Adjustment costs and threshold effects in factor demand relationships

It has been recently argued that producers may not respond to every input price change in the way that a linear factor demand model would predict. This lumpy response is due to adjustment costs that are inherent in the act of adjusting the mix of inputs applied in the underlying production technologies. This study aims to provide a solid conceptual framework for these nonlinearities in factor demand relationships. Industry-specific implications of convex and non-convex adjustment costs for the linearity of the factor demand relationships as well as price and substitution elasticities are explored. A two-regime threshold system of factor demand equations is estimated for several manufacturing industries in the United States. Empirical results suggest significant threshold effects in the factor demand relationships in most nondurable goods sectors. The size and the nature of thresholds depend upon industry characteristics, including input composition and (non)convexity of underlying adjustment costs. Complete matrices of price and substitution elasticities for each industry are derived using estimates of threshold factor demand systems. Discussion of two contrasting cases in greater detail sheds light on how the effect of price shocks on factor demand relationships varies across industries with different adjustment cost structures.