This is a rigid assumption of Cobb-Douglas production function. For example, the rate of substitution between and may be expressed as: The denominator in the above expression is known as the. It measures the strength of substitution effect. The inverse of elasticity of substitution is. .
The greater the convexity of ixoquant the less will be , and vice versa. In the adjacent figure you can see three of the most common kinds of isoquants. On the other extreme, suppose the two factors are perfect complements in the sense that both have to be combined in fixed proportions to produce a given output, i. Thus, A high elasticity of substitution means that the factors can he substituted freely for one another, while in the case of low elasticity they can be used only in definite proportions. The measure of elasticity depends on the curvature of the isoquauts.
Therefore, the coefficient of elasticity of substitution σ may be taken to be the We may simplify the value of σ as given by 8. It affects the distributive shares of the factors of production. The problem of autocorrelation can be reduced by adopting the first difference method. It measures the of an and thus, the substitutability between inputs or goods , i. Hence, one and only one combination of inputs can produce specified output. It can also be conceived as a measure of similarity of factors of production from a technological point of view.
We always substitute relatively cheaper factor for the dearer one. In this case, the goods are. In other words, the production technology has a constant percentage change in factor e. We cap it off by explaining the elasticity of substitution measure. Capital and labour are not good substitutes here.
Assume that people who drink Coke also drink Pepsi. Link to this page: elasticity of technical substitution. Article shared by Different factors of production are used in the process of production so as to get maximum profit. In other words, it shows the relation between inputs, and the trade-offs amongst them, without changing the level of total output. If the numerical value of σ is unity, then we have a Cobb-Douglas production function. In the case of cross section data, the problem of heteroscadacity and in the case of time-series data, the problem of auto-correlation would creep.
Lastly, the third graph represents complementary inputs. Therefore, Intuitively, elasticity of factor substitution can also be thought of as a measure of the degree of ease with which one factor is substituted for the other. Just as the marginal rate of substitution of Commodity X for commodity Y falls as X is substituted for Y along an indifference curve. Therefore, a fall in the price of one factor will induce the producer to replace the costly factor completely by the cheaper one. On the other hand, if p. That is, the direction of change is clear, but the extent of input substitution will be measured by the above formula of elasticity of substitution.
Elasticity of factor substitution can take any value from zero to infinity, always being positive. That is, we explained to what extent one good could be substituted by a consumer for another good. Hence, the elasticity of factor substitution becomes zero. However, there is no completely general way to do this. The above function is independent of changes in the capital — labour ratio.
Review of Economics and Statistics. Review of Economics and Statistics. If β is significant then there will be strong evidence of argument to retain capital — labour ratio along with wage rate for explaining the variations in the average productivity of labour. The above equation will be estimated underlying the assumption of constant returns to scale. On the other hand, if wages price of labour fall, the producer will use relatively more labour than capital.
Here we discuss to what extent a factor of production, sa labour, can be substituted for another factor. This aggregator function exhibits constant. From the above function, the marginal productivity of labour will be obtained as follows: The marginal productivity theory of wages will generally be accepted on the grounds that it gives an adequate explanation for wage determination. If the difficulty in substitution increases faster, i. In case the two factors inc perfect substitutes of each other and the isoquauts between them arc straight lines, substitution elasticity between them is infinite.
Thus, in equilibrium In practical life, replacement of marginal rate of technical substitution by factor price ratio is helpful, as information regarding latter is easily available. The above expressions may be illustrated graphically using equal product curves and. If they arc perfect substitutes, thai is, if either factor can he used equally well to produce the product, the marginal rate of sub. Now, the rate at which this difficulty increases, i. If capital can be freely substituted for labour.