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 prolongedperiod of recurrent droughts. The model used for analysis is TERM-H2O, a dynamicsuccessor to the bottom-up, comparative static TERM (The Enormous RegionalModel). We concentrate on the regions of the southern Murray-Darling basin.Large change simulations are a challenge for modellers. Drought brings substantialinward supply shifts for farm sectors. This paper outlines various theoreticalmodifications undertaken to improve the modelling of drought in a computablegeneral equilibrium (CGE) framework and then applies them to the period from2005–06 on. In particular, we apply a theory of sticky capital adjustment todownstream processing sectors, whereby processors temporarily retire capital inresponse to scarcer farm products, limiting upward price movements in farm outputsand resulting in more realistic modelling of drought.Results are explained using a back-of-the-envelope approach. This framework allowsus to estimate the economic impacts of allowing water trade. In addition, the approachprovides some estimate as to the impact of prolonged drought on structural change inpredominantly rural regions of south-eastern Australia.