A demand system for input factors when there are technological changes in production

Abstract

Abstract: In a system with n input factors there are n − 1 independent cost shares. An often-used approach in estimating factor demand systems is to (implicitly or explicitly) assume that there is a (independent) cointegrating relationship for each of the n − 1 independent cost shares. However, due to technological changes there might not be as many cointegrating relationships as there are (independent) cost shares. The paper presents a flexible demand system that allows for both factor neutral technological changes as well as technological changes that affect the relative use of the different factors. The empirical tests indicate that there are fewer cointegrating relationships than usually implied by using conventional estimation approaches. This result is consistent with technological changes. I argue that since such unexplained technological changes are likely to affect input factor decisions, a demand system that allows for such changes should be preferred.