The Factor Bias of External Inputs: Implications for Substitution between Capital and Labor

Department of Economics and Decision Sciences

Speaker: Dimitrije RUZIC (INSEAD)

Room : T-012

Abstract:

Production inputs coming from outside the firm—commodities, intermediate goods and services, imports, offshoring—can be factor biased, displacing disproportionately either capital or labor in production. Assuming only that input demand is homogeneous, this paper shows that factor-biased inputs lead the capital-labor ratio to respond asymmetrically to changes in labor and to changes in capital prices. Both indirect inference (based on a meta analysis of existing studies) and direct estimates (using U.S. data for 1963-2016) indicate that external inputs disproportionately displace labor. These findings imply (1) that the capital-labor ratio responds 30-80% more strongly to the price of labor than to the price of capital, (2) that capital and labor are not separable from external inputs in modeling production, and (3) that historical disagreements regarding substitution can be recast as an omitted variable bias involving external inputs.