Master Économie et Affaires Internationales Paris Dauphine -October 2007 Dr. Ramón Mahía Professor of Applied Economics Department 20 KEYS TO BETTER SIMULATING

STRUCTURE OF DOCUMENT AND EXPOSITION Not a technical document  Our experience in credible simulation for complex systems in the real world  Text focused on know-how to do useful real simulations rather than technical skills  Simulation as a way of using econometrics in a useful way with analytical restrictions

20 KEYS TO BETTER SIMULATING STRUCTURE OF DOCUMENT AND EXPOSITION  I. What does Simulation mean?  Concept  Simulation Vs other topics  Some Simulation “last-names”  II. Basic elements of a Simulation Model  III. 20 Keys for an Efficient Simulation

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  “To represent something, feigning or imitating what it is not”  Simplified representation of a real complex system useful for:  Understanding the working of a real system  Experimenting with, for evaluating different strategies to be developed on it.

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? Real System: A lot of elements inter-related Simulated System: Few elements and selected relations

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? Arrival of powerful computers and flexible programming systems = generalized use of simulation Modeler Use of complex techniques User Use of simple interfaces

Simulation with a model is a wide spread exercise: Macro economic relations: trade, labor, supply – demand, Financial markets: treasury ship, stock exchange, commodity prices… Technology innovation processes Business strategy games Business organization games… 20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? FINANCE: Wall Street Raider

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? MARKETING: MarktStrat

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? BUSSINES ORGANISATION: EIS Game

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? MACRO-POLICY: National Budget Simulation

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN? Structural Analysis Forecasting Simulation  Borders between Simulation, Forecast and Structural Analysis are diffuse.  But the analytical approach, technical resources, and ways of use permit us to distinguishes it.

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Simulations Vs. Optimization  Optimization systems concentrates mainly on reaching a well predefined objective given a set of restrictions.  Simulation is an open strategy that use the links between inputs and outputs without setting a priori what must be considered an optimum solution.  That’s why we usually say that simulation models are not “resolved”, but “runned”.

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Simulations Vs. Optimization: Design car routes to pick up employees to the factory from distant locations OPTIMISATION SIMULATION Objective function: Minimize time Restrictions: 3 cars 1 hour to finish 13 passengers Inputs: Cars time to finish # of passengers Ouputs (results): Route design Results: Route design

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Deterministic (MKT Mix effects evaluation) Deterministic Inputs (controlled values): Advertising effort Price policy Distribution policy Sales Force  Random (Agricultural Crop Yield) Random Inputs (not controlled values): Climate conditions Plagues

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Deterministic + Random (MKT Mix evaluation) Deterministic Inputs (controlled values): Advertising effort Price policy Distribution policy Sales Force Inputs to be randomly modeled (forecasted) MKT Mix of existing or new competitors Economic conditions of country Market Demand (2nd stage input) Regression analysis

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Static Vs. Dynamic: Does “passing of time” result in a key variable (even an input) for the simulation system?  Example: Time as a basic input of a simulation system (two real examples):  Economic impact of an immigration flow will not only depend on the amount of immigration, but in the speed of it.  Effects on prices or trade flows of a tariff removal between two areas, will drastically change if you consider a gradual removal or not.

20 KEYS TO BETTER SIMULATING I. WHAT DOES SIMULATION MEAN?  Time as a basic input….. (example from Femise)

20 KEYS TO BETTER SIMULATING II. BASIC ELEMENTS OF A SIMULATION MODEL?  (i) System to be analyzed.  The collection of elements and its interactions which is trying to be analysed by means of the simulation.  It is critical to identify the system (or sub-system) of interest and concentrate the effort on a suitable dimension, but…..  ….without missing the links with the rest of the systems or other collateral sub-systems

20 KEYS TO BETTER SIMULATING II. BASIC ELEMENTS OF A SIMULATION MODEL  (i) System to be analyzed TRADE BARRIES PRODUCTION STRUCTURES MACRO ECONOMIC ENVIROMENT TRADE SUPPORT TRADE FLOWS POLITICAL ISSUES

20 KEYS TO BETTER SIMULATING II. BASIC ELEMENTS OF A SIMULATION MODEL  (ii) Analytical – Mathematical Model (an example for international trade market equilibrium): Ad-Quantum Tariff Matrix Ad-Valorem Tariff Matrix Import Inverse Function Export Inverse Function Existing Quota Regimes Equilibrium reached making equal the inverse functions of imports and exports revenues

20 KEYS TO BETTER SIMULATING II. BASIC ELEMENTS OF A SIMULATION MODEL  (iii) Inputs, Outputs, (coherent design of inputs and outputs)  Tariffs to be removed  Span of time  Productivities  Fiscal pressure  Exchange rate  Saving rate  ……  Changes in trade flows  Changes in trade prices  Changes in Va by sector  Changes in employment  Changes in fiscal revenues  ……

20 KEYS TO BETTER SIMULATING II. BASIC ELEMENTS OF A SIMULATION MODEL  (v) Interface:

20 KEYS TO BETTER SIMULATING III. 20 KEYS

20 KEYS TO BETTER SIMULATING III. 20 KEYS 1.- Be sure that you a have a simulation problem  Have to deal with a multivariate problem  Can clearly identify inputs and outputs  Input variables can vary in a wide range of values  Output variables clearly respond to changes in inputs  There is not a single scenario to be established

20 KEYS TO BETTER SIMULATING III. 20 KEYS 2.- Offer feasibility of its prospects and involve the end users in the whole proposal  Don’t make the mistake of offer maximum proposals and bear in mind its realism.  The final user usually prefers work proposals in which they feel an active part from the beginning

20 KEYS TO BETTER SIMULATING III. 20 KEYS Program enough time to study deeply the system to be analysed 3.- Program enough time to study deeply the system to be analysed  The largest part of the technical decisions regarding the estimation, calibrating, scenario and interface design are conditioned by the comprehension of the elements and interrelations of the system to be analysed.

20 KEYS TO BETTER SIMULATING III. 20 KEYS Integrate in your team theoretical experts been familiar with the system 4.- Integrate in your team theoretical experts been familiar with the system  “Research needs more heads than hands”.  Save time, which could be used to improve the technical issues for the simulation model  Help even for taking technical decisions  Establish a theoretical rigour to the whole of the analysis  Give reality to the simulation mechanism

20 KEYS TO BETTER SIMULATING III. 20 KEYS 5.- Prioritise the wishes of users in all the stages of the construction of the simulation model and take their advices  Nobody is interested in a technically refined tool that does not serve their interests  The users only want the model to be adjusted to their demands, nor the other way round.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 6.- Study “in deep” the work carried out by others  Originality must never be an aim in itself  Explore previous main sources of data - limitations of the exercise - different techniques available

20 KEYS TO BETTER SIMULATING III. 20 KEYS 7.- Dedicate time to analyze all of the available data  "Measure twice, and cut once".  Use homogeneous data  Choose carefully the samples  Assess the data provided by the end user  Be extremely scrupulous in the handling of data  Agree with the user that data to be used responds faithfully to the reality perceived by him.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 8.- Explore the analytical - mathematical techniques that best adapt to the system  Its adaptation towards capturing the specific phenomena observed in the specific system  its feasibility in calculating  its flexibility  the quantity of theoretical hypothesis required  its robustness towards eventual changes  its simplicity  the available resources

20 KEYS TO BETTER SIMULATING III. 20 KEYS 9.- Try to adapt the analytical technique to the problem and not the other way round  Guide the technical procedures by the suitability of the real characteristics observed in the system.  The technique used is only valid if it works, independently of the “objective” scientific considerations

20 KEYS TO BETTER SIMULATING III. 20 KEYS 10.- Do not complicate the technical models if it does not lead to clear benefits  "If your intention is to discover the truth, do it with simplicity and leave the elegance for the tailors."

20 KEYS TO BETTER SIMULATING III. 20 KEYS 11.- Take care about the forecast power of the model  Try to anticipate the needs with regard to the prediction at the time of choosing the variables  Evaluate with the focus on “cross validation” its vulnerability to eventual prediction errors in the key variables  Avoid using single results as regards to the prediction; use always intervals of variation or alternative values with probabilities of occurrence.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 12.- If a prediction exercise is necessary try to involve the user criteria in the interface  "If you have to forecast, forecast often."

20 KEYS TO BETTER SIMULATING III. 20 KEYS 13.- If inferential statistics are used, check the sensitivity of the system to changes in the estimations  When the analytical procedure means the use of statistical inference, the system can depend more or less critically on these estimations  Check the sensitivity of the results of the system against variations in the estimated coeficients  Check the robustness of the estimations with question such as changes in the data sample

20 KEYS TO BETTER SIMULATING III. 20 KEYS 14.- Do not underestimate the political or qualitative aspects of which experts advise you  The systems are not capable of being modelled using purely quantitative structures.  It is not a question of choosing between a quantitative or qualitative approximation, rather than knowing how to combine both.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 15.- Let simplicity guide the design of the interface in all of its score  "The majority of the fundamental ideas in science are essentially simple and, as a general rule, they can be expressed in language understandable to everyone."

20 KEYS TO BETTER SIMULATING III. 20 KEYS Call for software professionals into the design of the interface

20 KEYS TO BETTER SIMULATING III. 20 KEYS 17.- Establish different levels of user for the handling of the interface  Directors, politicians, media technicians, technical experts, etc.  “There is no inept user, only badly designed systems”.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 18.- Instruct the users on the correct use of the system

20 KEYS TO BETTER SIMULATING III. 20 KEYS 19.- Limit the use of the model to real scenarios  The greatest part of the simulation systems can be labelled as “rubbish in / rubbish out”.  Design an interface which stops, or at least warns the user, of possible errors in the design of scenarios.

20 KEYS TO BETTER SIMULATING III. 20 KEYS 20.- Ensure the perfect display of the results  Pretest: Before giving the final ok to designs in this area, carry out several tests among your work colleagues to make sure that the results are understandable and do not oppose the proposals suggested to improve it.