Dynamic Factor Demands in a Changing Economy: An Irish Application

In this paper, more advanced models of the Irish supply side are examined and applied. In particular, a specification of a flexible and dynamic model, which nests more traditional approaches, is adopted. The approach consists of a two-stage process. Firstly, a static translog cost function for the entire economy is specified and associated factor demands are estimated. Then a more flexible dynamic specification is presented which has as a special case the initial static specification. Standard Likelihood Ratio tests can examine the validity of the restrictions underpinning the relatively standard static specification. Estimating a dynamic flexible functional form specification of the supply side has a number of advantages over more traditional approaches such as the Cobb-Douglas. The elasticity of substitution between the factor inputs labour and capital can be determined by the data and not imposed by the researcher. Also the standard static approach to supply-side analysis assumes that producers respond instantaneously in their factor input decisions vis-à-vis changes in factor input prices. This assumption is rather unrealistic particularly given the nature of capital usage and investment. Also the differences in long and short run elasticities for factor demands are examined. The relationship between the two sets of elasticities in formalised in the Le Chatelier principle. The use of the more dynamic and flexible specification is justified in an Irish case. Input use adjustment is found to occur on a multi-period basis and not in the instantaneous fashion assumed by a static approach. The Le Chatelier principle is also observed meaning that long-run price elasticities of factor demands in absolute terms are greater than the short-run equivalents.