THE ELASTICITY OF DERIVED DEMAND , FACTOR SUBSTITUTION AND PRODUCT DEMAND : CORRECTIONS TO HICKS ' FORMULA AND MARSHALL'S FOUR RULES

THE ELASTICITY OF DERIVED DEMAND, FACTOR
SUBSTITUTION AND PRODUCT DEMAND:
CORRECTIONS TO HICKS’ FORMULA AND
MARSHALL’S FOUR RULES


ROBERT S. CHIRINKO
DEBDULAL MALLICK


CESIFO WORKING PAPER NO. 1742
CATEGORY 1: PUBLIC FINANCE
JUNE 2006




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CESifo Working Paper No. 1742



THE ELASTICITY OF DERIVED DEMAND, FACTOR
SUBSTITUTION AND PRODUCT DEMAND:
CORRECTIONS TO HICKS’ FORMULA AND
MARSHALL’S FOUR RULES


Abstract

Nearly 75 years ago, John Hicks introduced and formalized the concept of the elasticity of
substitution between capital and labour and its relation to derived demand. The resulting
formula has proven very useful in understanding the derived demand for productive factors,
the distribution of factor incomes, and Marshall's Four Rules. This short paper notes that a
slip occurred in the original derivation, presents a modified formula, and shows that
Marshall's First Rule is no longer generally valid.
JEL Code: D21, D33, J23, A2.
Keywords: derived demand, substitution elasticity, John Hicks.





Robert S. Chirinko
Debdulal Mallick
Department of Economics
Department of Economics
Emory University
Emory University
Atlanta, Georgia 30322-2240
Atlanta, Georgia 30322-2240
USA
USA
robert.chirinko@emory.edu





May 2006
The authors thank Len Carlson, Hugo Mialon, and John van Reenan for helpful comments.
All errors, omissions, and conclusions remain the sole responsibility of the authors.

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The Elasticity Of Derived Demand, Factor Substitution,
And Product Demand:
Corrections To Hicks' Formula And Marshall's Four Rules


Nearly 75 years ago, John Hicks introduced and formalized the concept of
the elasticity of substitution between capital and labour. Hicks' substantial
achievement in The Theory of Wages (1932/1963) was to develop a serviceable
formal framework with which to analyze the concept and its implications for
demand theory. These efforts yielded an important formula linking the derived
demand for a factor of production to the extent to which it substituted with other
factors, its importance in production, the availability of competing factors, and the
ultimate demand for the good produced. This formula proved valuable in
evaluating Marshall's Four Rules of derived demand and continues in use today.
Leading U.S. labour economics texts discuss Hicks' formula and Marshall's Four
Rules.1 Molina (2005) relies on Hicks formula in analyzing capital theory debates,
and Chirinko and Mallick (2006) use it for inferring macro production function
parameters from estimates based on micro data. Hamermesh (1993, Chapter Two,
especially equation (2.7a')) evaluates extant empirical labour demand studies with
the Hicks formula, which he refers to as "the fundamental law of factor demand"
(p. 24).

However, a slip occurred in deriving the original formula. Hicks and later
Allen (1938/1964) assumed that factor shares are constant. While this assumption
is appropriate when the substitution elasticity is unity, we now know with the
benefit of the celebrated article by Arrow, Chenary, Minhaus, and Solow
(1961/1985) that factor shares vary with relative factor prices when the substitution

1 See Borjas (2005, pp. 130-132), Ehrenberg and Smith (2006, pp. 96-99), and Kaufman and
Hotchkiss (2003, pp. 234-238).

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elasticity differs from unity. This note presents a modified formula that recognizes
variation in factor shares. Section 1 introduces the formula and notation used
originally by Hicks. Section 2 offers a new derivation based on the CES
production function. Given its wide currency, the constant elasticity of substitution
(CES) production function is used to establish the required modification to the
Hicks formula for a range of values of the substitution elasticity. When factor
shares are constant, the original and modified formulas are identical. In light of the
modified formula, Section 3 re-evaluates Marshall's Four Rules, and we show that
the First Rule no longer holds in general when the substitution elasticity differs
from unity.

1. Hicks' Formula

The original formula was presented by Hicks (1932/1963) in Appendix (iii)
and is based on a neoclassical production function, x = f[a,b], relating output (x) to
two inputs (a, b). The formula is stated in terms of four elasticities and the factor
share for a:2

The elasticity of substitution between factors a and b,
σ ≡ (fa fb) / (fab x),
(1a)


= −((da / a) − (db/ b)) / ((dp
−
a / pa )
(dpb / pb)),
(1b)
= −(dlog(a / b)) / (dlog(pa / pb)),
(1c)



2 The only changes in notation from Hicks are to introduce explicit notation for the production
function (f[.]), replace the partial derivatives xa, xb, and xab by fa, fb, and fab, respectively, and
substitute factor prices for their marginal products.

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The price elasticity of demand for factor a,


λ ≡ −( a
∂ / a) / ( p
∂ a / pa) ,





(2)

The price elasticity of demand for the product x,


η ≡ −( x
∂ / x) / ( p
∂ x / px),





(3)

The price elasticity of supply of the substitute factor b,


e ≡ ( b
∂ / b) / ( p
∂ b / pb),





(4)

The factor shares for a and b, respectively,
κ
≡ (p a) / (p x),
(5a)


a
x

1− κ ≡ (pbb) / (pxx).
(5b)

The elasticity of substitution between factors a and b can be represented in three
equivalent ways. Equation (1a) is the original formulation by Hicks. Robinson
(1933/1959, p. 256) independently introduced the substitution elasticity as
specified in equations (1b) and (1c). Hicks (1963, Section VII, "Notes on the
Elasticity of Substitution", sub-section 1) showed that the two formulations are
equivalent, though Robinson's definition has proven the more convenient and
popular. Note that equations (5a) and (5b) state that factor shares are constant.

Computing a series of total derivatives, exploiting the linear homogeneity of
the production function, and using the above relations, Hicks (1963, pp. 242-244)
derives the following formula for the elasticity of the derived demand for factor a,3


3 See Allen (1938/1964, Section 14.8) for an alternative derivation.

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σ(η + e) + e(η − σ)κ


λ =
.





(6)
η + e − (η − σ)κ
To better focus attention on the slip that has occurred in deriving equation (6), we
examine the simpler formula based on an infinitely elastic supply of the substitute
factor of production. Letting e ∞, equation (6) can be rewritten as follows,



λ = σ − κσ + κη ,






(7a)


λ = σ + (η − σ)κ ,






(7b)


Equation (7a) captures in a succinct manner the substitution and scale effects
associated with a decline of the factor price of a on its derived demand. As
represented by the first term, there is a direct substitution effect holding output
price and output constant. The second term represents an additional indirect
substitution effect driven by the lower marginal cost of production. Under
competitive conditions, the decline in marginal cost translates into a decline in the
output price. The extent of this decline is determined by the relative importance of
factor a in production represented by its factor share (κ). The decline in output
price raises the relative price of and lowers the demand for factor a. The third
effect occurs because the lower factor price allows the firm to slide down the
product demand curve and increase output. This scale effect is represented by the
product of κ and the demand elasticity (η) in the third term of equation (7a).

2. A New Derivation and A Modification

To highlight the roles of the substitution elasticity and factor shares, we
develop our modified formula from the following CES production function,

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σ σ−


{ σ− σ
σ−
σ
= φ
+ − φ
}[ /( 1)]
[(
1) / ]
[(
1) / ]
x
a
(1
) b
,
(8)

where φ is the distribution parameter. Assuming that the firm is maximizing
profits subject to this CES production function and a vector of prices, the first-
order condition for factor a is as follows,



a
σ(p
−σ
= φ
a / px )
x .






(9)

Since output (x) and output price (px) will vary with the factor price (pa), they must
be restated in terms of factor prices and parameters describing the technology and
the output market. If the output market is competitive and the production function
is linear homogeneous, output price equals marginal cost that, in turn, equals
average cost. The latter is specified by starting with the basic cost function as the
sum of the purchase costs of each factor and using equation (9) and the kindred
relation for factor b to obtain the following expression for average cost qua output
price,

−σ


p
( σp −σ (1 )σp −σ
= φ
+ − φ
)(1/(1 ))
(1
)
(1
)
x
a
b
.


(10)

We assume that industry product demand is described by the following constant
elasticity function,



x p −η
= x W ,







(11)

where W represents a set of exogenous variables that affect the demand.

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Substituting equation (11) into (9) and equation (10) into the resulting expression,
we obtain the following equation for the derived demand for factor a,

(σ− )
η /(1−σ)


a
σ
= φ p −σ ( σ (1−σ)
σ
(1−σ)
a
φ pa
+ (1− φ) pb
)(
) W. (12)

Differentiation of equation (12) with respect to the factor price of a and some
transformations yield the following modified formula for the price elasticity of
demand for factor a, *
λ ,4



*
λ = σ + (η − σ) [
μ ,
φ (p
σ
a / px ), ],




(13a)



σ
(1−σ)
[
μ ,
φ (p
σ ≡ φ
a / px ), ]
(pa / px )
,



(13b)



[
μ ,
φ (p
σ = = φ
a / px ),
1]
.




(13c)



∂μ / ∂σ = (Ln[φ] − Ln[p
μ >=<
a / px ])
0 .
(13d)


The difference between the original (cf. equation (7b)) and modified
formulas is represented by [
μ ,
φ (p
σ
a / px ), ] defined in equation (13b), which
depends on the CES distribution and substitution parameters and the factor price
ratio. When σ takes on the restrictive Cobb-Douglas value of unity,
[
μ ,
φ (p
σ
a / px ), ] reduces to φ (equation (13(c)), and there is no discrepancy
between Hicks' original formula and λ*. For general values of the substitution

4 Consistent with the assumption that the supply of factor b is infinitely elastic, we assume that
variations in pa do not affect pb. If this assumption is relaxed, then the derivation becomes more
complicated; we need to also analyze the derived demand for factor b (similar to equation (12)),
differentiate this equation with respect to pa, and use the resulting relations to eliminate the
cross-price elasticity. Details are provided in the Appendix. The end result is that equation (13a)
is replaced by equation (6) with the κ's removed in favour of the μ[.] in equation (13b).

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parameter, however, the elasticity formula must account for the variability in factor
shares due to the relative price term and the substitution elasticity.5

This analysis of the CES production function suggests a "shortcut" method
for modifying the elasticity formula. The slip in the derivations by Hicks and
Allen occurred in treating the factor share of a as a constant. This assumption was
imposed toward the end of their derivations and did not affect the evaluation of
their differentials. Consequently, it is valid to merely use the CES production
function to derive the appropriate expression for the factor share of a and to insert
it into the original formula. We begin with the factor share of a (equation (5a)),

κ≡ (p a) / (p x)


a
x







(14)
= (pa / px) (a / x),

and use the first-order condition for factor a (equation (9)) to eliminate (a / x),

σ
(1−σ)
κ = φ (p / p )


a
x







(15)
= [
μ ,
φ (p
σ
a / px ), ].

Replacing κ in equation (7b) with [
μ ,
φ (p
σ
a / px ), ] in equation (15) yields the
modified formula for λ* in equations (13).


5 These newly defined factor shares sum to unity: [.]
μ + (1− [
μ .])
σ
= φ (p p )1−σ + (1− )σ
φ (p p )1−σ = ( σ 1−σ
σ
1
φ p
+ (1− φ) p −σ ) −(1−σ)
a
x
b
x
a
b
px
. The expression in
parentheses can be related to p
−σ
− −σ
x with equation (10); hence,
(1
)
(1
)
px
px
=1.

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3. Re-evaluating Marshall's Four Rules

Hicks used his formula to evaluate Marshall's Four Rules of derived
demand. He cast the Four Rules in terms of the response of λ (equation (6)) to four
parameters (σ, κ, e, η), and he confirmed that three of the four rules were valid.
Hicks' formal analysis did highlight that Marshall's Second Rule was not generally
true and depended on the sign of (η-σ). Since the correction factor,
[
μ ,
φ (p
σ
a / px ), ] , is always positive and only involves the parameter σ, Hicks'
analysis of three of Marshall's Rules remain valid. However, the modified formula
demonstrates that the first of Marshall's Four Rules is problematic. The First Rule
(Hicks, 1932/1963, p. 242) is as follows,

I. "The demand for anything is likely to be
more elastic, the more readily substitutes for
that thing can be obtained."

Following Hicks, we evaluate this Rule in terms of the derivative of λ* with
respect to σ,



*
∂λ / ∂σ =1− [
μ .] + (η − σ)(Ln[φ] − Ln[p
μ
a / px ]) [.],
(16)

When this derivative is based on Hicks' original formula, only the first two terms
appear and, since μ[.] lies between 0 and 1, the derivative is always positive, thus
confirming Marshall's First Rule. However, under the modified formula and as
captured in the third term, the derivative is also affected by variation in the factor
share. The sign of this additional term is indeterminate and depends on the
relations among η, σ, φ , and (pa/px). Even if quantities and prices are defined such
that the relative price entering equation (16) is unity, the indeterminacy remains,
and Marshall's First Rule is not generally valid.

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