Higher Profits and Lower Capital Prices : Is Factor Allocation Optimal?

From an international perspective, the European rate of unemployment has been high and growing over the last one to two decades; against this background, the parallel rise in profit shares in a number of European countries seems to be at odds with expected economic behaviour. This paper contributes to a solution of this apparent enigma in two steps. First, an empirical decomposition for two sub-periods (1966-81 and 1981-96) suggests that the rise in profit shares during the second sub-period primarily originated from three sources: a marked fall in real capital prices, a clear upward shift of the return to capital as a result of wage moderation, and a slowdown in the rate of growth of the capital/labour ratio, compared with the first sub-period. Second, based on various estimates of elasticities of substitution, this slowdown is analysed in greater depth. From the evidence it appears that the adjustment of firms to growing profits and falling user cost of capital compared with wages is, in some sense, sub-optimal. In the short run firms do not substitute capital for labour in full accordance with cost-minimising prescriptions and the speed of convergence towards a complete substitution is slow. Hence, during this transitional period, both investment and labour productivity growth have been relatively low