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Journal of Macroeconomics 30 (2008) 601603

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Introduction

So far as I know, the concept of the elasticity of substitution was introduced into economics by John Hicks in his Theory of Wages (1932). It appeared in a famous chapter on
Distribution and Economic Progress that was much discussed at the time, and then later
revised. Hickss interest at that point was not in the detailed classication of production
functions (or of utility functions). He was pursuing an ancient question in economics:
how should we expect the distribution of income among broad factors of production to
change as a market economy evolves, especially as capital accumulates? Hicks certainly
realized that the elasticity of substitution also says something precise about the shape of
the level curves (or surfaces) of a production function, and he understood the connection
between the economic and the geometric ways of thinking about the concept.
Now we know that the elasticity of (factor) substitution turns up as an important
parameter in many areas of economics. In growth theory it is one of the main determinants
of the location and character of steady-state paths, and of the intertemporal social utility
that can be achieved along growth paths. It turns up in discussions of trade and development patterns, of the bias of technological progress, of macroeconomic responses to supply shocks, even of the eectiveness of stabilization policy. Still other applications are
discussed in the papers included in this issue.
The denition of the elasticity of substitution involves second derivatives of a production function. When we think about how its value might change from point to point or
time to time, we must be engaging with at least the third derivatives of the function relating output to inputs. That is enough to explain why econometric approaches to the estimation of the elasticity of substitution tend to be so contestable and insecure. The rate
at which the rate of change of a ratio of marginal products itself changes from point to
point on a production function is not something that screams out loud to an observer.
Yet many of the papers in this special issue are trying to provide evidence on just that. This
can only be because a lot of interesting economics turns on the approximate answer.
The specication of a production function that has a constant elasticity of substitution
everywhere is obviously useful for organizing econometric work. At a minimum it provides a parameter to estimate. The same specication is also useful for theoretical work,
and for numerical exercises along the lines introduced by Hicks. This utility may take
the form of oering alternatives to the easy generalizations associated with the ubiquitous

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Editorial / Journal of Macroeconomics 30 (2008) 601603

and carefree use of the CobbDouglas function. One has to welcome careful econometric
exploration of the CES function using diverse bodies of data, however, they turn out
numerically. This is a way, probably the only way, to develop some intuition for best
guesses about the elasticity of substitution in various contexts, and for the reliability of
such guesses.
The dual nature of the elasticity of substitution as a parameter of microeconomic production functions and as a guide to the macroeconomic functional distribution of income
is both part of its interest and a source of problems. In microeconomic terms it tells us
how the cost-minimizing input proportions change as relative input prices change. In macroeconomic contexts it is telling us how wage rates and rental rates on capital seem to be
related to the normally increasing capital-labor ratio for the economy as a whole. The answer to the macro question depends on much more than the narrow technological facts, as
Hicks already understood in 1932. In particular the answer depends also on the responsiveness with which nal consumers can substitute capital-intensive goods for labor-intensive ones when the wage-rental ratio rises, and presumably the relative price of laborintensive goods rises with it. This is a very important issue for the aggregative theory of
growth and distribution. (Many of the major implications are spelled out in Olivier De
La Grandville (2008).)
This mixing together of production-side and consumption-side behavior must also be
relevant for an understanding of dierences among empirical estimates of the elasticity
of substitution. Generally speaking, the more inclusive the aggregates in an empirical
study the more demand responses are likely to gure in an estimate of the responsiveness
of factor proportions to factor prices (or vice versa).
This consideration is potentially important when it comes to interpreting the variety of
empirical results in this issue. It is a very crude but fair statement that macroeconomists
tend to be content with neutral technological change and CobbDouglas functions, and
can cite some (weak) empirical conrmation, whereas more data-intensive, more nearly
micro-based research has been leaning towards nding elasticities of substitution less than
one. This dierence may merely reect the yearning of macro-theorists for easy, neat results. Or it may reect the likelihood that more narrowly-based estimates, like those exemplied here, contain less in the way of demand-inuenced compositional eects.
It is not very useful to ask which results are better. That obviously depends on the
question being asked. If the goal is to understand the technological substitutability among,
say, unskilled labor, skilled labor, IT equipment and other equipment, with a view to
investment planning in developing countries, the compositional eects are less relevant.
If the goal is to understand the long-run growth possibilities in advanced industrial economies, then compositional eects are as important as technological eects, and should be
accounted for either explicitly, by aggregating disaggregated estimates, or implicitly, by
dealing with aggregates from the start, though that may prove to be dicult because
aggregate data can smooth away information-carrying variation.
Probably the most surprising implication of neoclassical growth theory was, and is, the
robust result that the long-run growth rate is independent of the saving-investment quota
and analogous factors. That result is precisely what endogenous growth theories are intended to evade. Opinions can dier about how successful this project has been, so far. The
source of the puzzle paradox is too strong a word is of course diminishing returns to
capital accumulation. That is where the elasticity of substitution between labor and
(broadly dened) capital enters the picture. From this point of view, easy demand-side

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substitution of capital-intensive for labor-intensive goods is just as eective a way of

fending o diminishing returns as technological substitution of capital for labor. So the
economy-wide elasticity of substitution, compositional eects included, is a very relevant
consideration, whether estimated explicitly or implicitly. (Some calculations by De La
Grandville show that a social planner might even be able to tease more intertemporal
social welfare out of a slightly higher elasticity of substitution than out of a slightly higher
rate of technological progress).
Better yet, of course, would be to get an empirical grip on the two eects separately. If
they were to become objects of policy, demand-side and supply-side approaches would
lead in rather dierent directions. The theory has been elucidated by Ronald Jones,
Edmond Malinvaud and Paul Samuelson, but it is hard to imagine how to make progress
as an empirical matter. I have thought about Monte Carlo simulations as an exercise that
might give some intuition for the interpretation of aggregative estimates, but I may not
have the intellectual or the computational wherewithal to carry them out.
In the meanwhile, the elasticity of substitution, and the CES production function as its
most convenient empirical embodiment, have come a long way from their beginnings as a
tool in macroeconomic distribution theory. As the articles in this special issue demonstrate, they have evolved into a useful vehicle for the econometric study of a whole variety
of problems in the analysis of production and distribution at every level of aggregation.
The variety of applications, data services and statistical methods suggests how much interesting research remains to be done.
References
De La Grandville, O., 2008. Economic Growth: A Unied Approach. Cambridge University Press,
in press.
Hicks, J.R., 1932. The Theory of Wages, rst ed. MacMillan, London.

Robert M. Solow
The Massachusetts Institute of Technology,
Department of Economics,
Cambridge, MA 02139,
United States
Fax: +1 617 253 0560.
Available online 10 March 2008