2.2. Oil revenue and manufacturing output growth relationship9
2.3.3 Oil as an input (energy source) and manufacturing output growth 18
Finally, the theoretical relationship between oil and manufacturing sector is clearly shown in these analyses of Dutch Disease phenomenon, which is a result of the resource curse hypothesis.
2.3.3.1 Growth theories with natural resources (A review)
These growth theories centred on natural resources as a source of energy for production process. Basically, natural resources are categorized to renewable and non renewable energy sources. Oil is referred to as non-renewable natural resources just like other fossil fuels; crude oil is produced from the remains of plants and animals over millions of years. Renewable natural resources must be replaceable within a reasonable amount of time, ranging from days to maximum of years. But in the case of oil it takes millions of years to be replaced, too long for people to wait around for more to be made (see Smulders, 1999).
The major issue growth theory assessed is the issue of sustainability of output level, since most of the renewable resources are exhaustible. Therefore, if growth depends on them, sustainable economic development might not be guaranteed. Conversely, non renewable resources like oil are believed to be inexhaustible depending on the production function. A situation where there are two inputs in a production function that is manufactured capital and natural resources (oil) offer alternative growth paths to economic growth. These growth paths depend majorly on institutional arrangements.
One of the growth paths followed the optimal growth model, which maximizes the discounted social welfare, mostly during an infinite period of time or achieves a sustainable social welfare (that is a non-declining social welfare). Therefore, the growth theories on natural resources and output growth centre on what permits sustainable economic growth, which is synonymous with a non-declining utility or consumption.
Consequently, the issue of “Sustainability” is very germane in assessing the role of natural resources like oil, in economic growth. Technical and institutional conditions have been identified as major factors, which can affect oil guaranteeing sustainable economic growth. The technical conditions have to do with the mixture of renewable and non-renewable resources, capital and natural resources endowment, and the possibility, as well as ease of substitution, among various inputs used in production process. While, the institutional set-up covers the market structure which can be
competition or central planning, it also involves issues of property rights which can be common property or private property and lastly the system values itself.
Solow (1974), through his growth model, showed that sustainable growth can be achieved with finite non-renewable resources with no extraction cost and capital that is assumed not to be depreciating. In other words, according to Solow, sustainability is only possible if the non-renewable resources are produced with the usage of natural resources and capital. Oil as a non-renewable resource and input in production, might not completely fit in into the Solow growth model due to the unrealistic assumptions. In addition, oil might not even guarantee sustainable growth, since the same model under a market competition may eventually lead to extinction of the natural resources used in the production of the non-renewable resources (oil) and this will also lead to the decline in social welfare and finally lead to the collapse of the economy (see Stiglitz, 1974;
Dagupta and Heal, 1979)
However, standard growth theory advocates for substitutions of the depleting natural resources. According to the theory, the substitutes must be more in abundance and it can also be equivalent to human or man-made capital, which may be machines, capital or factories among others. All these are still within technological arrangements to ensure growth sustainability. Notwithstanding, the neoclassical economists, are more concerned with how institutional arrangements can aid crude oil as a non-renewable resource, to guarantee growth sustainability as opposed to technical arrangements. The neoclassical growth theory believes the priori that technical arrangements can guarantee sustainable growth. But under what institutional arrangement is this feasible? This is the question theory tends to answer (see Stern, 2003).
Oil as a non-renewable resource in production process, is also affected by elasticity of substitution, in the production function for “substitutability” of the resources. This leads to sustainable economic growth. According to Stern(2003), the elasticity of substitution σ, between capital, that is, machines, factories and environmental inputs such as natural resources, ecosystem services and waste assimilation, is a term that measures how much
an input is to be reduced in order to increase another input and still maintain the same level of output. Economic theory shows that a large elasticity of substitution implies that a rising cost of input, say oil, can easily be ameliorated by switching to another production technique which makes use of alternative capital.
However, if elasticity of substitution σ=1, is a case of “perfect substitutability”, this means that if the ratio of two inputs is changed with a given percentage while holding output constant, the ratio of the marginal products of the two inputs will change in opposite direction. This implies that as the usage of resources (oil as an input) falls, the usage of capital in the production process can be increased to infinity and still maintains same level of output. This also means that cost of production remains constant along the isoquant. However, when elasticity of substitution σ=0 this is the case of no substitution. Under this condition the two inputs must be used in fixed ratios but where the inputs are infinitely substitutable, the producer cannot differentiate between the inputs and will only go for the cheaper one.
2.3.3.2 Factors affecting substitution of oil as an input in production process
Solow (1997), in his model, identified two different forms of substitution; substitution within category and between category. The within category is the substitution that takes place within category of the same input for example fuels. While substitution between categories refers to that substitution between different forms of inputs, such as the one between energy or say oil and machine. Solow attached more importance to the first category, in the case of oil as an input in production. The substitution of renewable resources for non-renewable resources has affected the usage of natural resources in most of the advanced countries. Example is substitution of wood for oil.
Notwithstanding, ecological economist have also identified another form of substitution which is manufactured capital for natural capital. The following factors have therefore been identified as variables that can affect the rate at which oil can be substituted in manufacturing production process (see Stern 2003).
Thermodynamic
This has to do with the level of energy fundamentally required in the transformation process of a certain material into different thermodynamic states ( See Ruth 1993;
Islam, 1985). The thermodynamic limit is strongly affected by the rate of energy usage during the transformation process. Therefore, where technological development shows a very strong diminishing returns owing to thermodynamic limits do normally have serious implications on possibility of substitution.
“Complimentarity”
Since production process is combination of different forms of capital to generate output consequently, oil as a natural capital substitution is prone to availability of relevant compliments like manufactured capital which is also used in the transformation process (See Cleveland et al; 1984). According to the Georgescu-Roegen’s (1976) fund flow model, manufacturing production process describes an activity which involves transformation of a flow of energy, materials and information by two agents namely;
labour and manufactured capital. Materials, energy and services from natural resources are been transformed while manufactured capital effect the transformation. For instance, in an energy industry more manufactured capital (machines) may be used to extract more oil from a petroleum reservoir if jointly used with some natural capital. Therefore
“complimentarity” limits substitution.
Critical Natural capital
It has been argued that some natural capital at macro level is not replaceable by manufactured capital at least beyond a certain critical stock size. According to Costanzaand Dlay, 1992, there is a limit to the stock of produced capital that can be used since certain level of stock provides life support for the economy as a whole.
Therefore excessive substitution of man-made capital for natural capital may approach a threshold beyond which natural system may not be able to cope again and cause a
system collapse. Therefore critical natural capital may definitely limits the ease of substitution of oil in production process.