1961 CapitalLaborSubstitutionandEcon

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Subject Headings: Capital-Labor Substitutability Measure

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Abstract

In many branches of economic theory, it is necessary to make some assumption about the extent to which capital and labor are substitutable for each other. In the absence of empirical generalizations about this phenomenon, theorists have chosen simple hypotheses, which have become widely accepted through frequent repetition. Two competing alternatives hold the field at present: the Walras-Leontief-Harrod-Domar assumption of constant input coefficients; 2 and the Cobb-Douglas function, which implies a unitary elasticity of substitution between labor and capital. From a mathematical point of view, zero and one are perhaps the most convenient alternatives for this elasticity. Economic analysis based on these assumptions, however, often leads to conclusions that are unduly restrictive.

The crucial nature of the substitution assumption can be illustrated in various fields of economic theory:

  1. The unstable balance of the Harrod-Domar model of growth depends in a critical way on the assumption of zero substitution between labor and capital, as Solow [ I5], Swan [ I8], and others have shown.
  2. The effects of varying factor endowments on international trade hinge on the shape of particular production functions. In this case, either zero or unitary elasticities of substitution in all sectors of the economy lead to Samuelson's strong assumption as to the invariability of the ranking of factor proportions. Variations in elasticity among sectors imply reversals of factor intensities at different factor prices with quite different consequences for trade and factor returns.
  3. In analyzing the relative shares of income received by the factors of production, it is tempting to assume unit elasticity of substitution to agree with the supposed constancy of the labor share in the United States.

Recent work has called into question both the observed constancy and the necessity of the assumption [9, 17].

References

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 AuthorvolumeDate ValuetitletypejournaltitleUrldoinoteyear
1961 CapitalLaborSubstitutionandEconKenneth J Arrow
Hollis B Chenery
Bagicha S Minhas
Robert M. Solow
Capital-labor Substitution and Economic Efficiency1961