Appendix: The ICES model
As in all CGE models, ICES (Eboli et al. 2010) makes use of the Walrasian perfect competition paradigm to simulate market adjustment processes, although the inclusion of some elements of imperfect competition is also possible. Industries are modeled through a representative firm, minimizing costs while taking prices as given. In turn, output prices are given by average production costs. The production functions are specified via a series of nested CES functions. Domestic and foreign inputs are not perfect substitutes, according to the so-called “Armington” assumption (Fig. 12).
A representative consumer in each region receives income, defined as the service value of national primary factors (natural resources, land, labor, capital). Capital and labor are perfectly mobile domestically, but immobile internationally. Land and natural resources, on the other hand, are industry-specific. This income is used to finance three classes of expenditure: aggregate household consumption, public consumption, and savings. The expenditure shares are generally fixed, which amounts to saying that the top-level utility function has a Cobb-Douglas specification.
Public consumption is split in a series of alternative consumption items, again according to a Cobb-Douglas specification. However, almost all expenditure is actually concentrated in one specific industry: non-market services.
Private consumption is analogously split in a series of alternative composite Armington aggregates. However, the functional specification used at this level is the constant difference in elasticities form: a non-homothetic function, which is used to account for possible differences in income elasticities for the various consumption goods (Fig. 13).
Investment is internationally mobile: savings from all regions are pooled and then investment is allocated to achieve equality of expected rates of return to capital. In this way, savings and investments are equalized at the world, but not at the regional level. Because of accounting identities, any financial imbalance mirrors a trade deficit or surplus in each region.
The recursive-dynamic engine for the model can replicate dynamic economic growths based on endogenous investment decisions. As standard in the CGE literature the dynamic is recursive. It consists of a sequence of static equilibria (one for each simulation period which in the present exercise is the year) linked by the process of capital accumulation. As investment decisions, which build regional capital stocks are taken 1 year to the other, i.e. not taking into account the whole simulation period, the planning procedure is “myopic”. Two factors endogenously drive investment and its international allocation—the equalization of the expected rate of return to capital and the international GDP differentials. In other words, a country can attract more investment and increase the rate of growth of its capital stock when its GDP and its rate of return to capital are relatively higher than those of its competitors.