Energy Modelling Production of Economy

Question: Discuss about the Essay for Energy Modelling and Production of Economy. Answer: a) The central issue analysed in this paper is the elasticity of substitution between energy and other inputs in contribution to the countrys GNP. This paper examines the cost or benefit of the energy policy in terms of consumption or GNP in the input output framework. b) The perspective of the authors are that decrease in physical availability of the energy increase the energy cost, which further causes a proportionate loss in GDP. According to authors view, if energy-GNP ratio is assumed constant, i.e.; zero input substitutability, the increase in both energy and non-energy inputs are required for the increase in GDP. On the other hand, elasticity of substitutions is infinitely elastic if the input is perfectly substitutable. c) Substitutability among inputs is necessary otherwise; decrease in energy inputs would reduce the total production of the economy. Hence, the energy policy makers have to choose the right combination of energy and non-energy inputs, which maximises output with minimum cost (Pahlavan, Omid and Akram 2012). As suggested by the paper of Hogan and Manne (1979), reduction in energy supply may have only 1% loss in the economy, however, this loss is large for the economy in monetary terms. 2. Initial price of energy = $1 per unit Price of capital = $3 per unit and price of labour = $3 per unit. Quantity of energy (E) = 100 units, capital (K) = 150 units, labour (L) = 200 units New price of energy = $2, new energy quantity = 70 units, capital = 170 units and labour = 200 units Elasticity of substitution indicates that the degree of substitution between the two inputs (Zhelobodko et al. 2012). Elasticity of substitution between the two inputs is given by = In equilibrium, marginal rate of technical substitution (MRTS) between energy and labour is = price of energy / wage (Raurich, Sala and Sorolla 2012). = $1/ $3 = 0.33 New MRTS = $2 / $3 = 0.67 Change in MRTS = 0.67- 0.33 = 0.34 Initial E/L = 100/200 = 0.5 and after policy change = 70/200 = 0.35 Therefore, change in E/L = 0.35 - 0.5 = - 0.15, however modulus value is taken. Hence, = (0.15 / 0.5) / (0.34 / 0.33) = 0.3 / 1.03 = 0.29 b) Elasticity of substitution between capital and labour is = Initial K/L = 150 / 200 = 0.75, new K/L = 170 / 200 = 0.85 Change in K/L = (0.85 - 0.75) = 0.10 Initial MRTS = 2/3 = 0.67. As the price of the other inputs except energy remains same, the MRTS will be the same. Hence, = (0.10 / 0.75) / (0.67/ 0.67) = 0.13/ 1 = 0.13 c) The first reason for the difference in the elasticity is that substitutability between the labour and energy is greater compared to labour and capital. The figure indicates that is higher for E/L ratio compared to K/L ratio, as it may be that increase in energy induces producers to substitute energy with labour (Chen 2012). The second possible reason is that labour and capital are more complementary in nature compared to energy. Marginal productivity of input reflects the price of the inputs and the higher rate of substitution reflects greater substitutability among factors across different sectors of the economy (Klump, McAdam and Willman 2012). Case 1 Use of energy = 100 units and use of capital = 150 units, total production = 1000 units. a) New energy inputs = 120 units, new output level = 1200 units Production elasticity of electricity indicates the response in output level, when there is a change in the level of electricity used in production (Raurich, Sala and Sorolla 2012). Production elasticity of electricity = (proportional changes in output)*100 / (proportional changes in energy *100) = {(1200 - 1000) / 1000} / {(120 100) / 100} = 0.2 / 0.2 = 1 b) Production elasticity of capital implies changes of output in response to the changes in unit of capital used in production (Klump, McAdam and Willman 2012). Use of capital input remains unchanged to 150 units Therefore, elasticity = {(1200- 1000) / 1000} / {(150 150) / 150} = 0.2 / 0 = Case 2 Employment of capital has increased to 160 units with unchanged energy inputs. The production elasticity of electricity is = {(1200 - 1000) / 1000} / {(100 100) / 100} = 0.2 / 0 = Production elasticity of capital = {(1200- 1000) / 1000} / {(160 150) / 150} = 0.2 / 0.067 = 2.985 4. Introduction This study analyses the assumptions of neo classical production function critically. Neo-classical production function is the function of two inputs such as labour and capital. A Neo classical production function has several assumptions to simply the analysis. Cobb-Douglas production function is mostly used neo classical production function in economic analysis. Several authors have criticized some of the assumptions. Assumptions of neo classical production function The assumptions of neo classical production function are as follows: i) The production function is differentiable with positive marginal productivity of the factors o production. ii) The factors exhibit the law of diminishing returns. iii) The factors of production are substitutable among themselves in a perfectly competitive market. Factors are perfectly mobile. iv) Absence of externality in production Philosophical critics According to the claim of the heterodox economics, the nature of neo classical production function, the substitution effect has not much effect in real economy (Fuss and McFadden 2014). However, in the view of Chen (2012), Cobb-Douglas production function has many real life applications. Moreover, the production only considers the effect of change in capital and labour. It cannot explain the residual element of the production function such as technology in Solow growth model. Schefold (2014) stated that neo classical production function estimates elasticity of output with respect to labour and capital according to the. However, this method of measuring output elasticity is not the correct one. Practically this estimation shows the share of profit in production and share of wage in income. Another assumption of the neo-classical theorists is that both the product and factor market are perfectly competitive, which is unrealistic. There exist other types of market structure such as monopolistic competition, monopoly and oligopoly. Therefore, production function varies across different sectors of the economy (Davis 2013). The neo classical production function assumes perfect mobility among the factors, which is not always possible in reality. Some of the industries are capital intensive, whereas some of are labour intensive. Hence, the mobility of factors is constrained by their productivity and requirement in the industry (Felipe and McCombie 2014). As depicted by Dosi et al. (2014), mathematical model of Cobb-Douglas model has similarity with the equation of national accounting identity derivative. However, Schefold (2014) mentioned that Cobb-Douglas production function correctly establish relationship with the national accounts, if the wage share is constant and technological progress is considered in production function. Fuss and McFadden (2014) cited that technological progress in the neo classical production function has been assumed linear. Dosi et al. (2014) contradicted this view to state that technological progress fluctuates overtime. Every production process has some externalities irrespective of primary, secondary or tertiary sectors of the economy. The externality may be positive or negative. Therefore, the assumption of no externality is unrealistic. Conclusion The analysis of production function is an important concept in mainstream Neo classical economics. Main inputs in this production function are labour and capital. Technology is used in this model as a residual factor in the production. This factor facilitates the production process. Despite having numerous uses, many economists have criticised this production function due to some of its unrealistic assumptions. The report has critically analysed the limitations of these assumptions. References Chen, B.Y., 2012. Classification of $ h $-homogeneous production functions with constant elasticity of substitution.Tamkang Journal of Mathematics,43(2), pp.321-328. Davis, J.B., 2013.The theory of the individual in economics: Identity and value. Routledge. 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