Substitution Elasticities for CGE Models

Combating climate change and other environmental problems are among the main challenges of the current century. As a consequence, researchers as well as policymakers are discussing worldwide how regulative interventions should be designed to cope with these tasks. From an economic perspective, effectiveness, cost-efficiency and distribution issues are crucial for any form of future regulation. Ultimately, this results in the need for capable and above all reliable instruments to assess environmentally motivated regulations ex ante. In modern applied economics and most notably in the field of environmental and climate policy, Computable General Equilibrium (CGE) models have proven to be one of the leading instruments to evaluate alternative policy measures. As is true also for other micro-consistent and policy-oriented models, elasticities are key parameters for CGE models. But despite the central role of elasticities, the current situation of elasticities is rather unsatisfying and there exist only few estimates of the required elasticities. As a consequence, modellers frequently feel impelled to employ in their models elasticities from various originally unrelated sources or to use elasticities derived from different conceptual frameworks, thereby exposing themselves to criticism with respect to the usage of potentially inconsistent parameters estimates. In this paper we seek to contribute to the solution of this problem and aim at overcoming the lack of adequate estimates.We consistently estimate substitution elasticities for the well-established three level nested CES KLEM production structure on the on the basis of different non-linear least squares estimation processes. In the process we take advantage of the World Input-Output Database (WIOD). The new WIOD database allows us for the first time to use one consistent dataset for the estimation process and gives us the opportunity to derive elasticities from the same data which researchers can also use to calibrate their models.Our results show that compared to standard linear estimations using Kmenta approximations, in this context non-linear estimation techniques perform significantly better. Moreover, during the time period we consider, no significant change in input substitutability takes place over time. Hence for most sectors we do not observe technological change through this channel. Although technological progress in the form of changing substitution elasticities may potentially be an issue when studying longer time periods. On the basis of our estimations, we demonstrate that the common practice of using Cobb-Douglas or Leontief production functions in economic models must be rejected for the majority of sectors. As a consequence we object a simplified approach to the choice of substitution elasticities in the framework of policy oriented economic modelling. In particular in response to this result, we provide a comprehensive set of consistently estimated substitution elasticities covering 35 sectors. Therewith we hope to make a valuable contribution to making instruments designed to evaluate policy measures ex-ante more reliable and support policy makers in their efforts to cope with global environmental problems such as climate change.