The Capital-Energy Controversy: An Artifact of Cost Shares?

Abstract

Any serious empirical study of factor substitutability has to allow the data to display complementarity as well as substitutability. The standard approach reflecting this idea is a translog specification—this is also the approach used by the majority of studies analyzing the substitutability of energy and capital. Yet, the substitutability between capital and energy and the source of discrepancies in the results still remain controversial. This paper offers a straightforward explanation for at least the divergent results provided by the translog studies: Using a translog approach reduces the issue of factor substitutability to a question of cost shares. Our review of translog studies demonstrates that this argument is empirically far more relevant than the distinction between time-series and panel studies being favored in the literature. More generally, we provide ample empirical evidence for our argument that the magnitudes of cross-price elasticity estimates of two factors gleaned from static approaches like the translog functional form are mainly driven by the cost shares of these factors.