The role of elasticity of substitution in economic growth: a cross-country test of the de La Grandville Hypothesis

The elasticity of substitution between capital and labor (σ) is a second-order parameter of the production function but has a first-order effect on economic growth. Although the importance of this elasticity has long been recognized in several branches of economics, it has received too little attention in the growth literature. Grandville (1989) showed theoretically that at any stages of an economy’s development, the growth rate of income per capita is increasing with σ. The higher is σ, the greater the similarity between capital and labor in the production function, and thus diminishing returns sets-in very slowly. To the best of our knowledge, this is the first paper that tests the Grandville hypothesis at the cross-country level. We estimate σ for 90 countries from direct estimation of the normalized CES production function and then include these estimators as an explanatory variable in cross-country growth regression. We investigate the sign and significance of the coefficient of σ conditioning on country characteristics, initial conditions, institutions and a set of policy variables. Since the unobservable σ is “generated” from the first-step estimation of the CES production function, in the second-step cross-country growth regression it is measured with sampling errors (Pagan, 1984; Murphy and Topel, 1985). After accounting for measurement errors and other sources of endogeneity, we find strong support for the de La Grandville hypothesis. We find that σ can explains about 30% of the growth rate differential between East Asia and Sub-Sahara Africa. We check the robustness of our results by Leamer’s (1983) extreme value analysis, and the coefficient of σ remains positive and the t-statistics remain large for all combinations of the conditioning variables.