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Elasticity of Substitution

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  • 29-12-2013 10:34pm
    #1
    lauz94
    Registered Users Posts: 146 ✭✭


    Going through questions regarding Cobb Douglas production technology frameworks and calculations of the output elasticities and their elasticity of substitution.

    Just wondering if anyone could give any ideas as to the economic policy significance of the elasticity of substitution between labour and capital?
    Thanks in advance!


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    #2
    [Deleted User]
    Posts: 0 ✭ [Deleted User]


    http://www.ft.com/cms/s/0/0ca021c0-680b-11e3-a905-00144feabdc0.html


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    #3
    Sgro
    Registered Users Posts: 48 ✭Sgro


    lauz94 wrote: »
    Going through questions regarding Cobb Douglas production technology frameworks and calculations of the output elasticities and their elasticity of substitution.

    Just wondering if anyone could give any ideas as to the economic policy significance of the elasticity of substitution between labour and capital?
    Thanks in advance!

    Are you doing Schols exams in TCD?
    I'm assuming you are as I just googled your question also hahah.

    My own brief understanding of the signifigance is;
    Elasticity of substitution is equal to %deltaK/L divided by %deltaMRTS.
    In equilibrium, the MRTS is equal to w/r (ie. wage rate and cost of capital).
    if Elasticity of substitution equals one (this is the clinch - the question doesn't specify it does, are we to assume?) - that means a percent change in the MRTS will equal a percent change in the K/L ratio.
    In other words, if labour becomes more expensive (ie. higher wage rates) or if capital becomes cheaper, firms can simply make people unemployed and enjoy the same level of output [although the inverse is also true ie. hire more people/get rid of capital if labour is cheaper than capital].

    From an immediate short term social perspective, this is bad as unemployment *may* rise.

    That was my take on it, but there's so much more to it that I don't think its thorough enough. Will you let me know if you derive a better explanation yourself? Thanks.


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