The Factor Bias of External Inputs: Implications for Substitution between Capital and Labor

Abstract This paper reevaluates the longstanding debate on capital-labor substitution by examining the role of external inputs: raw materials, intermediate goods and services, imports, offshoring. Both a meta-analysis (analyzing existing estimates of substitution) and direct estimation (using U.S. data for 1963-2016) indicate that external inputs disproportionately displace labor. These findings imply (1) that the capital-labor ratio responds 40-80% more strongly to the price of labor than to the price of capital, (2) that value added cannot be modeled separably from gross output, and (3) that historical disagreements regarding substitution can be recast as an omitted variable bias involving external inputs.