An Empirical Model of Factor Adjustment Dynamics: Working Paper 2006-13

Working Paper
November 20, 2006

Juan M. Contreras

This paper investigates how firms dynamically adjust their use of capital, labor, energy, and materials when there are both smooth and lumpy adjustment possibilities and interrelation among adjustments. The Colombian Annual Census of Manufacturing provides evidence of these kinds of adjustment. The innovation of this paper lies in three areas: in considering the joint adjustment and interrelation of labor and capital at the establishment level; in describing the dynamic adjustment of all the production factors; and in a rich description of adjustment costs, which includes disruption of the production process and reallocation of internal resources, and fixed costs of installing capital and creating or discontinuing a job vacancy. The model also includes both a convex cost component, aimed at capturing smooth adjustments, and congestion effects, which means that it is more costly for firms to adjust capital and labor at the same time than it is to adjust them separately. Using a simulated method of moments, the study finds empirical support for the existence of disruption costs for capital and labor, the existence of convex costs for capital but not for labor, and the existence of congestion effects. An important implication of the model is that, in response to shocks, firms decide to adjust either capital or labor alone or both, depending on the initial capital to labor ratio and the magnitude of the shocks.