Factor Substitution and Employment

Abstract

This paper explores how employment among an educated workforce depends on production technology represented by factor substitution and factor-augmenting technical progress. We consider a variant of the Diamond overlapping generations model that can explain the empirical finding about the elasticity of substitution being less than unity observed in some developed economies. Depending on factor substitution, a decline in the wage rate has positive and negative effects on employment. When the elasticity of substitution is less than unity, a low wage rate can imply a low employment rate as well as a low human capital level. Given the elasticity of substitution, being less than unity, labor-augmenting technical progress can decrease the employment rate and human capital level via a decrease in the marginal product of labor.