Substitution Elasticities in the Large-Scale Manufacturing Industries of Pakistan (Report‪)‬

This paper examines substitution elasticities between capital and labour in the manufacturing sector of Pakistan. It is found that whereas the substitution possibilities between the capital intensive and labour intensive techniques of production are rather limited, the substitution possibilities between various activities do exist. It is also found that changes in capital-labour ratio have a significant influence on the substitution elasticity and as such CES estimates, in general, are biased. Factor-market distortions in Pakistan have reduced welfare by inducing 'wrong' specialisation and the adoption of capital-intensive techniques ill-suited to the country's factor endowments. These consequences of factor-market distortions are important because capital-intensive techniques of production and/or capital-intensive activities create far less job opportunities compared to the situation in which labour-intensive techniques of production are employed and/or country specialises in the labour-intensive activities. The removal of such distortions should, therefore, enhance social welfare by promoting a higher growth rate of GNP and by easing the unemployment problem. Thus a systematic exploration of the possibilities of factor substitution should be of considerable significance for economic analysis and policy making. If the elasticity of substitution is large, a small reduction in the relative prices of labour would lead to a rapid growth of employment. On the other hand, if it is low, the removal of distortions from the factor market will not have much effect on the choice of production techniques. Moreover, even if the substitution elasticity is low for each industry but is significantly high for the manufacturing sector as a whole, the appropriate changes in factor prices would lead to an increase in welfare by inducing specialisation in the right direction. Furthermore, a low substitution elasticity would imply a rather limited choice between production techniques, and as such it will highlight the importance and need of developing new and appropriate techniques. In view of these considerations, the importance of determining the magnitude of the relevant elasticities of substitution should be selfevident.