Elasticity of Substitution

Definition

Elasticity of substitution is a measure of the ease with which one factor of production can be substituted for another in the production of a good or service. It quantifies how responsive the relative usage of inputs is to changes in their relative prices.

5 Must Know Facts For Your Next Test

1. The elasticity of substitution is a key determinant of how firms will respond to changes in relative input prices.
2. A higher elasticity of substitution means inputs are more easily substitutable, allowing firms to adjust their input mix more readily.
3. The elasticity of substitution is inversely related to the curvature of the isoquant, with flatter isoquants indicating a higher elasticity.
4. The elasticity of substitution is an important parameter in many economic models, including those related to growth and income distribution.
5. The Cobb-Douglas production function has a constant elasticity of substitution of 1, while the CES production function can have any positive elasticity.

Review Questions

• Explain how the elasticity of substitution between inputs affects a firm's production decisions.
  • The elasticity of substitution between inputs determines how easily a firm can substitute one input for another in the production process. If the elasticity is high, the firm can more easily substitute between inputs in response to changes in their relative prices. This allows the firm to minimize costs by adjusting the input mix. Conversely, if the elasticity is low, the firm has a harder time substituting between inputs, limiting its ability to respond to price changes and potentially increasing production costs.
• Describe the relationship between the elasticity of substitution and the curvature of the isoquant.
  • The elasticity of substitution is inversely related to the curvature of the isoquant. Isoquants with a higher elasticity of substitution will be flatter, indicating that the firm can more easily substitute between inputs to maintain the same level of output. Isoquants with a lower elasticity of substitution will be more curved, meaning the firm has a harder time substituting between inputs without significantly changing the output level. The curvature of the isoquant is a visual representation of the underlying elasticity of substitution between the inputs.
• Analyze how the elasticity of substitution influences the implications of economic models, such as those related to growth and income distribution.
  • The elasticity of substitution is a crucial parameter in many economic models, as it determines the flexibility firms have in adjusting their input mix. In models of economic growth, a higher elasticity of substitution allows for greater substitution between capital and labor, potentially leading to higher rates of growth. In models of income distribution, the elasticity of substitution affects the degree to which changes in relative factor prices (e.g., wages vs. returns to capital) impact the distribution of income between workers and capital owners. A higher elasticity implies a greater responsiveness of input usage to price changes, which can have significant implications for the distributional consequences of economic policies.

Related terms

Isoquant: A curve that shows all the different combinations of inputs that can produce the same level of output.

Marginal Rate of Substitution (MRS): The rate at which one factor can be substituted for another without changing the level of output.

Constant Elasticity of Substitution (CES) Production Function: A production function that has a constant elasticity of substitution between inputs, regardless of the input mix.