The "Elusive" Capital-User Cost Elasticity Revisited

This paper sheds new light on the estimation of the long-run elasticity of the demand for business capital---for a measure of capital that includes both equipment and structures---to changes in its user cost using a quarterly panel of two-digit manufacturing industries from South Africa from 1970 to 2000. Highly significant estimates of the user cost elasticity that are in the vicinity of the -1.0 benchmark implied by a Cobb-Douglas production function are obtained using a variety of specifications, including panel cointegration techniques that correct for small sample bias. Unlike most previous studies, meaningful elasticity estimates are also obtained using stationary panel specifications. The robustness of these estimates may be due, in part, to the possibility that the capital demand curve is better identified in a small open economy where shocks to capital supply are more likely to be exogenous. The economic embargo imposed on South Africa from 1985 to early 1994 temporarily forced its economy to become more closed and therefore provides a unique opportunity to assess the importance of identification in the estimation of the user cost elasticity. User cost elasticity estimates using embargo and non-embargo period data are consistent with a substantial bias from endogeneity.