CHAPTER 6 - Specifying Values for Substitution Elasticities  pp. 156-180

Specifying Values for Substitution Elasticities

By John Piggott and John Whalley

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In this chapter we discuss some of the problems involved in selecting elasticities of substitution for industry production functions and household demand functions. We discuss difficulties in interpreting these parameters in light of the empirical estimates we have been able to find, and outline the sources used in our choice of values for the model. We also comment on the reliability of the estimates.

Elasticity values are critical parameters in determining impacts of policy changes generated by the model, and careful discussion of their values is needed prior to presentation of results. We separately report and discuss elasticity values we use for production functions, demand functions, and foreign trade behaviour. In view of the extensions to our basic variant model, we also summarize the elasticities we use in modelling labour supply and savings behaviour.

Production Function Elasticities

Our model incorporates CES value added functions for each industry. We therefore need to specify a separate value for the elasticity of substitution between capital and labour for each industry in the model.

Since the introduction of the CES function in the early 1960's, there has been a continuing debate as to whether the elasticity of substitution for manufacturing industry is approximately unity. If unity is a correct value, the more complex CES form can be replaced by the simpler Cobb-Douglas form which has unitary elasticity of substitution. This debate has concentrated primarily on substitution elasticities for aggregate manufacturing rather than component industries as specified in the model.