# 1 Introduction

The effects of output growth and changing fuel prices on the demand for energy depend on interfuel substitution and the substitutability of energy and other factors of production. Over the years, these issues have attracted a great deal of attention in a large number of energy demand studies, with most of these studies taking the approach of using a flexible functional form for the underlying aggregator function, following Diewert’s (1971) influential paper. In fact, this approach to empirical energy demand analysis was pioneered by Berndt and Wood (1975), Fuss (1977), and Pindyck (1979). It involves specifying a differentiable form for the cost function, and applying Shephard’s lemma to derive the resulting cost share (or input-output) equations. Using these equations and relevant data, one then could estimate the parameters and produce inferences about the demand for fuels (including those about the own- and cross-price elasticities as well as the elasticities of substitution).

Although the role of energy in the structure of production has been the focus of a large number of econometric studies, the evidence on interfactor and interfuel substitutability is mixed. For example, the early studies by Berndt and Wood (1975), Hudson and Jorgenson (1974), Fuss (1977) and Magnus (1979) all used time series data for a single country and found substitutability between energy and labor, but complementarity between energy and capital. Also, Fuss (1977), using Canadian data, found oil, gas and coal to be substitutes, but found no substitutability between each of these energy inputs and electricity. Moreover, Pindyck (1979), taking a similar approach to that used by Fuss (1977), used pooled timeseries data for a cross section of countries and found energy and labor to be substitutes and also energy and capital to be substitutes, and not complements as earlier studies had indicated.

In this regard, it should also be noted that the results of most energy and climate change policy models, no matter whether they are partial equilibrium or general equilibrium type, are highly sensitive to elasticity parameters, particularly the elasticity of interfuel substitution. However, there also exists only limited literature estimating such elasticity parameters. Moreover, with the exception of a few sporadic local papers, there is still a huge void in the literature dealing with energy demand and interfuel substitution in developing countries. This study is expected to contribute in filling the literature gap by estimating interfuel substitution elasticities through the use of recent advances in microeconometrics.

Over the years, there have been a large number of other studies investigating interfuel – substitution and the demand for energy see, for example, Uri (1979), Considine (1989), Hall (1986) and Jones (1995), among others. The major contributions in this area, however, are quite outdated by now, since their data incorporate observations before the 1970s. Also, very few studies deal with energy demand and interfuel substitution in developing countries, probably due to the lack of reliable data at that time. Moreover, most of this literature ignores the theoretical regularity conditions of neoclassical microeconomic theory. However, as Barnett (2002, p. 199) put it, without satisfaction of the theoretical regularity conditions, 2