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Estimate of the elasticities of substitution of

the CES and translog production functions in
Tunisia

ARTICLE in INTERNATIONAL JOURNAL OF ECONOMICS AND BUSINESS RESEARCH · MARCH 2015

DOI: 10.1504/IJEBR.2015.068544

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Int. J. Economics and Business Research, Vol. 9, No. 3, 2015 245

Estimate of the elasticities of substitution of the CES

and translog production functions in Tunisia

Kamel Helali* and Maha Kalai

Department of Applied Quantitative Methods,
Faculty of Economics and Management of Sfax,
University of Sfax, Tunisia
Email: helali.kamel@gmail.com
Email: helali.kalai.maha@gmail.com
*Corresponding author

Abstract: On the basis of the CES and translog production functions, this study
compares the degrees of capital-labour substitution of a developing country. In
order to change the tradition of some modellers, we try to present estimates of
substitution elasticity caused by these two production functions applied to the
Tunisian economy. In these estimations, we use statistical data about the
1961/2010 period for the five sectors of the global economy by choosing two
factors of production. We apply the nonlinear least squares method to estimate
the substitution elasticity in each sector of the CES function using the GAMS
software and the SURE method in order to estimate the translog function by
means of the STATA software. The results indicate a strong similitude between
the elasticity substitution estimates for each function, which are significantly
below the unity.

Keywords: production function; elasticity of substitution; nonlinear least

square; Tunisia.

Reference to this paper should be made as follows: Helali, K. and Kalai, M.

(2015) ‘Estimate of the elasticities of substitution of the CES and translog
production functions in Tunisia’, Int. J. Economics and Business Research,
Vol. 9, No. 3, pp.245–253.

Biographical notes: Kamel Helali is an Assistant Professor in Quantitative

Methods at the Faculty of Economics and Management of Sfax, University of
Sfax.

Maha Kalai is a PhD student in Quantitative Methods at the Faculty of

Economics and Management of Sfax, University of Sfax.

This paper is a revised and expanded version of a paper entitled ‘Estimate of

the elasticities of substitution of the CES and translog production functions
in Tunisia’ presented at The Second Annual Scientific Meeting on Applied
Finance and Economics, Sfax, 26 April 2014.

1 Introduction

In its most general form, the production function establishes a relationship between the
inputs and outputs. It can also be designed as a possible frontier for an economy or any

Copyright © 2015 Inderscience Enterprises Ltd.

246 K. Helali and M. Kalai

other decision unit. The study of the production decisions can be carried out in the short
or long run. The distinction between both depends on the degree of flexibility of the
production factors. In the short run, one production factor is variable whereas in the long
run, all the factors are variable. It is most often assumed that the variable factor is labour.
This choice corresponds to an empirical observation that the firm can adapt the work load
faster than that of the capital.
A key parameter that determines the results of general equilibrium models is the
elasticity of substitution in production functions. Juselius (2008) proposes a different
approach to draw inference on the elasticity of substitution, which is based on the idea
that estimates of the elasticity of substitution may be retrievable from behavioural
equations derived from more realistic models by conducting comparative statics with
respect to the parameter. This approach avoids difficulties with direct inference about
elasticity values in a constant elasticity of substitution (CES) production function by
exploiting theoretical relationships discovered using an economic model which assumes
market imperfections.
The use of the factors depends on the techniques of production that are reflected by
the function of the latter. In the short run, the proportions are often fixed, whereas in a
relatively long run, the techniques can possibly be changed. The degree of technical
substitution indicates the substitution facilities or difficulties of a factor by another.
However, the major drawback of this rate is its dependence on measurement units of the
factors. It seemed then necessary to apply the substitution elasticity as a unit of
independent measurement which is, like any elasticity, the ratio of two percentage
changes, the percentage change of the ratio of factors d ln(K/L) and the marginal rate of
technical substitution d ln TMST = d ln(fL/fK).
In this paper, our purpose is to estimate two production functions; the translog and the
CES which reflect, to a large extent, the empirical difficulty of explaining the actual
production development (growth) by taking into account the quantitative evolution of
factors: capital and labour. Both of the functional forms chosen will be estimated in five
sectors of the Tunisian economy. The results acquired enable us to make an analysis of
the evolution of the substitution elasticity so that we can study the characteristics of the
production process in the Tunisian economy. We are particularly interested in two
aspects of this process; the returns to scale and the substitution possibilities between the
factors of production.
Having introduced and defined the parameters which help characterise a production
function, we are committed to calculate them in the case of the CES and translog
functions (Section 2). The data, the estimation method as well as the estimation results
are presented in Section 3. Finally, the conclusions are put in Section 4.

2 Production functions and returns to scale

In the economic theories, economists often use the Cobb-Douglas function in their
studies since the parameters of this function can be easily analysed and identified.
Moreover, other economists, such as Arrow et al. (1961), suggested that the assumption
of the unitary substitution elasticity of the Cobb-Douglas production function is not
investigated in the empirical studies. For this reason, the authors suggested the CES
production function which includes the added value of an activity with two factors of
production, labour and capital.
 Estimate of the elasticities of substitution of the CES and translog production 247

2.1 CES production function

The CES production function is a special form of the neoclassical production function
(Kmenta, 1967). In this approach, the production technology uses percentages of constant
changes and proportions of factors (capital and labour) as a result of a 1% change in the
marginal rate of technical substitution (Chongela et al., 2013).
ηi
−
Y = F ⎡⎣δ i K − ρi + (1 + δ i ) L− ρi ⎤⎦ ρi (1)

with Y the production; F the factor productivity; δi the partition parameter; K and L the
primary production factors (capital and labour) and ρi = (1 – σi)/σi where σi is the
substitution elasticity. This CES form may be a specific function: Cobb-Douglas
(if ρi = 0) and Leontief (if ρi tends towards infinity). Actually, when ρi equals –1, the
substitution elasticity tends towards infinity and the production factors become perfectly
substitutable. Moreover, ηi represents the function homogeneity degree. In fact, Brown
and De Cani (1963) gave the general version of the CES function for non-constant returns
to scale which makes it homogeneous on the basis of ηi degree. In our study, ηi = 1
corresponds to the case of the constant returns to scale; ηi > 1 corresponds to the case of
the increasing returns to scale, ηi < 1 corresponds to the case of decreasing returns to
scale.

2.2 Translog production function

In order to have a characterised productive combination without resorting to specific
structural hypotheses, current specifications of the Cobb-Douglas type should be
substituted by flexible forms that impose a priori no restrictions on the production
structure. The most commonly used flexible form is the translog function defined by
Christensen et al. (1973). The translog function flexibility can be described by comparing
the elasticities derived from this formulation with the ones generated by a Cobb-Douglas
function: elasticities of factors and returns to scale are constant for a Cobb-Douglas
function; however, they depend on the factor level in the translog function.
The functional form chosen in the previous estimates, if it corresponds to the
theoretical growth model, has a number of limits regarding its flexibility. Particularly, the
factors here are considered substitutable and production elasticity in each factor is seen to
be identical for all the regions and throughout the whole period. The translog production
function is, from this point of view, much more flexible than that of the Cobb-Douglas
type. Moreover, it identifies the hypotheses of the factor substitutability and of the
production homogeneity in relation to these factors. A translog production function takes
the following general form:
n n n
1
Ln Y = β 0 + ∑
i =1
βi Ln X i +
2 ∑∑ ρ Ln X .LnX
i =1 j =1
ij i j (2)

Production elasticity regarding each factor is as the following:

∂ Ln Y
∂ Ln X i
= βi + γ ii Ln X i + ∑ ρ .Ln X
j ≠i
ij j (3)
248 K. Helali and M. Kalai

Elasticities are therefore no longer fixed and identical for all the individuals and periods.
The factor elasticity will be based not only on the available part of this factor but also on
the quantities of other factors that each region has at each period.

3 Empirical analysis

In the context of modelling the general equilibrium, economists should take into account
the elasticity corresponding to each applied function. Most modellers often prefer to
borrow the elasticity values of the developed economies that exist in literature. Actually,
elasticity estimation is made on the basis of the availability of statistical data specific to
each sector and to each country. Regarding the developing countries, the non-availability
of some statistics is permanent. Nevertheless, this does not prevent us from applying
methods on the basis of our statistical data.
In this paper, we are going to estimate the elasticity of the Tunisian production
function substitution of the CES and translog type. In Tunisia, we have five main sectors
of the global economy: agriculture and fishing (AF), manufacturing industries (MI),
non-manufacturing industries (NMI), market services (MS) and non-market services
(NMS). Production in these sectors uses two factors: labour and capital. Therefore, we
can identify the substitution elasticity of both factors. To achieve this estimate, we use the
statistical data provided by the Tunisian Institute of Competitiveness and Quantitative
Studies (TICQS) for the period 1961-2010. Using this source, we could have the data
relevant to the capital stocks (volume in million dinars, MD) and the employed
population (in thousands).
It is in this belief that we use the most known methods in literature in order to
estimate substitution elasticity. As far as the CES production function is concerned, there
are several approaches to estimate its parameters. Although each approach has its own
advantages and disadvantages depending on the considered sector, we used the nonlinear
least square method (NLLS), in our study. On the basis of this approach, we will try to
determine the shape of the production function (CES, Cobb-Douglas or Leontief) for
each sector. This procedure is performed using the GAMS software. For the translog
production function, the parameter estimation is made directly from the SURE iterative
approach using the STATA software. With this step, we can establish the specific form of
the production function of Tunisia for each sector.

3.1 Empirical models

We start by presenting the CES production function of the ith sector, which uses two
production factors (labour and physical capital) as follows:
−η i
1−σi
Yit = Ait ⎣⎡δ i Kit− ρi + (1 − δ i ) L−it ρi ⎦⎤ ρi where ρi = , 0 < σi < ∞ (4)
σi
To make the evaluation of this nonlinear function easy, we apply the linearisation
logarithmic form which gives us the following equation:
ηi
LnYit = γ − × Ln ⎡⎣δ i K it− ρi + (1 − δ i ) L−it ρi ⎤⎦ (5)
ρi
 Estimate of the elasticities of substitution of the CES and translog production 249

Kumar and Gapinski’s (1974) NLLS consists in minimising the squared error under the
constraint of the above equation:
N
Min ∑ei =1
2
it
(6)
η
s.t. LnYit = γ − i × Ln ⎡⎣δ i K it− ρi + (1 − δ i ) L−it ρi ⎤⎦ + eit
ρi
with i an index for the sector, t an index for the period, Yit the production, Kit the capital
stock, Lit the labour, eit the measurement error, γ the log of the efficiency parameter
(γ > 0), δi a sector distribution parameter (0 < δi < 1), ρi a sector substitution parameter
(–1 ≤ ρi ≤ ∞) and σi a measure of the sector substitution elasticity.
The substitution elasticity estimation is carried out for the five sectors over the period
1961–2010. Using the GAMS software, we will estimate the various parameters of our
CES production function. According to Balistreria et al. (2002, 2003), Koetsea et al.
(2008) and Henningsen and Henningsen (2011), substitution elasticity is identified on the
basis of the following equation:
1
σi = (7)
1 + ρi

The second step consists in presenting the translog production function which takes the
following form:

LnYit = β 0 + β L Ln Lit + β K Ln K it + βt t + 0.5 γ LL ( Ln Lit )

2

+ 0.5 γ KK ( Ln K it ) + 0.5γ tt t 2
2
(8)
+ ρ LK Ln Lit .Ln K it + ρtL t.Ln Lit + ρtK t.Ln K it + ε it

and production elasticity εYi in relation to each factor will be:

∂ Ln Yit wit . X it
ε Yi = =
∂ Ln X it Yit (9)
= β i + γ ii Ln X it + ρij Ln X jt + ρti .t ; ∀ i; j = L, K

On the other hand, we can calculate the substitution elasticity between both factors xi and
xj in the Allen (1938) sense as the following:

1 ⎛ ∂Y ∂Y ⎞ H ij
σ ij = ⎜ xi . + xj. ⎟ (10)
xi .x j ⎜ ∂xi ∂x j ⎟ H
⎝ ⎠
where H is the Hessian matrix associated with the production function and Hij the
co-factor of the ijème element of H. As a result, we will for K and L:
2
∂ 2Y ∂Y ∂Y ∂ 2Y ⎛ ∂Y ⎞ ∂ 2Y ⎛ ∂Y ⎞
H =2 . . − .⎜ ⎟ − 2 .⎜ ⎟
∂K .∂L ∂K ∂L ∂K 2 ⎝ ∂L ⎠ ∂L ⎝ ∂K ⎠
and
250 K. Helali and M. Kalai

∂Y ∂Y Y2
H ij = . = ε YK .ε YL .
∂K ∂L K .L
These two expressions will bring us to define the substitution elasticity between K and L
as follows:
( wK .K + wL .L ) .ε YK .ε YL
σ KL = (11)
2 ρ LK .L.K .ε ε − ( γ KK + ε YK ( ε YK − 1) ) ε YL
2 2
YK . YL
2
− ( γ LL + ε YL ( ε YL − 1) ) ε YK
2

In the case of two factors, this concept brings us back to the usual definition of
substitution elasticity as an elasticity of the ratio of capital to labour relative compared
with the marginal rate of substitution between these factors. It is generally interpreted as
the impact of a change of the relative prices of two factors on the ratio of demands for
these two factors, at a fixed production level. On building up an equation system
composed of the production function and the equation of the production elasticity in
relation to the labour ratio, we will estimate the various system parameters using the
SURE iterative method found in the STATA software.

3.2 Empirical results

In order to estimate the substitution elasticities of the CES production function, and by
referring to Rainer et al. (2007), we created a minimisation programme of the quadratic
errors under the logarithmic constraint of the production function. After applying the
minimisation programme to each sector using the GAMS software, we gathered the
numerical values of the substitution elasticity for each sector in Table 1.
Table 1 Nonlinear estimation of the CES production function

Sectors γ δ ρ η σKL
AF 3.468 –0.218 0.278 0.373 0.746
MI –0.684 0.322 0.518 1.163 0.659
NMI –2.482 0.226 0.701 1.347 0.588
MS –0.419 0.749 –0.252 1.251 1.336
NMS 1.091 1.100 3.067 1.596 0.246

The estimated values of the substitution elasticity for each sector clearly show that there
is a relationship between both of the CES production factors: capital and labour. The
production function for most sectors takes the CES form since substitution elasticity is
different from 1. Moreover, the sector of the NMS, where the value of ρ is very high,
takes the Leontief form. In addition, all the sectors, except for the agricultural sector,
show increasing returns to scale where the η value is below one despite the recorded high
efficiency value (3.47). In total, we notice that most of the elasticities, with the exception
of the sector of the NMS (1.34), are inferior to 1.
In order to compare the results of the CES model, we have estimated a system of two
equations, which includes the translog production function and the equation of the
production elasticity in relation to labour. The use of the SURE constrained iterative
method gave the results in Table 2 in which the significance of all the coefficients, with
the exception of the square variable tendency, is at 99% and 95%. In addition, this
 Estimate of the elasticities of substitution of the CES and translog production 251

estimate shows strong adjustments and outbuildings. On the basis of this estimation, we
calculated the various elasticities defined above.
Table 2 Estimates of the translog production function

Variables Coefficient Standard deviation P-value

Dum 1 –3.88** 1.858 0.037
Dum 2 –3.97** 1.857 0.032
Dum 3 –4.14** 1.857 0.026
Dum 4 –3.44* 1.857 0.064
Dum 5 –3.98** 1.861 0.032
βL 1.13*** 0.250 0.000
βK 1.40*** 0.482 0.004
βt –0.07** 0.033 0.027
γLL 0.37*** 0.032 0.000
γKK 0.19*** 0.069 0.005
γtt 0.3.e–4 0.3.e–3 0.933
ρLK –0.43*** 0.030 0.000
ρtL 0.03*** 0.002 0.000
ρtK –0.01** 0.004 0.021

R 2
LY 0.999 χ = 1.21.e + 6
2
14 0.000

Rσ2L 0.72 χ 32 = 668.4 0.000

Preusch-Pagan test χ12 = 122.8 0.000

Notes: ***, ** and *significance at 1%, 5% and 10%. Dum: dummy variable
representing the constant related to the sector.
Table 3 shows a very high similarity of the elasticity results of the translog function
compared with that of the CES. In fact, most of the substitution elasticities, except for the
NMS (1.392), are different and inferior to 1.
Table 3 Average estimations of the elasticities of the translog production function

Sectors εYL εYK σKL

AF 0.620 0.768 0.929
MI 0.350 0.517 0.672
NMI 0.361 0.440 0.488
MS 0.801 0.668 1.392
NMS 0.634 0.264 0.517

The analysis of the substitution elasticities indicates that there is a strong heterogeneity
between the sectors. Two kinds of explanations can be advanced to explain this result. On
the one hand, elasticity variability may be caused by problems of estimation: the
calculation formula is relatively complex and involves, in particular, the second
252 K. Helali and M. Kalai

derivatives of the translog function. Moreover, this variability also be explained by the
heterogeneity between the different sectors.

4 Conclusions

Two main conclusions come out from this work. First, our results confirm the existence
of increasing returns to scale for most sectors of the Tunisian economy, except for the
agricultural one. Secondly, the hypothesis showing the correct model corresponding to
the CES function cannot be rejected for four out of five sectors.
The estimating results shown here strongly support the hypothesis that substitution
elasticity between the factors; capital and labour, is below the unity. These results seem
not to be very affected by the assumption related to the process of the variable of
technological efficiency. Furthermore, the assumption that this parameter is equal to 1
was rejected in the different considered estimation frameworks. Thus, the estimation
results suggest that production factors are very complementary. Therefore, on the basis of
the information obtained in our analysis, a CES formulation having a substitution
elasticity of about 0.8 seems more consistent with the Tunisian data.

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