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DEPARTMENT OF ECONOMICS
M.Phil. Economics
TERM PAPER
SESSION 2016-2018
SUPERVISOR
Dr.Bilal Mehmood (Lecturer)
(NAME/DESIGNATION)
TABLE CONTENT
1. INTRODUCTION…………………………………………………………………….…..1
1.1 OBJECTIVE………………………………………………………………………2
2. LITERATURE REVIEW…………………………………………………………………2
4.3 RESULTS………………………………………………………………………....9
4.5 INTERPRETATION…………………………………………………………….11
5.2 RESULTS………………………………………………………………………..13
5.3 INTERPRETATION……………………………………………………………..13
6. REFRENCES………………………………………………………………………….....14
7. ANNEXURE …………………………………………………………………………….16
1. Introduction:
In modern applied economics and especially in making policies, Computable General Equilibrium
(CGE) models have become one of the leading tools to evaluate policy measures and alternative
scenarios (Goulder, 2002, Böhringen, 2003). CGE, econometric, input-output or linear
programming models use different types of nested production function with Constant Elasticity of
Scale (CES) to describe the production of an economy (Kemfert, 1998). Substitution elasticities
are key parameters in these models since measure the ease or difficulty of substituting between
inputs in production. Therefore elasticities play an important role in any economic assessment of
any policy. In this paper I’ll discuss special production functions. Nature imposes technological
constraints on firms. Only certain combinations of inputs are feasible ways to produce a given
amount of output. And firms must limit itself to technological feasible production plan. So, much
attention is being paid to establishing its production relationship. The possibility of efficient
capital-labor substitution is crucial for the success of most fiscal, financial and technological
policies that are designed to increase employment in developing countries through the adoption of
labor-intensive techniques of production. The easiest way to describe feasible production plan is
to list the set of all combination of inputs and outputs that comprise a technological feasible way
is called a production function. It’s purely a technical relation which connects factor inputs and
outputs. It shows the maximum amount of output that can be produced from any specified set of
inputs given the existing technology. It’s a flow concept so production refers to units of output
over period of time. If the possibilities exist for efficient capital labor substitution then they can be
substituted for capital without necessarily resulting in a decline in output. This issue crucially
depends on whether elasticity of substitution is positive or not. . The variation in the estimates of
the capital labor substitution mainly depends on the type of production function used i.e. Constant
Elasticity of Substitution (CES) and Variable Elasticity of Substitution (VES). In empirical
literature, much attention is being paid to establishing its production relationships which are based
on certain restrictive assumptions. The most famous of these production functions is in CES
production function (CESPF) and is also known as ‘Work Horse’ production function. It comes
with the assumption of EOS = 1. However, EOS ⋛ 1 is a more realistic assumption which is
permitted in constant elasticity of substitution (CES) production function, formulated in CESPF.
1
The CES production function (CESPF) arbitrarily constrains EOS to be a constant and does not
allow it to vary with a change in factor input ratio.
This paper uses the same to find the elasticity of substitution (EOS) between inputs in Itehad
Chemicals industry in Pakistan to evaluate the possibility of substitution between them without
compromising their performance.
1.1 Objectives
Following are the objectives of the paper:
1 To estimate the elasticity of substitution between labor and capital, this is done on the basis of
CES Production Function in Itehad Chemicals ltd of Pakistan.
2 To find the type of returns to scale that is applicable in Itehad Chemicals ltd of Pakistan.
3 To estimate Cobb-Dougles Production Function (CDPF).
4 And to estimate Transcendental Logarithmic Production Function (TPF)
2. Literature Review
Kemfert (1998) estimates the substitution elasticity of a nested CES production function for the
entire German industry and individual industrial sectors. She estimates the elasticity for tree nested
structures1 and concludes that a nested CES function with a nest of capital and energy ((KE)L) is
the most useful for the entire German industry, but for several industrial sectors a nest of capital
and labor ((KL)E) might be closer to the reality.
2
Koesler & Schymura (2012) confirm that non-linear estimation techniques perform significantly
better than standard linear estimations using Kmenta approximation.
Su, Zhou, Ichi, Ren, & Mu (2012) estimate the China’s elasticity of substitution of two-level CES
KLE production function by three possible combination of nesting: (KL)E, (KE)L and (EL)K.
Mehmood, B., Nisar, A., & Rehman, H. U. (2015) studied the magnitude of elasticity of
substitution (EOS) among factors of production to analyze the impact on the Pakistani banking
sector. They draw upon a comprehensive time series dataset covering the period 1980-2013. To
achieve that purpose the analysis employed Constant Elasticity of Substitution (CES) production
function in order to follow up a quantitative evaluation of Elasticity of Substitution in the
Pakistan’s banking sector. The paper also investigated returns to scale during the time period under
consideration.
3
L = the amount of labor expended, which is typically expressed in hours.
K = the amount of physical capital input, such as the number of hours a particular machine,
operation, or perhaps factory.
A = the total factor productivity (TFP) that measures the change in output that isn't the result of
the inputs. Typically, this change in TFP is the result of an improvement in efficiency or
technology.
The beta 1 and 2 reflect the output elasticity of the inputs where β1 is constant between 0 and 1 (0
< β < 1 ). Output elasticity is the change in the output that results from a change in either labor
or physical capital.
Least squares regression of log output (value added) on a constant and the logarithm of labor and
capital produce parameter estimates of a Cobb-Douglas production function.
Ln Y = B0 + B1 ln K + B2 ln L
4
Ln (natural logarithmic series) generated.
Taking antilog of the production function we get the elasticity of the respective factors in their
powers
Y= 0.41*K0.13L0.62
The model represents the Cobb-Douglas production function under decreasing return to scale as
the inputs will increase, the output will increase but at a lesser rate.
18.6
18.4
.06 18.2
.04
18.0
.02
17.8
.00
-.02
-.04
05 06 07 08 09 10 11 12 13 14 15
In the above model, 0.13+0.62= 0.75 that is less than 1 so the model is under DRS (decreasing
return to scale).
5
DY
4,800
4,400
4,000
3,600
3,200
2,800
2,400
2,000
1,600
1,200
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
dl
2,400
2,000
1,600
1,200
800
400
0
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
dk
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
6
4. CES production function:
Arrow, Chenery, Minhas and Solow in their new famous paper of 1961 developed the Constant
Elasticity of Substitution (CES) function. This function consists of three variables Y, K and L, and
three parameters.
In this study I have used fixed assets as capital denoted by “K” and employee’s salaries as labor
denoted by “L”, as my independent variable which are regressed against total sales i.e “Y”.
𝐾𝑡 = 𝛽𝐾𝑡−1 + µ2𝑡
𝛥𝐾𝑡 = (𝛽 − 1)𝐾𝑡−1 + µ2𝑡
And labor,
𝐿𝑡 = 𝜏𝐿𝑡−1 + µ3𝑡
𝛥𝐿𝑡 = (𝜏 − 1)𝐿𝑡−1 + µ3𝑡
7
δ = the distribution parameter or capital intensity factor coefficient concerned with the relative
factor shares in the total output.
𝑌 = 𝐴 [𝛿𝐾− 𝑝+ (𝑙 − 𝛿)𝐿− 𝑝] − 𝑣/ 𝑝
CESPF yields any value of EOS (i.e. 0 < EOS < ∞). It posits log-linear relationships among
variables and also requires that the elasticity of substitution be the sables and requires that the
elasticity of substitution be same at all points of the isoquant map. Therefore, applying Kmenta
approximation to the CES.
𝛽1 −2 𝛽3 (𝛽1 +𝛽2 ) 1
Where, δ = 𝛽 ; 𝑣 = 𝛽1 +𝛽2 , ; 𝑝 = ;𝜎=
1 +𝛽2 𝛽1 𝛽2 1+𝜌
Variables ADF
At level 1st Difference
𝑙𝑛|𝑌| -1.283792 2.724457
𝑙𝑛|𝐾| 2.915914 0.113380
𝑙𝑛|𝐿| -2.157979 0.633874
𝐾
(𝑙𝑛 | | )2 -0.349154 -0.089182
𝐿
8
4.4. Parameters of Kamenta Approximation and CES
𝐾
𝑙𝑛|𝑌𝑡 | = +(𝑙𝑛|𝐾𝑡 |) + (𝑙𝑛|𝐿𝑡 |) + (𝑙𝑛 | |)2
𝐿
9
LN(DK_DL) -0.089182 0.090681 -0.983468 0.3448
isoquant at D(-1.85)
12
C 10
a
8
p
i 6
t 4
a
2
l
0
0 1 2 3 4 5 6 7
labor
= (1-a/a))-1.85+1(K/L)-1.85K/L2
= (0.15/0.84)-0.85(K/L)-1.85K/L2
10
As the values are positive we will be get the answer positive so Quasi-convexity is evident.
4.5. Interpretation
For CD production function, the EOS is equivalent to 1. σces = 0.35 implies that production function
for Itehad chemicals is quite close to case of Cobb Dougles but CES is more suitable functional
form. Value of δ shows the share of capital in total sales i.e. 15.1% and (1- δ) depicts the labor-
share in total sales i.e. 84.9%. ⱱ shows the elasticity of scale, which allows for increasing and
decreasing return to scale degree of homogeneity of function can be observed from ⱱ(= 0.7463<1).
It implies DRS prevail in Itehad Chemicals industry. p = -0.114, represents the substitution
parameter that determine EOS (σces). σces is 0.35 < 1 implying low substitution-ability between
inputs i.e. employee wages (proxy for labor) labor and total assets (proxy for capital). This shows
that labor and capital are relatively not easily substitutable in long run. It implies changes in
capital. The R2 shows that 92% of the variations in the dependent variable are explained by the
independent variables. The low elasticity of substitution between factors of production implies that
there exists low flexibility to adjust the factors of production in response to changes in factor prices
and/or growth in demand for products of the Itehad chemicals industry emanating from any
external or internal reasons.
Y= f (K.L)
Ln (Y) = Bo + B1ln (K) + B2ln (L) + B3ln (K) 2 + B4ln (L) 2 + B5ln (K)* ln (L) + µ
11
Where,
ln = Natural Logarithm
Y = total sales
K = Fixed Assets
L = Employee’s wages
Where β0, β1, β2, β3, β4, β5, are associated output elasticities that are to be estimated and µ is the
regression disturbance.
Conventionally, symmetry conditions are imposed on Translog function i.e.
βLK = βKL
Moreover, constant returns to scale (CRS) requires following conditions
to hold:
βL + βK = 1
βKK + βLK = 0
5.1. Results
12
S.E. of regression 0.047206 Akaike info criterion -2.988583
Sum squared resid 0.022284 Schwarz criterion -2.698863
Log likelihood 29.90867 Hannan-Quinn criter. -2.973747
F-statistic 53.54492 Durbin-Watson stat 1.389615
Prob(F-statistic) 0.000001
Substituting the values in the model
Log(Y) = -0.78 – 3.21 log(K) + 5.32 log(L) – 0.34 log(K) 2 – 1.74 log(L) 2 + 1.85 log(K)*log (L)
We get the translog model with the respective coefficients
5.2. Interpretation:
The model represents that the production of Itehad Chemicals in Pakistan is having a positive
relationship with labor while negative relation with fixed assts. So we can state that the company
is labor-intensive. Itehad Chemicals is growing manufacturing set of industries and the rate of the
capital and labor significance points out the rate of technology the industry uses.
6. References
1. Arrow, K. J., Chenery, H. B., Minhas, B. S., & Solow, R. M. (1961). Capital-labor
substitution and economic efficiency. The Review of Economics and Statistics, 225-
250.
2. Goulder, L. H. (2002). Environmental policy making in economies with prior tax
distortions. Edward Elgar Publishing.
3. Henningsen, A., & Henningsen, G. (2011). Econometric Estimation of the" Constant
Elasticity of Substitution" Function in R: Package micEconCES. Institute of Food and
Resource Economics, University of Copenhagen.
4. Kemfert, C. (1998). Estimated substitution elasticities of a nested CES production
function approach for Germany. Energy Economics, 20(3), 249–264.
doi:10.1016/S0140-9883(97)00014-5
5. Khan, A., Mehmood, B., & Sair, S. A. THE VARIABLE ELASTICITY OF
SUBSTITUTION PRODUCTION FUNCTION: A CASE STUDY FOR PAKISTANI
BANKING SECTOR.
6. Kmenta, J. (1967). On estimation of the CES production function. International
Economic Review, 8(2), 180-189.
13
7. Koesler, S., & Schymura, M. (2012). Substitution Elasticities in a CES Production
Framework-An Empirical Analysis on the Basis of Non-Linear Least Squares
Estimations.
8. Mehmood, B., Nisar, A., & Rehman, H. U. (2015). TECHNOLOGY MATTERS:
EVIDENCE FROM PAKISTANI BANKING SECTOR USING FLEXIBLE
TRANSCENDENTAL LOGARITHMIC PRODUCTION FUNCTION. Pakistan
Economic and Social Review, 53(2), 203.
9. Rečka, L. (2013). Estimation of the elasticity of substitution of production factors in
CEE economies (No. 5420). EcoMod.
10. Revankar, N. S. (1971). A class of variable elasticity of substitution production
functions. Econometrica: Journal of the Econometric Society, 61-71.
11. Su, X., Zhou, W., Nakagami, K. I., Ren, H., & Mu, H. (2012). Capital stock-labor-
energy substitution and production efficiency study for China. Energy
Economics, 34(4), 1208-1213.
12. Van der Werf, E. (2008). Production functions for climate policy modeling: An
empirical analysis. Energy economics, 30(6), 2964-2979.
14
7. Annexure:
15
2,014 4,104 2,485 1,704 3.613207 3.395326 11.52824 3.23147 10.4424 10.97189
2,015 4,046 3,756 1,437 3.607026 3.574726 12.77866 3.157457 9.969533 11.28704
2,016 4,557 3,638 2,040 3.658679 3.560863 12.67974 3.30963 10.95365 11.78514
16