Working Paper No. 300
By Colin Ellis
Conventional techniques for estimating the elasticity of substitution between capital and labour in the production process typically focus on factor-demand equations. An implicit assumption in this approach is normally that the markup is stationary. But that may not be true. This paper considers a new approach that models the markup as an unobserved variable. Using the factor-demand equations for capital and labour, technical progress can also be estimated as a stochastic process, rather than just imposing a time trend. The resulting estimates of the whole-economy markup for the UK economy suggest that it has fallen over the past 30 years, and this result appears to withstand a variety of robustness checks. The estimated elasticity is somewhat lower than most previous estimates. This implies that conventional techniques may be misleading.