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

From an international perspective, the European rate of unemployment has been relatively high and growing over the last one to two decades; on this background, the parallel rise in profit shares in a number of European countries seems to be at odds with expected economic behavior. The paper contributes to a dissolution of this apparent enigma in two steps. First, an empirical decomposition for two sub periods (1966-1981 and 1981-1996) 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/labor ratio, compared with the first sub-period. Second, based on various estimates of elasticities of substitution, this slowdown is analyzed in greater depth. It turns out that the adjustment of firms to growing profits and falling user cost of capital compared with wages is sub-optimal. In the short run they do not substitute capital for labor in full accordance with cost minimizing prescriptions and the speed of convergence towards a complete substitution is low. Hence, during this transitional period, investment--and thus labor productivity--has been lower than would follow from rational behavior