A Measure of Substitution Elasticity: Case of

Pakistan’s Manufacturing Industry

Submitted to: Sir Bilal
Submitted By: Mehwish Pervaiz
M.Phil (Economics)

Government College University, Lahore

 A Measure of Substitution Elasticity: Case of Pakistan’s Manufacturing
Industry
Intriduction
Pakistani Policy makers are paying keen attention to employment generation in different
sectors of Pakistan. Currently, it is major challenge for policy makers to create employment
opportunities for thisperpetually growing labor force. Pakistan’s Economic Survey (2000-2001)
reported that there is total 39.4 million man power available from which 2.4 million remained
unwaged in 2013-2014. As per Economic Survey of Pakistan (2015-2016), the rate of
unemployment for the year 2014-2015 was 6 %. These statisticsare undervalued and do not
represent the real scenario of Pakistani job market due to the informal and cloakedemployment.
Industrial sector of Pakistan is growing rapidly since 1980s but it is not engaging as much work
force as expected. Economic survey of Pakistan (2013-2014) reported annual business growth
rate of 10% in 1980-85 and 6.2% in 2005-2006 and occupation rate increased with the pace of
1.1% annually in 1980-85 but remained unchanged during the regime of 2005-2006 and in the
last year the business growth rate was 7.89%. GDP share of manufacturing sector is raised from
14 to 15.41 percent from the year 1960 to 2016 respectively but employment rate reduced from
14.7% to 11.2% in 1960 to 2016.

Manufacturing sector of Pakistan epitomize strong and rigorous capital biasness in output
and employment. After 1980s, government of Pakistan claimed autonomous interaction of
market. Government has given many incentives to manufacturing sector such as low interest rate
to local and international investors, tax lesions and low rental capital cost.

In Pakistan still factor prices are defining the factor permutations in the production
process. The reason for using more capital than human resource lies in the fact of relative cost.
Industrialists use more capital than labor because cost of labor force is higher than the cost of
capital which untimely affects employment rate. In this research article, researcher is trying to
explore the influence of factor prices on employment in manufacturing sector of Pakistan. This
paper will also scrutinize the prospectiveemployment opportunities in different industries of
Pakistan. This is analyzed by the estimation of elasticity between capital and labor force in
particular sector. More easy and high rate of elasticity of substitution represents more
employment in that sector.

Research Hypothesis
To test our estimates we developed a number of hypotheses. The hypotheses for this
research are that

Ho: Elasticity of substitution is zero

H1: Elasticity of substitution is not zero and there exist potentials that capital and labor
substitute each other according to the relative factor prices in manufacturing industry of Pakistan.
We have also hypothesized that technological factors also effects elasticity in different sectors.
As per rule, we have assumed that if value of elasticity of substitution is equal to or greater than
0.5 then factor prices are effecting employment and labor productivity but if value of elasticity of
substitution is less than0.5 then it is due to the rigid technology and permanent factor proportion.
Model and Assumptions
Arrow, Chenery, Minhasand Solow (1961) introduced the concept of constant elasticity of
substitution for production. This model is used to measure the degree of exchangeoflabor and
capital. This model is has restriction to assume the constant returns to scale. This restriction is
relaxed with the use of various variables of sales. There are some assumptions of this model

1. Company should be profit oriented

2. Alternative techniques of production can be used
3. Transition of technology should not charge cost
4. Company should be production edge

These assumptions are very rigid and have received lot of criticism by many economists (Clark,
1985). The function of Constant elasticity of substitution for productioncan be written as
Y = g [dK-r + (1-d)L-r]-v/r V=1 (1)
In this equation

 Y means total production value.

 K represents the value of inputs of capital services. It is estimated in term of money
 L denotes labor force intake annually
 g is the parameter of efficiency, measures the volume of production
 d is the parameter of distribution, measure capital force of the technology
 r is the parameter of substitution and is written as:(s = 1) & (1 + r)
 v is the grade of homogeneousness.

In the case of constant returns, v will be 1 and if decreasing returns to scale then v will be
less than 1, forincreasing returns to scalev will be greater than 1.
The mathematical procedure of obtaining the estimation form of theCES production function is
based on the marginal productivity of laborrelation derived from the equation. The estimated
form of the function is:
Log Y/L = a + blogw + u) (2)
The above indirect specification of the CES production function hasbeen widely used in
empirical studies for the estimation of the elasticity ofsubstitution in developing countries. The
advantage of this formulation,despite its restrictive assumption is that it does not require capital
stockdata, the estimation of which involves many problems especially indeveloping countries.

Slackening Assumptions and Returns to Scale

Equation (2) is very restrictive and assumes constant returns to scale.In the presence of
economies of scale, output increases more thanproportionately to the increase in inputs and the
escalation in labour productivity may also reflect the existence of economies of scale. In this
caseemployment will be reduced by the degree of economies of scale through their effect on
labour productivity.

The general version of theCES production function takes the following form for
estimation purposes:
Log Y/L = a + blogw + clogV + u) (3)
 Where a & b has the same properties as in equation (2) and V is realvalue added while c
measures the economies of scale and is equal to:

c = (1-b)(v-1)/v (4)
Knowing the value of this expression and the value of b permits theestimation of v, the
degree of returns to scale in each industry. According toequation (4) for any given value of v
greater than unity (increasing returns toscale), c is a linearly decreasing function of the elasticity
of substitution.Equation 3 relates labor productivity to real wages and output. Inthis model the
coefficient on log wages measures the elasticity of labordisplacement by capital due to increase
in real wages. Similarly, holdingwages constant, any increase in output will increase productivity
throughreturns to scale. Increasing returns to scale at a point of time may reflectthe scale and size
of firms.

Research Methodology

We estimate the elasticity of substitution between capital and labour for the large-scale
manufacturing sector as a whole and then at different groupof industries level by using two
specifications of the model given below:
log Y/L = a + blog w + u) (equation 2) Model 1
log Y/L = a + blog w + clog V + u) (equation 3) Model 2
We have fitted the above-mentioned two different specifications ofthe CES function
(equation 2 and 3) to the data on 144 five-digit industriesaccording to the Pakistan Industrial
Standard Classification (PISC) andestimated the elasticity of substitution. Later, we have
grouped industriesinto three broad categories according to the end use like consumer goods,
intermediate goods and capital goods industries and estimated the elasticityof substitution among
them.

The cross-section data has been used for the period 1995-96. In theperspective of
numerous problems in time-series estimates (Bhalla, 2005; Wynn and Holden, 2006) we have
confined our analysis to the cross-sectionestimates.
The main source of data is the Census of Manufacturing Industries(CMI), which is the
comprehensive and systematic record for the manufacturingsector. Data in Pakistan like other
developing countries suffer from manyshortcomings, which require caution in deriving any
conclusion based on these results.

Analysis

To test our hypothesis, we conducted the test of regression model 1 (equation 2) and
model 2 (equation 3). We also conduct various tests to check heteroscedasticity in our models.
We regressed the value of residuals on the independent variables to conduct the Glejser test
(Johnston, 1987). The Glejser test was performed to resolve the issue related to
heteroscedasticity. With 5 per cent level of significance, variance of the disturbance
termconfirms the presence of heteroscedasticity in the second model for all industries.
 After correcting secondmodel (equation 3)for heteroscedasticity, the final result rejects
the presence of heteroscedasticity at the 5% significance level.The result of our first model
(equation 2) ishighly significant (Table 1).The elasticity of substitution with respectto the wage
rate is significantly different from zero in manufacturing sector of Pakistan at the significance
level of 1%. The sign of the coefficient was according to our expectations. Theelasticity of
substitution indicates that productivity of the work force change with their wage rate. The R2 of
regression model also indicated some immeasurable factors that effects labor productivity
changes. These factors are undetermined by our specified model.

Elasticity of substitution inconsumer goods in manufacturing industry of Pakistan is

significant at the 5 per cent level with structural view point but low magnitude of R2 represents
that theoverall fit is not good. The result shows that low elasticity of substitutionrepresent
thatchanges in real wages may not have any significant effect on employmentand
labortechnology in consumer goods industries is not flexible. Due to the imperfections in product
and factor markets, consumer goods industries maynot be responding to market signals. It is
evident from the results that there are some other factors that affect thelaborproductivity in
consumer goods industries other than the increase in wage rate.Intermediate goods industries
however, give highly significantresults. The elasticity of substitution is greater than unity (1.62)
indicating avery strong effect of real wages on labor productivity in intermediate goods
industries. The value of R2 for intermediate goods industries is.60 which show that 60 %
variation in dependent variable are explained by the independent variables.

Table-1: Cross-Section Estimates of the Elasticity of Substitution for Pakistan’s

Manufacturing Sector (2005-2006)
Model 1: (log Y/L –a+blogw+u)
Source A B t-ratio R2 No. of
Observations
All Industries 1.46 0.96 7.79 * 0.23 144
Consumer 5.79 0.35 2.18 ** 0.02 66
Goods
Intermediate -2.54 1.62 724 * 0.60 39
Goods
Capital 2.36 0.85 3.51 * 0.24 39
Goods
* Significant at the 1% level. ** Significant at the 5% level.

The size 0.85 indicates the elasticity of substitution’s size in capital goods and it reflects
that this size is equilateral to unity. The after effects of real wages and productivity declare it is
significant and it is the best substitute for labor and capital. In table 2, there is specification
given, this specification model describes equation 3. The description of the model indicates that
the model fitness is good as R2 value shows increasing trend, and this R-square value further
describes that rest of model variables are more explanatory. The results conclude that labor
productivity is get affected by real wage rate changes and output changes both. The analysis
further shows that in both models the value of elasticity is different as compare to each other, as
the model 1 describes elasticity of substitution value as 0.96 and the model 2 describe elasticity
of substitution value as 0.61. furthermore, it is highlighted that the reason behind decreasing
elasticity of substitution value in model 2 is that the second model is get influenced by output
variable and changes in an increase of labor productivity have been declared as changes in output
as shown in scale effect, this is the reason behind declining of elasticity substitution.
Furthermore, labor productivity also enjoys significant of value added changes. As if the value
added will rise by 1% then there will increase in labor by 17% and the wages will remain
constant. The t-table also indicates that wage and value added both explanatory variables are
significant and the t-tables describe 1% significance level of both the variables.

Table-2: Cross-Section Estimates of the elasticity of substitution for

Pakistan’s Manufacturing Sector (2005-2006)
Model 2: log Y/L= a + blog w + clogV + u)

Source a b t-ratio C t-ratio R2

All Industries 4.85 0.61 3.15* 0.17 4.56* 0.44
Consumer 7.57 0.26 1.33 0.14 3.82* 0.24
Goods
Intermediate 1.79 0.89 3.32* 0.15 2.63** 0.24
Goods
Capital 6.30 0.36 1.04 0.25 2.75** 0.37
Goods

Moreover, the variation of the dependent and independent variable has been highlighted
by R value, as R2 value declares 44% variation among the variables. F-test as been adopted here
2

to justifies the model significance and the value of F-test shows model is 51.58% significance
represented as F (3 144) = 51.58 and the critical value of F-test shows the 99percent level of
confidence represented as F (3 144) = 3.91. This value shows the clear evidence of rejection of
joint hypothesis as this value declares that there is no effect found of wages and value added on
labor productivity. On the basis of these results, it is proceeded to conclude that employment
effect due to variation in labor productivity is highly influenced by wages and value added at
manufacturing sector as a whole. On the contrary, if the value of the coefficient of value added is
smaller than the value of the coefficient of wages than it would influence a strong impression in
productivity as compare to the effect of value added.

Table 2 figures intimate the calculation of second model and highlights that here is less
influence of elasticity of substitution found in different industries. Moreover, the evidence shows
that good industries enjoy the significant impact of elasticity of substitution. On the contrary, it is
also highlighted that there is multicollinearity found between real wages and value added
because there is the insignificant effect of elasticity of substitution have been found in consumer
and capital goods industries. However, the presence of multicollinearity has been rejected by the
test applied on consumer and goods industries. It is further concluded that there is equilateral
effect have been found in consumer goods industries and also there is no effect has been
highlighted on labor productivity through substitution of labor and capital. In addition, there is
0.72 the value of correlation is highlighted, which shows the evidence that there is correlation
exists between real wages and value added and it is further explained that labor productivity is
highly influenced by real wages rate. And in all the industries categories there is significant
effect found of labor productivity.

Return to Scale:

Coefficient of V is defined as:

c = (1-s)(v-1)/v
Once the value of s and c are known through the estimation of model 2, one can easily
derive the returns to scale (v) parameter.

Table-3: Returns to Scale in Different Groups of Industries

Industries V
All Industries 1.52
Consumer Goods 1.26
Intermediate Goods 3.20
Capital Goods 1.42

Returns calculating figures indicates that there is an increasing return to scale have been
noticed in the manufacturing sector of Pakistan. Although, there is the existence of increasing the
return to scale found in all three industries, but industries are highly affected by internal and
external both economies of scale. It is further said that true scale effect is not represented
accurately in the manufacturing sector of Pakistan. As Guade (1975) highlights that in cross
section calculation there is more availability of increasing the return to scale will found that
shows the trend of idle capacity. In conclusion, it is to say that the more the existing capacity is
being utilized the more the output will proceed.

Conclusion and Policy Implications:

Statistical analysis is limited due to factors and estimation problems availability.

Although there is numerous limitation have been faced, but the results declare appropriate
justification of overall analysis. In statistical analysis, we worked on two variables wage rate and
value added as these both variables shows important participation towards research. It is further
concluded that in manufacturing sector there is potential exist of employment and intermediate
and capital goods industries show significant results. On the other hand, in all categories of
industries, the elasticity of substitution values shows less than unity. These results further
conclude that there is high potential exist in the manufacturing sector of Pakistan related to
technology and a numerous people can be employed by the projection of new industries in
Pakistan. Moreover, the second model results provide evidence that there is need to reject null
hypothesis because the choice of technique is not playing a vital role due to factor prices. This
analysis further suggests that in Pakistan there is need to have diversification of capital as
supported by Government of Pakistan and the incentives are being enjoyed by investors, so big
employment opportunities will provide to the employer and the economy of Pakistan will lead to
improving because manufacturing sector of Pakistan will improve. On the other hand, the
existence of previous capital in industries is being highlighted by determining increasing return
to scale implemented on all industries categories.
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