Production and substitution in two‐gap models

Abstract

The paper examines the assumptions about production and factor substitution in two‐gap models. It focusses on the basic assumption of substitution between domestic and imported capital inputs implicit in the foreign exchange constraint argument. The elasticity of substitution between these two sets of inputs is measured using time series regressions employing data from Argentina. It is concluded that in Argentina the observed capacity to substitute domestic for imported inputs was substantial. It is argued that for countries with a somewhat developed industrial sector, rigid assumptions of complementarity between domestic and imported inputs might be inappropriate, and that projection of foreign exchange requirements based on such assumptions, commonly employed in two‐gap models, would be questionable.