ECONOMICS PAPER No.: 5- Advanced Microeconomics

ECONOMICS PAPER No.: 5- Advanced Microeconomics

MODULE No. : 6-

Subject ECONOMICS

Paper No and Title Paper-5 Advanced Microeconomics

Module No and Title Module-6: Elasticity of Technical Substitution, Technical Progress and Factor Shares, Product Exhaustion Theorem

Module Tag ECO_P5_M6

ECONOMICS PAPER No.: 5- Advanced Microeconomics

MODULE No. : 6-

Table of Contents

3. Elasticity of Technical Substitution 4. Technical Progress & Factor Shares 5. Product Exhaustion Theorem

5.1. Euler’s Theorem of Product Exhaustion

5.2. Clark, Wicksteed & Walras Theorem of Product Exhaustion.

6. Summary

ECONOMICS PAPER No.: 5- Advanced Microeconomics

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1. Learning Outcome

After studying this module

 You will understand how change in factor price affect the distributive shares of the factors.

 You will know how to relate elasticity of technical substitution with shares of factors.

 You will know different concepts of technical progress and how these affect the shares of factors.

 You will understand the meaning and derivation of product exhaustion theorem.

2. Introduction

In this module we will derive the relation between factor shares and changes in relative factor prices.

The degree of this relationship is measured by the concept of elasticity of technical substitution or elasticity of factor substitution. Since technology of production changes continuously over time, the shares of factors may be affected by this technical progress. If the factors are paid according to their value of marginal productivity, the value of total output will be exhausted between the factors’

payment. Euler proved this by assuming linearly homogeneous [production function, while Clark, Wicksteed and Walras established this product exhaustion relation without considering the homogeneous production function. All the above concepts we analyze in details in the following sections.

3. Elasticity of Technical Substitution

In this section we analyze how changes in factor prices affect the share of factors and distribution of factors’ income. When input prices change the firm will employ cheaper input in place of relatively costly one. For example, if the cost of labour increases relative to the cost of capital, the firm will substitute more capital in place of labour. This happens due to profit maximization of firm. In order to maximize profit the firm has to change the ratio of capital to labour (𝐾/𝐿) due to the change factor prices. This results in the change in the relative shares of the factors. The change in factor price affects how much depend on the responsiveness of the change of 𝐾/𝐿 ratio to the change in factor price. This responsiveness is measured by the concept of elasticity of substitution which is defined as the percentage change in the 𝐾/𝐿 ratio due to the percentage change of the marginal rate of technical substitution of labour for capital (𝑀𝑅𝑇𝑆_𝐿𝐾). That is,

ECONOMICS PAPER No.: 5- Advanced Microeconomics

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𝜃_𝐿𝐾 = ^∆(

𝐾 𝐿)/(^𝐾_𝐿)

∆(𝑀𝑅𝑇𝑆_𝐿𝐾)/(𝑀𝑅𝑇𝑆_𝐿𝐾) (1)

In perfectly competitive factor market the profit maximization condition occurs when the marginal rate of technical substitution of factors equals to the ratio of factor prices, that is:

𝑀𝑅𝑇𝑆_𝐿𝐾 = 𝑤/𝑟

We can therefore rewrite the elasticity of substitution as 𝜃_𝐿𝐾 = ^∆(

𝐾 𝐿)/(^𝐾_𝐿)

∆(𝑤/𝑟)/(𝑤/𝑟) (2)

The sign of 𝜃_𝐿𝐾 will be always positive except when 𝜃_𝐿𝐾 = 0 as the numerator and denominator change in same direction. This implies that if w/r increases, labour is relatively costlier than capital and the firm, therefore, substitutes capital for labour leading to increase in 𝐾/𝐿. The values of 𝜃_𝐿𝐾 lie between the range from 0 to ∞. When 𝜃_𝐿𝐾 = 0, there will be no substitution of one factor to another. This is a case of fixed proportion production function. The factors are perfect substitutes to each other when 𝜃_𝐿𝐾 = ∞. In this situation, the isoquant will be negatively sloped straight line. The factors will be substitutable to each other to a certain extent when 0 < 𝜃_𝐿𝐾 < ∞ and the isoquant will be convex to origin. For Cobb-Douglas type production function the value of elasticity of substitution equals to unity. We can compare the degrees of substitutability by considering the following three cases:

(i) 𝜃_𝐿𝐾 < 1 (Inelastic substitutability) (ii) 𝜃_𝐿𝐾 = 1 (Unitary elastic substitutability) (iii) 𝜃_𝐿𝐾 > 1 (Elastic Substitutability)

How the distribution of factors’ share is related to different values of elasticity of substitution analyzed below. The share of labour and capital can be written as:

𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟 =_𝑃^𝑤.𝐿

𝑌𝑌 & 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 =_𝑃^𝑟.𝐾

𝑌𝑌

Hence, the relative factor share is

𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙=𝑤. 𝐿

𝑟. 𝐾 Or

𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟

𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙=^𝑤/𝑟_𝐾/𝐿 (3)

The equation (3) traces the relationship between change in 𝑤/𝑟 ratio to the relative shares of labour and capital. Now when 𝜃_𝐿𝐾< 1, a given percentage change in the 𝑤/𝑟 ratio induces a smaller change in the 𝐾/𝐿 rato. This results an increase in relative factor share. The 𝜃_𝐿𝐾 = 1 implies that there will be equal

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percentage change in 𝐾/𝐿 ratio for a given percentage change of 𝑤/𝑟 and consequently the relative factor share will be unchanged. However, in case of 𝜃_𝐿𝐾 > 1, the relative factor share will decline as percentage increase in 𝑤/𝑟 ratio causes relatively smaller percentage increase in 𝐾/𝐿 ratio. It is important to note that there is a two-way causation between 𝑤/𝑟 ratio and 𝐾/𝐿. That is, change in 𝐾/𝐿 ratio induces change in the ratio of factor prices which in turn changes the shares of factors to output.

4. Technical Progress and Factor Shares

In a dynamic and growing economy technical progress happens continuously. This leads to a change in ratio of capital to labour (𝐾/𝐿) and elasticity of substitution with the shifts of production functions.

It is, therefore, important to examine how factor shares are affected by technical progress.

There are three different types of technical progress observed in production: (i) Capital deepening, (ii) labour deepening, and (iii) neutral. These various types of technical progress are shown by the downward shift of isoquants for a given level of output in figure-4 (a) – (c).

(i) Capital Deepening Technical Progress

Capital deepening technical progress occurs when 𝑀𝑅𝑇𝑆_𝐿𝐾 declines at a constant 𝐾/𝐿 ratio. This will lead an increase in rental cost of capital (𝑟) relative to wage rate 𝑤 and consequently fall in equilibrium 𝑤/𝑟 ratio. The resulting impact of this technical progress on factor shares is that the ratio of factor shares falls. That is, share of labour declines while, the share of capital rises. This is shown in Figure-4(a).

(ii) Labour Deepening Technical Progress

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Technical progress is said to be labour deepening when 𝑀𝑅𝑇𝑆_𝐿𝐾 rises for a given level of 𝐾/𝐿 ratio.

However, the equilibrium 𝑤/𝑟 ratio improves when technological progress happens shown in figure- 4(b). Consequently the share of labour increases, while the share of capital decreases.

(iii) Neutral Technical Progress

In neutral technical progress the 𝑀𝑅𝑇𝑆_𝐿𝐾 remains constant for a given level of 𝐾/𝐿 ratio. Therefore, in equilibrium, 𝑤/𝑟 ratio will be constant shown in figure-4(c). This implies that the share labour and capital will be unchanged.

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5. Product Exhaustion Theorems

In the context of income distribution, the marginal productivity theory of factor price determination suggests that the value of total product is distributed among the cost of labour and cost of capital. This accounting identity can be written as,

𝑃_𝑌. 𝑌 = 𝑤. 𝐿 + 𝑟. 𝐾 (1)

The above identity can also be written as in terms of factor shares. Dividing equation (1) both side by 𝑃_𝑌. 𝑌 , we will get the summation of factor shares equal to unity:

i.e. 1 =_𝑃^𝑤.𝐿

𝑌.𝑌+_𝑃^𝑟.𝐾

𝑌.𝑌 (2)

Where 𝑃_𝑌. 𝑌 = Value of output 𝑤. 𝐿 = Cost of labour

𝑟. 𝐾 = Cost of capital

_𝑃^𝑤.𝐿

𝑌.𝑌= Share of labour

𝑟.𝐾

𝑃𝑌.𝑌= Share of capital

This implies that the value of output should be exhausted by payments of factors used in production.

Now, it is important to examine whether the marginal productivity theory of factor price determination satisfy the income distribution identity given in equation (2).

That is, 𝑇𝑃 = 𝑇𝑃_𝐿+ 𝑇𝑃_𝐾

or 𝑌 = 𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾 And multiplying by 𝑃_𝑌 both side we get

𝑃_𝑌. 𝑌 = 𝑃_𝑌. 𝑀𝑃_𝐿. 𝐿 + 𝑃_𝑌. 𝑀𝑃_𝐾. 𝐾 (3)

Where, 𝑃_𝑌. 𝑀𝑃_𝐿= Value of marginal productivity of labour 𝑃_𝑌. 𝑀𝑃_𝐾= Value of marginal productivity of capital

According to marginal productivity theory of factor price determination, factors are paid equal to their value of marginal productivity. That is,

𝑃_𝑌. 𝑀𝑃_𝐿= 𝑤 and 𝑃_𝑌. 𝑀𝑃_𝐾= 𝑟 (4)

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If the above relation is satisfied, total output is exhausted between factor payments. Hence we have 𝑃_𝑌. 𝑌 = 𝑤. 𝐿 + 𝑟. 𝐾

5.1. Euler’s Theorem of Product Exhaustion

Leonhard Euler examined the product exhaustion relation (eqation-3) and showed that the identity expressed in equation-3 is satisfied under the linearly homogenous production function. The Euler’s theorem states that when production function exhibits constant returns to scale(CRS) or linearly homogenous, the following relationship will be held:

𝑌 =𝜕𝑌

𝜕𝐿. 𝐿 +𝜕𝑌

𝜕𝐾. 𝐾

Or, 𝑌 = 𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾 [Where ^𝜕𝑌_𝜕𝐿= 𝑀𝑃_𝐿 & _𝜕𝐾^𝜕𝑌= 𝑀𝑃_𝐾 ]

Hence, if the marginal productivity theory of factor price determination holds, the product exhaustion relation stated in equation-2 can be obtained from the Euler’s relation. The formal proof of Euler’s theorem is given below:

Let us consider a production function 𝑌 = 𝑓(𝐾, 𝐿) which is homogeneous of degree 𝑚 if 𝑓(𝜌𝐾, 𝜌𝐿) = 𝜌^𝑚. 𝑓(𝐾, 𝐿)

Differentiating with respect to 𝜌 we have 𝐿.𝑑𝑓

𝑑𝐿+ 𝐾.𝑑𝑓

𝑑𝐾 = 𝑚. 𝜌^𝑚−1. 𝑓(𝐾. 𝐿)

By putting 𝑚 = 1, we obtain constant returns to scale production function and then we have 𝐿. 𝑀𝑃_𝐿+ 𝐾. 𝑀𝑃_𝐾= 𝑓(𝐾, 𝐿)

Or

𝑌 = 𝐿. 𝑀𝑃_𝐿+ 𝐾. 𝑀𝑃_𝐾 Multiplying both side of the above expression by price 𝑃_𝑌, we have

𝑃_𝑌𝑌 = 𝐿. 𝑃_𝑌𝑀𝑃_𝐿+ 𝐾. 𝑃_𝑌𝑀𝑃_𝐾

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This implies that by paying factors according to their value of marginal product, the value of output will be exhausted. Hence, we prove the Euler’s product exhaustion theorem. This theorem is an identity as it is satisfied for all values of the variables.

5.2. The Clark-Wicksteed-Walras Theorem of Product Exhaustion

According to Clark, Wicksteed and Walras the product exhaustion relation based on the marginal productivity theory of factor price determination can be held for any production function under long run competitive equilibrium situation. Their theory implies that when firms operate at the long run competitive equilibrium point and factors are paid equal to their value of marginal productivity, total product will be exhausted among the factors used in the production. Here, homogenous production function is not necessary condition for satisfying the product exhaustion relation.

The Clark-Wicksteed-Walras proof of product exhaustion relation is not satisfied for all level of output. It only holds for that level of output at which long run average cost is minimum. That is long run competitive equilibrium level of output. Therefore their product exhaustion relation is not an identity.

The mathematical proof of their product exhaustion relation is given below:

The total product is exhausted when

𝑌 = 𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾 (1)

Taking total differentiation of the above expression, it gives that

𝑑𝑌 = 𝑀𝑃_𝐿. 𝑑𝐿 + 𝑀𝑃_𝐾. 𝑑𝐾 (2)

Suppose that capital and labour are increased by a constant proportion, say 𝜇

It follows that 𝜇 =^𝑑𝐿_𝐿 =^𝑑𝐾_𝐾 (3)

Or 𝑑𝐿 = 𝜇. 𝐿 & 𝑑𝐾 = 𝜇. 𝐾

Substituting these in equation-2 we have

𝑑𝑌 = 𝑀𝑃_𝐿. 𝜇. 𝐿 + 𝑀𝑃_𝐾. 𝜇. 𝐾 Or

𝑑𝑌 = 𝜇(𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾) Or

𝑑𝑌

𝜇 = (𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾)

Multiplying and dividing the left hand side of the above expression by 𝑌 we obtain

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𝑌^𝑑𝑌

𝜇𝑌= (𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾) (4)

By substituting equation (3) we have 𝑌 [𝑑𝑌/𝑌

𝑑𝐿/𝐿] = 𝑌 [𝑑𝑌/𝑌

𝑑𝐾/𝐾] = (𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾)

Here, [^{𝑑𝑌/𝑌}

𝑑𝐿/𝐿] = 𝜀_𝑌𝐿 =labour elasticity of output, [_{𝑑𝐾/𝐾}^{𝑑𝑌/𝑌}] = 𝜀_𝑌𝐾 = labour elasticity of output

In general [^{𝑑𝑌/𝑌}_𝜇 ] = 𝜀 = input elasticity of output.

Substituting 𝜀 in equation (4) we have 𝑌. 𝜀 = (𝑀𝑃_𝐿. 𝐿 + 𝑀𝑃_𝐾. 𝐾)

Multiplying both side by 𝑃_𝑦 we have

𝑃_𝑦𝑌. 𝜀 = 𝑃_𝑦𝑀𝑃_𝐿. 𝐿 + 𝑃_𝑦𝑀𝑃_𝐾. 𝐾 (5)

When 𝜀 =1, the equation (5) gives the expression which is identical with Euler’s product exhaustion theorem. This implies that when 𝜀 =1, firm operates under constant returns to scale in which long run average cost curve in minimum and constant and it occurs only at long run competitive equilibrium. Thus equation (5) does not hold for any other values of 𝜀. The product exhaustion relation proved by Clark, Wicksteed & Walras is, therefore, not an identity holding for any values of the variables.

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6. Summary

 Elasticity of factor substitution( 𝜃_𝐿𝐾) measures the degree of responsiveness of change in relative factor price on relative shares of factors. It is defined as the percentage change in the 𝐾/𝐿 ratio due to the percentage change of the marginal rate of technical substitution of labour for capital (𝑀𝑅𝑇𝑆_𝐿𝐾). It lies between 0 and∞.

 𝜃_𝐿𝐾 < 1 implies that increase in 𝑤/𝑟 ratio will increase labour’s share relative to share of capital.

 If 𝜃_𝐿𝐾> 1, an increase in 𝑤/𝑟 ratio will reduce the ratio of share labour to capital.

 When 𝜃_𝐿𝐾 = 1, there will be no change of relative factor shares in response to change 𝑤/𝑟 ratio.

 There is a two-way causation between 𝑤/𝑟 ratio and𝐾/𝐿. That is, change in 𝐾/𝐿 ratio induces change in the ratio of factor prices which in turn changes the shares of factors to output.

 Technical progress affects the factor shares by shifting the production function.

 Technical progress is classified into three types: capital deepening, labour deepening and neutral.

 Capital deepening technical progress occurs when 𝑀𝑅𝑇𝑆_𝐿𝐾 declines at a constant 𝐾/𝐿 ratio.

 Technical progress is said to be labour deepening when 𝑀𝑅𝑇𝑆_𝐿𝐾 rises for a given level of 𝐾/𝐿 ratio.

 In neutral technical progress the 𝑀𝑅𝑇𝑆_𝐿𝐾 remains constant for a given level of 𝐾/𝐿 ratio.

 The product exhaustion means that the value of output is exhausted by payments of factors used in production when factors are paid according to their marginal product.

 According to Euler, product exhaustion relation is satisfied under the assumption of linearly homogeneous production function.

 Clark, Wicksteed & Walras theorem of product exhaustion states that when firms operate in the long run competitive equilibrium point and factors are paid equal to their value of marginal productivity, total product will be exhausted among the factors used in the production. In order to satisfy this theorem the production function is not required to be homogeneous.