The Dynamic Demand for Capital and Labor: Evidence from Chinese Industrial Firms

Abstract

This paper employs a structural econometric approach to investigate the joint dynamic demand for capital and labor in Chinese industries from 1998-2007. First, we summarize several stylized facts on factor input adjustments, such as the mix of smooth and lumpy adjustments in capital and labor, and the interrelation in factor adjustments. Based on these facts, we then propose a dynamic model that incorporates the key features: fixed costs of installing capital and creating or discontinuing a job vacancy; convex costs aimed at capturing smooth adjustments; and inter-relational costs associated with joint adjustments in capital and labor. The structural parameters in capital and labor adjustment costs are recovered via simulated moment matching method, so the proposed dynamic model is able to reproduce the stylized facts that are directly observable from the Chinese firm-level data. Our structural estimations show: (1) firms prefer to make small adjustments in capital and labor simultaneously, and make large adjustments in two factors sequentially; (2) for both capital and labor, the convex adjustment cost is dominant comparing to the fixed cost; (3) ignoring labor adjustment costs leads to a larger bias than ignoring capital adjustment costs. The existence of joint adjustment costs indicates that reform in capital (labor) market will affect firm's demand in labor (capital) accordingly.