Elasticity of Factor Substitution

Elasticity of Factor/Technical Substitution:

The marginal rate of technical substitution (MRTS) decreases along a convex isoquant. The MRTS refers only to the slope of the isoquant, i.e., to the ratio of only marginal changes in the inputs. It does not reveal how ‘difficult’ or ‘easy’ it is to substitute one input for another. Besides, the measurement of the MRTS depends on the units of the measurement of the factors, which does not tell much about the substitutability of factors.

Economists have devised a method of measuring the degree of substitutability of factors, called the Elasticity of Substitution. The elasticity of substitution () is formally defined as the percentage change in the capital-labour ratio (K/L) divided by the percentage change in the marginal rate of technical substitution (MRTS), i.e.

The concept of elasticity of substitution is graphically presented in figure below:

The movement from point A to point B on the isoquant Q gives the ratio of change in the MRTS. The rays OA and OB represent two techniques of production with different factor intensities, i.e., K/L while process OA is capital intensive, the process OB is labour intensive. The shift of OA to OB gives the change in factor intensity. The ratio between the two changes measures the elasticity of substitution. The value of elasticity depends on the curvature of the isoquants. It varies between O and, depending on the nature of the production function, which determines the curvature of the various kinds of isoquants. For example, in the case of a fixed-proportion production function yielding an L-shaped isoquant,  . If the production function is such that the resulting isoquant is linear, . And, in the case of a homogeneous production function of degree 1 of the Cobb-Douglas type, .

Reading Lists:

1) Barthwal, R. R. (1992), Microeconomic Analysis (1st Edition). Wiley Eastern Limited, New Delhi, India.

2) Koutsoyiannis, A. (1990), Modern Microeconomics (2nd edition). Macmillan, London.

3) Henderson, J. M. and R. E. Quandt (1980), Microeconomic Theory: A Mathematical Approach (3rd edition). McGraw Hill, New Delhi. 

4) Samuelson, P. A., & Nordhuas, W.D (1992), Economics (14th edition). McGraw Hill International edition, U.S.

5) Samuelson, P. A., & Nordhuas, W.D (2013), Microeconomics (19th edition). McGraw Hill Education (India) Pvt. Ltd.

6) Dwivedi, D. N. (2016), Microeconomics: Theory and Applications (3rd edition). Vikas Publication House Pvt. Ltd. Noida (UP), India.

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