Two models of dynamic input demand : estimates with Canadian manufacturing data

Over the past decade there has been a number of innovations in the estimation of input demand equations. In particular, ways of incorporating the hypothesis of rational expectations into empirical models of the firm have been developed and improved upon. This research agenda was perhaps inspired by the Lucas critique of econometric policy evaluation, which suggested that econometric models which did not explicitly take account of how expectations of the future affect current behaviour would give misleading results regarding the possible effects of various government policies. Lucas specifically directed part of his critique at empirical models of business investment, which had been used previously in the assessment of tax policies designed to affect investment. This thesis has a dual purpose. First, two distinct models of input demand are estimated with Canadian manufacturing data. Each of the models incorporates to some degree the hypothesis of rational expectations, but the specifications of technology differ. Neither of these models, to our knowledge, has been estimated with Canadian data. We are interested in whether either model explains well the behaviour of the Canadian manufacturing sector, and in how the results compare with the (few) U.S. applications of this type of model. The second purpose is to use the results of these models in simulations to assess the effect of changes to the after-tax rental rate of capital on investment and employment in manufacturing. While there have been studies in Canada (and elsewhere) that attempt to calculate the effects of various tax policies on investment, most studies were done prior to the innovation of techniques in estimating models with rational expectations. This thesis is able to examine the effects of a particular change while remaining immune to the Lucas critique. If the modelling of expectations is correct, this could not only improve the reliability of the estimates, but also give some indication of the empirical importance of the Lucas critique. The results can be summarized as follows. The two models give very different estimates of price elasticities of demand for capital and labour, even though they are similar in many respects and are estimated with a common data set. It is also the case that their estimates of the effects of temporary and permanent changes to the rental rate are different. Adjusting the reduced form parameters of the input demand equations to account for changes in tax policy regimes alters the results to a significant degree, suggesting that the explicit modelling of expectations matters in an empirically relevant sense. However, these effects are in opposite directions for the two models considered here. All this suggests that more research is required into the relationship between expectations of future policy and investment behaviour.Arts, Faculty ofVancouver School of EconomicsGraduat