We would like to thank Chris Udry and seminar participants at the Korea Institute for International Economic Policy, the ECAAR Congress, Southern California, Stanford, Georgetown, Hawaii, and the Australian National universities for helpful comments on an earlier draft.

Abstract

We construct the Korean Integration Model (KIM), a two-country computable general equilibrium (CGE) model linking the North and South Korean economies. Using KIM, we simulate the impact of a customs union and an exchange rate unification of the two economies both in the presence and absence of cross-border factor mobility, treating technological transfer in three ways. Factor mobility is of critical importance. If factor markets do not integrate, the macroeconomic impact on South Korea of economic integration with the North is relatively small, while the effects on North Korea are large. With a unified exchange rate and factor market integration, there is a significant impact on the South Korean income and wealth distribution. If investment flows from South to North and labor flows from North to South, there is a shift in the South Korean income distribution toward capital, and within labor toward urban high skill labor, suggesting growing income and wealth inequality in the South. Similarly, the specific form of technological transfer is important: if North Korea succeeds in adopting South Korean technology, it experiences a tremendous boost in productivity in the traded goods sector, which tends to increase the magnitude of change in macroeconomic aggregates and distributional shares exhibited by South Korea. If integration is accompanied by large capital inflows, there is a significant appreciation of the real exchange rate with deleterious implications for the South Korean traded-goods sector.

JEL codes: F1, O5, P2 Keywords: Korean unification, North Korea, economic integration

I. Introduction

The worsening economic plight of North Korea has been widely documented.1 In response, the regime has initiated some modest reforms that do not alter the fundamental centrally planned character of the economy, but the policy changes to date are probably inadequate to address the task at hand. In one poll of scholars, 38 percent of the respondents predicted that the current regime would not last a decade (Y.S. Lee, 1995). In a more recent poll, the respondents' mean subjective probability of collapse was 26 percent, while the mean estimate of significant reform was 40 percent (Noland, 1998, Table 1).

One obvious direction of reform would be to marketize the economy and open it to greater interaction to the outside world-including South Korea. Greater North-South economic integration, either in the context of a reform strategy initiated by the North, or in the context of collapse and absorption by the South, potentially could have profound effects on both economies, yet scant effort has been devoted to constructing economic models to analyze this possibility. In this paper we construct the Korean Integration Model (KIM), a two-country computable general equilibrium (CGE) model linking the North and South Korean economies, extending earlier modeling work on the North Korean economy by Noland, Robinson, and Scatasta ((NRS), 1997). That work developed an eight sector, four factor, constant returns to scale CGE model of the North Korean economy. The single-country NRS model was used to examine three issues associated with economic reform: the static gains to trade liberalization, the increase in total factor productivity induced by the importation of capital goods embodying new technologies, and the "obsolescence shock" reduction in the capital stock as a result of the introduction of new goods and significant changes in the structure of relative prices. The model was calibrated to 1990, the last year before North Korea entered a period of severe macroeconomic instability.

The main results obtained by NRS are that (1) the static gains from trade liberalization for North Korea are potentially huge-on the order of 25 to 35 percent of GDP depending on specific assumptions about factor market adjustment; (2) total factor productivity could increase by 18 percent, leading to a roughly 50 percent increase in national income in the complete liberalization scenario; and (3) that North Korea could absorb up to an approximately 50 percent "obsolescence shock" reduction in the capital stock before national income fell under successful economic reform.

Sectoral results reported in that paper indicated that there would be an enormous shift in the composition of output and employment towards the light industry sector (and to a lesser extent mining), while agriculture and the capital goods sector would tend to contract as factors were reallocated in a more economically rational way.

The NRS model was then used to calculate the "cost of unification" defined as the addition to the North Korean capital stock necessary to increase North Korean per capita incomes to 60 percent of those of the South, a target thought adequate to choke off incentives for mass migration.² In 1990 this "cost of unification" was $319 billion, rising to $754 billion in 1995, and $1,721 billion in 2000 as the gap between North and South Korean incomes grew with delay in the initiation of reform.³ In this paper we alter and extend the NRS model to a two-country setting by constructing a similar eight sector, four factor, constant returns to scale model of the South Korean economy and linking it to the North Korean model.⁴ The Korean Integration Model (KIM) is a member of a growing family of trade-focused, multi-country, computable general equilibrium models designed to analyze the impact of trade liberalization and the formation of free trade areas and customs unions. KIM consists of two linked country CGE models, one for North Korea and one for South Korea. The rest of the world is included by means of a simple representation of fixed world prices for North and South Korean exports and imports. The countries are linked by trade flows, and the model solves for all internal prices, including commodity and factor prices, and external prices of all goods traded between the two countries. Domestically produced and traded goods are specified as imperfect substitutes, which provides for a realistic continuum of "tradability" and allows for two-way intersectoral trade.

KIM has a standard neoclassical specification, except that the model incorporates severe quantity controls in exports and imports, with concomitant distortions in domestic product and factor markets. The markets for goods, factors, and foreign exchange are assumed to respond to changing demand and supply conditions, which, in turn, are affected by government policies, the external environment, and other exogenous influences. The model can be considered medium-to-long run in that all factors are assumed to be intersectorally mobile. It is Walrasian in that only relative prices matter. Sectoral product prices, factor prices, and the exchange rate are determined relative to an aggregate consumer price index, which defines the numeraire.⁵

The model allows us to examine three issues of major importance-the mechanism of technological convergence, the macroeconomic impact on the North and South Korean economies of different modes of economic integration, and the impact on the distribution of income in and across the two economies. Using KIM we simulate the impact of a North Korea-South Korea customs union, and an exchange rate unification linking the two economies both in the presence and in the absence of cross-border factor mobility. Our results indicate that this distinction is of critical importance. If factor markets do not integrate, the macroeconomic impact on South Korea of economic integration with the North is relatively small. Far larger macroeconomic results are obtained when we unify the real exchange rates and begin allowing factor market integration. Indeed, factor market integration has a significant impact on the South Korean income and wealth distribution. If investment flows from South to North and labor flows from North to South, there is a shift in the South Korean income distribution toward capital, and within labor toward urban high skill labor, suggesting increased income and wealth inequality in the South. The magnitude of these effects is increased if North Korea adopts South Korean technology. If integration is accompanied by large capital inflows, there is a significant appreciation of the real exchange rate and output falls in the South Korean traded-goods sector.

Given the model's medium-to-long-run orientation, our focus in this paper is primarily of sectoral adjustment issues in the context of a simple macroeconomic framework. For two principal reasons we do not address a number of interesting macroeconomic issues such as exchange rate overshooting which have been prominent in the literature on German unification.⁶ First, the disimilarity of factor endowments is far more pronounced in the Korean case than in the German case (Noland, 1997). As a consequence, integration may have more dramatic sectoral implications in the Korean case compared to the German case. This fact, combined with the far larger differences in economic size between the two Koreas compared to pre-unification Germany, suggests that in certain respects NAFTA may be a closer analogue to the prospective Korean situation than the German experience with unification. KIM is well-suited for examining these integration issues.

Second, history does not operate by analogy: there is no particular reason to believe that adjustment issues that have arisen in the German case which have been at least partly due to avoidable policy mistakes (such as the wage equalization policy) will occur in the prospective Korean case. In point of fact, the Koreans can learn from the German experience and avoid some of the German errors.⁷

To cite a specific example, in contrast to the German wage equalization policy, mainstream Korean analysts expect the maintenance of the existing demilitarized zone to control population movements post-economic integration, and the perpetuation of greatly differing wage structures in the two halves of the peninsula for some extended period of time (cf. Young, Lee, and Zang, 1998). Finally, we should observe that what is modeled in this paper are a customs union and exchange rate unification; these do not require political unification, just economic integration, and on the political issue our paper is agnostic.

II. The Korean Integration Model (KIM)

KIM has eight sectors: agriculture/forest/fisheries, mining, light manufacturing, industrial intermediates, capital goods, construction, public administration, and services. There are three "demanders a single aggregate household which buys consumer goods government spends on and public administration an capital account purchases investment goods. Primary factors of production are agricultural laborhigh-skill urban low-skill labor. Land is not explicitly modeled as separate factor can be considered subsumed in capital. Sectoral production technology is represented by a set of Cobb-Douglas functions of the primary factors, while intermediate inputs are demanded according to Leontief, fixed input-output coefficients.⁸ On the demand side, import demand functions are specified as AIDS (Almost Ideal Demand System)-translog-which allows substitution elasticities to differ between domestic-, Korean partner-, and rest-of-the-world-produced goods.

KIM focuses on real trade flows, relative prices, and the real exchange rate. The aggregate price level in each country is taken as exogenous, and the model does not include money or other assets. The model includes the basic macro aggregates for each country, including the government deficit, the balance of trade, and the savings-investment balance. The balance of trade for each country is fixed exogenously (except when modeling full integration), so the model does not consider any possible macro feedbacks from trade liberalization to changes in international capital flows. The macro "closure" for each country is simple. Government revenue is determined endogenously, given a variety of fixed tax rates, while government expenditure is fixed endogenously. The government deficit is endogenous. Aggregate investment in each country is assumed to be a fixed share of GDP, and aggregate savings is assumed to adjust to equate total savings and investment.

KIM includes quantity rationing of both exports and imports. North Korea is assumed to have levels of "desired" exports and imports that would be typical for a country of its size and per capita income, but that exports and imports are rationed physically, yielding the low levels observed in the base data.⁹ South Korean trade with North Korea is similarly assumed to be rationed in physical terms, and "desired" trade between the two countries is assumed to equal levels that would be predicted from a gravity model. Trade liberalization and integration in the form of a customs union is modeled by removing all quantity rationing and imposing a common external tariff equal to South Korean tariffs.

KIM also includes a facility for modeling exchange rate unification by specifying: (1) a fixed exchange rate between North and South Korea, and (2) a unified, fixed, balance of trade for the two countries together. The result is that, in the various experiments done with this specification, the separate North and South Korean trade balances can vary, but their sum is fixed.

Modeling Quantity Controls in Trade

In the case of North Korea, the major distortion in the economy is assumed to be quantitative controls on both imports and exports. Because of data problems, discussed below, we assume no other sources of price distortions such as sectorally differentiated taxes and subsidies, which we treat explicitly in the case of South Korea. Such sectoral distortions undoubtedly exist in North Korea, but due to the organization of the North Korean economy are effectively impossible to conceptualize much less measure, so we focus only on trade liberalization.¹⁰ Demanders are assumed to treat imports and domestically produced goods as imperfect substitutes (the Armington assumption), and have an AIDS-translog sectoral import demand function that depends on the relative prices of imports and domestically produced goods on the domestic market. These demand functions are parameterized according to the "normal" levels of sectoral imports that one would expect North Korea to have without any rationing, given the results from the gravity model. Then, we assume the difference between desired imports and observed imports is due to the imposition of quantity rationing by the government. That is:

Equation

where M is imports, D is domestic supply, qr is the quantity rationing rate, and the subscript I refers to the sector.¹¹

The model also specifies sectoral export supply functions, where the export supply ratio depends on the ratio of the export price to the price on the domestic market.12 The supply functions are parameterized so that the desired ratio is consistent with the results from the gravity model. Symmetrically with the treatment of imports, quantity controls are specified so that actual exports are less than desired.

The result is that demanders are forced off their import demand curves and producers are forced off their export supply curves.¹³ The distortions are quite large, indicating large potential gains from liberalizing trade and allowing markets to clear. The trade rationing leads to major distortions in the domestic price system as well.

Data

The model utilizes four main databases, macroeconomic and microeconomic Social Accounting Matrices (SAMs) of North and South Korea for 1990, the most recent year for which data were relatively unaffected by the severe macroeconomic shocks that North Korea began to suffer in 1989 (see Appendix 1). In the case of South Korea, construction of the SAMs was straightforward. However in the case of North Korea, the approach we adopted was to draw on a variety of data sources and use a new matrix balancing technique to ensure consistency that uses an approach in the area of maximum entropy econometrics that is essentially Bayesian in that it stays "close" to known controls (or Bayesian prior) while imposing all the consistency requirements of the balanced accounts.¹⁴

Data for the North Korean macroeconomic SAM were primarily derived from North Korean government budget data as reported in Hwang (1993). One assumption made to build the macro SAM is that the North Korean government makes all investments. Government revenues are treated as being derived solely from direct household and enterprise taxes. Indirect taxes, import tariffs, and export tax rates are set to zero. In reality, revenues are raised from a transaction tax which varies depending on the legal status (state-owned, co-op, etc.) of the transacting parties, thus obviating the whole notion of a sectoral tax rate. In the absence of precise information about tax incidence, this was computed on the basis of a number of assumptions: (i) households' marginal propensity to save is between 30 percent and 40 percent; (ii) private savings are seized by the government via a number of instruments which are here summarized as a direct income tax; (iii) data about government current expenditure and investment are assumed to be reliable; (iv) part of capital/land returns are distributed to households, but capital/land income from public enterprises is appropriated by the government in the form of a enterprise tax.

The input-output coefficients are contained in a microeconomic SAM which was derived from a pre-reform (1979) Chinese input-output table compiled by the World Bank. This table was constructed to SNA standards, expanding on the material product accounts (World Bank, 1985). The assumption is that a good starting point (or prior) for inter-industry input-output relations in North Korea is pre-reform China, reflecting their common links to 1970s vintage Soviet manufacturing technology. (This assumption is subsequently relaxed, as explained below.)

Urban workers are divided into high skilled (professional, technical, and managerial) and low skilled (the remainder). The initial starting point for industry employment structure was taken from the Chinese data. The wage premium was calculated on the basis of South Korean data. While one might expect a priori that wage dispersion in the North would be less than in the South, at this level of sectoral aggregation, the skilled wage premium obtained from the South Korean data was within the dispersion observed in fragmentary data on North Korean wages. Sectoral outputs are derived from estimates of North Korean GDP (Noland, 1996) and output shares reported by the Korea Development Bank (1994). When these output shares were applied to the labor data they yielded a rural wage that was too high relative to urban wages. The agricultural sector's share was reduced to about 21 percent of value-added which reduced agricultural wages to a level more consistent with the fragmentary North Korean wage data.¹⁵ A real exchange rate was constructed from the GDP estimates reported in Noland (1996). The real (PPP adjusted) North Korean won-US dollar exchange rate was used to convert export and import data from dollars into won to obtain the domestic resource equivalent of external trade. (The model equations and further description are presented in Appendix 2.)

III. Policy Experiments

Integration is studied under two main scenarios. The formation of a customs union which involves: (a) the elimination of North Korean quantity rationing of trade, (b) the elimination of intra-Korean barriers to trade, and c) the adoption of South Korea tariffs as the common external barrier. In this scenario, there is product, but not factor, market integration between North and South Korea. The second main scenario involves exchange rate unification, fixing the real exchange rate between North and South Korea. Three variants are examined. In the first, capital moves from South to North Korea until North Korean per capita income rises to 60 percent that of the South's. In the second variant, this is achieved by allowing labor to migrate from North to South Korea. In the third variant, the per capita income target is achieved through the movement of both labor and capital. This formulation not only allows us to calculate the macroeconomic impacts of product and factor market integration, but also permits us to calculate income and its distribution with respect to the both the original populations of North and South Korea, and the post factor market integration distribution of population on the Korean peninsula.

A final issue involves the specification of the North Korean economy. As argued in NRS, liberalization of the North Korean economy is likely to involve at least three identifiable effects: static reallocation of factors according to comparative advantage; an increase in total factor productivity (TFP) associated with importation of capital equipment embodying new, superior, technology developed abroad; and an "obsolescence shock" reduction in the value of the existing capital stock.

The Static Reallocation Effect

This is illustrated graphically in Figure 1, which presents a simplified model with an imported good (M), an export (E), and a domestic non-traded good (D). The country produces two goods, D and E, and consumes two goods, D and M. The production possibility frontier is given in quadrant IV (lower right) and the balance-of-trade constraint is given in quadrant I (upper right). The consumption possibility frontier is given in quadrant II (upper left), which indicates supplies to the domestic market of domestically produced goods (D) and imports (M), with M being purchased from export receipts (quadrant I).

Figure 1 shows the movement from rationing equilibrium A to free trade equilibrium B in quadrants II and IV.¹⁶The movement from point A to point B in the fourth (lower right) quadrant changes the structure of production and will yield an increase in real output (GDP) measured in base prices, even though it represents a movement along the same production possibility frontier. In quadrant II, real expenditure (absorption) measured at base prices also increases, as does welfare (measured by the difference between two indifference curves). These three measures all reflect the increase in efficiency arising from the removal of rationing. ¹⁷

Technological Transfer

Recent research suggests that the world is characterized by international technological spillovers. These are quite important in the case of developing countries which benefit from technological innovations abroad primarily transmitted through international trade in capital goods embodying these innovations. In the case of North Korea, the parameters estimated by Coe, Helpman, and Hoffmaister (1996) indicate that complete liberalization would result in a total factor productivity gain of approximately 18 percent.¹⁸ This is depicted in Figure 1 as the movement from the rationing equilibrium A to the free trade equilibrium C on the new, larger, production and consumption possibility frontiers.

However, the specific case in hand may differ fundamentally from the generic phenomenon analyzed by Coe, Helpman, and Hoffmaister. For the purposes of their regression model they classify South Korea as a developing country. Thus no technological spillovers would be attributed to North Korea importing capital goods from the South. Moreover, in the monetary union simulations, we allow cross-border factor flows; in particular, we allow capital to move from South to North Korea. In this case it would be plausible to expect that the North would adopt South Korean technology embodied in the capital. We model this channel of technology transfer in two ways.

In the first approach, the North Korean average level of productivity is assumed to converge to the South's. Operationally, the North's production function shift parameter (its productivity level) increases to the level of the South's. In the second, more sophisticated version, not only does the North attain the South's level of productivity, but it also adopts its technology in the form of the South's input-output coefficients. The rationale behind this approach is that as new plants are built using South Korean capital, and new production technologies are adopted in North Korea, this will be reflected in the allocation of basic inputs and produced intermediates. Thus as South Korean techniques become the norm, the input-output coefficients in the North converge to those of the South. These are presumably optimal given the existing factor prices and distortions in South Korea, so their adoption by North Korea would imply the elimination of non-trade related distortions which we are unable to model explicitly.¹⁹

In the model, the sectoral production technologyIn the model, the sectoral production technology is described by a CES real value-added function of primary inputs (labor and capital) and fixed input-output coefficients, which give the demand for intermediate inputs. In the first step, we assume that North Korea achieves the South's value-added technology (sector by sector). In the second step, we assume that the North also adopts the South Korean input-output coefficients. To allow North and South value-added productivity levels to converge, we first measure the differences in the level of value-added total factor productivity (by sector) in the two countries. The value-added productivity gap is defined as:

where PRODGAPi is the productivity gap in sector I; MRP is the value-added marginal revenue product, which equals

where Xi is the output; FCTR is a primary factor (labor or capital); and PVi is the value-added price of output.

In the first approach, we adjust the sectoral shift parameters in North Korea to reflect capital transfers from the South, with the Northern shift parameter attaining the South Korean value in the final experiment.

While the technology transfer mechanism described above is arguably an improvement over the simple uniform increase in TFP in the particular application at hand, it has some unrealistic features. Although North Korea now possesses the same value-added productivity level as does South Korea, Northern production still embodies an inefficient set of production processes as embodied in its input-output coefficients. In the second step, we also allow the input-output coefficients to converge gradually. This is implemented by computing a linear combination of the North and South Korean input-output coefficients. The only difference here is that the weight or the share of the linear parameter changes in each experiment as capital investment starts to move from the South to the North. So at the last experiment, the weight attached to the South Korean input-output coefficients is one and the weight attached to the North Korean coefficients is zero. Thus, at the end of the simulation, North Korea fully adopts the South Korean input mix. This feature, combined with the North Korea productivity convergence, fully captures the technology spillover effect associated with capital migration. Indeed, in the final experiment, North Korea can be said to have adopted South Korean technology.

These two types of technology transfer are illustrated graphically in Figure 2. Before the cross-border factor flows take place, North and South Korean outputs and technologies are represented by their respective isoquants, Q(NK1) and Q(SK1), and their respective rates of factor substitution, RTSnk1 and RTSsk1. The tangent points, A1 and B1, represent the equilibrium (and optimal) factor usage, given technology and factor prices. As factor flows and technology transfers occur, the North Korean isoquant moves outward to A2 due to the increased capital investment from the South, and the South Korean isoquant moves inward to B2 due to the capital outflow to the North and labor inflow from the North. Although South Korean output declines slightly, the combined output of North and South Korea increases.

Technology transfer is indicated by the convergence of the technical rates of substitution between capital and labor in North Korea (RTSnk2) and South Korea (RTSsk2). The parallel slopes indicates that the North and South are using the same input factor proportions (though at different levels of aggregate factor supplies). If the figure were redrawn, using unit isoquants, the unit isoquants for North and South Korea would converge.

As expected, the overall level of North Korean TFP is considerably below that of the South. Sectoral differences range from no difference in TFP in the case of agriculture (remember the model is calibrated for 1990-probably the peak year of North Korean agricultural output) to more than 300 percent higher TFP in South Korean construction, with TFP differences in the non-agricultural traded goods sectors ranging between 49 percent (industrial intermediates) to 110 percent (light manufacturing). Patterns of intermediate input usage vary significantly across the two economies as well, with North Korea's use of intermediate inputs in its traded-goods sectors higher than South Korea's in most cases, and in some cases significantly so. Wastage of intermediate inputs is typical of centrally planned economies. In summary we have three ways of modeling technological transfer. In the first, North Korea experiences a uniform increase in TFP across sectors. In the second, it experiences a sectorally non-uniform convergence to South Korean productivity levels. In the third it adopts the South Korean pattern of input usage as well as achieving the South Korean level of productivity.

Capital Obsolescence

Finally, an important question involves the value after liberalization of the pre-existing capital stock. There are two points to consider. First, due to the putty-clay nature of technology, the capital stock accumulated under one set of output and factor prices is likely to be sub-optimal for different relative prices. While this is true for all economies, the impact is particularly acute for transition economies, where the relative prices under central planning were wildly at variance with those observed in world markets (and the notion of optimizing choice of technique with respect to factor prices was of questionable relevance). Second, economies sheltered from international trade may manufacture products that are essentially worthless in world markets. (Think of televisions or radios without tuners-both of which are produced in North Korea.) To the extent that capital is product-specific, this capital will be effectively worthless when the economy is opened up to trade.²⁰ Sinn and Sinn (1992) report that one-half to two-thirds of East Germany's capital stock was worthless after unification.²¹ If lack of exposure to international trade is taken as a proxy for internal distortion, the North Korean economy is likely to be even more distorted than the East German economy was. This is depicted as equilibrium D on the new, smaller, production and consumption possibility frontiers.²²

IV. Simulation Results

The key results are that the impact on South Korea of product market integration in the customs union scenario is relatively minor: trade with North Korea simply substitutes for trade with other countries and, given the small size of North Korea relative to South Korea, trade creation and diversion have a trivial impact on South Korea (Tables 1 and 2).²³ With regards to North Korea, the results are similar to those obtained under MFN liberalization as reported by NRS, and are completely dominated by the assumed size of the obsolescence shock.²⁴

The integration of factor markets is a different story, however. With exchange rate unification, it is natural to expect the capital market, if not the labor market, to integrate. For heuristic purposes, however, we initially consider the hypothetical case in which the inter-Korean labor market integrates but the inter-Korean capital market does not (that is to say labor flows from North to South, but capital does not flow the other direction). This could happen if, for example, North Korea suddenly collapsed a la East Germany before political rapprochement and cross-border capital flows had occured. In this case, three-quarters of the population of North Korea would migrate South before the 60 percent per capita income target was attained (Figure 3).²⁵ This extreme result serves to underscore the critical importance of generating capital inflows into North Korea.²⁶

In the more plausible converse case, where capital flows North and North Korea adopts South Korean technology, but labor is not permitted to move South, around $240 billion of capital (11 percent of the South Korean capital stock) would be required to move in order to attain the per capita income target, underlining the implicit trade-off between capital and labor flows as equilibrating adjustment mechanisms (Figure 4).²⁷

Having established the extreme bounds of cross-border factor mobility necessary to achieve the per capita income convergence target, we focus on the intermediate case in which there is a degree of cross-border movement in both labor and capital (Figure 5). Five experiments are run. In EXP1, North Korea experiences income gains from static reallocation of factors and induced total factor productivity increase, but these are not sufficient to maintain income in the face of a two-thirds of the capital stock obsolescence shock. In the succeeding experiments we allow workers to migrate from North Korea to South Korea in increments of three percent of the population (approximately 600,000 people). At the same time we transfer capital from South to North Korea in increments of approximately 30 percent of the North Korean capital stock, or around $60 billion per experiment.

Real GDP rises significantly in North Korea and falls slightly in South Korea in response to these factor movements (Figure 5). Income for the combined Koreas rises as the returns to factors are equalized in the two economies, with combined income exceeding the base by more than twelve percent in experiment 6 (EXP6).

The capital-labor ratio and the returns to labor rise in North Korea, which experiences capital inflow and labor outflow. The opposite is true in South Korea. The rate of return on capital rises in both Koreas, however. (The capital-labor ratio is falling in South Korea. Due to the obsolescence shock, it also falls in North Korea, plus the increase in TFP increases the productivity and returns to all factors, including capital.) In EXP5, where approximately $240 billion of capital flows North, and roughly 1.2 million workers come South, the 60 percent per capita income target is attained. Further increases in capital transfers and labor migration (EXP6) lead to even greater per capita income convergence. As for GDP changes, North Korean GDP increases by nearly half, whereas South Korean GDP declines by less than one percent. Combined GDP increases by more than five percent (Figure 5). These results are reasonably robust to the treatment of technological transfer.

The specific model of technological transfer has a significant effect on the composition of output, as shown in Figure 6.²⁸ As noted earlier, the productivity gap between North and South Korea varies across sectors. Moreover, North Korea's traded-goods production is more intermediate input-intensive than South Korea's. As a consequence, when North Korea adopts South Korean technology and stops wasting inputs, production of traded-goods, especially light manufactures, soars.

The implications for the trade balance are depicted in Figure 7. When North Korea receives the Coe, Helpman, Hoffmaister-derived 18 percent uniform increase in TFP, its trade with the rest of the world (ROW) rises sharply, while South Korean trade with the ROW remains roughly constant. Inter-Korean trade increases enormously with the elimination of inter-Korean trade barriers, with the small North Korean surplus vis-a-vis the South growing to a surplus on the order of one to one and one half billion dollars, across the six experiments. With the aggregate trade balance fixed, the rise in the North Korean deficit is offset by South Korea, which goes from a small deficit to a small surplus with the rest of the world. The unified currency experiences a slight real depreciation.

If North Korea adopts South Korean technology however, its prime sector of comparative advantage, light manufactures, receives a tremendous productivity boost, and North Korea actually generates a surplus with both South Korea and the ROW, forcing South Korea into a significant deficit. When North Korea attains the South Korean TFP level, but not its input usage pattern, the results are more like the simple 18 percent TFP increase case: the North Korean trade deficit increases and South Korea goes from deficit to surplus to offset the larger North Korean deficit with the ROW, with the magnitude of these effects larger than under the first approach. The reason for the significantly different results obtained in the two approaches involving the transfer of South Korean technology is the previously mentioned North Korean wastage of intermediate inputs in traded-goods production. Competitiveness in traded-goods receives a double boost when North Korea attains the South Korean level of productivity and stops wasting produced intermediates.

In the simulations thus far, the process of capital transfer amounts literally to taking capital from the South Korean capital stock and moving it north. It would be desirable to model external capital inflows as well. In the comparative statics set-up, one could model capital inflow as either an exogenous increase in the capital stock (which does not affect the current account balance) or as an exogenous increase in the trade or current account deficit-which does not affect the capital stock. One could think of the latter as representing the moment imported capital goods are purchased, and the former the moment they are installed.

A key issue is how the inflow of foreign capital would affect the real exchange rate. To explore this issue, we took the unified exchange rate and subjected it to a series of trade balance shocks that would leave the measured capital stocks in the two countries unaffected. (These should be thought of as medium-to-long run effects, abstracting from short-run movements in nominal variables that KIM is poorly suited for modeling.) The experiments are summarized in Figure 8, which depicts the response of the real exchange rate to a series of trade balance shocks. In experiment 6, the union's trade deficit is increased by $319 billion and the real exchange rate appreciates by 50 percent. Predictably, the level of output in the South Korean traded-goods sectors falls, while the non-traded goods sectors (construction, public administration, and services) exhibit increases in output.

The model can also be used to examine the impact of factor market integration on the distribution of income-both among income classes, and between capital and labor, both inclusive and exclusive of migrants. For the sake of brevity, we focus exclusively on EXP5, where approximately $240 billion of capital flows from South to North Korea, and around 1.2 million North Korean workers migrate South. In this case, the distribution of income in South Korea shifts away from capital and toward labor when the capital flow is treated as a pure grant and the distribution of income is calculated inclusive of wages earned by immigrants from North Korea (Table 3), regardless of the way technology transfer is modeled. Within labor there is a slight shift concentration of income in the high skilled group.

However, if the capital transfer is treated as investment yielding a stream of remitted profits, the income distribution shifts strongly toward capital and away from labor. This outcome is reinforced if the income distribution is calculated with respect to current residents of South Korea-that is to say if immigrants' wages are excluded from the calculation. In this case there is both a shift in the income distribution toward capital and within labor a shift in the distribution toward the high skilled group. Ownership of capital is presumably concentrated in the high skilled group, which suggests that economic integration along the lines of EXP5 would result in widening income and wealth inequality among current South Koreans.²⁹

V. Conclusion

The Korea Integration Model (KIM) is, to our knowledge, the first behavioral economic model of economic integration between North and South Korea. We have used it to focus on the macroeconomic impact on the two economies of economic integration and the impact of economic integration on the distribution of income. From the standpoint of South Korea the results highlight the critical role of cross-border factor mobility. As shown in Tables 1 and 2, if factor markets do not integrate, the macroeconomic impact of economic integration with the North on South Korea is relatively small, regardless of assumption about the magnitude of the obsolescence shock to the North Korean capital stock. The North Korean economy is small relative to South Korea and inter-Korean trade simply substitutes for trade with third parties. The degree of trade creation and diversion are trivial under a customs union without cross-border factor movements. However, far more significant results are obtained when we create a unified exchange rate and begin allowing factor market integration. As shown in Figures 3 through 5, labor and capital movements are in effect substitutes: enormous movements of labor are required to attain the per capita income convergence target in the absence of capital flows from South to North. Some results depend on the specific modality of technological transfer. Three approaches are modeled: in the first, North Korea experiences a sectorally uniform increase in TFP in response to liberalization and opening. In the second, sectoral TFP levels converge to South Korea's level (implying sectorally non-uniform increases) as a function of capital transfers from South to North. The final approach involves North Korea adopting South Korea's input mix as well as achieving South Korean productivity levels. One implication of the third approach is that North Korea stops wasting produced intermediates and as a consequence gets a big boost in competitiveness in the traded goods sectors. As a consequence the external trade results using in this set-up differ appreciably from those obtained using the other two approaches.

The qualitative effects of cross-border factor mobility are invariant to the approach to modeling technological spillovers. These capital and labor flows have a significant impact on the distribution of income in both economies, which we calculate with respect to both the pre- and post-migration distribution of the population (Table 3). As might be expected, the results depend critically on whether the capital transfer is treated as a grant or as investment yielding remitted profits. In the latter case, the South Korean distribution of income shifts toward capital and away from labor, and within labor toward urban high skill labor.

A final caveat is in order. The model is calibrated for 1990, the most recent year for which the North Korean data are not contaminated by severe macroeconomic shocks. One possibility would be to update the South Korean part of the model using actual data, and the North Korean part of the model using conjectured data. If the model were recalibrated in this way, the amounts of labor and capital that would have to move to attain per capita income convergence would increase. Calculations reported by NRS indicate that on current trends the doubling rate of the divergence between North and South Korean per capita income is roughly every five years, so for example, if the model were recalibrated to 1995, roughly twice as much capital or labor would have to move to achieve the same degree of convergence.

Notes

1. See Noland (1996) for an overview of the North Korean economy and additional references not cited in this paper.

2. This is derived from comparisons of inter-jurisdactional differences in levels of per capita income among South Korean provinces, US states, and members of the EU. It is used in this study to facilitate comparison with previous studies. See Noland (1997) for further discussion and citations.

3. While this is described as the Acost of unification@ in the literature and popular discussion, it is a definition that most economists would find inadequate. See Noland, Robinson, and Liu (1998) for discussion and calculation of more appropriate measures.

4. The KIM model differs from the NRS model in that the North Korean social accounting matrix (SAM) has been recalibrated and specified different substitution and transformation introduced.

5. The exchange rate variable in the model can be seen as a price level deflated (PLD) real exchange rate, deflating by the numeraire cost of living index.

6. There is now a sizable literature on German unification. See Lipschitz and McDonald (1990), Akerlof et al (1991), Sinn and Sinn (1992), Dornbusch and Wolf (1994), Carlin and Meyer (1994), Thimann and Breitner (1995), Hughes Hallett, Ma, and Melitz (1996), Dyck (1997) among others.

7. See Yeon (1994), Flassbeck and Horn (1996), Noland (1997), and Wolf (1998) for analyses of the lessons for Korea from the German experience.

8. In the case of North Korea, aggregate production functions were estimated for aggregate capital and labor using data reported in Hwang (1993) and Y.S. Lee (1994). The results are remarkably robust and plausible given the quality of the underlying data. Constant elasticity of substitution specifications yielded estimates of the substitutability between capital and labor of around unity. The hypothesis that the aggregate production function was Cobb-Douglas could not be rejected. In most specifications, North Korea exhibited slightly negative total factor productivity growth, which is typical of many pre-reform socialist economies.

9. The volume of "desired" trade is obtained through the use of a gravity model of international trade. The sectoral composition of that trade was estimated using detailed sectoral data on North Korean trade, together with the equivalent data from South Korea and Japan-North Korea's principal "natural" trading partners according to the gravity model. See Noland, Robinson, and Scatasta (1997) for details.

10. Sectoral tax rates, for example, are impossible to conceptualize: government revenues are raised through a transaction tax whose rate varies depending on the legal status (state-owned, co-op, etc.) of the transacting parties. Similarly, we implicitly assume that North Korea is on, rather than inside, its production possibility frontier, though as argued below, our method of modeling technological transfer would put them on the frontier whether they started off on it or not.

11. This approach to modeling import rationing was first used by Dervis, de Melo, and Robinson (1982), who discuss the properties of this approach, including questions of incentive compatibility.

12. The sectoral export transformation functions are specified as constant elasticity of transformation (CET) functions.

13. The degree of sectoral quantity rationing is given in Appendix Table 1.

14. The technique we used minimizes the entropy difference between the estimated parameters and the prior and is described in Golan, Judge, and Robinson (1994).

15. This highlights the importance of working within a SAM framework which enables the researcher to detect potential discrepancies between the available data sources and to adjust the data sets in a way which is internally consistent.

16. As drawn, the economy is initially on (rather than inside) the production possibility frontier. As argued below, our method of modeling technological transfer would put them on a new, enhanced PPF regardless of whether they were the starting point was on or inside the original PPF.

17. Empirically, these three measures turn out to assume very similar values.

18. This estimate is derived from a regression model relating total factor productivity to imports of capital goods from developed countries, secondary school enrollments, and interaction terms.

19. One could also rationalize the linkage of capital investment and productivity convergence along the lines of the management perspective of Dyck (1997) who argues that in the German case, replacement of East German managers with West German managers was key to enterprize rehabilitation and viability.

20. This treatment is obviously a stylized one. One way to think of it is that there are goods with positive prices in autarchy and a world price of zero. When the economy is opened up, product specific capital depreciates instantly.

21. This of course depends on both output and factor prices on the one hand, and demand on the other. With respect to the former, Akerlof et al. (1991) argue that given the wage equalization strategy, a wage subsidy could have significantly increased the number of viable enterprizes in East Germany. With respect to the latter, East German consumers were well-acquainted with West German consumer goods at the time of unification, and it has been argued that this familiarity together with consumption transfers caused a temporary shift in preferences away from East German-produced goods. High wages and demand shocks may have contributed to the size of the "obsolescence shock" in the German case.

The particular relevance of these arguments in the Korean case is unclear. There is no reason to believe that under unification the Korean government would follow a policy of income or wage equalization as the Germans did (indeed Young, Lee, and Zang (1998) advocate the opposite) or under unilateral reform by an independent North Korea that the necessary resources for a wage subsidy would be available. Consequently, there is a counter argument that the North Korean capital stock might not decline by as much as the East German case. Three reasons are given. First, there is no reason to expect the Koreans to follow a wage equalization policy as the Germans did in the event of unification. Second, the North Koreans are considerably more isolated than the East Germans and are presumably less familiar with South Korean consumer goods, and may not have access to consumption transfers on the scale the East Germans did. Moreover, it is possible that having observed the German case, in the event of a North Korean collapse, South Korean authorities would restrain their firms from flooding the North Korean market with consumer goods. All of these forces would encourage North Koreans to continue buying home goods, maintaining the value of the North Korean capital stock.

Second, the East Germans lost their major markets in other centrally planned economies, contributing to the decline in the capital stock. It has been asserted that China represents a viable market for cheap, low quality North Korean manufactured goods. If one accepts these arguments, then one should focus on the previously described scenarios in which the value of the North Korean capital stock is implicitly maintained.

22. There is anecdotal evidence that under the pressure of famine, North Korea has been dismantling its capital stock and bartering it with China as scrap in exchange for food.

23. In the interests of parsimony, we report only the experiments in which North Korea undergoes complete liberalization and suffers an "obsolescence shock" reduction of two-thirds of its capital stock (unless otherwise indicated). In the customs union experiments and the monetary union experiments where there is no capital mobility, we apply the uniform 18 percent increase in TFP. In the monetary union scenario where cross-border capital transfers occur, we report the North Korea adopting South Korean technology results unless otherwise noted.

24. The decline in the agricultural wage while urban wages are rising would presumably lead to rural-urban migration. The model was re-run allowing for migration between the rural and low-skill urban labor. In the baseline case in which the large wage relative difference arose in the customs union model with trade liberalization and TFP growth, when migration was permitted, 540,000 workers in North Korea, and 40,000 workers in South Korea left agriculture for the urban sector. In the customs union model with trade liberalization, TFP increase, and two-thirds capital stock reduction, the rural to urban migration figures are 310,000 for North Korea and 61,000 for South Korea. These results are summarized in Table 2. Results reported in the remainder of the paper allow for rural-urban migration.

25. The invocation of collapse raises the issue of adjustment times that given the comparative static framework are not addressed directly in this model. Specification of adjustment dynamics in quite difficult in this case given the sui generis nature of any prospective outcome. Noland, Robinson, and Liu (1998) present what amounts to a temporary equilibrium version of KIM in which adjustment occurs over a decade. The magnitude of factor flows presented in this paper do not appear to be unsustainable over such a period, by implying implausibly large current account deficits, for example.

26. We have assumed that this migration solely takes the form of North Korea-South Korea migration. It is quite possible that in reality there might also be emigration to other destinations, in particular China. If this were the case it would obviously effect the precise calculation of migration necessary to achieve the income convergence target.

27. We have treated the capital movement as a pure grant. It is also possible to calculate the rents and impute them to South Korean national income as remitted profits, as is done in one calculation below.

28. For the sake of brevity, only results from EXP 5 are reported in this section.

29. Noland, Robinson, and Liu (1998) examine the possibility of Pareto-improving redistribution.

30. For a detailed treatment of Social Accounting Matrices see Pyatt and Round (1985), Stone (1986), or Devarajan, Lewis and Robinson (1994).

31. GAMS is designed to make complex mathematical models easier to construct and understand. In our case, we are using it to solve a large, fully-determined, non-linear CGE model (where the number of equations and number of variables are equal), although GAMS is suitable for solving linear, non-linear, or mixed integer programming problems as well. For a thorough intro-duction to model-building in GAMS, see Brooke, Kendrick, and Meeraus (1988).

32. There are a few other syntax rules and conventions that appear in the equations shown below. The "$" introduces a conditional "if" statement in an algebraic statement. For example, PM(i,k,cty1)$imi(i,k,cty1) = xxx will carry out the expression shown for all PM(i,k,cty1) that belong to the set imi(i,k,cty1); in other words, calculate an import price for all sectors in which there are imports.

References

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Table 1: Korean Customs Union

	Trade Liberalization, TFP increase, no obsolescence shock	Trade Liberalization, TFP increase, 2/3 reduction in capital stock

	Percentage changes from base

GDP Growth
South Korea	0.1	-0.1
North Korea	29.3	-32.3
Combined	3.8	-4.1
Agricultural Labor Wage
South Korea	-1.2	-0.6
North Korea	23.1	-29.5
Low-Skill Urban Wage
South Korea	0.5	0.5
North Korea	43.9	-5.6
High-Skill Urban Wage
South Korea	0.5	0.4
North Korea	35.2	-6.1
Rental Rate on Capital
South Korea	0.5	0.3
North Korea	36.6	87.4

Table 2: Korean Customs Union with Rural-Urban Migration

	Trade Liberalization, TFP increase, no obsolescence shock	Trade Liberalization, TFP increase, 2/3 reduction in capital stock

	Percentage changes from base

GDP Growth
South Korea	0.2	0.0
North Korea	29.8	-31.7
Combined	3.9	-4.0
Agricultural Labor Wage
South Korea	0.1	0.2
North Korea	37.5	-12.8
Low-Skill Urban Wage
South Korea	0.1	0.2
North Korea	37.5	-12.8
High-Skill Urban Wage
South Korea	0.6	0.4
North Korea	34.9	-6.6
Rental Rate on Capital
South Korea	0.4	0.3
North Korea	37.0	88.0

Table 3: South Korean Income Distribution

	Percentage Share of National Income
FACTOR	Base	EXP4, capital transfer treated as grant	EXP4, capital transfer treated as remitted profits	EXP4, defined with respect to current residents - capital transfer treated as profits, migrants' wages excluded

Uniform TFP case
Agricultural Labor	2.8	2.9	2.6	2.4
Low Skill Labor	19.4	20.6	17.9	17.1
High Skill Labor	28.5	28.8	25.1	25.4
Capital	49.4	47.6	54.4	55.1
South Korean Technology case
Agricultural Labor	2.8	2.8	2.4	2.3
Low Skill Labor	19.4	20.0	17.2	16.6
High Skill Labor	28.5	29.4	25.3	25.0
Capital	49.4	47.8	55.0	56.1

Appendices

Appendix 1: Social Accounting Matrices

KIM utilizes two main databases for North Korea, a macroeconomic and a microeconomic Social Accounting Matrix (SAM) of North Korea for 1990, which is the most recent year for which data were relatively unaffected by the severe macroeconomic shocks that began in 1989. A Social Accounting Matrix (SAM) is a consistent array of economic transactions among agents that reconciles the input-output and national accounts. Each non-zero cell in the SAM represents the value of an economic transaction between actors. The accounts of the SAM define the transactions and income flows among five basic actors in the economy: producers/enterprises, households, government, capital account and the rest of the world. The input-output notion of inter-industry linkages is generalized to the idea that each actor's purchase is another actor's sale. Any flow of money from one actor to another is recorded in the SAM as a payment by some actor (the column) to some other actor (the row). The SAM also generalizes the national income accounting notion that income equals expenditure. The SAM must in fact be balanced: the total sum of each column must be equal to the total sum of each row, so that a budget constraint is imposed on each productive sector, labor category, household type and so forth. This means that (1) costs (plus distributed earnings) exhaust revenues for products, (2) expenditure (plus taxes and savings) equals income for each agent, and (3) demand equals supply for each commodity.

The SAM is divided into a number of blocs. The Activities bloc describes the .costs and revenues for domestic producers. In the columns the producers buy intermediate inputs, make value added payments to primary factors and transfer indirect, value added and export taxes to (or receive subsidies from) the government. In the rows they sell goods on domestic and foreign markets. The Commodities bloc describes markets for final products. The row describes sales on the domestic market, distinguishing between intermediate, consumption and investment demand. The column identifies absorption, which equals the value of domestic products sold on the domestic markets plus imports (valued at world prices), consumption taxes, value added taxes and tariffs. The Factors bloc describes value added payments to primary factors (in the row) and their distribution to specific institutions (enterprises, households, and government) plus the payment of direct factor taxes (in the column). The remaining blocs describe transfers among institutions.

Appendix 2: Structure of the KIM-CGE Model

Solving the CGE Model

The two-country CGE model presented here has been developed and solved using a package called the General Algebraic Modeling System (or GAMS). To a great extent, the GAMS representation of model equations is easily read as standard algebraic notation. Subscripts indicating countries, sectors, or factors appear in parentheses [Xij becomes X(i,j)], and a few special symbols are used to indicate algebraic operations [ Sigma becomes SUM, becomes PROD]. For example, the Cobb-Douglas consumer price index equation:

Equation

is represented in GAMS as:

Equation

where PROD stands for the product operator , the I at the left of the parenthetic expression is the sectoral index over which summation occurs, and the two asterisks (**) indicate exponentiation.

Table I lists the countrywide, sectoral, and factor classifications used in the model, as well as identifying the sectoral subsets that are needed in the equations of the model. Table II contains the variable definitions used in the CGE model. Table III contains the parameter definitions that appear in the model equations.

Table I: Variables in the KIM-CGE Model

Price block
EXR(k)	Exchange rate
PC(i,k)	Consumption price of composite good
PD(i,k)	Domestic prices
PDA(i,k)	Processors actual domestic sales price including subsidy
PE(i,k,cty1)	Domestic price of exports
PEK(i,k)	Average domestic price of exports
PINDCON(k)	Consumer price index
PM(i,k,cty1)	Domestic price of imports
PQ(i,k)	Price of composite goods
PREM(i,k)	Premium income from import rationing
PVA(i,k)	Value added price including subsidies
PVAB(i,k)	Value added price net of subsidies
PWE(i,cty1,cty2)	World price of exports
PWM(i,cty1,cty2)	World price of imports
PX(i,k)	Average output price
TM2(i,k,cty1)	Import premium rates
Production block
D(i,k)	Domestic sales of domestic output
E(i,cty1,cty2)	Bilateral exports
EK(i,k)	Aggregate sectoral exports
INT(i,k)	Intermediate demand
M(i,cty1,cty2)	Bilateral imports
Q(i,k)	Composite goods supply
SMQ(i,k,cty1)	Import value share in total sectoral Demand
X(i,k)	Domestic output
Factor block
AVWF(iff,k)	Average wage with current weights
FDSC(i,iff,k)	Factor demand by sector
FS(iff,k)	Factor supply
WF(iff,k)	Average factor price
WFDIST(i,iff,k)	Factor differential
YFCTR(iff,k)	Factor income
Migration block
WGDFL(la,k,lb,l)	Wage differentials
MIGL(la,k)	Labor migration flows (within category)
MIGRU(la,k)	Labor migration flows (across category)
Income and expenditure block
CDD(i,k)	Private consumption demand
CONTAX(k)	Consumption taxes
ENTSAV(k)	Enterprise savings
ENTAX(k)	Enterprise taxes
ENTT(k)	Government transfers to enterprises
ESR(k)	Enterprise savings rate
EXPTAX(k)	Export tax revenue
FBAL(k)	Overall current account balance
FBOR(k)	Foreign borrowing by government
FSAV(k,cty1)	Bilateral net foreign savings
FTAX(k)	Factor taxes
GD(i,k)	Government demand by sector
GDPVA(k)	Nominal expenditure GDP
GDTOT(k)	Government real consumption
GOVSAV(k)	Government saving
GOVREV(k)	Government revenue
HHT(k)	Government transfers to households
HSAV(k)	Aggregate household savings
HTAX(k)	Household taxes
ID(i,k)	Investment demand (by sector of origin)
INDTAX(k)	Indirect tax revenue
MPS(hh,k)	Savings propensities by households
REMIT(k)	Remittance income to households
TARIFF(k,cty1)	Tariff revenue
VATAX(k)	Value added taxes
YH(hh,k)	Household income
YINST(ins,k)	Institutional income
ZFIX(k)	Fixed aggregate real investment
ZTOT(k)	Aggregate nominal investment

Table II: Country, Sectoral, and Factor Classifications in the KIM-CGE Model

Countries and regions
CTY1, CTY2	Universe	NK	NORTH KOREA
		SK	SOUTH KOREA
		RT	REST OF THE WORLD

K(CTY1)	Countries	NK	NORTH KOREA
		SK	SOUTH KOREA
Sectors and groupings
I,J	Sectors of production	AGRFSH	AGRICULTURE/FOREST/ FISHERY
		MINING	MINING
		LMANUF	LIGHT MANUFACTURES
		INTERM	INTERMEDIATE GOODS
		KGOODS	CAPITAL GOODS
		CONSTR	CONSTRUCTION
		PUBADM	PUBLIC ADMINISTRATION
		SVC	SERVICES
im(i,k)	Import sectors
imn(i,k)	Non-import sectors
ie(i,k)	Export sectors
ien(i,k)	Non-export sectors
imi(i,k,cty1)	Bilateral imports in base data
iei(i,k,cty1)	Bilateral exports in base data
ie1(i,k)	Aggregate CET export sectors
ied(i,k)	Downward sloping export demand from rest of world
ik(I)	Capital and intermediate goods sectors (INTER, KGOODS)
iag(I)	Agricultural sectors (AGRFSH)
iagn(I)	Non-agricultural sectors
iserv(I)	Service sector (SCV)
Factors and groupings
iff,f	Factors of production	CAPITAL	Capital stock
		AGLAB	Rural agricultural labor
		URBUNSK	Urban unskilled labor
		URBSKLD	Urban skilled labor
Households and institutions
hh	Households	HHALL	Single household category
ins	Institutions	LABR	Labor
		ENT	Enterprises

Table III: Parameters in the KIM-CGE Model

Basic model parameters
CLES(i,hh,k)	Household consumption shares
EB(i,cty1,cty2)	Exports, base data
EKB(i,k)	Total sectoral exports, all destinations, base data
ENTR(k)	Enterprise income tax rate
FS0(iff,k)	Aggregate factor supply, base data
FT(k)	Factor tax rate
GLES(i,k)	Government expenditure shares
GOVGDP(k)	Government expenditure to GDP ratio
HHTR(hh,k)	Household income tax rate
INVGDP(k)	Investment to GDP ratio
IO(i,j,k)	Input-output coefficients
LSH(hh,k)	Household transfer income shares
PVAB0(i,k)	Base-year value added price
PWEB(i,cty1,cty2)	World price of exports, base data
PWM0(i,cty1,cty2)	World market price of imports, base data
PWTC(i,k)	Consumer price index weights (PQ)
RHSH(hh,k)	Household shares of remittance income
SINTYH(hh,ins,k)	Household distribution of value added income
SPREM(i,k)	Share of premium revenue to the government
TC(i,k)	Consumption tax rates
TE(i,k)	Tax rates on exports
THSH(hh,k)	Household transfer income shares
TM(i,k,cty1)	Tariff rates on imports
TX(i,k)	Indirect tax rates
VATR(i,k)	Value added tax rate
ZSHR(i,k)	Investment demand shares
Production and trade function parameters
AD2(i,k)	CES production function shift parameter
AE(i,k)	CET export composition function shift parameter
AT(i,k)	CET function shift parameter
ALPHA2(i,k)	Coefficient in CES production function
GAMMA(i,k,cty1)	CET export composition function share parameters
GAMMAK(i,k)	CET function share parameter
RHOE(i,k)	CET export composition function exponent
RHOT(i,k)	CET function exponent
Parameters for AIDS import demand functions
SMQ0(i,k,cty1)	Base year import value share
AQS(i,k)	Constant in Stone price index
AMQ(i,k,cty1)	Share parameter in AIDS function
AQ(i,k)	Constant in translog price index
BETAQ(i,k,cty1)	Coefficient in AIDS function
GAMMAQ(i,k,cty1,cty2)	Price parameter in AIDS function

Table IV: Quantity Equations

(1) X(i,k)	= AD2(i,k)( SUM(iff$FDSC0(i,iff,k), ALPHA2(i,iff,k)FDSC(i,iff,k)(-RHOP(i,k))) )(-1/RHOP(i,k)) ;
(2) (1-ft(k))WF(iff,k)WFDIST(i,iff,k)	= SCALE(i,k)(1 - vatr(i,k))pva(i,k)AD2(i,k)( SUM(f$FDSC0(i,f,k), ALPHA2(i,f,k)FDSC(i,f,k) (-RHOP(i,k))) )((-1/RHOP(i,k)) - 1)ALPHA2(i,iff,k)FDSC(i,iff,k)*(-RHOP(i,k)-1);
(3) INT(i,k)	= SUM(j, IO(i,j,k)*X(j,k));

Model Specification

In addition to eight sectors for each country model, the model has four factors of production (agriculture labor, unskilled urban labor, skilled urban labor, and capital), as identified in Table I. The output-supply and input-demand equations are shown in Table IV. Output is produced according to a CES function of the primary factors (equation 1), with intermediate inputs demanded in fixed proportions (equation 3). Producers are assumed to maximize profits, implying that each factor is demanded so that marginal product equals marginal cost (equation 2). In each economy, factors are not assumed to receive a uniform wage or "rental" (in the case of capital) across sectors; "factor market distortion" parameters (the WFDIST that appears in equation 2) are imposed that fix the ratio of the sectoral return to a factor relative to the economywide average return for that factor.

Table V: Price Equations

(4) PM(imi,k,cty1)	= PWM(imi,k,cty1)EXR(k) (1 + TM(imi,k,cty1) + tm2(imi,k,cty1) ) ;
(5) PE(iei,k,cty1)	= PWE(iei,k,cty1) * (1 - te(iei,k))*EXR(k) ;
(6) PEK(ie,k)	= SUM(cty1$pt(k,cty1), PE(i,k,cty1) * E(i,k,cty1) ) / EK(i,k) ;
(7) PDA(i,k)	= (1 - TX(i,k)) * PD(i,k) ;
(8) PQ(i,k)*Q(i,k)	= PD(i,k)D(i,k) + SUM(cty1$imi(i,k,cty1), (PM(i,k,cty1)M(i,k,cty1))) ;
(9) PX(i,k)*X(i,k)	= PDA(i,k)D(i,k) + SUM(cty1$iei(i,k,cty1), (PE(i,k,cty1)E(i,k,cty1))) ;
(10) PC(i,k)	= PQ(i,k) * (1 + TC(i,k)) ;
(11) PINDCON(k)	= PROD(i, PC(i,k)**pwtc(i,k)) ;
(12) PVA(i,k)	= PX(i,k) - SUM(j,IO(j,i,k)*PC(j,k)) ;
(13) PWE(i,cty1,cty2)	= PWM(i,cty2,cty1) ;

The price equations are shown in Table V. In equations 4 and 5, world prices are converted into domestic currency, including any tax or tariff components. Equation 13 guarantees cross-trade price consistency, so that the world price of country A's exports to country B are the same as the world price of country B's imports from country A. Equation 6 defines the aggregate export price as the weighted sum of the export price to each destination. Equation 7 calculates the domestic price, net of indirect tax. Equations 8 and 9 describe the prices for the composite commodities Q and X. Q represents the aggregation of sectoral imports (M) and domestic goods supplied to the domestic market (D). X is total sectoral output, which is a CET aggregation of total supply to export markets (E) and goods sold on the domestic market (D). Equation 10 defines the consumption price of composite goods from the composite good price (PQ) and consumption taxes (tc). Equation 12 defines the sectoral price of value added, or "net" price (PVA), as the output price minus the unit cost of intermediate inputs (from the input-output coefficients).

In the KIM-CGE model, the aggregate consumer price index in each region is set exogenously (PINDCON in equation 11), defining the numeraire. The advantage of this choice is that solution wages and incomes are in real terms; moreover, since our Cobb-Douglas price index is consistent with the underlying Cobb-Douglas utility function, the changes in consumption levels generated by the model are exactly equal to the equivalent variation. The solution exchange rates in the sub-regions are also in real terms, and can be seen as equilibrium price-level-deflated (PLD) exchange rates, using the country consumer price indices as deflators. The exchange rate for the rest of the world is fixed, thereby defining the international numeraire.

Table VI: Income and Expenditure Equations

(14) YFCTR(iff,k)	= SUM(i, (1-ft(k))WF(iff,k)WFDIST(i,iff,k)*FDSC(i,iff,k));
(15) TARIFF(k,cty1)	= SUM(i$imi(i,k,cty1), TM(i,k,cty1)M(i,k,cty1)PWM(i,k,cty1))*EXR(k) ;
(16) PREM(i,k)	= SUM(cty1$imi(i,k,cty1), TM2(i,k,cty1)M(i,k,cty1)PWM(i,k,cty1))*EXR(k) ;
(17) INDTAX(k)	= SUM(i, TX(i,k)PD(i,k)D(i,k)) ;
(18) EXPTAX(k)	= SUM((i,cty1), te(i,k)PWE(i,k,cty1)E(i,k,cty1)*EXR(k)) ;
(19) YINST("labr",k)	= SUM(la, YFCTR(la,k)) ;
(20) YINST("ent",k)	= YFCTR("capital",k) + EXR(k)FKAP(k) - ENTSAV(k) - ENTAX(k) + ENTT(k) + SUM(i,(1-sprem(i,k))PREM(i,k)) ;
(21) YINST("prop",k)	= YFCTR("land",k) ;
(22) YH(hh,k)	= SUM(ins, sintyh(hh,ins,k)YINST(ins,k)) + rhsh(hh,k)EXR(k)REMIT(k) + HHT(k)thsh(hh,k) ;
(23) ENTAX(k)	= ENTR(k)*(YFCTR("capital",k) + ENTT(k)) ;
(24) FTAX(k)	= SUM((iff,i), ft(k)WF(iff,k)WFDIST(i,iff,k)*FDSC(i,iff,k));
(25) HTAX(k)	= SUM(hh, hhtr(hh,k)*YH(hh,k)) ;
(26) VATAX(k)	= SUM(i, vatr(i,k)PVA(i,k)X(i,k)) ;
(27) CONTAX(k)	= SUM(i, TC(i,k)PQ(i,k)Q(i,k)) ;
(28) GOVREV(k)	= SUM(cty1, TARIFF(k,cty1)) + INDTAX(k) + EXPTAX(k) + FTAX(k) + HTAX(k) + CONTAX(k) + SUM(i,sprem(i,k)PREM(i,k)) + ENTAX(k) + VATAX(k) + FBOR(k)EXR(k);
(29) GOVSAV(k)	= GOVREV(k) - SUM(i, GD(i,k)*PC(i,k)) - HHT(k) - ENTT(k) ;
(30) HSAV(k)	= SUM(hh, MPS(hh,k)* ((1.0-hhtr(hh,k))*YH(hh,k)));
(31) ENTSAV(k)	= esr(k)*YFCTR("capital",k) ;
(32) ZTOT(k)	= GOVSAV(k) + HSAV(k) + ENTSAV(k) + EXR(k) * FSAVE(k);
(33) FSAVE(k)	= FBAL(k)-FBOR(k)-REMIT(k) ;
(34) CDD(i,k)	= SUM(hh, CLES(i,hh,k)YH(hh,k)(1.0-hhtr(hh,k))*(1.0-mps(hh,k))) / PC(i,k) ;
(35) GD(i,k)	= gles(i,k)*GDTOT(k) ;
(36) ID(i,k)	= zshr(i,k)*ZFIX(k) ;
(37) ZTOT(k)	= SUM(i, PC(i,k)*ID(i,k)) ;
(38) GOVGDP(k)	= SUM(i, pc(i,k)*gd(i,k)) / gdpva(k) ;
(39) INVGDP(k)	= SUM(i, pc(i,k)*id(i,k)) / gdpva(k) ;
(40) GDPVA(k)	= SUM(i, PC(i,k)* (CDD(i,k)+GD(i,k)+ID(i,k))) + SUM((i,cty1), PWE(i,k,cty1) * E(i,k,cty1))EXR(k) - SUM((i,cty1), PWM(i,k,cty1) M(i,k,cty1))*EXR(k) ;

The circular flow of income from producers, through factor payments, to households, government, and investors, and finally back to demand for goods in product markets is shown in the equations in Table VI. The country models incorporate official tariff revenue (TARIFF in equation 15) which flows to the government, and the tariff equivalent of non-tariff barriers (PREM in equation 16) which accrues as rents to the private sector. Each economy is modelled as having a number of domestic market distortions, including sectorally differentiated indirect, consumption, and value-added taxes as well as factor, household, and corporate income taxes (equations 17-18 and 23-27). The single household category in each economy has a Cobb-Douglas expenditure function (equation 34). Real investment and government consumption are set in equations 35 and 36, while aggregate government consumption and investment are set to fixed shares of GDP in equations 38 and 39.

Table VII: Export Equations

(41) X(ie1,k)	= AT(ie1,k)(GAMMAK(ie1,k)EK(ie1,k)*(-RHOT(ie1,k)) + (1 - GAMMAK(ie1,k))D(ie1,k)(-RHOT(ie1,k)))(-1/RHOT(ie1,k)) ;
(42) X(ien,k)	= D(ien,k) ;
(43) EK(ie1,k)	= D(ie1,k)(PDA(ie1,k)/PEK(ie1,k)GAMMAK(ie1,k)/(1-GAMMAK(ie1,k))) **(1/(1+RHOT(ie1,k)));
(44) E(iec,k,cty1)	= EK(iec,k) * (((gamma(iec,k,cty1)PEK(iec,k)) / (ae(iec,k)rhoe(iec,k) pe(iec,k,cty1))) **(1/(1+rhoe(iec,k)))) ;
(45) M(i,cty1,cty2)	= E(i,cty2,cty1) ;
(46) EKPTL(k)	= SUM((cty1,i), PWE(i,k,cty1)*E(i,k,cty1)) ;
(47) MKPTL(k)	= SUM((cty1,ik), PWM0(ik,k,cty1)*M(ik,k,cty1)) ;

Export-related functions are shown in Table VII. Exports are supplied according to a CET function between domestic sales and total exports (equation 41), and allocation between export and domestic markets occurs in order to maximize revenue from total sales (equation 43). The rest of the world is modeled as a large supplier of imports to each country at fixed world prices. Rest of world demand for the North and South Korean exports is modelled as occurring at fixed world prices. The world prices for North and South Korea are assumed to be exogenous, a typical small country assumption.

Table VIII: AIDS Import Demand Equations

(48) PM(i,k,k)	= PD(i,k) ;
(49) LOG(PQ(i,k))	= LOG(AQS(i,k)) + SUM(cty2, SMQ0(i,k,cty2)*LOG(PM(i,k,cty2))) ;
(50) SMQ(imi,k,cty1)	= AMQ(imi,k,cty1)+BETAQ(imi,k,cty1)LOG(Q(imi,k)) + SUM(cty2,GAMMAQ(imi,k,cty1,cty2)LOG(PM(imi,k,cty2))) ;
(51) SMQ(i,k,k)	= 1 - SUM(cty1, SMQ(i,k,cty1)) ;
(52) M(i,k,cty1)	= smq(i,k,cty1)PQ(i,k)Q(i,k) / PM(i,k,cty1) ;
(53) PD(i,k) * D(i,k)	= SMQ(i,k,k) * Q(i,k)*PQ(i,k) ;

The specification of the almost ideal demand system (or AIDS) for imports is shown in Table VIII. The expenditure shares SMQ are given by equation 50, where subscript imi refers to sectors, subscript k refers to the importing country, and subscript cty1 refers to the source of the imports (another region or the rest of the world). We adopt the notation convention that when k = cty1, we are describing the domestic component of composite demand (D). Hence in equation 48 the "own" price of imports is simply the domestic price, and in equation 53, D is determined by the SMQi,k,k share, while the import demands are determined in equation 52. The composite price index, PQ, is defined in equation 49 as a Stone price index [Deaton and Muellbauer (1980)].

Table IX: Migration Relations

(54) (AVWF(la,k)/EXR(k))	= wgdfl(la,k,la,l)*(AVWF(la,l)/EXR(l)) ;
(55) FS(i,k)	= FS0(la,k) + MIGL(la,k) + MIGRU(la,k) ;
(56) SUM(k, MIGL(la,k))	= 0 ;
(57) SUM(la, MIGRU(la,k))	= 0 ;

Table IX outlines the labor and capital migration relations in the model (which are in the simulations reported in this paper), Cross-border capital and labor flows in this paper are determined by the per capita GDP differentials between North and South Korea. The 60 percent per capita income differential is used as the criteria to decide how much capital from South Korea and how many people from North Korea need to be moved in opposite direction across the border. Internal migration in each country maintains a specified ratio of average real wages between the rural and unskilled urban markets (the EXR terms become irrelevant). Domestic labor and capital supply in each country is then adjusted by the capital and labor movements (equation 55), while the other two equations insure that workers do not "disappear" or get "created" in the migration process.

Table X: Market-Clearing Equations

(58) Q(i,k)	= INT(i,k) + CDD(i,k) + GD(i,k) + ID(i,k) ;
(59) FS(iff,k)	= SUM(i, FDSC(i,iff,k)) ;
(60) AVWF(iff,k)	= SUM(i, (1- ft(k))wfdist(i,iff,k)wf(iff,k)*fdsc(i,iff,k))/SUM(j, fdsc(j,iff,k)) ;
(61) FSAV(k,cty1)	= SUM(i, PWM(i,k,cty1)M(i,k,cty1)) - SUM(i, PWE(i,k,cty1)E(i,k,cty1)) ;
(62) FBAL(k)	= SUM(cty1, FSAV(k,cty1)) ;

To complete the model, there are a number of additional "market-clearing" or equilibrium conditions that must be satisfied, as shown in Table X. Equation 58 is the material balance equation for each sector, requiring that total composite supply (Q) equal the sum of composite demands. Equation 59 provides equilibrium in each factor market; Equation 61 is the balance condition in the foreign exchange market, requiring that import expenditures equal the sum of export earnings and net foreign capital inflows; equation 62 is the overall trade balance equation, summing up the bilateral trade balances.

Model Closure

The KIM model permits a number of different "closure" choices that affect the macroeconomic relationships in the model. In all simulations reported in this paper, we have assumed that the aggregate trade balance (FBAL) is fixed for both countries, and that the exchange rate (EXR) varies to achieve external balance in the customs union part of model. However, in monetary union part of model, the exchange rate is fixed between the North and South and in addition, the balance of trade for the two countries are also fixed and unified. The separate North and South Korean trade balances can vary, though their sum is fixed. Government revenue is determined endogenously, given a variety of fixed tax rates, while government expenditure is fixed exogenously. Aggregate investment in each country is assumed to be a fixed share of GDP, and aggregate saving is assumed to adjust to equate total savings and investment.

Appendix Table 1 (a): Import Rationing Ratios (Actual over Desired)

Sector	North Korea	South Korea	Rest of the World
AGRFSH(NK)	1.000	0.899	0.036
AGRFSH(SK)	0.566	1.000	1.000
MINING(NK)	1.000	0.245	0.368
MINING(SK)	0.050	1.000	1.024
LMANUF(NK)	1.000	0.072	0.353
LMANUF(SK)	0.010	1.000	1.488
INTERM(NK)	1.000	0.075	0.942
INTERM(SK)	0.289	1.000	1.004
KGOODS(NK)	1.000	0.020	0.312
KGOODS(SK)	0.717	1.000	1.000
CONSTR(NK)	1.000	1.000	1.000
CONSTR(SK)	1.000	1.000	1.000
PUBADM(NK)	1.000	1.000	1.000
PUBADM(SK)	1.000	1.000	1.000
SVC(NK)	1.000	0.024	0.619
SVC(SK)	0.023	1.000	1.006

Note: Sectors with NK or SK in parentheses indicate the rates of import rationing imposed with respect to themselves and their respective foreign sectors. For example, the row of AGRFSH(NK) shows that the rationing parameters imposed on the same sector in South Korea and the rest of the world are .899 and .036, respectively. If the rationing parameter is less than one, quantity restriction takes place. If the ration parameter is equal to one, there is no rationing. If the rationing parameter is greater than one, import quantity diversion takes place. As in the case of LMANUF(SK), the light manufacturing sector in South Korea imports too much from the rest of the world and not enough from North Korea. The smaller the ratio, the larger the distortion.

Appendix Table 1 (b): Export Rationing Ratios (Actual over Desired)

Sector	North Korea	South Korea	Rest of the World
AGRFSH(NK)	1.000	0.566	5.094
AGRFSH(SK)	0.899	1.000	0.924
MINING(NK)	1.000	0.050	0.314
MINING(SK)	0.245	1.000	1.106
LMANUF(NK)	1.000	0.010	0.071
LMANUF(SK)	0.072	1.000	1.197
INTERM(NK)	1.000	0.289	1.401
INTERM(SK)	0.075	1.000	0.991
KGOODS(NK)	1.000	0.717	2.581
KGOODS(SK)	0.020	1.000	0.997
CONSTR(NK)	1.000	1.000	1.000
CONSTR(SK)	1.000	1.000	1.000
PUBADM(NK)	1.000	1.000	1.000
PUBADM(SK)	1.000	1.000	1.000
SVC(NK)	1.000	0.023	0.204
SVC(SK)	0.036	1.000	1.002

Note: Sectors with NK or SK in parentheses indicate the rates of export rationing imposed with respect to themselves and their respective foreign sectors. For example, the row of AGRFSH(NK) shows that the rationing parameters imposed on the same sector in South Korea and the rest of the world are .566 and 5.094 respectively. If the rationing parameter is less than one, quantity restriction takes place. If the ration parameter is equal to one, there is no rationing. If the rationing parameter is greater than one, export quantity diversion takes place. As indicated in the example, the agriculture sector in North Korea exports too much to the rest of the world and not enough to South Korea.

Appendix Table 2: Elasticities

	SK	SK	ROW	ROW
Sector	Import Substitution	Export Transformation	Import Substitution	Export Transformation

AGRFSH(NK)	2.0	2.0	2.0	2.0
MINING(NK)	1.0	2.0	1.0	2.0
LMANUF(NK)	4.0	2.0	4.0	2.0
INTERM(NK)	2.0	2.0	2.0	2.0
KGOODS(NK)	2.0	2.0	2.0	2.0
CONSTR(NK)	0.6	2.0	0.6	2.0
PUBADM(NK)	0.6	2.0	0.6	2.0
SVC(NK)	1.4	2.0	1.4	2.0

	NK	NK	ROW	ROW
Sector	Import Substitution	Export Transformation	Import Substitution	Export Transformation

AGRFSH(SK)	2.0	2.0	2.0	2.0
MINING(SK)	1.0	2.0	1.0	2.0
LMANUF(SK)	4.0	2.0	2.0	2.0
INTERM(SK)	2.0	2.0	2.0	2.0
KGOODS(SK)	2.0	2.0	2.0	2.0
CONSTR(SK)	0.6	2.0	0.6	2.0
PUBADM(SK)	0.6	2.0	0.6	2.0
SVC(SK)	1.4	2.0	1.4	1.4

Note: Sectors with NK and SK in parentheses indicate the substitution and transformation elasticities used in these sectors against their respective partners. For example, the row of AGRFSH(NK) shows that North Korean agriculture sector's elasticities of import substitution and export transformation with respect to goods from the same sector of South Korea and the rest of the world are 2.

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Full Name Li-Gang Liu

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Full Name Marcus Noland

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Full Name Sherman Robinson

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More on This Topic

Korean Preparation for National Unification

Going Beyond Economic Engagement: Why South Korea Should Press the North on Labor Standards and Practices

The Microeconomics of North-South Korean Cross-Border Integration

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Sherman Robinson