On the Interrelation of Capital and Labor Adjustment Costs at the Firm Level

In this paper, we study capital and labor adjustment costs by allowing interrelation among adjustments when estimating a dynamic model of factor demand for Greek manufacturing firms. A balanced panel dataset of 1299 firms on 9093 observations for the period 1998-2004 has pointed to strong evidence of (a) inaction, (b) lumpiness, and (c) interrelation of factor adjustment. On account of these empirical observations, we set up and estimate models with alternative factor adjustment costs, using the Method of Simulated Moments. We show that a model incorporating convex, non convex, and interrelation adjustment processes fits the data best. Moreover, the results indicate that (i) labor and capital adjustment should be analyzed together, (ii) capital and labor’s slow adjustment is generated and can be explained by costs associated with changing input demand, and (iii) the firm has an incentive to adjust input factors at the same time period, since adjustment costs decrease when the firm decides to adjust the two factors, namely capital and labor, simultaneously.