Constant elasticity of substitution From Wikipedia, the free encyclopedia
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In
economics,
Constant elasticity of substitution (
CES) is a property of some
production functions and
utility functions.
More precisely, it refers to a particular type of aggregator function which combines two or more types of consumption, or two or more types of productive inputs into an aggregate quantity. This aggregator function exhibits constant
elasticity of substitution.
[
edit] CES production functionThe CES
production function is a type of production function that displays constant
elasticity of substitution. In other words, the production technology has a constant percentage change in factor (e.g.
labour and
capital) proportions due to a percentage change in
marginal rate of technical substitution. The two factor (Capital, Labor) CES production function introduced by
Solow [1] and later made popular by
Arrow,
Chenery,
Minhas, and
Solow is:
[2][3]
where
- Q = Output
- F = Factor productivity
- a = Share parameter
- K, L = Primary production factors (Capital and Labor)
- r =
- s = = Elasticity of substitution.
As its name suggests, the CES production function exhibits constant elasticity of substitution between capital and labor.
Leontief, linear and
Cobb-Douglas production functions are special cases of the CES production function. That is, in the limit as
s approaches 1, we get the Cobb-Douglas function; as
s approaches positive infinity we get the linear (perfect substitutes) function; and for
s approaching 0, we get the Leontief (perfect complements) function. The general form of the CES production function is:
where
- Q = Output
- F = Factor productivity
- a = Share parameter
- X = Production factors (i = 1,2...n)
- s = Elasticity of substitution.
Extending the CES (Solow) form to accommodate multiple factors of production creates some problems, however. There is no completely general way to do this.
Uzawa [4] showed the only possible n-factor production functions (n>2) with constant partial elasticities of substitution require either that all elasticities between pairs of factors be identical, or if any differ, these all must equal each other and all remaining elasticities must be unity. This is true for any production function. This means the use of the CES form for more than 2 factors will generally mean that there is not constant elasticity of substitution among all factors.
Nested CES functions are commonly found in partial/general equilibrium models. Different nests (levels) allow for the introduction of the appropriate elasticity of substitution.
The CES is a
neoclassical production function.
[
edit] CES utility functionSee also:
Isoelastic utility
The same functional form arises as a utility function in
consumer theory. For example, if there exist
n types of consumption goods
ci, then aggregate consumption
C could be defined using the CES aggregator:
Here again, the coefficients
ai are share parameters, and
s is the elasticity of substitution. Therefore the consumption goods
ci are perfect substitutes when
s approaches infinity and perfect complements when
s = 0. The CES aggregator is also sometimes called the
Armington aggregator, which was discussed by
Armington (1969).
[5]
A CES utility function is one of the cases considered by
Avinash Dixit and
Joseph Stiglitz in their study of optimal product diversity in a context of
monopolistic competition.
[6]