2.4) (0.5) (3.1) (0.3) (0.9) (0.3) Source: Copenhagen Economcs (2005). Note: The values for EU-25 are gven n parentheses. Table 2. Smulaton results: Effects on macroeconomc varables (% change from benchmark) Scenaros RCB CCB PPR GDP 1.11 0.41 0.63 Welfare 5.30 4.59 4.90 Real wage rate 1.37 0.23 0.98 Real captal rental rate 1.05 0.70 0.43 Employment -0.20-0.14-0. Unemployment rate 0.07 0.05 0.04 Exports 0.57-0.12 0.22 Imports 0.35-0.20 0.

Table 3. Smulaton results: Effects on prces (% change from benchmark) Scenaros RCB CCB PPR Agrculture 0.59 0.33 0.39 Energy and water 0.19 0.07 0.08 Nonenergy mnerals, chemcals -0.28-0.19-0.08 Metal and machnery -0.19-0.21-0.05 Other manufacturng 0.08-0.01 0.18 Constructon -0.10-0.15-0.05 Wholesale and retal trade -1.35-0.11 0.02 Hotel and restaurant servces 0.46 0.23 0. Communcaton servces 0.07 0.04-0.12 Fnancal ntermedaton servces 0.11-0.06-0.24 Rentng 0.61 0.37-0.01 Busness servces -7.19-3.78-0.10 Other servces 0.43-0.05-0.14 SMP sectors -3.24-1.36-0.17 Non-SMP sectors -0.00 0.14-0.08 Table 4. Smulaton results: Effects on output (% change from benchmark) Scenaros RCB CCB PPR Agrculture -0.06-0.46 0.02 Energy and water 0.22-0.07 0.40 Nonenergy mnerals, chemcals 1.34 0.38 0.51 Metal and machnery 1.85 0.57 1.01 Other manufacturng 0.65 0.10 0.37 Constructon 1.55 0.70 0.66 Wholesale and retal trade -0.81 0.44 0.67 Hotel and restaurant servces 0.43 0. 0.55 Communcaton servces 0.16 0.36 0.59 Fnancal ntermedaton servces 0.00 0.45 0.26 Rentng 0.40 0.26 0.61 Busness servces -7. 2.22 0.37 Other servces 0.05 0.08-2.36 SMP sectors -2.15 0.87 0.56 Non-SMP sectors 0.73 0.25 0.01 14

Table 5. Smulaton results: Effects on the rato captal/labour (Benchmark level and % change from benchmark) Benchmark Scenaros level RCB CCB PPR Agrculture 5.97 0.10-0.29-0.06 Energy and water 3.55-0.02-0.68-0.99 Nonenergy mnerals, chemcals 1.07 0.00-0.69-0.81 Metal and machnery 0.51-0.04-0.69-0.74 Other manufacturng 0.78 0.08-0.69-0.67 Constructon 0.69 0.11-0.77-0.67 Wholesale and retal trade 1.79 0.11 0.01-0.63 Hotel and restaurant servces 2.89 0.14-0.69-0.47 Communcaton servces 1.42 0.04-0.71-0.86 Fnancal ntermedaton servces 1.01 0.02-0.70-0.88 Rentng 25.90 0.08-0.71-0.75 Busness servces 0.60 0.10 11.65-0.78 Other servces 0.24 0.10-0.70-0.63 Table 6. Smulaton results: Effects on fnal consumpton (% change from benchmark) Scenaros RCB CCB PPR Food and non-alcoholc beverages 0.93 0.32 0.65 Tobacco and alcoholc beverages 1.34 0.49 2.58 Clothng and footwear 1.00 0.35 1.00 Housng 0.94 0.33 0.72 Home applances 0.98 0.35 0.91 Health servces 0.19-0.04-2.69 Transport servces 1.09 0.39 1.39 Communcaton servces 1.04 0.37 1.16 Recreatonal, cultural servces 0.97 0.34 0.92 Educaton servces 0.29-0.06-3.16 Hotel and restaurant servces 0.95 0.33 0.75 Other consumpton 0.98 0.34 0.87 Socal work servces 0.42 0.02-2.36 Communty servces 0.12-0.16-4.14 15

Table 7. Senstvty analyss: Effects on macroeconomc varables (% change from benchmark) Scenaros RCB CCB PPR LAB SOE CRTS LAB SOE CRTS LAB SOE CRTS GDP 1.10 1.16 1.08 0.41 0.42 0.40 0.63 0.65 0.62 Welfare 11.19 5.34 5.27 10.49 4.59 4.58 10.79 4.92 4.89 Real wage rate 1.37 1.44 1.33 0.24 0.24 0.22 0.98 1.01 0.97 Real captal rental rate 1.04 1.07 1.04 0.69 0.70 0.67 0.43 0.44 0.41 Employment -0.21-0.20-0.20-0.15-0.14-0. -0. -0.12-0.12 Unemployment rate - 0.07 0.07-0.05 0.04-0.04 0.04 Exports 0.57 1.33 0.57-0.12 0. -0.11 0.22 0.60 0.22 Imports 0.35 0.94 0.36-0.20-0.41 0.00 0. 0.43 0. 16

Appendx. The model As a general rule, the notaton n the model s as follows: endogenous varables are denoted by captal letters, exogenous varables by captal letters wth a bar, and parameters by small Latn and Greek letters. There are (, j = 1,, ) producton sectors, where sectors 2 to 5 are exporters under the large open economy assumpton; and there are 14 (k = 1,, 14) consumpton goods. All endogenous varables, and the exogenous varables and parameters, are lsted n tables A1 and A2, respectvely. The model s equatons are as follows. A. 1. Producton The base model presents ncreasng returns to scale due to some fxed costs, and a noncompettve prcng rule. Gven that the upper nest s a Leontef functon, the zero-proft condton for sector s: PROFIT X = PX ( 1 ot ) RKF + WLF ( )N c 0 PVA c j PO j = 0 ( = 1,, ) X j =1 (A1) where, accordng to the nested structure, the unt cost of the value added composte for sector s a CES functon: PVA = 1 α LK σ a ( 1+ socce + soccw ) 1 σ LK LK W 1 σ + (1 a ) σ LK R 1 σ ( ) LK 1 1 σ LK ( = 1,, ) (A2) We assume that the domestc producers maxmze profts, and choose the optmal mx of domestc producton and mports, and that of domestc sales and exports. Ths leads to the two zero-proft condtons: PROFIT A A σ = PA e PX 1 σ A + (1 e ) σ ( A PFXFC) 1 σ A ( ) PROFIT CET = PA 1 ε d ε PO +1 + (1 d ) ε PFXFC ζ ( ) ε +1 1 A 1 σ = 0 ( = 1,, ) (A3) 1 ε +1 = 0 ( = 1, 6 to ) PROFIT CET = PA 1 ε d ε PO +1 + (1 d ) ε ε PEXP +1 ( ) 1 ε +1 = 0 ( = 2 to 5) ζ (A4) (A4 ) These zero-proft condtons are used to get derved demand functons, by applyng the Shepard s Lemma on cost functons. Next, we ntroduce the correspondng market clearng equatons, wth demands and supples showng n the left-hand and the rght-hand sde, respectvely: X PROFIT X PO j = II j (, j = 1,, ) (A5) N KF + X PROFIT X R = K RC + K G (A6) =1 =1 N LF + X PROFIT W =1 =1 X = ( L Q l )1 ( U) (A7) 17

A A A A PROFIT PX PROFIT FC A A PROFIT CET PO PROFIT CET FC = X = IMP = O = EXP ( = 1,, ) (A8) ( = 1,, ) (A9) ( = 1,, ) (A10) ( = 1, 6 to ) (A11) A PROFIT CET PEXP = EXP ( = 2 to 5) (A11 ) X + IMP = O + EXP ( = 1,, ) (A12) I + II j + CF = O ( = 1,, ) (A) j =1 Fnally, the markup functon s: PX ( 1 + ot ) c 0 PVA c j PO j j =1 MARKUP = PX ( 1+ ot ) ( = 1,, ) (A14) that corresponds to the Lerner ndex: Ω MARKUP = N ELAS ( = 1,, ) (A15) wth: ELAS =σ A σ A 1 ( ) PX X =1 PX X ( = 1,, ) (A16) A. 2. Consumpton The fnal demand functons are derved from the maxmzaton of the representatve consumer s nested welfare functon: 1 τ ( Q ) ( ) sav τ WF = sav c Qsav (A17) subject to the budget constrants: Y RC = W( L Q l )1 ( U)+ RK RC + NTPS (A18) 14 RC Y RC = P sav Q sav + PB k ( 1 + vat k )CFB k k =1 (A19) where the nests n the welfare functon are defned by: Q c = b σcl 1 σ ( Q cg + (1 b) σcl 1 σ Q CL l ) 1 1 σ CL (A20) 14 ( ) τ k RC Q cg = CFB k (A21) k =1 18

The transformaton from producton goods nto consumpton goods follows a fxed coeffcent structure: CFB k = CF 1,..., CF f 1k f k (k = 1,, 14) (A22) and consumpton goods are purchased by the representatve consumer and the publc sector: CFB k = CFB RC G k + CFB k (k = 1,, 14) (A23) The soluton to the maxmzaton problem yelds the demand functons for savngs, lesure, and fnal demand. Fnally, the demand for exports n the large open economy sectors s modelled through a constant-elastcty demand functon such as: EXP = ( PEXP ) µ ( = 2 to 5) (A24) A. 3. Publc sector The ncome of the publc sector s gven by: 14 Y G = RK G + ( SOCCE + SOCCW + OIT ) + VAT k NTPS (A25) =1 where revenues come from several taxes: SOCCE = Wsocce X PROFIT X W SOCCW = Wsoccw X PROFIT X W k =1 ( = 1,, ) (A26) ( = 1,, ) (A27) OIT = PX ot X PROFIT X PX ( = 1,, ) (A28) VAT k = PB k vat k CFB k (k = 1,, 14) (A29) Due to the assumpton of neutralty n the behavour of the publc sector, the macro closure rules are: BALPUB = SAVPUB INVPUB (A30) 14 G CFB k = Y G SAVPUB (A31) k =1 A. 4. Investment, savngs, and foregn sector The macro closure of the model nvolve some other constrants related to nvestment and savngs n the open economy: PO I = PINV INVTOTAL (A32) =1 5 PFX EXP + PEXP EXP FC + PFX EXP 1 PFX IMP = D (A33) = 2 = 6 P sav Q sav + SAVPUB PINV INVTOTAL = D FC = 1 (A34) 19

A. 5. Factor markets To conclude, the equlbrum n the captal market s gven n (A6), and the equlbrum n the labour market n (A7), wth some restrctons related to the matchng unemployment assumptons: 1 W = W 0 (A35) H ( ) H = 1 U =1 =1 X X PROFIT X W PROFIT X W η 0 η1 U U (A36) 20

Table A1. Endogenous varables Symbol Defnton A CF CFB k CFB G k Armngton aggregate (total amount of goods suppled) of sector Fnal domestc consumpton of goods produced by sector Fnal domestc consumpton of good k Fnal publc domestc consumpton of good k RC CFB k Fnal prvate domestc consumpton of good k ELAS Perceved elastcty of demand n sector EXP Exports of sector FC Factor of converson of foregn currency nto domestc currency H Inverse of the premum on the reservaton wage rate I Investment (gross captal formaton) n goods produced by sector II j Intermedate nputs from sector j used by sector IMP Imports from sector IT Revenue from tarffs on mports from sector MARKUP Prce-cost margn n sector N Number of frms n sector O Producton of sector sold n the domestc market OIT Revenue from other ndrect taxes n sector P sav Shadow prce of savngs PA Unt cost of the Armngton aggregate of sector PB k Prce of good k PEXP Unt cost of exports of sector PINV Unt cost of aggregate nvestment PO Unt cost of the producton of sector sold n the domestc market A PROFIT Unt profts for A (accordng to orgn) CET PROFIT Unt profts for A (accordng to destnaton) X PROFIT Unt profts for X PVA Unt cost of the prmary factors used n sector PX Prce of the goods produced by sector Q c Demand for aggregate consumpton Q cg Demand for aggregate consumpton of goods Q l Demand for lesure Q sav Demand for savngs R Captal rental rate SOCCE Revenue from socal contrbutons pad by employers of sector SOCCW Revenue from socal contrbutons pad by employees of sector U Unemployment rate VAT k Revenue from the value added tax on good k W Wage rate W 0 Reservaton wage rate WF Welfare X Producton of sector Dsposable ncome of the representatve consumer Y RC 21

Table A2. Exogenous varables and parameters Symbol Defnton BALPUB D Balance of the publc sector Trade balance surplus INVPUB Investment of the publc sector INVTOTAL Total nvestment of the economy K Captal endowment of the representatve consumer RC K G Captal endowment of the publc sector KF Fxed requrements of captal n sector L Labour endowment LF Fxed requrements of labour n sector NTPS Net transfers from the publc sector to the representatve consumer PFX World prces SAVPUB Savngs of the publc sector U Unemployment rate n the base year X Effectve producton of sector n the base year Y G Income of the publc sector a, b, c 0, c j, d, e, f k Share parameters ot Other ndrect taxes rates, ad valorem, n sector socce Socal contrbutons rates, ad valorem, pad by employers n sector soccw Socal contrbutons rates, ad valorem, pad by employees n sector vat k Value added tax rates, ad valorem, on good k Ω Conjectural varatons parameter n sector α, ζ ε η 0, η 1 Scale parameters Elastcty of transformaton n sector Externaltes n the matchng unemployment rule, from labour demand and unemployment µ Elastcty of the demand for exports n sector Armngton elastcty of substtuton n sector k σ CL σ Elastcty of substtuton between consumpton and lesure LK σ Elastcty of substtuton between labour and captal n sector τ k, sav τ Share parameters 22