Capital-labour substitution and economic growth (in collaboration with Robert M. Solow)

Abstract

Ever since its emergence in John Hicks’ Theory of Wages (1932), the elasticity of substitution has figured primarily in the theory of distribution. The standard proposition states that, with two factors, constant returns to scale and cost minimization, the faster-growing factor increases or decreases its share in income accordingly as this parameter is larger or smaller than one. However, the elasticity of substitution is by definition a technological fact, a characteristic of a production function which would turn out to play an important role. Indeed, as shown in La Grandville (1989) and extended in this chapter, a higher value of the elasticity of substitution ceteris paribus does more than merely alter production possibilities, it expands them. Naturally, then, the elasticity of substitution should have significance in all branches of economics where technology matters. And it does. The purpose of this chapter is to explore the role of the elasticity of substitution in the aggregative theory of economic growth. There are historical overtones to this technical theme. Broadly speaking, the capital–labour ratio has probably been rising since the beginning of sedentary agriculture made large-scale accumulation of capital possible. The ratio of the wage to the rental rate of capital has presumably also increased through history, though less regularly than the factor ratio. In the tradition of economics, accounting for these characteristics of the long-term growth path involves an interplay between technical progress and the evolution of capital–labour substitution possibilities (along with possible non-market forces that are not our concern here). In practice, growth theory has placed more emphasis on the analysis of technical change. We propose to focus our attention on the significance of a changing elasticity of substitution. It is understood that in any one-composite-good representation of a many-good economy, substitution on the consumption side between goods of different capital intensity will function much like direct input substitution. An early reference on this is R. Jones (1965); see also the more recent work by Klump and Preissler (2000) and E. Malinvaud (2002, 2003). It has been known since the beginning of “neoclassical” growth theory that permanently sustained growth is possible even without technological progress, provided that diminishing returns to capital-intensity operates very weakly.