Estimating the long-run user cost elasticity for a small open economy: evidence using data from South Africa

This paper estimates the long run elasticity of the demand for fixed nonresidential capital (both equipment and structures) to changes in its user cost using a quarterly panel of two-digit manufacturing data from South Africa from 1970 to 2001. Using a difference specification that does not rely on cointegration, we find highly significant estimates of the user cost elasticity on the order of -0.80. These estimates contrast sharply with many previous studies that obtained small and/or statistically insignificant estimates of the user cost elasticity using U.S. data. This discrepancy may owe to the possibility that the capital demand curve is better identified in a small open economy because shocks to capital supply are more likely to be exogenous. The economic embargo imposed on South Africa from 1985 to 1993 forced its economy to become more closed and therefore provides a unique natural experiment to assess this conjecture. Estimates of the user cost elasticity over this period are small and statistically insignificant, similar to the findings of previous studies where the user cost was likely endogenous. These findings underscore the importance of identification in estimating the user cost elasticity of capital demand.