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The Elasticity of Substitution

The document discusses the elasticity of substitution between inputs, specifically focusing on perfect substitutes and perfect complements. It explains how isoquants illustrate these relationships, with linear isoquants indicating perfect substitutes and right-angled isoquants indicating perfect complements. The elasticity of substitution quantifies the change in the capital/labor ratio due to changes in relative prices, with extreme cases showing zero elasticity for perfect complements and infinite elasticity for perfect substitutes.

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villancioigieronald
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64 views6 pages

The Elasticity of Substitution

The document discusses the elasticity of substitution between inputs, specifically focusing on perfect substitutes and perfect complements. It explains how isoquants illustrate these relationships, with linear isoquants indicating perfect substitutes and right-angled isoquants indicating perfect complements. The elasticity of substitution quantifies the change in the capital/labor ratio due to changes in relative prices, with extreme cases showing zero elasticity for perfect complements and infinite elasticity for perfect substitutes.

Uploaded by

villancioigieronald
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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The Elasticity of

Substitution
Perfect substitutes vs. Perfect Complements
Isoquants When Inputs Are Either Perfect
Substitutes or Perfect Complements

• a) The isoquant is a straight line, with a


slope equal to −0.5. In other words, output
remains constant whenever the firm lays off
two workers and replaces them with one
machine. The “rate of exchange” between
labor and capital is the same regardless of
how many workers or how much capital the
firm already has. The marginal rate of
technical substitution is constant when the
isoquant is a line. Whenever any two inputs
can be substituted at a constant rate, the two
inputs are called perfect substitutes.

The Elasticity of Substitution 2


Isoquants When Inputs Are Either Perfect
Substitutes or Perfect Complements

• b) The right-angled isoquant implies that using


20 workers and 5 machines yields q0 units of
output. If we hold capital constant at five units,
adding more workers has no impact on output.
Similarly, if we hold labor constant at 20
workers, adding more machines has no impact
on output. A firm that does not wish to throw
away money has only one recipe for producing
q0: Use 20 workers and 5 machines! When the
isoquant between any two inputs is right-angled,
the inputs are called perfect complements.

March 2025 The Elasticity of Substitution 3


The Elasticity of Substitution

The substitution effect is very large when labor and capital are perfect substitutes.
When the isoquant is linear, the firm minimizes the cost of producing output q0
by using either 100 machines or 200 workers, depending on which alternative is
cheaper. If input prices change sufficiently, the firm will jump from one extreme to
the other.
In contrast, there is no substitution effect when the two inputs are perfect
complements. Because there is only one recipe for producing q0, a change in the
wage does not alter the input mix at all. The firm must always use 20 workers and
5 machines to produce q0, regardless of the prices of labor and capital.

March 2025
The Elasticity of Substitution 4
The Elasticity of Substitution

There are many substitution possibilities in between these two


extremes, depending on the curvature of the isoquant. The closer the
isoquant is to a line, the larger the size of the substitution effect. To
measure the curvature of the isoquant, we use the elasticity of
substitution. This elasticity is defined by

March 2025
The Elasticity of Substitution 5
The Elasticity of Substitution

The elasticity of substitution gives the percentage change in the capital/labor


ratio resulting from a 1 percent change in the relative price of labor, holding
output constant. As the relative price of labor increases, the substitution
effect tells us that the capital/labor ratio increases (that is, the firm gets rid of
labor and replaces it with capital). At the extremes, the elasticity of
substitution is zero if the isoquant is right-angled (as in Figure b), and infinite
if the isoquant is linear (as in Figure a). The elasticity will be a positive
number for isoquants that have the usual convex shape. The size of the
substitution effect depends directly on the size of the elasticity of
substitution.
March 2025
The Elasticity of Substitution 6

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