The approach of this paper is based on ex-ante macro-micro simulation methodologies developed in the recent literature: Bourguignon, Bussolo and Pereira da Silva (2008) describe its advantages and drawbacks. Variants of this methodology have been used in various case studies, including Bourguignon and Pereira da Silva (2003), Ferreira and Leite (2003), Chen and Ravallion (2004), and Bussolo, Lay, and van der Mensbrugghe (2008). ehe present paper belongs to the long literature on welfare effects of large infrastructure projects. Exploiting the fact that river gradient affects a district‘s suitability of dam construction, Duflo and Pande (2007) find that such infrastructure projects in India increase agricultural productivity in villages located downstream from the dam. Using a difference-in-difference approach, Lokshin and Yemtsov (2005) find that improvements in school and road infrastructure increase welfare among the poor in Georgia. Using a variety of GMM estimators on a panel data including over 100 countries covering the period 1960-2000, Serven and Calderon (2004) show that infrastructure development can be highly effective for poverty alleviation. Our approach differs from existing papers in two important ways: (1) the CGE-microsimulation model developed here allows capturing the economy-wide effects of the Canal expansion without losing the heterogeneous impacts on different households; (2) based on stylized facts, we assume that the Canal is a separate sector with only marginal linkages with the rest of the Panamanian economy, hence having marginal, if any, effects on total factor productivity.

# **_3.1. Macro framework_**

The CGE model used in this paper is the World Bank's prototype single-country model.<sup>4</sup> Production takes place under perfect competition and constant returns to scale, and is modeled in a nested constant elasticity of substitution (CES) fashion to reflect various substitution possibilities across inputs (see Figure 2). While the production nesting for the canal sector is similar to other activities, we assume that the canal uses a Leontief technology and employs a canal-specific capital stock. All labor and capital income accrues to the households, with the exception of capital income from publiclyowned enterprises (e.g., the canal sector).

The model differentiates between formal and informal production activities, with the latter having no access to financial markets or public services. The output of these activities is transformed into consumed commodities by means of a transition matrix, which takes into account the fact that multiple activities can produce the same commodity (e.g., construction services can be provided by both the formal and informal sectors) and that multiple commodities can be the output of a single activity (see Annex 4 for a full listing of commodities and activities in the model). Household demand is allocated across commodities according to the linear expenditure system (LES), in which consumers maximize a Stone-Geary utility function subject to the disposable income constraint.<sup>5</sup> Other final demand agents—government and investment—use the CES expenditure system.

> 4 See Annex 4 for model equations. Detailed model documentation and the user‘s guide are available in van der Mensbrugghe (2005b) and van der Mensbrugghe (2005a), respectively.

> 5 See Deaton and Muellbauer (1980, Chapter 3) for a detailed discussion of the LES demand system, and Stone (1954) for the Stone-Geary utility function.

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