Working Paper No. 342
By James Smith
There is often assumed to be a unit elasticity of substitution between capital and labour. But estimates based on neoclassical capital demand equations frequently find a smaller value. Recent time-series work for the United States and Canada has suggested that, once the biases inherent in estimating cointegrating vectors are properly accounted for, the elasticity could indeed be close to 1. This paper investigates this possibility for the United Kingdom. First the analysis considers aggregate data where the estimated elasticity is close to 0.4. Then a unique industry-level data set for the United Kingdom is exploited in order to further pinpoint the estimated elasticity. Estimates using dynamic panel data methods are close to those from aggregate data, providing a robust statistical rejection of a unit elasticity in UK data.
That elusive elasticity and the ubiquitous bias: is panel data a panacea?