Elasticity of substitution is the elasticity of the ratio of two inputs to a production functionwith respect to the ratio of their marginal products. In a competitive market, it measures the percentage change in the ratio of two inputs used in response to a percentage change in their prices. It measures the curvature of an isoquant and thus, the substitutability between inputs, i.e. how easy it is to substitute one input for the other.
History of the concept
introduced the concept in 1932. Joan Robinsonindependently discovered it in 1933 using a mathematical formulation that was equivalent to Hicks's, though that was not realized at the time.
Definition
The general definition of the elasticity of X with respect to Y is, which reduces to for infinitesimal changes and differentiable variables. The elasticity of substitution is the change in the ratio of the use of two goods with respect to the ratio of their marginal values or prices. The most common application is to the ratio of capital and labor used with respect to the ratio of their marginal products and or of the rental price and the wage. Another application is to the ratio of consumption goods 1 and 2 with respect to the ratio of their marginal utilities or their prices. We will start with the consumption application. Let the utility over consumption be given by and let. Then the elasticity of substitution is: where is the marginal rate of substitution. The last equality presents which is a relationship from the first order condition for a consumer utility maximization problem in Arrow–Debreu interior equilibrium. Intuitively we are looking at how a consumer's relative choices over consumption items change as their relative prices change. Note also that : An equivalent characterization of the elasticity of substitution is: In discrete-time models, the elasticity of substitution of consumption in periods and is known as elasticity of intertemporal substitution. Similarly, if the production function is then the elasticity of substitution is: where is the marginal rate of technical substitution. The inverse of elasticity of substitution is elasticity of complementarity.
Example
Consider Cobb–Douglas production function. The marginal rate of technical substitution is It is convenient to change the notations. Denote Rewriting this we have Then the elasticity of substitution is
Economic interpretation
Given an original allocation/combination and a specific substitution on allocation/combination for the original one, the larger the magnitude of the elasticity of substitution means the more likely to substitute. There are always 2 sides to the market; here we are talking about the receiver, since the elasticity of preference is that of the receiver. The elasticity of substitution also governs how the relative expenditure on goods or factor inputs changes as relative prices change. Let denote expenditure on relative to that on. That is: As the relative price changes, relative expenditure changes according to: Thus, whether or not an increase in the relative price of leads to an increase or decrease in the relative expenditure on depends on whether the elasticity of substitution is less than or greater than one. Intuitively, the direct effect of a rise in the relative price of is to increase expenditure on, since a given quantity of is more costly. On the other hand, assuming the goods in question are not Giffen goods, a rise in the relative price of leads to a fall in relative demand for, so that the quantity of purchased falls, which reduces expenditure on. Which of these effects dominates depends on the magnitude of the elasticity of substitution. When the elasticity of substitution is less than one, the first effect dominates: relative demand for falls, but by proportionally less than the rise in its relative price, so that relative expenditure rises. In this case, the goods are gross complements. Conversely, when the elasticity of substitution is greater than one, the second effect dominates: the reduction in relative quantity exceeds the increase in relative price, so that relative expenditure on falls. In this case, the goods are gross substitutes. Note that when the elasticity of substitution is exactly one, expenditure on relative to is independent of the relative prices.
