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UTT~RWORTH E I N E M A

Resoutz'es Polio Vol. 21, No. 4, pp. 255-261. 1995 T.

N N

Copyright 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4207/95 $10.00 + 0.00

Pig iron production structure in Japan

H S Chang
Department o f Agriculture and Resource Economics, University o f New England, Armidale NSW 2351, Australia

Japan is the world's largest steel producing country, and around half of its total input requirements for coking coal and iron ore are sourced from Australia. Moreover, around half of Australia's total coking coal and iron ore exports go to Japan each year. Therefore, changes in the demand for these two inputs are likely to have a significant impact on Australia. The purpose of this paper is to investigate the production structure of the blast furnaces in Japan and factors affecting the demand for iron making raw materials. The empirical study is based on the generalized Leontief cost function. Because of its functional flexibility, the model allows testing various hypotheses regarding pig iron production from blast furnaces. Based on the data from 1974 to 1991, the modelling results show that the Japanese ironmaking technology, when considered as an aggregate production process using fuel and iron ore as major inputs, could be characterized by fixed factor proportions, constant returns to scale and technical changes that can be explained by systematic changes in input mix. Moreover, while there is little variation in the iron ore usage rate, variations in fuel usage rate can be explained largely by changes in the make-up of iron ore charge and blast furnace production capacity over the sample period.

Australia is the world's largest coking coal exporter and the second largest in iron ore export. Together, coking coal and iron ore exports contributed about A$7.5 billion in export earnings in 1994. Japan is by far Australia's largest consumer for these two commodities; around 50% of Australia's coking coal and iron ore exports go to Japan annually. Japan has been leading the trends towards improved steelmaking technology and more efficient input uses. The effects of such technological changes can be seen in the changes in demand for steelmaking raw materials, such as fuel oils, iron ore, coking coal and pulverized coal injection (PCI) coals. The purposes of this paper are to examine the structure of the blast furnace production process in Japan and to determine the extent to which changes to relevant input prices and technology affect demand for coking coal and iron ore. The paper begins with a brief introduction of the iron and steelmaking process in the Japanese steel industry. In the second part of the paper, the input demand functions for fuel and iron ore are derived and econometrically esResources Policy Volume 21 Number 4 December 1995

timated based on a generalized Leontief cost function. In the process, various hypotheses regarding the production structure of blast furnaces in Japan are tested. Implications for demand for principal steel making raw materials are then provided based on the modelling results.

Iron and steel making process

Steel can be produced either from the blast furnace or the electric arc furnace. About 70% of world steel is produced in the blast furnace, where iron ore is reduced to molten iron or pig iron. Molten iron or pig iron is then converted to steel in either a basic oxygen furnace or an open heart furnace. Alternatively, steel can be produced in the electric arc furnace which uses scrap steel as feedstock. In the ironmaking process, substantial heat is required to melt iron ore. The major heat source used in the blast furnace is coke. Coke is produced by heating coking coal in coke ovens to a very high temperature in the absence of air. Coke also serves as a reducing agent
255

Pig iron production structure in Japan." H S Chang

600

1800 Iron ore 1600

580

560

540

1400

520

Fuel

1200 -~

500
o

1000 -~ 480

460

800

440

600
420

400

400 1991

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

Figure I Fuel and iron ore rates in the blast furnace in Japan, JFY 1965-91

in the process as well as structure support for blast furnace charges. The latter function allows air to ascend from the top and molten iron to descend to the bottom of the blast furnace. Auxiliary fuels, such as fuel oils, pulverized coal, liquefied natural gas, liquefied petroleum gas, coke oven gas and treated blast furnace gas, have been used to varying degrees to supplement coke. Among them, fuel oils were used in significant amounts by the Japanese steel industry during the 1960s and 1970s. However, after the first oil shock, the use of fuel oils had been drastically reduced because of increases in oil prices and was subsequently supplanted by pulverized coal injection. Regardless of changes in fuel mix, blast furnace productivity in Japan, as measured by output per cubic metres of blast furnace, has increased gradually during the past few decades. The increased productivity is the result of improved feedstock qualities, elevated operating temperature and pressure, advanced monitoring and control system and larger and better designed blast furnaces (Dwyer and Muir, 1992; Hilly, 1989). However, further improvements in blast furnace productivity

through the similar processes have become increasingly difficult because of technical limits of the existing technology. As an alternative, attempts have been made to reduce operating costs by using lower cost energy sources. One such example is the use of PCI coals in place of fuel oils. Figure 1 shows fuel and iron ore consumption patterns during the period Japanese fiscal year (JFY) 1965-91, expressed in terms of variations in input--output ratios for total fuel and iron ore. The input-output ratios represent the amount of input required to produce a tonne of pig iron in blast furnaces. One key feature of Figure 1 is that the fuel--pig iron ratio during the same period is substantially more varied than the iron ore-pig ore ratio. Indeed, the iron ore-pig iron ratios averaged 1624 kg, with a standard deviation of 11 kg, while the fuel--pig iron ratio averaged 513 kg but with a much larger standard deviation of 24 kg. The reason for this result is that not only is there no substitute for iron ore in producing pig iron, but the iron content of ore, which determines the quantity of iron ore required per unit of pig iron, tends to be rather stable over time (Hilly, 1989). The fact that most iron ore used
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Pig iron production structure in Japan: H S Chang

in blast furnaces has an iron content of around 64-456% means that about 1600 kg of ore is required to produce one tonne of pig iron (Gooday and Labson, 1993). By comparison, fuel usage rates are more variable because they can vary according to changes in blast furnace design and quality of other inputs. As can be seen in Figure 1, the fuel rate declined during the 1970s, rose during the early 1980s, and then became relatively stable thereafter. According to Hilly (1989), the declining phase in the 1970s was owing mainly to continuous improvements in blast furnace control and input qualities. However, no specific factors were identified and no specific explanation was given for subsequent changes. One of the objectives of this analysis is therefore to determine more explicitly the causes for changes in fuel rotes during the observation period.

cost function proposed by Lopez (1980) was used. The GL model is flexible and is able to test for various hypotheses regarding the nature o f pig iron production technology such as fixed factor proportions, scale economies and technical change. The proposed GL cost function takes the form

C(p, Q, T) = Q giZ# ~o.Pil/2pj 1/2

+ 02 ]~i tiPi + Q T ~'i ?i Pi

(2)

where Pi and pj are prices of inputs i and j, respectively, T stands for a time trend which used to represent technical change, and ct, 13 and ? are parameters of the cost function. Other variables are as previously defined. The associated derived input demand function for input i, xi, is:

Data
Xi = OC/Opi = ~-'j ~ij" (Pj/Pi) 1/2 Q + eti Q2 + Yi QT
The data used for the empirical analysis are annual Japanese data on quantities consumed and prices of iron ore, coke (or coking coal), fuel oils and PCI coals, and the quantity produced of pig iron in blast furnaces. Other data include technical factors such as blast furnace production capacity and the compositions of the iron ore charge and fuel mix. These data were extracted from various issues of the Tex Report. Although most data are available for the period JFY 1965-91, estimation is based on data from JFY 1974-91 because steaming coal prices are variable only after the first oil shock. (3) Alternatively, derived input demand functions can be expressed in terms of input-output ratios. This can be done by dividing Equation (3) by the output level, Q. The resuiting derived demand equation is:

xi/Q = Zjf3ij (Pj/Pi) 1/2 + t~i* Q + yiT

(4)

The model
It has been shown that if there exists a production function, F(x), that is well behaved then there exists a cost function, C(p, Q) such that C(p, Q) = [minp'x: F(x) > Q] (1)

where p is a vector of input prices; x is a vector of input quantities consumed; and Q is the amount of output produced (Varian, 1993, p 64). The cost function C(p, Q) as defined in Equation (1) is non-decreasing, linearly homogeneous, concave, continuous function of prices, and it summarizes all the economically relevant information about a technology characterized by F(x). Moreover, input demand fimctions can be derived, based on Shepbard's lemma, by taking the first derivative of the cost function with respect to input prices. The assumptions underlying the optimizing model are: (1) that both factor and output markets are competitive; and (2) that the output level is taken as predetermined. To apply the cost minimization paradigm to the Japanese steel industry, the generalized Leontief (GL)
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where cti* = 2 (X i. The derived input-output ratio demand functions specified in Equations (3) and (4) are homogeneous of degree zero in input prices by construction. Symmetry conditions are satisfied if 13~j= ~Jjifor i :~j. Further, the derived input-output ratio demand function reflects a fixed factor proportions production technology if 13# = 0 for all i :#j, constant returns to scale if cti* = 0 for all i, and no technical change i f ? / = 0 for all i. Equation (4) is preferred over Equation (3) and hence used in current application because it helps reduce the occurrence of heteroscedasticity and multicollinearity during empirical estimations (Lopez, 1980). The tests for fixed factor proportions, scale economies and technical change are particularly relevant because of special features of iron and steel production. In particular, because the blast furnace operation is of large scale, capital intensive and highly technically specific, substitutability among inputs may be limited and hence the derived demand for inputs can be expected to be relatively price inelastic (Lau and Tamura, 1972). The economic interpretations of the tests are as follows. First, a fixed factor proportions technology implies that the elasticity of substitution between inputs is zero, and that derived input demand is independent of changes in relative prices, other things being equal. Constant returns to scale implies that the derived input de257

Pig iron production structure in Japan: H S Chang

mand is independent of changes in the output level, other things being equal. The absence of technical change implies that the input usage rates can be expected to remain constant over time, other things being equal. Applying Equation (4) to the Japanese steel industry, the derived input demand functions, expressed in terms of input-output ratios, are written as:
Xl.t/Qt = 1311 + 1312 (P2,t/Pl,t) 1/2 + 1313 Q, +1314 TIME + gl t
(5)

Table 1 Estimated derived d e m a n d for fuel and iron ore, JFY 1974-91 (basic G L f o r m ) a Fuel Iron ore

INTERCEPT Pz/PI PI/P2

Q

899.78 (4.56) b ~80.57 (-2.85) -1.07E-06 (~).94) 5.81 (3.28) 0.32 1.07

1494.5 (39.58) 44.72 (1.74) 4.92 E-07 (I .32) 1.29 (2.52) 0.44 1.38

TIME
Adjusted R 2 DW statistics

for fuel, and as

x2,t/Qt = 1322 + 1321 (Pl,t/P2,t) 1/2 + 1323 Qt
+ 1324 TIME

(6)

aThe estimates were obtained based on OLS on original data. bFigures in parentheses are t-statistics.

+ e2,t
For exploratory purposes, Equations (5) and (6) were estimated individually by the ordinary least squares (OLS). The estimated results are presented in Table 1. Judging from the statistical fit of the estimated equations, it is suspected that the estimated model may have been misspecified. First, the model has very low explanatory power because the R2's have very low values. Second, some estimated results are counter-intuitive. For example, the negative price coefficient in the fuel equation indicates that fuel and iron ore are complements while the positive price coefficient in the iron ore equation indicates that the two inputs are substitutes. Further, the positive coefficients associated with the time variable in both equations imply that there had been increased in the usage rate of both inputs and hence a decrease in productivity over time. Finally, although low values of Durbin-Watson statistics suggest autocorrelation in both equations, attempts to correct for various orders of autocorrelation using CochraneOrcutt iterative procedures fail to improve the values of the Durbin-Watson statistics. These results suggest that the basic structure of the GL cost function may not adequately represent the blast furnace production process in Japan. One possible cause for model misspecification is that the model is too general to account for changes in input qualities and blast furnace control which occurred in the Japanese steel industry over the sample period. The two omitted variables are likely to be the composition of iron ore changes (sinter ratio) and the aggregate size of blast furnaces (blast furnace production capacity). The sinter ratio represents the proportion of iron ore which is in agglomerated forms, including sinter and pellets, in the total iron ore charge. An increase in the sinter ratio reduces the fuel rate and increases productivity in the blast furnace because sintering improves the strength and chemical reactivity of iron ore charge (BHP Steel, 1992). An increase in the size of blast furnaces,
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for iron ore, where x I and x 2 are quantities consumed of fuel and iron ore, respectively, Pl and P2 are prices of fuel and iron ore, respectively, Q is the quantity of pig iron produced, TIME is the time trend used as a proxy for technical change occurring in the Japanese steel industry during the sample period, and the error terms, e l and ~2, are assumed to be contemporaneously correlated. Note that using the trend variable as a proxy for technical change, although a common practice, implies that technical change takes place at a constant rate. This is appropriate when it is used as a surrogate for a number of unknown factors that change slowly over time and when the aim is to test for the existence of technical change rather than to obtain exact measures of technical change (Lopez, 1980). To adjust for differences in the energy content of various fuels, the quantity index for the composite fuel input, x I, is defined, in coke equivalent, based on the following formula: x 1 = (27 GJ/t* (KRATIO + PRATIO) + 40.8 MJ/L* FRATIO)/27 GJ/t where KRATIO, PRATIO and FRATIO are, respectively, the quantities of coke, PCI coal and fuel oils to produce one tonne of pig iron; 27 GJ/t is the energy content of both coke and PCI coal and 40.8 MJ/L is the energy content for fuel oils (Jones et al, 1991, pp 38-39). The associated price index for fuel, Pl, is defined, following Deaton and Muellbauer (1980), as ln(pl) = Sk * ln(pk) + Sp * ln(pp) + Sf* in(p/) (8) (7)

where Sk, Sp and Sf are the cost shares in total fuel of coke, PCI coal and fuel oils, respectively, Pk, Pp and pf are the average import prices of coking coal, PCI coal and fuel oils, respectively, and In is the logarithmic operator.
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Pig iron production structure in Japan: H S Chang

Table 2 Estimated derived demand for fuel and iron ore, JFY 1974-91 (extended GL with additional variable, OLS results) Fuel Iron ore b

Table 3 Estimated derived demand for fuel and iron ore, JFY 1974-91 (extended GL with additional variables, SUR results)a Fuel Iron ore

INTERCEPT p2/p! P!/P2

Q

898.05 ( l 1.46) a 7.81 (0.07) 2.31E-07 (0.53) -0.68 (-0.61) -4.56E-04 (-2.79) 4.20

1623.2 (19.28)

INTERCEPT Pz/Pj

(-0.19)
5.16E-07 (1.46) ~.32 (-0.39) -2.44E-04 (-1.70) 0.13 Q

-5.96

PI/P2

919.50 (l 5.83) b ~2.75 (~).69) -2.06E-07 (~).61) ~).04 (-0.04) -3.81 E-04 (-3.02) -3.79 (-6.86)

1620.8 (21.91 ) -8.27 (-0.33) 4.14E-07 (1.48) ~).36 (~.49) ~.72E-04 (-2.22) 0.34 (0.56)

TIME BF CAPACITY SINTER RATIO

Adjusted R 2 DW statistics

TIME BF CAPACITY SINTER RATIO

(~.02)
0.91 1.91

(0.18)
0.55 1.79

aFigures in parentheses are t-statistics. bThe estimates for iron ore equation were obtained based on the Cochrane~)rcutt iterative procedure to correct for autocorrelation of first order. The estimated coefficient of autocorrelation was 0.44.

aVariables in the iron ore equation were transformed based on an estimated coefficient of autocorrelation of 0.44. bFigures in parentheses are t-statistics.

on the other hand, is understood to lead to higher productivity because of economies of size (Hilly, 1989). Since these two variables are likely to have an impact on the production efficiency and hence demand for inputs, the basic model presented in Equations (4) and (5) are extended to include the sinter ratio and the blast fumace production capacity as additional explanatory variables. Equations (5) and (6) when extended to include the additional variables become
Xl,t/Qt = [311 + [312 (P2,t/Pl,t) 1/2 + [313 Qt + [314 TIME

+ ~15 SINTER RATIO t + [316 B F CAPACITY + ~ l,t (9)

Xz,t/Qt = [322 + [321 (P2,t/Pz,t) 1/2 + [323 Qt + [324 TIME

+ ~25 SINTER RATIO t + [326 B F CAPACITY

+ e2, t (10)

For diagnostic and comparison purposes, Equations (9) and (10) are estimated based on OLS and the estimated results are reported in Table 2. Note that the iron ore equation (Equation (10)) was estimated based on the Cochrane-Orcutt iterative procedure because first order autocorrelation was detected. Comparing the results presented in Table 2 with those in Table 1, it is clear that with additional variables the statistical fit of the fuel equation in particular is much improved - the adjusted R 2 was increased from 0.32 to 0.91 and autocorrelation was no longer present. Although the statistical fit of the iron ore equation only improved slightly, the intercept term is now very close to the sample mean of the iron ore:pig iron ratio. This is consistent with the fact that little variation exists in the sample observations, as discussed earlier.
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Further, the estimated coefficients associated with the sinter ratio and blast furnace production capacity are statistically significant at the 1% level while neither of the estimated price coefficients is statistically significant. Note also that with the inclusion of the additional variables, the estimated coefficients associated with time variables became statistically insignificant. This result indicates that technical change, which was assumed to occur at a constant rate in the first model, does not refleet the nature of a technical change in the Japanese steel industry. In the second model, technical change was found to result largely from changes in input mix and blast furnace production capacity. Although single-equation estimation procedures based on OLS are useful for exploring the model structure, the two equations must be estimated jointly to account for cross-equation restrictions and to conduct hypothesis tests. The joint estimation was conducted using the seemingly unrelated regression (SUR) procedure on the transformed data to account for autocorrelation of the errors in the iron ore equation, as suggested in Kmenta (1986, pp 646q547). Individual parameter estimates from the SUR procedures are presented in Table 3. Note that the SUR estimates have smaller variances compared with OLS results reported in Table 2, as can be expected from a systems estimation where crossequation correlation is accounted for. Hypotheses of fixed factor proportion, constant returns to scale and no technical changes were tested based on the test procedures provided in SHAZAM. SHAZAM is an econometrics computer program developed by White (1993). The test results are summarized in Table 4. Specifically, the table shows that all the null hypotheses being tested cannot be rejected at the 5% level - the calculated
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Pig iron production structure in Japan: H S Chang

Table 4 Test statistics for various hypotheses regarding iron production structure Null hypothesis X 2 value

Degrees of freedom

Result

Fixed factor proportions: ~21 = ~12 ---- 0 Constant return to scale: [313= 1323= 0 No technical change: [~14 = [~24 = 0

1.26 5.25 0.40

2 2 2

Fail to reject Fail to reject Fail to reject

X 2 values are all lower than the corresponding tabulated X 2 values, which is 5.99 at 5% significant level. Note that with the inclusion of additional variables, the test result indicates that no technical change had occurred during the sample period. This implies that technical change can be explicitly accounted for by changes in input qualities and blast furnace production capacity without the use of a time trend which service, at best, as a surrogate for constant rate of change. It should be noted that the analysis presented here was based on highly aggregate data. Therefore, caution must be exercised in carrying the results over to a less aggregate level. There are three aspects worthy of a word of caution. First, although fixed factor proportions imply that given the output level, the derived input demands are independent of input prices, it does not necessarily imply that input prices do not matter at all. This is because once output levels are allowed to change in respect to changes in input and output prices, input prices may influence input demand, although less directly, by influencing the level of production. Second, the results may not be applicable at the plant level. This is because blast furnaces generally differ in design and management practices; therefore, firms can be expected to respond differently to changes in relative input prices and technology. Finally, although demand for both iron ore and coking coal is not responsive to price changes at the aggregate level, demand for iron ore and coking coal from different sources may still be sensitive to changes in relative prices for inputs from different sources. In summary, the modelling results show that the Japanese iromnaking technology, when considered as an aggregate production process for pig iron using fuel and iron ore as major inputs, could be characterized by (1) fixed factor proportions, (2) constant returns to scale, and (3) technical change which occurs as a result of systematic changes in the input mix. Moreover, while there is little variation in the iron ore usage rate, variations in fuel usage rate can be explained largely by changes in the composition of iron ore charge and blast furnace production capacity.
Policy implications

iron ore in Japan can be estimated readily based on the estimated demand for blast furnace steel. To estimate the aggregate demand for coking coal, however, is more complicated. This is because variations in total fuel requirements can be affected by factors such as changes in sinter ratio and blast furnace production capacity. Moreover, the fuel mix can change depending on changes in the relative prices of various fuel inputs as well as technological change which allows for substitution among fuels to take place. Therefore, to estimate demand for coking coal, more detailed information on factors influencing the composition of iron ore charge and fuel mix is required. This can be done partly by monitoring closely the development in the entire production process of the integrated steel mills, including coking, sintering, ironmaking, steel making and in-plant energy production and consumption. Although considerable productivity improvements have occurred in the Japanese steel industry in the past few decades, the process can be expected to continue because of increased competition from new steel producers and rising yen. Additional productivity gains are likely to be achieved by cutting raw materials input costs through new technology which uses inputs more efficiently and more cheaply. For input suppliers, the capacity to anticipate such technological developments and to meet the resulting changes in the demand for raw materials are crucial to securing their market positions.
Conclusions

The finding that the iron ore usage rate shows little variation over time suggests that the aggregate demand for 260

The structure of pig iron production process and the derived demand for steelmaking raw materials in Japan were analysed based on cost minimization models which take into account changes in economic factors and technology. On the basis of the modelling results, the iron production in Japan was found to be characterized by (1) fixed factor proportions, (2) constant returns to scale, and (3) technical change that resulted from systematic changes in input mix. Moreover, while there is little variation in the iron ore usage rate, variations in fuel usage rate can be explained largely by changes in sinter ratio and blast furnace production capacity. The results also suggest that the demand for iron ore can be readily estimated because of the rather rigid transformation process from iron ore to iron. However, the estimation of demand for coking coal is more c o m Resources Policy Volume 21 Number 4 December 1995

Pig iron production structure in Japan: H S Chang

plicated. To derived accurate demand forecasts, additional information regarding factors influencing the composition of iron ore charge and fuel mix may be required.

References
B H P Steel (1992) The Making oflron and Steel Deaton, A and Muellbauer, J (1980) 'An almost ideal demand system' American Economic Review 70 312-326 Dwyer, G and Muir, D (1992) 'Pulverized coal injection and coal demand: a focus on Japan' Agriculture and Resource Quarterly 4 (3) Gooday, P and Labson, S (1993) 'Electric arc furnace technology and its impact on iron ore and coal use' Agriculture and Resource Quarterly 5 ( 1)

Hilly, S (1989) 'Trends in steel making technology and Australia's mineral exports' Agriculture and Resource Quarterly 5 (I) Jones, B, Bush, S, Kanakaratnam, A, Leonard, M and Gillan, P (1991) Projections of Energy Demand and Supply: Australia 1990-91 to 2004-4)5 Australian Bureau of Agricultural and Resource Economics Kmenta, J (1986) Elements of Econometrics 2nd edn, Macmillan, New York Lau, L J and Tamura, S (1972) 'Economics of scale, technical progress, and the nonhomothetic Leontief production functions: an application the Japanese petrochemical processing industry' Journal of Political Economy 80 I 167-1187 Lopez, R E (1980) 'The structure of production and the derived demand for inputs in Canadian agriculture' American Journal of Agricultural Economics 39-45 Tex Report (1993) Coal Manual 1993 plus various issues, Tokyo Varian, H R (1993) Microeconomic Analysis 3rd edn, W W Norton, New York White, K J (1993) SHAZAM: Econometrics Computer Program, U~er's Reference Manual, Version 7.0 McGraw-Hill, New York

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