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CES Prodn FN

The document describes how to specify the Constant Elasticity of Substitution (CES) production function in the EasyReg software. It begins by defining the homogenous CES production function and its parameters. It then explains how to rewrite the CES production function as a nonlinear regression model that can be specified recursively in EasyReg. This involves selecting initial variables, storing parameters as variables, and recursively building up the full production function through a series of transformations and combinations. The process is similar to writing a computer program or macro. Finally, it describes how to specify the non-homogenous CES production function, which allows for increasing or decreasing returns to scale.

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120 views4 pages

CES Prodn FN

The document describes how to specify the Constant Elasticity of Substitution (CES) production function in the EasyReg software. It begins by defining the homogenous CES production function and its parameters. It then explains how to rewrite the CES production function as a nonlinear regression model that can be specified recursively in EasyReg. This involves selecting initial variables, storing parameters as variables, and recursively building up the full production function through a series of transformations and combinations. The process is similar to writing a computer program or macro. Finally, it describes how to specify the non-homogenous CES production function, which allows for increasing or decreasing returns to scale.

Uploaded by

spmisra
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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1

The CES production function

The homogenous Constant Elasticity of Substitution (CES) production function takes the form Q = K + (1 )L
n o1/

exp(U), 1, 0 1, > 0, (1)

where K is capital, L is labor, Q is output, and U is an error term satisfying E[U |K, L] = 0. The CES production function was introduced by Arrow, Chenery, Minhas and Solow1 in 1961 Formally, the elasticity of substitution measures the percentage change in factor proportions due to a percentage change in the marginal rate of technical substitution. In particular, for a canonical production function Q = f(K, L) with marginal products fK = f (K, L)/K and fL = f (K, L)/L, the marginal rate of technical substitution is fL /fK , i.e., minus the slope of the isoquant in point (L, K), hence the elasticity of substitution between capital and labor is given by: = d ln(L/K)/d ln(fL /fK ). In the case of the deterministic homogenous CES production function Q = {K + (1 )L }1/ we have fL = K + (1 )L fK = K + (1 )L
n n o(1+)/ o(1+)/

(1 )L1 , K 1 ,

hence d ln (fL /fK ) = ( + 1)d ln (L/K) and thus = 1/( + 1). In order to estimate the parameters of the CES production function via EasyReg, rewrite (1) as ln(Q/L) = ln() 1 ln { [exp ( ln(L/K)) 1] + 1} + U ln { [exp ( ln(L/K)) 1] + 1} = ln() [exp ( ln(L/K)) 1] exp ( ln(L/K)) 1 ( ln(L/K)) + U. ln(L/K) (2)

Arrow, K.J., H.B. Chenery, B.S. Minhas and R.M. Solow (1961), Capital-Labor Substitution and Economic Eciency, Review of Economics and Statistic.

It is an elementary calculus exercise to verify that lim ln { [exp ( ln(L/K)) 1] + 1} ln(1 + ) ln(1) = lim 0 [exp ( ln(L/K)) 1] d ln(x) = = 1, dx x=1

hence it follows that for 0 (2) becomes ln(Q/L) = ln() ln(L/K) + U. Thus, for = 0 the CES production function becomes a Cobb-Douglas production function: ln(Q) = ln() + ln(K) + (1 ) ln(L) + U. Y = g(x, b) + U, where Y = ln(Q/L), x = ln(L/K), b = (b(1), b(2), b(3))0 = (ln(), , )0 , and g(x, b) = b(1) ln {b(3) [exp (b(2)x) 1] + 1} b(3) [exp (b(2)x) 1] exp (b(2)x) 1 (b(3)x) . b(2)x (4) (3)

exp ( ln(L/K)) 1 exp() exp(0) d exp(x) lim = lim = = 1, 0 0 ln(L/K) dx x=0

The CES production function (2) is now a nonlinear regression model,

2
2.1

Specifying the CES production function in EasyReg


Selection of the initial X variables

In EasyReg a nonlinear regression function is build up recursively by augmenting the list of X variables with nonlinear transformations and linear and/or multiplicative combinations of previous X variables. In order to build up (4), we have to select two initial X variables, X(1) = ln(L/K) and X(2) = 1. The latter is necessary for two reasons: First, EasyReg does not allow to specify constants directly. Second the parameters b(2) and b(3) are common to dierent transformations. The constant X(2) = 1 enables us to associate them to new X variables. 2

2.2

Storing the parameters in X variables

Thus, we need to specify three new X variables rst, each associated with a parameter, by selecting X(2) and choosing the Linear combination option three times: X(3) = b(1)X(2), X(4) = b(2)X(2), X(5) = b(3)X(2). Then (4) becomes: g(x, b) = X(3) ln {X(5) [exp (X(1)X(4)) X(2)] + 1} X(5) [exp (X(1)X(4)) X(2)] exp (X(1)X(4)) 1 X(1)X(5), X(1)X(4)

Now the CES production function involved is build up recursively as follows. X(.) X(1) X(2) X(3) X(4) X(5) X(6) X(7) X(8) X(9) X(10) = = = = = = = = = = Transformation ln(L/K) 1 b(1)X(2) = b(1) b(2)X(2) = b(2) b(3)X(2) = b(3) X(1)X(4) exp(X6)) X(7) X(2) X(5)X(8) ln (X(9) + 1) /X(9) Actual transformation Transformation option

ln() ln(L/K) exp ( ln(L/K)) exp ( ln(L/K)) 1 (exp ( ln(L/K)) 1)


ln((exp( ln(L/K))1)+1) (exp( ln(L/K))1) exp( ln(L/K))1 ln(L/K)

Linear combination Linear combination Linear combination Multiply EXP(z) [z = X(6)] Subtract Multiply LOG(z+1)/z [z = X(9)] (EXP(z)-1)/z [z = X(6)] Multiply

X(11) = (exp (X(6)) 1) /X(6) X(12) = X(1)X(5)X(10)X(11)

X(13) = X(3) X(12)

ln(L/K) ln((exp( ln(L/K))1)+1) (exp( ln(L/K))1) exp( ln(L/K))1 ln(L/K) ln() ln(L/K) ln((exp( ln(L/K))1)+1) (exp( ln(L/K))1) ln(L/K))1 exp( ln(L/K) = g(b, x)

Subtract

As you see, this is actually a simple computer program, like a macro in MS Word or Corel Wordperfect.

2.3

The non-homogenous CES production function


n o /

The general CES production function takes the form exp(U), 1, 0 1, > 0, > 0, (5) where is the degree of homogeneity: if K and L are both increased with a factor , then Q increases with a factor . Thus, if > 1 we have increasing return to scale, and if < 1 we have decreasing returns to scale. In this case (2) becomes ln(Q/L) = ln() ln { [exp ( ln(L/K)) 1] + 1} + U ln { [exp ( ln(L/K)) 1] + 1} = ln() [exp ( ln(L/K)) 1] exp ( ln(L/K)) 1 ( ln(L/K)) + U. ln(L/K) (6) Q = K + (1 )L

The specication of (6) in EasyReg is the same as steps X(1) through X(12), with X(13) replaced with the following three steps: X Transformation X(13) = b(4)X(2) = b(4) (= ) X(14) = X(12)X(13) X(15) = X(3) X(14) Transformation option Linear combination Multiply Subtract

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