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Capital-labor substitution and misallocation

Mallick, Debdulal and Maqsood, Nabeel (2023): Capital-labor substitution and misallocation.

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Although the role of the elasticity of substitution between capital and labor (σ) has been emphasized in many areas in macroeconomics, it has been neglected in the misallocation literature. We explore the role of σ in misallocation of resources both analytically and empirically using cross-country firm level survey data. We document that extent of misallocation and aggregate output gain from reallocation of resources are substantially large for low σ (<1) compared to the Cobb-Douglas value of 1 that the extant literature invariably assumes. When σ is low, dispersion of capital-labor ratios generate larger misallocation because marginal product of capital now declines rapidly with increasing capital-labor ratio. Given the overwhelming evidence that σ<1, our findings raise serious concerns about using the Cobb-Douglas production function in the misallocation literature. This is crucial from policy perspectives because σ is influenced by institutional and policy features of a country.

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