Capital-labor substitution and misallocation

Mallick, Debdulal and Maqsood, Nabeel (2022): Capital-labor substitution and misallocation.

Abstract

We explore the role of the elasticity of substitution between capital and labor (σ) in misallocation of resources. We show, both analytically and empirically using the cross-country firm level survey data, that the extent of misallocation is substantially large for low σ compared to the Cobb-Douglas value of one that the extant literature invariably assumes. When σ is low, dispersion in marginal products of capital across firms will be larger for given dispersion in capital-labor ratios because marginal product now declines more rapidly with increasing capital. The extent of misallocation is even larger when σ varies across firms. Given the overwhelming evidence that σ<1, our findings raise serious concerns about using the Cobb-Douglas production function in the misallocation literature. Careful accounting of the extent of misallocation is also important for policymaking.

• Item Type: MPRA Paper
• Language: English
• Keywords: misallocation; elasticity of substitution; CES production function; total factor productivity
• Subjects: D - Microeconomics > D2 - Production and Organizations > D24 - Production ; Cost ; Capital ; Capital, Total Factor, and Multifactor Productivity ; Capacity; O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O11 - Macroeconomic Analyses of Economic Development; O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O14 - Industrialization ; Manufacturing and Service Industries ; Choice of Technology; O - Economic Development, Innovation, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity > O47 - Empirical Studies of Economic Growth ; Aggregate Productivity ; Cross-Country Output Convergence

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