Closing the factory doors until better times: CGE modelling of drought using a theory of excess capacity

The aim of this paper is to analyse the regional economic impacts of a prolonged period of recurrent droughts. The model used for analysis is TERM-H2O, a dynamic successor to the bottom-up, comparative static TERM (The Enormous Regional Model). We concentrate on the regions of the southern Murray-Darling basin. Large change simulations are a challenge for modellers. Drought brings substantial inward supply shifts for farm sectors. This paper outlines various theoretical modifications undertaken to improve the modelling of drought in a computable general equilibrium (CGE) framework and then applies them to the period from 2005–06 on. In particular, we apply a theory of sticky capital adjustment to downstream processing sectors, whereby processors temporarily retire capital in response to scarcer farm products, limiting upward price movements in farm outputs and resulting in more realistic modelling of drought. Results are explained using a back-of-the-envelope approach. This framework allows us to estimate the economic impacts of allowing water trade. In addition, the approach provides some estimate as to the impact of prolonged drought on structural change in predominantly rural regions of south-eastern Australia.