Reconciling Alternative Estimates of the Elasticity of Substitution

Author(s): Ernst R. Berndt

Source: The Review of Economics and Statistics, Vol. 58, No. 1 (Feb., 1976), pp. 59-68
Published by: The MIT Press
Stable URL: http://www.jstor.org/stable/1936009 .
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 RECONCILING ALTERNATIVE ESTIMATES OF THE
ELASTICITY OF SUBSTITUTION
Ernst R. Berndt*
I. Introduction
A large numberof econometricstudieshave
focused on possibilities for capital-labor
substitution in U.S. manufacturing. The evi-
dence, however, indicates substantial disagree-
ment over the value of the elasticity of substi-
tution (cr). Studies based on cross-sectional
data provide estimates which are quite close
to unity, but time series studies generally re-
port lower estimates. Furthermore, estimates
of or seem to vary systematically with the
choice of functional form: regressions based
on the marginal product of capital relation
generally produce lower estimates of cr than
regressions based on the marginal product of
labor relation. A variety of hypotheses have
been advanced to explain the diversity of re-
sults, including cyclical changes in the utiliza-
tion of factors (Nerlove, 1967), random mea-
surement errors (Leontief, 1964), systematic
variation of input prices with product prices
(Nerlove, 1967), embodied and disembodied
technical change and problems in the measure-
ment of inputs (Griliches, 1967a; Hildebrand
and Liu, 1965), simultaneous equations bias
(Maddala and Kadane, 1966; Nerlove, 1967),
serial correlation (Griliches, 1967a), and lagged
adjustment (Griliches, 1967a; Lucas, 1969;
Jorgenson, 1972). In general, empirical studies
attempting to take account of these deficiencies
have produced unsatisfactory results. Zvi Gri-
liches, for example, finds that "the labor qual-
ity variables . . . contribute little in the elas-
ticity-of-substitution context" (1967a, p. 296),
while R. E. Lucas, Jr. concludes that lagged
adjustment hypotheses "make essentially no
contribution to the reconciling of time series
Received for publication March 26, 1974. Revision ac-
cepted for publication December 30, 1974.
* The helpful comments of L. R. Christensen, M. K.
Denny, W. Erwin Diewert, Arthur S. Goldberger, Charles
R. Hulten, Dale W. Jorgenson, T. J. Wales, A. D. Wood-
land, and Paul Zarembka are gratefully acknowledged.
Any remaining errors are the sole responsibility of the
author.
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and cross-sectional evidence of substitution"
(1969, p. 259).
In this paper we report results of a rather
successful attempt to reconcile the differing
estimates of cr. While it may be desirable to
consider separately and systematically the con-
tribution of each of the above hypotheses in
reconciling the cr estimates, here we limit our
concern to two principal areas: (1) data -we
attempt to construct time series data on the
cost of capital services in a more detailed man-
ner than previous researchershave, taking into
account real and nominal rates of return, asset
prices, depreciation, tax policies, and composi-
tional changes in aggregate capital between
equipment and structures; (2) stochastic spec-
ification -we estimate cr by a two-stage least
squares (2SLS) procedure to circumvent the
problemof simultaneousequations bias by ordi-
nary least squares (OLS). We then compare
estimates of a- based on six different functional
forms, five alternative measures of the rental
price of capital services, and two estimation
methods.
Our most sobering result is that estimates
of Cr are extremely sensitive to differences in
measurement and data construction. In this
respect we concur with Nerlove who finds that
"even slight variations in the period or con-
cepts tend to produce drastically different esti-
mates of the elasticity" (1967, p. 58). How-
ever, with our preferred set of data we obtain
OLS and 2SLS time series estimates of o-
which exhibit robustness over a variety of
functional forms and time periods, and are
consistent with the cross-sectional evidence.
II.
Review of the Literature
Let there be an aggregate production func-
tion V - V(K,L,X3,X4,.. ., Xm,A) character-
ized by constant returns to scale in the input
quantities, where V is the flow of gross output,
K is the flow of services from capital equipment
and structures, L is the flow of services from
productionand nonproductionlabor, the X's are
[ 59 1
60 THE REVIEW OF ECONOMICS AND STATISTICS
other inputs, and A is an index of technical effi-
ciency. We assume that any technical change
affecting the inputs is Hicks-neutral. This
allows us to write V - AH, where A is in-
terpreted as the index of total factor produc-
tivity and H is the aggregate input function'
H H(K,L,X3,X4, . . , XM). Further, we
. (2) with a time trend term added; he concludes
assume that K and L are weakly separable from
all other inputs in H, i.e., H - J(F(K,L),X3,
X4, . . ., X,). Like previous researchers, we
specify that F can be represented by the CES
form F - (8K-P + (1 - 8)L-P)-'1P in which
case , - 1/ (1 + p). Assuming that markets
are competitive, we take logarithms of the mar-
ginal productivity relations, rearrange,and ob-
tain
In (F/K) a, + crln (PK/P) (1)
In (F/L) - a2 + cr n (PL/P), (2)
where PK and PL are the input prices of capital
and labor services, P is the price of aggregate
input F, and the constant terms a, and a2 are
nonlinear combinations of 8 and o. If we sub-
tract (1) from (2), we obtain a third equation
independentof F and P:
In (K/L) - a3 crln (PK/PL)*
- (3)
Assuming that P is constant across states and
regions, Zvi Griliches (1967b), Robert Solow
(1964), Paul Zarembka (1970), Paul Za-
rembka-Helen Chernicoff (1971), and Phoe-
bus Dhrymes-Paul Zarembka (1970) have re-
written (1) and (2) as
In (PF/K) a', + clnPK,
and
In (PF/L) a'2 + o-in PL- (2')
The general conclusionemergingfrom the cross-
section studies based on (2') is that "there is
no significant evidence that the elasticity of
substitution at the two-digit level departs from
unity" (Zarembka, 1970, p. 53) .2 Dhrymes and
1 The concept of an aggregate input function was intro-
duced by Robert M. Solow (1957). It has also been em-
ployed by Jorgenson and Griliches (1972), Christensen,
Jorgenson, and Lau (1973), and Berndt and Christensen
(1973, 1974).
2Nerlove (1967, pp. 73-74) has argued that the assump-
tion of constant P across regions is questionable, for P is
likely to be positively correlated with PK or PL. Failure
to take account of this when estimating (1') and (2')
biases the estimated value of o- toward unity. Griliches
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Zarembka report results in which estimates of
a- based on (1') are generally lower than those
based on (2').
Time series studies have generally provided
lower (r estimates than cross-section studies.
Robert E. Lucas, Jr. has estimated o- based on
that "the time series estimates are centered in
the range 0.3 to 0.5" (1969, p. 251). Robert M.
Coen (1969) has estimated a distributed lag
function based on (1) and finds that his best
fit occurs when cr- 0.2. Similar low time series
estimates of o- have been obtained by Robert
Eisner and M. I. Nadiri (1968) based on a dis-
tributed lag variant of (1). The time series
results of Lucas, Coen, and Eisner-Nadiri are
similar to the cross-sectional evidence of
Dhrymes-Zarembka in that estimates of o-
based on the marginal product of capital rela-
tion are generally smaller than estimates based
on the marginalproduct of labor relation. G. S.
Maddala (1965) has estimated oCbased on the
ratio of marginal products (3). Although his
time series estimates vary considerably, they
are centered in the range 0.1 to 0.2.
The finding that time series elasticities are
lower than cross-sectionalestimates is a familiar
one in demandanalysis. Based on lagged adjust-
ment models, Lucas has attempted to reconcile
the evidence. He finds, however, that the lagged
adjustment hypotheses "make essentially no
contribution to the reconciling of time series
and cross-sectional evidence of substitution"
(1') (1969, p. 259). A related finding has been re-
ported by Griliches (1967a), who compares
successive cross-sections for 1957 and 1958 and
finds that he must reject the partial adjustment
model, but cannot reject the serial correlation
model.
In the above studies it has been assumed that
prices are exogenous. If, in fact, prices are
endogenous, OLS estimation will yield incon-
sistent parameter estimates. In our context, the
direction of the bias cannot be determined; see
G. S. Maddala and Joseph B. Kadane (1966).
Even if both prices and quantities are endog-
enous, in small samples it may be desirable
(1967a), however, has found the bias to be negligible. For
further discussion of the potential biases using (2'), see
Lucas (1969, pp. 236-245) and Griliches (1967a).
 ELASTICITY OF SUBSTITUTION
to ignore the simultaneous equations bias and
estimate the reciprocal regressions from (1),
(2) and (3) by OLS:
ln (PK/P) a4 (1/o-) ln (F/K) (4)
ln (PL/P) (1/o-) ln (F/L)
a4 +
ln (PK/PL) a6 -(i/o-) ln (K/L).
Hereafter we denote the estimates of o- based on
equations ( 1) through (6) by o-r,i 1,.. , 6.
Since the direction of the possible simulta-
neous equations bias cannot in general be de-
termined,Maddala and Kadane have performed
a Monte Carlo study in which they compare
small sample properties of 02 and or5.4They
find that 02 estimates are biased downward,
that the bias is fairly large except when true
values of o- are close to unity, and that 0r5 esti-
mates are more robust in the face of simulta-
neous equations misspecification.To our knowl-
edge, however, cross-section or time series
studies estimating o5 have not been reported
in the literature. Maddala (1965) has estimated
cr3and cr6 from the reciprocal regressions (3)
and (6); his OLS time series estimates of or3
are centered in the range 0.1 to 0.2, while those
based on o-6 are centered in the range 0.4 to
0.6.5 F. W. Bell (1965) has obtained cross-
sectional estimates of o-6which in general are
insignificantly different from unity;6 however,
his o-6estimates are on average larger than his
o-2 estimates.
The above survey suggests that not only do
cross-section and time series estimates of oC
differ considerably, but estimates of o- are also
sensitive to the equation fitted. It is easy to
show that a systematic variation in o- estimates
is due solely to choice of the equation fitted.
In bivariate regressionanalysis it is well known
3 The disturbance terms in (4), (5), and (6) are, of course,
not the same as those in (1), (2), and (3). For a discussion
of the potential empirical significance of this problem, see
Maddala-Kadane (1966) and Bodkin-Klein (1967).
4 Nerlove (1967) notes that if both prices and quantities
are subject to random measurement error (or if both are
endogenous in some larger system), then a2 and o-5 bracket
the consistent estimate.
5 The Maddala (1965) results are tabulated in table 7 of
Nerlove (1967).
6Actually, Bell adds In (KIL) to both sides of (6). The
implicit OLS estimate of C- based on Bell's equation is, of
course, numerically equivalent to the OLS estimate based
on (6) itself.
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61
that the R2 based on a simple regression model
Y = a + ,/X + u is the same as the R2 from
X = 8 + yY + v (R2 here is merelythe squared
sample correlation coefficient between X and
(5)
Y); further, R2 =38"y", where /8" and y" are
least squares estimates of /8 and y. Thus, in
(6)
our context OLS estimates of o- will always be
subject to the inequality relations:
cTl < 04, 2< -5, and 03 < 06, (7)
because cr1/o-4 R12 R42, o2/or5 R2
R52, and oJ3/'6 = R3- 2 R62, where the sub-
script on R2 refers to the squared correlation
coefficientof the equation being estimated.
As a matter of historical development,
Dhrymes (1965) reportedthat his results were
based on (2'); subsequently Dhrymes and
Zarembka (1970) discovered that the Dhrymes
reported results were erroneousand were based
on the "other regression"-the logarithm of
the wage rate on the logarithm of the output-
labor ratio. Dhrymes and Zarembka (1970)
claim to have corrected this error. A puzzling
aspect of their correction, however, is that R2
figures reported by Dhrymes (1965) should
equal the R2 figures from the "corrected" re-
ciprocal regression reported in Dhrymes-
Zarembka (1970). This never occurs; in SIC
35, for example, the two R2 figures are 0.2422
and 0.0043, while in SIC 37 they are 0.5129
and 0.7547. All one can conclude is that the
"correction"is incomplete; either one or both
of these studies must contain additional numer-
ical errors.
III. Data Construction and Sources
The separationof capital outlay from owner-
utilized assets into price and quantity com-
ponents is based on the equality in competitive
equilibrium of the acquisition price of an asset
and the discounted value of its services. This
equality implies a correspondence between
acquisition prices and rental or service prices.
Following Jorgenson (1974), we assume that
the service flow of a given capital asset declines
geometrically over time. The service price Pt
obtained from the implied sequence of acquisi-
tion prices, is Pt qt-1rt + qt5 - (qt -qt-1),
where qt is the acquisition price of the asset, r
62 THE REVIEW OF ECONOMICS AND STATISTICS
the rate of return,and 8 the rate of depreciation.
The service price is the sum of the nominal cost
of capital, qt-lrt, the current cost of deprecia-
tion, qt8, and the cost of capital loss on the
value of the asset, -(qt - qt-i). Since the
nominal rate of return rt is distinguished from
the real rate of return, r*t, r*t rt- (qt-
qt-l)/qt--, the service price is alternatively
expressed as the sum of the real cost of capital
and the current cost of depreciation.
The presenceof tax policies alters this service
price. Tax rates on property and income reduce
the after-tax rate of return, while investment
tax credits and accelerated depreciation allow-
ances reduce the net acquisition price of the
asset. It might be reasonable to assume that at
a particular point in time, effective tax rates
and capital gains are equal across regions or
states. Over time, however, it seems reasonable
to expect considerablevariation in nominalrates
of return, effective tax rates, and capital gains.
The time series studies by Hall and Jorgenson
(1967, 1969), Coen (1969), and Eisner and
Nadiri (1968) have taken asset prices and rates
of depreciationinto account, but tax parameters
have been set to their statutory (rather than
effective) rates, capital gains have been ignored,
and before-tax real rates of return have been
assumed to be constant.
Based on earlier work by Hall and Jorgenson
(1967) and Coen (1968), Christensenand Jor-
genson (1969) have derived service price for-
mulas for producers' durable equipment (Pe)
and nonresidential structures (Ps) that take
these tax, depreciation, capital gains, and real
rate of return variables into account. Specifi-
cally, for the corporate sector in U.S. manu-
facturing 1929-1968, the formulas are
1 utZet- kt + Yt
1 Ut
4- qet6e - (qet - qe t-)
1utzst
-Ut
Pst 1 - (qs,t- irt + qjt8s
(qst qs,t-1) )+ qsttty
where the subscript e refers to producers'dura-
ble equipment, s to nonresidential structures, t
to the time period, u is the corporateprofits tax
rate, ze and z, are the present value of deprecia-
tion deductions on a dollar's investment in e
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or s over the lifetime of the asset,7 k is the in-
vestment tax credit, y is kuze for 1962-1963
and zero all other years, q, and q, are price
indices of new e or s in U.S. manufacturing,8r
is the nominal after-tax rate of return on cor-
porate property, t is the tax rate on corporate
property, and 8e and As are rates of deprecia-
tion in U.S. manufacturing.9
In order to assess the sensitivity of cr esti-
mates to alternative data construction pro-
cedures, we propose to construct five differing
price series for Pe and Ps:
(a) Set all tax parametersin (8) and (9) to
zero, the real rate of return to the Moody AAA
corporatebond yield,"9and ignore capital gains.
The Moody AAA bond yield has been employed
as a measure of the cost of capital by Coen
(1968), Evans (1967), and Grunfeld (1960).
(b) Set u and k to their statutory rates, t to
zero, ze and z, to the values computed by
Christensen-Jorgenson,"the before-tax rate of
returnr' to be a constant 20%o,but let the after-
tax rate of return vary according to r (1 -
u)r', and continue to ignore capital gains. The
principal advantage of price series (b) over
(a) is that (b) takes into account statutory tax
rates. The above relation between before- and
after-tax rates of return has been suggested by
Hall and Jorgenson (1967, 1969) and followed
by Coen (1969).
(c) Follow all steps as in (b), except set the
tax parameters u, k, and t equal to their effec-
tive rates.'2 The principal advantage of this
service price over (b) is that (c) takes into
account effective ratherthan statutory tax rates.
(d) Follow all procedures as in (c), except
use as the after-tax rate of return the nominal
after-tax rate of return calculated by Christen-
sen and Jorgenson (1969). The nominal after-
7 The discount rate used in computing ze and zS is 10%,
which is very close to the mean nominal rate of return
+ qettt (8) (9.39) over the 1929-1968 sample period.
8 The source of these data is Grose, et al. (1969); "con-
stant cost 2" deflators are chosen because they represent
an attempt to measure the unit price of output rather
than the unit cost of inputs.
(9) 9 These depreciation rates are based on Berndt (1972)
and Berndt-Christensen (1973); 8E = .135 and 8A = .07 1.
10 The data series on the Moody AAA bond rate is taken
from the Economic Report of the President, 1971.
11 The data series on u, k, ze and z8 is found in Christen-
sen-Jorgenson (1969), table 5.
12 These rates are presented in Christensen-Jorgenson
(1969), table 5.
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 ELASTICITY OF SUBSTITUTION 63
tax rate of return is computed from national we also construct an aggregate service price
accounting data as property income after taxes based on a fixed weight proceduresuggested by
and depreciation divided by the value of the Coen (1969), P*K .6Pe + .4P8. We construct
aggregate capital stock.'3 The principal advan- aggregate service prices of capital based on the
tage of this service price measureover (c) is that Pe and P8 series (a) and (b) using Coen's pro-
(d) is based on historical nominal after-tax rate cedure; those based on (c), (d), and (e) are
of return data as published in the U.S. National constructed using Tornqvist's (1936) discrete
Income and Product Accounts. Althoughrate of approximation to the continuous Divisia for-
return measures have been employed in numer- mula,
ous studies on investment behaviour, the return ln Pkt - ln P7,t1- i wi-t(ln Pit - InPi,t-)
measures in (a), (b), and (c) above are essen- i - e, s
tially unrelated to the historical national ac- where the weights Wit are arithmetic means of
counting data. the shares in the two periods
(e) Follow proceduresas in (d), but employ Wet = (PetEt/(PetEt + PstSt)), Wst
the real rather than the nominal rate of return -(PstSt/ (PetEt + P,tSt) ) .15
as the cost of capital measure. One possible The aggregate service prices based on series
problem with using such historical national ac-
counting data is that it may yield erratic and P, and P8 (a), (b), (c), (d), and (e) are de-
noted with capital letters A, B, C, D, and E;
volatile rates of return. A priori, it would seem table I summarizes their distinguishing fea-
reasonableto expect producersto look at a more
stable rate of return when deciding upon opti- TABLE 1. - SUMMARY OF ALTERNATIVE PROCEDURES
mal input levels. Over the 1929-1968 period USED TO CONSTRUCT PK

under consideration, the sample means of the

PK Rate of Return Aggregation Procedure
real and nominal rates of return are 6.4% and Index Measure Employed Used to Construct PK
9.3 %; more important, however, the sample Moody AAA corporate Coen's fixed weights
A
variance of the real after-tax rate of return is bond yield; no taxes
only about 30%7as large as that of the nominal B Constant before-tax Coen's fixed weights
after-tax rate of return. Because it is based on rate of return = 20i
historical data, and because the real after-tax statutory tax rates
rate of return is more stable than the nominal C Constant before-tax Divisia index
rate of return = .20;
after-tax rate of return, we prefer service price effective tax rates
measure (e). No doubt some errorsstill remain; D Nominal rate of return Divisia index
for example, producers are not always able to computed from historical
accurately predict the real rate of return even data; effective tax rates
though it is more stable than the nominal return. E Real rate of return com- Divisia index
However, we believe that (e) most accurately puted from historical
data; effective tax rates
measures the actual capital rentals faced by
producers.
Having computed these five alternative ser- tures. A is the index of poorest quallty; B takes
vice price measures of Pe and P8, we must now into account statutory tax rates and corresponds
construct an aggregate service price PE. We closely with the time series data construction
choose to construct our preferred data series by procedures followed by Coen (1969); C em-
employing a discrete approximation to the ploys effective tax rates and Divisia aggregation
Divisia index.'4 For purposes of comparison, methods; D uses as the rate of return measure
the nominal after-tax rate of return computed
13 The property income figure is net of capital gains from the National Income and Product Ac-
from sale of property. For further information regarding
procedures employed in measuring this rate of return, see 15 Measures of E and S are obtained by employing a
Christensen-Jorgenson (1969) and table 7.5, Office of Busi- perpetual inventory method with constant rates of deprecia-
ness Economics (OBE) (1966). tion, using data on investment in constant dollars from the
14Properties of the Divisia index have been discussed by OBE Capital Stock Study (Grose et al., 1969); see Berndt
M. Richter (1966), C. R. Hulten (1973), W. E. Diewert (1972) and Berndt-Christensen (1973) for further informa-
(1974), and Jorgenson-Griliches (1972, pp. 83-84). tion.

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64 THE REVIEW OF ECONOMICS AND STATISTICS-
counts; and E, our preferredmeasure, employs
real after-tax rates of return based on the his-
torical national accounting data.
Correspondingto each of the five alternative
service prices, we construct series on K as K=
(PetEt + P8tSt)/PKt.'6 Our measure of L is per-
sons engaged in U.S. manufacturing;PL is com-
puted as compensation to employees in U.S.
manufacturing, adjusted for the earnings of
proprietors, divided by L."7
We now turn to a discussion of output price
and quantity indexes. Recall that in our gross
output production function V = V(K,L,X3,X4,
... , X,,,A) we assumed the existence of a
weakly separable subfunction F F (K,L).
The "output" of the subfunction is, of course,
an unobservable variable; the observable out-
put is gross output from the production func-
tion V. It has been traditionalin productionand
investment studies to use as a measure of the
"output"of the subfunction F published series
on value added, deflated perhaps by some index
of Hicks-neutraltechnicalefficiency.Since value
added is constructed as gross output minus in-
termediate materials, such a value added index
corresponds with F only if all quantities or
prices of the intermediate inputs move propor-
tionally with output quantity or price. His-
torically such proportionalityhas not occurred;
for example, since until recently the price of
energy has risen less rapidly than that of other
intermediate inputs, the quantity of energy de-
manded has risen more rapidly.'8Thus, propor-
tionality among intermediate inputs has not
occurred and the conventional value added in-
dex is an inappropriatemeasure of F.
The concept of value added also serves as a
device for allocating the origins of income to
services of the primary inputs - all types of
capital and labor inputs. The vast majority of
empirical studies on production and investment
16For price indexes C, D, and E, PK is computed as a
Divisia index; the quantity index K is therefore an approxi-
mate Divisia index. The empirical results reported in section
IV are essentially unchanged when the order is reversed,
i.e., if K is first computed as a Divisia quantity index, and
then PK is constructed implicitly as an approximate Divisia
price index.
17 Compensation to employees includes wages, salaries,
and supplements. For further discussion of these data, see
Berndt-Christensen (1974) and OBE (1966), tables 6.1
and 6.6.
18 For further discussion, see Berndt and Wood (1975).
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behaviour have been concerned with only a
subset of capital inputs - equipment.and struc-
tures. Other capital inputs like land, inventories,
and working capital have been ignored. The
measure of output employed in these studies of
equipment,structures,and labor is value added.
This is, of course, an inappropriateprocedure;
nominalvalue added will be larger than the sum
of the costs of equipment,structures,and labor,
because the costs of land, inventories,and work-
ing capital are ignored."9We conclude that for
two reasons- lack of proportionality among
intermediate inputs and omission of certain
capital inputs - it would be inappropriate for
us to use published value added figures as the
measure of the "output" of the subfunction F.
Robert M. Solow (1957) has suggested an
alternative method for constructing a measure
of F which is based on a Divisia aggregateinput
index of K and L. Thus, the unobservable"out-
put" of the subfunction F is measured as ag-
gregate input. One potential problem with
Solow's method is that if markets do not adjust
rapidly, the resulting disequilibriummay iinply
that the value of output will not equal the sum
of the values of the inputs. Such a problem
might be of considerableimportancewith quar-
terly time series data, but (hopefully) would be
less significant with annual data. In this paper
we adopt Solow's procedurebecause we believe
that with annual data the benefits of not assum-
ing proportionalityamong the prices or quanti-
ties of the intermediate inputs and the omitted
capital inputs outweigh the costs of temporary
disequilibriumcaused by lagged adjustment.
Correspondingwith each of the five alterna-
tive aggregate service prices, we construct P,
the price of aggregate input F, as a Divisia
price index of PK and PL; F is then constructed
as ((PKK + PLL)/P). This measure of the
unobservable output F, like that of aggregate
capital services K, obviously depends on the
method employed in measuringthe rental price
PK-
20
19 Value added would be perfectly correlated with F
only if the prices or quantities of all intermediate inputs
and the omitted capital inputs moved proportionally. This
certainly has not been the case over the 1929-1968 period,
e.g., the price or quantity indexes of land and energy have
not moved proportionally.
20 Printouts of the data and constructed variables are
available from the author upon request.
 ELASTICITY OF SUBSTITUTION
IV. Empirical Results
Table 2 presents OLS and 2SLS estimates
of Crfor the 1929-1968 time period, based on
six different functional forms and five alterna-
tive data constructionprocedures.2'Three strik-
ing conclusions emerge from table 2: (1) OLS
time series estimates of o approach unity as
better methods of data measurement are used;
(2) 2SLS estimates of Cr are larger than OLS
estimates; and (3) alternative 2SLS estimates
of Cr based on the six functional forms are
reconciled with each other - all six estimates
fall within the narrow range of 1.148 to 1.245.
The OLS estimates of Cr based on A are
negative. Using data construction procedures
and functional forms similar to those of Coen
(1969), we obtain a o- estimate based on B
of 0.269 -very close to the 0.2 estimate re-
ported by him. For functional forms 1, 3, 4,
and 6, the OLS Crestimates based on B compare
21 The excluded exogenous variables employed in the
2SLS regressions are those used in Berndt and Christensen
(1973, 1974); they are tabulated in the appendix tables of
(1973).
TABLE 2. - ALTERNATIVE ESTIrMATES OF 0
65
favorably with those based on C, which indi-
cates that employing effective (rather than
statutory) tax rates and Divisia (rather than
fixed weight) indexing procedures has only a
limited effect here. An obvious problem with
the OLS estimates based on B and C is their
lack of robustness with different functional
forms; for example, the B estimates range from
0.024 to 64.6555 and the C estimates from
-85.981 to 5.007.
The pattern of estimates changes dramati-
cally, however, when rate of return data based
on the historical.national income and product
accounts are employed (procedures D and E).
The variation among alternative OLS estimates
is reduced substantially; for D the range is
0.441 to 0.707, while for E it is 0.960 to 1.238.
OLS estimates based on D in equations 1, 2,
and 3 are larger, while those in equations 4, 5,
and 6 are smaller in absolute value than the
corresponding OLS estimates based on A, B,
and C data construction procedures. Further-
more,when real rate of returndata are employed
(procedure E), we find that all OLS estimates
are larger than those based on nominal rates of
FOR TOTAL U.S. MANUFACTURING 1929-1968

Estimation
Procedure: OLS OLS OLS OLS OLS 2SLS
Data
Procedure: A B C D E E
Functional
Form:

1 O*i -.079 .269 .250 .441 .967 1.148

S.E. (.202) (.149) (.156) (.035) (.082) (.098)
R2 .004 .079 .063 .805 .785 .757
D.W. .121 .154 .156 .618 2.162 2.656
2 0(2 -.651 .024 -.020 .604 .960 1.165
S.E. (.242) (.202) (.212) (.041) (.084) (.103)
R2 .161 .001 .001 .854 .776 .740
D.W. .148 .166 .168 .934 2.119 2.668
3 0(3 -.164 .234 .211 .466 .966 1.151
S.E. (.208) (.156) (.163) (.036) (.082) (.098)
R2 .016 .056 .042 .813 .784 .755
D.W. .125 .156 .158 .669 2.160 2.663
4 o4 -19.722 3.412 3.943 .548 1.231 1.233
S.E. (50.493) (1.892) (2.459) (.043) (.103) (.108)
R2 .004 .079 .063 .805 .785 .785
D.W. .036 .058 .048 1.008 2.699 2.699
5 Ur, -4.056 64.655 -85.981 .707 1.238 1.245
S.E. (1.504) (543.74) (915.33) (.046) (.108) (.113)
R2 .161 .001 .001 .854 .776 .775
D.W. .066 .051 .043 1.203 2.705 2.705
6 0e -10.137 4.171 5.007 .573 1.232 1.235
S.E. (12.820) (2.773) (3.869) (.044) (.104) (.108)
R2 .016 .056 .042 .813 .784 .784
D.W. .036 .055 .046 1.044 2.704 2.704
Note: S.E. refers to the estimated standarderror, while D.W. refers to the Durbin-Watson statistic.

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66 THE REVIEW OF ECONOMICS AND STATISTICS
return (procedureD). Althoughthe E estimates specification may be of considerable impor-
fall on both sides of unity, all six OLS estimates tance, "all econometric results are no better
of C- based on the E procedure are insignifi- than the data that went into them" (Griliches,
cantly different from unity at the 0.025 level 1967a, p. 308). The data used in this study
of significance. Finally, when the OLS method have been constructed with considerable care,
of estimation is replaced by 2SLS, we find that but no doubt some errors still remain. Two po-
all estimates increase to values greater than tential sources of error are particularly worthy
(but insignificantly different from) unity. of further consideration.
It is interesting to note that the Durbin- First, if inputs adjust to their desired levels
Watson statistics generally increase as the qual- only after some time lag, marginal products
ity of the data constructionprocedureimproves. and relative input prices will differ, and markets
An abrupt increase in the D.W. statistic occurs will not be in full equilibrium. The theoretical
when real rather than nominal rates of return justification of our data construction is based
are employed (procedure E instead of D). This on the equilibrium assumption. For example,
suggests that the appropriate "remedy" for the rate of return calculation and the capital
serial correlation here is to construct better rental price measure are based on Euler's
data, ratherthan to employ a more sophisticated theorem and the equality in full competitive
estimation procedure on the inferior data. equilibriumof the acquisition price of an asset
It is also of interest to examine the stability and the discounted value of its services. Thus,
of the C- esti'mates throughout the 1929-1968 the theoretical justification of our data con-
time period. A variety of hypotheses could be struction measures is not strictly valid when
tested. Since substantial data gathering changes lagged adjustment is postulated. To fully ac-
took place in 1947, we choose to test the null count for lagged adjustment, it would be neces-
hypothesis that, based on the E data, the regres- sary to develop theoretical foundations of in-
sion coefficients for the 1929-1946 period are dexing prices, quantities, and marginalproducts
equal to those for the postwar 1947-1968 in disequilibrium markets. It might be con-
period.22We perform a Chow test on each of jectured that our failure to account for lagged
the six functional forms.23 Although point adjustment systematically biases certain of our
estimates of C- from the 1947-1968 period are cr estimates. The direction and magnitude of
slightly less than those from the 1929-1946 such a bias would be difficult to determine un-
period, with our E data the null hypothesis of less the specific form of the lag distribution
parameter equality in the two subperiods can- and the appropriate indexing procedures were
not be rejected. The calculated F-statistics with known. Table 2 suggests that if such a bias
2.36 degrees of freedom are 0.34, 0.28, 0.33, exists, it appears to be neutral with respect
1.64, 2.06, and 1.71 for the OLS regressions to functional form: E estimates of Cr based
based on (1) to (6) respectively, while the com- on the marginal product of capital relation,
parable 2SLS calculated F-statistics are 0.85, the marginal product of labor relation, and the
0.68, 0.84, 1.63, 2.05, and 1.70; the critical ratio of these marginal products (which is in-
value at the 0.05 level of significance is 3.26. dependent of F and P) are all close to one
another.24
Concluding Remarks A second possible source of error worthy of
Frequently, economists are faced with the further consideration is the proper treatment
task of attempting to reconcile inconsistent
24 It might also be conjectured that the cyclical sensitivity
empirical evidence. A common approach is to
of our D and E measures biases the results in favour of
investigate possible errors in functional and these service price formulas. In particular, when capital
stochastic specification. The implication of this gains or "pure profits" are large, investment and employ-
study is that although errors in stochastic ment also tend to be high. Thus, cyclical sensitivity of the
D and E measures would produce larger estimates of o-i
22 A similar hypothesis was tested in Berndt-Christensen and ur2.Although the D measure has a larger sample vari-
(1973, 1974). A discussion of the Bureau of Labor Statistics ance than E, the E index is particularly sensitive to cyclical
data gathering changes is provided in the statistical appendix fluctuations; for example, in periods of prosperity and sub-
of Berndt-Christensen (1974). stantial capital gains, the E service price measure is smaller
23See Johnston (1963), pp. 136-138. than D.

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 ELASTICITY OF SUBSTITUTION 67
of non-neutral technical change. Considerable Evans, M. K., "A Study of Industry Investment Deci-
theoretical work still remains to be done on sions," this REVIEW (May 1967), 151-164.
appropriateindexing procedures for inputs and Griliches, Z., "Production Functions in Manufacturing:
Some Preliminary Results," in M. Brown (ed.),
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simple Hicks or Harrod neutral form. For ex- Studies in Income and Wealth, vol. 32 (New York:
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technical change impingeson primary and inter- Grose, L., T. Rottenberg, and R. Wasson, "New Esti-
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