Economic growth and interfactor / interfuel substitution in Korea

Contents

1 Introduction

2 The model
2.1 The static model
2.2 The dynamic model

3 Estimation
3.1 Data description and estimation procedure
3.2 Interfactor model
3.3 Interfuel substitution

4 Sub-period analysis

5 Conclusion

List of Figures

1 Gross Domestic Product

2 World Energy Consumption

3 Energy Supply and Demand

4 Primary Energy Consumption

5 Plot of the own-price elasticities of factor demand

6 Plot of the own-price elasticities of fuel demand

List of Tables

1 Implied elasticity of substitution (σij ) and price elasticity (ηij ) for the interfactor substitution

2 Implied elasticity of substitution (σij ) and price elasticity (ηij ) for the interfuel substitution

3 Total implied fuel-price elasticity (η∗ij ) for the interfuel substitution

1 Introduction

South Korea, the Asian peninsula of Manchuria separating the Yellow Sea and the Sea of Japan, once known to be one of the world’s poorest agrarian societies, has undertaken economic development since 1962 what has become known as the “economic miracle on the Hangang River”. Nevertheless, Korea’s remark- able economic achievements were threatened by the Asian crisis beginning in late 1997 when the Asian tiger nations suffered from overvalued currencies and a lack of regulation in the financial system led to business incest, inflated asset values, high foreign debt and many other problems. But thanks to successful foreign debt restructuring with creditor banks, the nation is currently on track to resume economic growth. “Korea’s macroeconomic performance since the crisis has been impressive, with strong real growth, low inflation, and rapidly growing official foreign reserves.”¹ Furthermore, since the onset of the crisis, Korea has been rapidly integrating itself into the world economy. To visualize this performance Figure 1² shows the impressive economic development of Ko- rea since 1980 and displays the differences in growth to Taiwan and Austria. With this history as one of the fastest growing economies in the world, Korea is working to become the focal point of a powerful Asian economic bloc.

As a result of this overwhelming development within the last two decades, the Korean economy, as well as many other representative developing countries, has experienced both a dramatic increase in oil consumption and an upward shift in wage rates. From a general scientific point of view the relationship between energy consumption and economic growth has been the subject of intense research over the past three decades. However, the empirical evidence is ambiguous. Although numerous studies including all different parts of the world into their analysis have investigated the causal relationship between eco- nomic development and energy consumption, it is still hard to say that find-

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Figure 1: Gross Domestic Product

ings from these studies have reached an overall consensus. However, following a recent study from Wankeun Oh from the Department of Economics at the Hankuk University of Foreign Studies in Seoul, “the empirical results for the case of Korea suggest the existence of a long run bidirectional causal relationship between energy and GDP”³. Besides, forecasts of the Energy Information Administration (EIA), shown in Figure 2⁴, predict that energy requirements of developing countries will further increase and will reach the demand level of the so-called industrialized world by 2025.

However, since Korea experienced dramatic shifts in its energy usage by substituting oil for coal and because of no domestic oil reserves, the tiger nation is forced to import all of its crude oil, which makes up the largest share

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Figure 2: World Energy Consumption

in the country’s energy consumption. Korea presently is the seventh largest oil consumer and the fifth largest oil importer in the world. The fraction of imports and exports in comparison to Korea’s energy production is visualized in Figure 3⁵.

Another important resource for the country is coal, which, due to indige- nous resources of low-quality anthracite has to be imported since it supplies about 21 % of Korea’s total energy requirements. The fraction of consumption of the individual energy sources is displayed in Figure 4⁶ showing the primary energy consumption.

To handle dramatic increases in energy consumption, Korea and many other energy importing countries often aim at stabilizing dramatic shifts in en-

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Figure 3: Energy Supply and Demand

ergy demands by imposing non-market based control mechanisms over energy prices. However, individual fuel-price changes not only have a substitution effect among individual fuels, for example crude oil, but also have a substi- tution effect among factors of production. On the other hand changes due to interfactor substitution also influence interfuel substitution. Ignoring this interdependences and limiting this causality to a usual standard model assum- ing no correlation between both substitution effects could lead to unreliable conclusions, especially when analyzing data from developing countries, such as Korea, facing rapid economic growth, a sudden increase in energy consumption and an upward shift in the wage rate.

Investigating this relationship of price-change effects can be done by pro- ceeding on a two-stage estimation method suggested by Fuss (1977), Pindyck (1979) and Andrikopoulos et al (1989), incorporating the interdependences be- tween interfactor and interfuel substitution where producers first choose fuel

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Figure 4: Primary Energy Consumption

sources to minimize energy costs and then minimize total costs by choosing optimal levels of production factors. This approach can be implemented by the help of an instrumental variable estimation method where the computed aggregate energy price using estimates from the interfuel substitution model are used as a variable in the interfactor substitution model.

2 The model

2.1 The static model

First of all it has to be modeled how changes in individual fuel prices affects its fuel consumption through the feedback effect between the interfuel and interfactor substitution. Assuming that the production function is weakly separable in the major components of capital (K), labour (L) and energy (E), an aggregate energy-price index can be composed. Furthermore assuming that capital, labour and energy are homothetic in their components - i.e. energy is a function of coal (CO), oil (OI) and electricity (EL) - the aggregate production function is given by:

Y = F[K,L,E(CO,OI,EL)] (1)

To express this production function as a cost function it has to be assumed that factor prices and the output level are exogenously determined:

C = C[PK,PL,PE(PCO,POI,PEL);Y ] (2)

In order to develop tests on the feedback effect described above that do not employ additivity and homogeneity as part of the maintained hypothesis, and by the help of a representation of the production possibility frontier and the price possibility frontier suggested by Laurits R. Christensen et al. (1973)⁷, the production function can be expressed as follows:

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where i, j = K, L, E and due to requirements that the cost function should be homogeneous of degree one and due to the adding-up criteria, and the Slutsky symmetry restriction the following restrictions have to be applied:

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[...]

¹ The World Bank Group: Financial Sector Assessment Korea; June 2003, p. 2.

² data: Energy Information Administration, International Energy Annual 2002.

³ Oh, Wankeun and Lee, Kihoon: Causal relationship between energy consumption and GDP revisited: the case of Korea 1970-1999 ; Energy Economics, Vol. 26, 2004, p. 59.

⁴ data: Energy Information Administration, International Energy Annual 2002.

⁵ data: Minstry of Commerce, Industry and Energy: Statistical Handbook of Korea 2002 ; Seoul, 2002.

⁶ data: Korea Energy Economics Institute, 2003.

⁷ Christensen, Laurits R., Jorgenson, Dale W., Lau, Lawrence J.: Transcendental Loga- rithmic Production Frontiers; The Review of Economics and Statistics, Vol. 55, No. 1, Feb. 1973, p. 7.