What Determines the Elasticity of Substitution between Capital and Labor? A Literature Review

Aufsätze referiert extern - Web of Science

Michael Knoblach, Fabian Stöckl

In: Journal of Economic Surveys 34 (2020), 4, S. 847-875


This paper provides the first comprehensive review of the empirical and theoretical literature on the determinants of the elasticity of substitution between capital and labor. Our focus is on the two-input constant elasticity of substitution (CES) production function. We start by presenting four concise observations that summarize the empirical literature on the estimation of σ. Motivated by these observations, the main part of this survey then focuses on potential determinants of capital–labor substitution. We first review several approaches to the microfoundation of production functionswhere the elasticity of substitution (EOS) is treated as a purely technological parameter. Second, we outline the construction of an aggregate elasticity of substitution (AES) in a multi-sectoral framework and investigate its dependence on underlying intra- and inter-sectoral substitution. Third, we discuss the influence of the institutional framework on the extent of factor substitution. Overall, this surveyhighlights that the effective elasticity of substitution (EES), which is typically estimated in empirical studies, is generally not an immutable deep parameter but depends on a multitude of technological,non-technological, and institutional determinants. Based on these insights, the final section identifiesa number of potential empirical and theoretical avenues for future research.

Fabian Stöckl

Research Associate in the Energy, Transportation, Environment Department

Keywords: Aggregate elasticity, Cobb–Douglas and CES production function, Elasticity of substitution, Microfoundation