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Concept
Constant elasticity of substitution
Summary
Constant elasticity of substitution (CES), in economics, is a property of some production functions and utility functions. Several economists have featured in the topic and have contributed in the final finding of the constant. They include Tom McKenzie, John Hicks and Joan Robinson. The vital economic element of the measure is that it provided the producer a clear picture of how to move between different modes or types of production.
Specifically, it arises in a particular type of aggregator function which combines two or more types of consumption goods, or two or more types of production inputs into an aggregate quantity. This aggregator function exhibits constant elasticity of substitution.
Despite having several factors of production in substitutability, the most common are the forms of elasticity of substitution. On the contrary of restricting direct empirical evaluation, the constant Elasticity of Substitution are simple to use and hence are widely used. McFadden states that; The constant E.S assumption is a restriction on the form of production possibilities, and one can characterize the class of production functions which have this property. This has been done by Arrow-Chenery-Minhas-Solow for the two-factor production case. The CES production function is a neoclassical production function that displays constant elasticity of substitution. In other words, the production technology has a constant percentage change in factor (e.g. labour and capital) proportions due to a percentage change in marginal rate of technical substitution. The two factor (capital, labor) CES production function introduced by Solow, and later made popular by Arrow, Chenery, Minhas, and Solow is:
where
= Quantity of output
= Factor productivity
= Share parameter
= Quantities of primary production factors (Capital and Labor)
= = Substitution parameter
= = Elasticity of substitution
= degree of homogeneity of the production function. Where = 1 (Constant return to scale), < 1 (Decreasing return to scale), > 1 (Increasing return to scale).
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