Chapter 4: The Elasticity of Substitution
Robert Dixon The elasticity of substitution was discovered independently of each other by John Hicks (1932) and Joan Robinson (1933). Both authors were discussing the ease with which one factor of production may be substituted for another. Robinson presented two definitions. One was expressed in terms of input prices: The degree to which substitution of factors is possible can best be measured by considering the change in the ratio of the factors which occurs when the relative prices alter . . . It appears appropriate to call the proportionate change in the ratio of the quantities of factors employed divided by the proportionate change in the ratio of their prices to which it is due, the elasticity of substitution (1933, p. 256). The second definition was expressed in terms of marginal products and was described as being ‘equivalent but more fundamental’ than the first. This definition is ‘the proportionate change in the ratio of the amounts of the factors divided by the proportionate change in the ratio of their marginal physical productivities’ (p. 330 n2). Figure 4.1 illustrates the relationship between relative factor prices and relative factor use (this is the basis for Robinson’s first definition). The convex line I–I is an isoquant showing the rate at which K and L may be substituted for each other holding output constant. The lines C1–C1 and C2–C2 are iso-cost or budget lines showing combinations of K and L that can be purchased with a fixed budget, given the prices of the two...
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