Do producers respond to every input price change? A note on nonlinearities in factor demand systems

Abstract

Factor demand relationships, as they are represented by parameters of the cost function, are generally assumed to be linear (in the parameters) in the existing empirical literature. In this note, we argue that this might not always be true, because firms may incur adjustment costs that are inherent in the act of adjusting the mix of inputs applied in the underlying production technologies. We estimate a two-regime threshold system of factor demand equations for several manufacturing industries in the United States. Our results suggest significant nonlinear effects in the factor demand relationships in most nondurable goods sectors. Failure to account for this threshold sensitivity to input price change may cause the estimates of price elasticities to be biased.

Keywords:

• factor demand systems
• threshold nonlinearities
• input price elasticity

JEL Classification:

• E23
• D24

Notes

¹ The choice of common threshold variable, symmetric thresholds and two regimes was dictated by our available data and degrees of freedom limitations.

² BLS reports another KLEM data set based on the North American Industrial Classification System (NAICS). However, earlier SIC data have not completely been bridged to be consistent with the NAICS data; the new NAICS data set has insufficient number of observations.