Primary Factor Substitution and the Real Wage Explosions

This paper reports estimates of the demand for labour across broad industry categories in the Australian economy obtained from time series data spanning 1962-63 through 1985-86. The focus is the empirical estimation of the elasticity of substitution between the primary factors of capital and labour. The model developed employs an error correction mechanism whereby disequilibrium in periods of change can be corrected in later periods. Over the study period two major wages shocks occurred, the first in 1973-74 and the second in 1981-82. In the underlying model adopted here allowance is made for the effects of these two events on the elasticity of primary factor substitution and on the capital intensity of the technology which is of related interest. Allowance is also made for disequilibrium, at the height of the wages shocks, which is not adequately accounted for by error correction. For certain of the industry groups studied, it was difficult to achieve convergence in maximum likelihood searches. For these groups modifications to the model were made and in some cases modifications were also made to the data. Generally, the results show relatively high substitution elasticities (mostly between 0.6 and 1.0); whenever specification allowed, moreover, the substitution elasticities increased in the aftermath of the wages shocks. Exceptional cases are Agriculture (with a low estimated elasticity) and Manufacturing (with an apparently declining elasticity). Capital deepening is also indicated in most cases.