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Capital-labor substitution and misallocation

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

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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.

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