Constant elasticity of substitution (CES) production function can greatly overestimate the economic costs of climate policies.

Abstract

In this paper, we look at a modification to the conventional constant-elasticity-of-substitution (CES) production function to arrive at a more general specification which can allow for varying, or ‘flexible’ elasticity of substitution (FES). The function reduces to the CES as a special case, hence it is more general. We use the new function in a climate policy experiment to test the usefulness and robustness of the new function. It turns out that using the new function in an economic model can give estimates of the economic costs of a climate policy which is about half of the costs as estimated from a conventional CES production function specification. This has significant implication, not only for climate policy, but also for any other economic policy which relies on models which use the CES production function specification as a basic building block.