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Constant elasticity of substitution

The constant elasticity of substitution (CES) is a functional form used in neoclassical economics for production functions and utility functions, relating output (or utility) to multiple inputs while maintaining a constant elasticity of substitution between them irrespective of input proportions.^[1] This feature allows it to flexibly capture varying degrees of substitutability, generalizing simpler forms like the Cobb-Douglas function.^[1] Introduced by economists Kenneth J. Arrow, Hollis B. Chenery, Bhagwati S. Minhas, and Robert M. Solow in their seminal 1961 paper "Capital-Labor Substitution and Economic Efficiency," the CES function emerged from empirical efforts to reconcile observed variations in capital-labor ratios across industries and countries with theoretical production models.^[2] The paper demonstrated that traditional assumptions of fixed or unitary substitution elasticities failed to explain international productivity differences, proposing the CES as a more realistic alternative that permits a constant but arbitrary elasticity of substitution.^[2] The standard mathematical formulation for a two-input CES production function is:

Y = A \left[ \alpha K^{\rho} + (1 - \alpha) L^{\rho} \right]^{1/\rho}

where Y denotes output, K and L represent capital and labor inputs, A > 0 is a total factor productivity parameter, \alpha \in (0,1) is the distribution parameter reflecting the relative efficiency or share of capital, and \rho \leq 1 is the substitution parameter determining the elasticity of substitution \sigma = \frac{1}{1 - \rho}.^[1] For constant returns to scale, the exponent $1/\rho applies with \nu = 1; more generally, it is \nu / \rho where \nu captures returns to scale.^[1] The parameter \sigma measures the percentage change in the capital-labor ratio resulting from a one percent change in their relative marginal products, with values greater than, equal to, or less than 1 indicating easier, unitary, or harder substitution compared to the Cobb-Douglas case.^[1] A key strength of the CES function lies in its ability to nest other canonical production functions as limiting cases, enhancing its versatility for theoretical and empirical analysis: it approaches the Cobb-Douglas form Y = A K^{\alpha} L^{1 - \alpha} as \sigma \to 1 (i.e., \rho \to 0); the Leontief fixed-proportions function as \sigma \to 0 (i.e., \rho \to -\infty), where inputs are perfect complements; and a linear function with perfect substitutability as \sigma \to \infty (i.e., \rho \to 1).^[1] These properties make the CES particularly useful in macroeconomic models, where it facilitates analysis of technological change, income distribution, and long-run growth dynamics.^[1] Since its inception, the CES function has been extended to multiple inputs, normalized forms for improved estimation (e.g., fixing baseline values to stabilize parameters), and applications in computable general equilibrium models, international trade, environmental economics, and utility representations of preferences.^[1] Empirical estimates of \sigma vary across studies but often cluster below 1 as of 2020, suggesting limited substitutability in aggregate production, with implications for wage inequality and the effects of automation.^[3]

Overview

Definition

The elasticity of substitution between two inputs in production, or between two goods in consumption, measures the percentage change in their relative quantities induced by a given percentage change in their marginal rate of technical substitution (MRTS) or marginal rate of substitution (MRS), respectively.^[4] The MRTS represents the rate at which one input can replace another while holding output constant, equivalent to the ratio of the inputs' marginal products, and it typically diminishes as substitution occurs along an isoquant.^[5] Similarly, the MRS in utility theory is the rate at which a consumer is willing to trade one good for another while maintaining the same utility level, given by the ratio of marginal utilities.^[6] The constant elasticity of substitution (CES) describes a family of production or utility functions for which this elasticity, denoted σ, is invariant and constant across all input or good proportions.^[7] Unlike fixed-proportions functions such as Leontief (where σ = 0, implying no substitutability and rigid input ratios) or perfect-substitutes functions such as linear (where σ → ∞, implying unlimited substitutability at a fixed rate), CES allows for a flexible constant σ > 0 that captures intermediate degrees of substitutability.^[7]^[5] Intuitively, when σ = 1, the CES form aligns with the Cobb-Douglas function, featuring logarithmic linearity in its properties and moderate substitutability. As σ approaches 0, the function behaves like Leontief, with inputs acting as complements in fixed proportions and isoquants forming right angles. In the limit as σ approaches infinity, it resembles the linear case, with straight-line isoquants indicating inputs as perfect substitutes.^[7] These properties make CES a versatile tool for modeling both production technologies and consumer preferences in economic analysis.^[7]

Economic Significance

The constant elasticity of substitution (CES) function is widely adopted in economic modeling due to its key advantages in balancing analytical flexibility with mathematical tractability. By maintaining a constant elasticity of substitution across all input combinations, the CES simplifies the analysis of how factors respond to relative price changes, enabling clear predictions about substitution patterns without the complexities of variable elasticities.^[1] Furthermore, the CES nests prominent functional forms as special cases—such as the Cobb-Douglas (when the elasticity σ approaches 1), Leontief (σ = 0), and linear (σ → ∞)—allowing economists to test and compare a range of substitution behaviors within a unified framework.^[1] This nesting property enhances its versatility, making it superior to ad-hoc specifications that lack such generality, while its tractable form facilitates both theoretical derivations and empirical estimation.^[1] In general equilibrium models, the CES plays a central role by providing a consistent structure for production and utility aggregation, where properties like insensitivity of certain price elasticities to the degree of substitution (ranging from near zero to perfect) allow robust analysis without precise parameter knowledge.^[8] Extensions of the Solow growth model incorporate normalized CES functions to explore how varying elasticities influence steady-state output and transition dynamics, revealing that higher substitution elasticities can amplify per capita growth by enabling more efficient factor reallocation.^[9] Similarly, in international trade theory, the Armington assumption relies on nested CES structures to differentiate goods by origin, modeling imperfect substitutability between domestic and imported inputs and justifying two-way trade flows in a tractable manner.^[10] For policy analysis, CES functions are integral to computable general equilibrium (CGE) models, where they simulate the economy-wide effects of shocks such as taxes or trade reforms by capturing substitution responses in production, trade, and consumption nests.^[11] This application supports quantitative assessments of welfare impacts and resource allocation under policy changes, leveraging the CES's calibration to social accounting matrices for realistic baselines.^[11] However, the assumption of constant elasticity carries limitations, as empirical estimates of the substitution parameter often vary across studies and contexts, potentially misrepresenting scenarios where elasticities are endogenous or non-constant, such as in environmental policy analyses of energy transitions.^[12]^[13] Despite these challenges, the CES remains preferable to more restrictive forms like Cobb-Douglas in contexts requiring nuanced substitution effects, provided estimation biases are addressed.^[12]

Historical Development

Origins in Production Theory

The constant elasticity of substitution (CES) production function emerged in the early 1960s as a response to empirical anomalies in international manufacturing data that challenged the prevailing assumptions of fixed or unitary factor substitutability in production models. Economists observed that capital-labor ratios varied significantly across countries even within the same industries, suggesting factor intensity reversals that neither the Leontief fixed-proportions model (with elasticity of substitution σ = 0) nor the Cobb-Douglas function (σ = 1) could adequately explain. This motivation stemmed from the need to reconcile theoretical growth and trade models with real-world patterns where relative factor prices influenced production techniques differently across economies, particularly in developing versus developed nations.^[2] In their seminal 1961 paper, Kenneth J. Arrow, Hollis B. Chenery, Bagicha S. Minhas, and Robert M. Solow introduced the CES production function to address these issues, drawing on cross-country data to demonstrate that the elasticity of substitution typically fell between 0.5 and 0.7, neither zero nor unity. Empirical analysis of manufacturing sectors revealed that σ values varied across industries, confirming greater substitutability in labor-intensive economies like Japan compared to capital-abundant ones like the United States. This finding highlighted how differing σ could account for observed disparities in factor intensities without invoking changes in production technology itself.^[2] The key innovation of the ACMS framework was parameterizing the production function to allow σ to differ across countries or sectors while preserving a consistent functional form, enabling flexible modeling of technological and efficiency differences. Early empirical tests utilized 1950s international data from 19 countries, including the U.S., Japan, the UK, and India, covering labor inputs (measured in man-years per $1,000 value added), capital stocks, and wage rates for 24 manufacturing industries such as textiles, chemicals, and machinery from 1949 to 1955. These tests, based on national statistical sources, estimated efficiency parameters showing Japanese manufacturing productivity significantly lower than U.S. levels in several sectors, while cross-country regressions confirmed σ estimates underscoring the CES's ability to explain production divergences.^[2]^[14]

Extensions and Adoption

Following the foundational work on CES production functions by Arrow, Chenery, Minhas, and Solow in 1961, the framework saw significant extensions in the early 1960s that facilitated its broader application. Houthakker's 1960 analysis of additive preferences provided a precursor for CES-like structures in consumer demand systems, where constant elasticities emerged from preferences exhibiting fixed income elasticity ratios across goods.^[15] Shortly thereafter, Uzawa (1962) generalized the CES form to multiple inputs, demonstrating conditions under which constant elasticities hold and introducing two-stage or nested CES structures to handle non-uniform substitution across factor groups. In the 1970s, the CES framework gained traction in consumer theory through its adaptation to utility functions, enabling analysis of substitution between consumption goods under varying elasticities. A seminal application appeared in Dixit and Stiglitz (1977), who employed CES utility to model demand for differentiated products in monopolistic competition, highlighting optimal product diversity and fixed markup pricing. This integration allowed CES to capture realistic substitution patterns in household behavior, paving the way for its use in demand system estimation and welfare analysis. From the 1980s onward, CES functions became integral to dynamic stochastic general equilibrium (DSGE) models in macroeconomics, where they aggregated inputs in production and utility to simulate business cycles and policy impacts. Early real business cycle models, such as those by Kydland and Prescott (1982), laid the groundwork for this adoption, with CES increasingly used for flexible labor and capital substitution in subsequent extensions. By the 1990s, CES specifications were standard in New Keynesian DSGE frameworks, facilitating quantitative assessments of monetary and fiscal shocks. The 1990s and 2000s marked the spread of CES to environmental economics, particularly through nested forms incorporating energy as a distinct input alongside capital and labor. Kemfert (1998) estimated substitution elasticities in a nested CES production function for Germany, revealing low energy-capital substitutability and informing climate policy simulations. In development economics, CES applications focused on factor shares and growth accounting in low-income contexts. Gollin (2002) applied CES to reconcile observed labor income shares across countries, adjusting for self-employment distortions prevalent in developing economies and emphasizing the role of elasticity in productivity differences. These extensions underscored CES's versatility in addressing real-world constraints like resource scarcity and structural transformation.

Mathematical Formulation

General CES Function

The constant elasticity of substitution (CES) function provides a flexible mathematical representation that allows for a constant but arbitrary elasticity of substitution between inputs while accommodating varying returns to scale. In its general two-input form, the CES function is specified as

F(x, y) = \left[ \alpha x^{\rho} + (1 - \alpha) y^{\rho} \right]^{\gamma / \rho},

where x and y are the two inputs, \rho = 1 - 1/\sigma with \sigma > 0 denoting the constant elasticity of substitution, \alpha \in (0, 1) is the distribution parameter reflecting the relative importance of each input, and \gamma is the returns-to-scale parameter.^[2] This formulation generalizes to a multi-input setting with n inputs as

F(x_1, \dots, x_n) = \left[ \sum_{i=1}^n \alpha_i x_i^{\rho} \right]^{\gamma / \rho},

where the \alpha_i > 0 are distribution parameters for each input i. A key assumption underlying the CES function is that \rho < 1 (corresponding to \sigma > 0) to ensure the production surface is well-defined, increasing, and typically concave for economic applications.^[2] The function exhibits homogeneity of degree \gamma, meaning that scaling all inputs by a factor t > 0 scales output by t^{\gamma}; the case \gamma = 1 corresponds to constant returns to scale, which is commonly assumed.^[1] For interpretability, the distribution parameters are normalized such that \sum_{i=1}^n \alpha_i = 1, which aligns the weights with factor shares under competitive conditions.^[1]

Derivation of Elasticity Parameter

The elasticity of substitution \sigma between two inputs x and y for a production function F(x, y) measures the percentage change in the input ratio in response to a percentage change in the marginal rate of technical substitution (MRTS) and is formally defined as

\sigma = -\frac{d \ln(x/y)}{d \ln(\mathrm{MRTS})},

where \mathrm{MRTS} = \frac{\partial F / \partial x}{\partial F / \partial y}.^[2] Consider the two-input constant elasticity of substitution (CES) production function

F(x, y) = \left[ \alpha x^{\rho} + (1 - \alpha) y^{\rho} \right]^{1/\rho},

where \alpha \in (0, 1) is a distribution parameter and \rho \leq 1 is the substitution parameter.^[2] The partial derivatives are

\frac{\partial F}{\partial x} = F^{1 - \rho} \alpha x^{\rho - 1}, \quad \frac{\partial F}{\partial y} = F^{1 - \rho} (1 - \alpha) y^{\rho - 1}.

Thus, the MRTS simplifies to

\mathrm{MRTS} = \frac{\alpha (1 - \alpha)^{-1} \left( \frac{x}{y} \right)^{\rho - 1}}{1} = \frac{\alpha}{1 - \alpha} \left( \frac{x}{y} \right)^{\rho - 1}.

Taking natural logarithms yields

\ln(\mathrm{MRTS}) = \ln\left( \frac{\alpha}{1 - \alpha} \right) + (\rho - 1) \ln\left( \frac{x}{y} \right).

Differentiating with respect to \ln(x/y) gives

d \ln(\mathrm{MRTS}) = (\rho - 1) \, d \ln\left( \frac{x}{y} \right),

\frac{d \ln(x/y)}{d \ln(\mathrm{MRTS})} = \frac{1}{\rho - 1} = -\frac{1}{1 - \rho}.

Therefore,

\sigma = -\frac{d \ln(x/y)}{d \ln(\mathrm{MRTS})} = \frac{1}{1 - \rho},

which is constant and independent of the input ratio x/y.^[2] The constancy of \sigma follows directly from the logarithmic form of the MRTS, where the coefficient (\rho - 1) does not depend on the levels of x or y, ensuring the elasticity remains fixed across all input combinations along an isoquant.^[2] For the CES function to exhibit concavity (negative semi-definiteness of the bordered Hessian), a necessary condition is \rho < 1, which also ensures diminishing marginal rates of substitution and aligns with \sigma > 0. When \rho = 1, the function reduces to linear (perfect substitutes, \sigma = \infty); when \rho \to -\infty, it approaches Leontief (perfect complements, \sigma = 0); and when \rho = 0, it becomes Cobb-Douglas (\sigma = 1).^[2] In the dual expenditure minimization problem for a CES utility function, the constant \sigma in the primal implies that the compensated (Hicksian) cross-price elasticity of demand between goods i and j is \sigma_{ij}^c = \sigma s_j, where s_j is the expenditure share on good j, linking the substitution parameter directly to price responsiveness in the dual form.^[8]

Properties and Characteristics

Homotheticity and Aggregability

The constant elasticity of substitution (CES) function exhibits homotheticity, a property characterized by isoquants that are radial expansions of one another, ensuring that the marginal rate of substitution remains constant along any ray from the origin.^[16] This stems from the CES function's homogeneity of degree one, which aligns with the definition of homothetic functions as monotonic transformations of homogeneous functions.^[17] Consequently, the CES satisfies Euler's theorem for homogeneous functions, stating that for a production function f(\mathbf{x}) homogeneous of degree one, f(\mathbf{x}) = \sum_i x_i \frac{\partial f}{\partial x_i}(\mathbf{x}), implying constant returns to scale along rays and facilitating the analysis of proportional expansions in inputs.^[17] A key advantage of the CES form is its aggregability, allowing micro-level CES production functions to combine into a macro-level CES aggregate without introducing bias, provided the elasticity of substitution \sigma is identical across all agents or firms.^[2] This result, established in the seminal work introducing the CES, holds under assumptions of a common \sigma and appropriate distributions of efficiency parameters among heterogeneous units, ensuring the aggregate inherits the constant elasticity property.^[2] Such aggregability underpins the validity of representative agent models in macroeconomics, where individual-level behaviors can be summarized by a single CES representative without distorting substitution elasticities.^[18] Additionally, homotheticity enables separability in multi-stage production processes, permitting nested CES structures to model intermediate aggregations while preserving overall consistency.^[16] In the special case where \sigma = 1, the CES function collapses to the Cobb-Douglas form, which retains homotheticity and perfect aggregability under the same conditions, highlighting the Cobb-Douglas as a limiting benchmark within the CES family.^[2]

Comparative Statics

In the constant elasticity of substitution (CES) framework, input demand responses to changes in factor prices are derived from the dual cost function using Shephard's lemma, which states that the conditional factor demand for input i is the partial derivative of the unit cost function with respect to its price w_i. For a CES production function under constant returns to scale, the unit cost function takes the form c(\mathbf{w}) = \left( \sum_j \alpha_j w_j^{1-\sigma} \right)^{1/(1-\sigma)}, where \sigma is the elasticity of substitution and \alpha_j are distribution parameters. The resulting factor demand is x_i(y, \mathbf{w}) = y \cdot \alpha_i^{1/\sigma} w_i^{-\sigma} \left( \sum_j \alpha_j w_j^{1-\sigma} \right)^{\sigma/(1-\sigma)}, implying that the share of input i in total cost, s_i = w_i x_i / (y c(\mathbf{w})), varies with relative wages according to s_i = \left[ \alpha_i (w_i / \bar{w})^{1-\sigma} \right] / \sum_j \alpha_j (w_j / \bar{w})^{1-\sigma}, where \bar{w} is a reference price; thus, an increase in w_i reduces s_i if \sigma > 0, with the magnitude of the response increasing in \sigma.^[19] The output effects of parameter changes in CES functions highlight the role of the scale parameter \gamma, often incorporated as the homogeneity degree in the generalized form Y = A \left( \sum_i \alpha_i X_i^\rho \right)^{\gamma / \rho}, where \rho = 1 - 1/\sigma. When \gamma = 1, the function exhibits constant returns to scale, meaning a proportional increase in all inputs yields a proportional increase in output; for \gamma > 1, returns are increasing, amplifying output growth beyond proportional input expansion, while \gamma < 1 implies decreasing returns, dampening output responsiveness. The elasticity of output with respect to an individual input, \partial \ln Y / \partial \ln X_i = \gamma \cdot s_i, thus scales with \gamma, reflecting how the parameter governs overall production responsiveness to input variations under homotheticity, which allows ray-scaling along expansion paths. Sensitivity analysis of the elasticity parameter \sigma reveals its direct influence on substitution intensity: as \sigma approaches 0, substitution between inputs becomes minimal, resembling fixed proportions where factor demands are rigid to price changes; conversely, higher \sigma enhances flexibility, enabling larger shifts in input mixes to maintain output. For instance, when \sigma < 1, the responsiveness of the capital-labor ratio to relative wage changes is limited, constraining reallocation; at \sigma = 1, it aligns with Cobb-Douglas neutrality in shares. This parameter-driven variation underscores CES's utility in modeling diverse technological rigidities. Graphically, the intuition for these effects is captured in isoquant shapes, which vary systematically with \sigma. For $0 < \sigma < 1, isoquants are bowed inward (convex to the origin), indicating diminishing marginal rates of technical substitution and limited flexibility; as \sigma \to 1, they approach the hyperbolic form of Cobb-Douglas; for \sigma \to \infty, isoquants become linear, reflecting perfect substitutability where inputs trade at constant ratios. These configurations illustrate how lower \sigma enforces complementarity, while higher values permit easier input trade-offs along the same output level.^[20]

Applications

CES Production Functions

The constant elasticity of substitution (CES) production function provides a flexible framework for modeling output as a function of capital (K) and labor (L) inputs, allowing the elasticity of substitution between factors to remain constant regardless of input proportions.^[2] In its standard two-factor form for production, it is expressed as

Q = \left[ \alpha K^{\rho} + (1 - \alpha) L^{\rho} \right]^{1/\rho},

where Q denotes aggregate output, \alpha (between 0 and 1) represents the distribution parameter interpreted as the long-run share of capital in total factor income under competitive conditions, and \rho \leq 1 is the substitution parameter such that the elasticity of substitution is given by \sigma = \frac{1}{1 - \rho}.^[2] This formulation generalizes the Cobb-Douglas case, where \rho = 0 (\sigma = 1), and accommodates values of \sigma < 1 often observed empirically in aggregate data.^[18] The marginal product of capital under this production function is given by

\frac{\partial Q}{\partial K} = \alpha \left( \frac{Q}{K} \right)^{1 - \rho},

which declines as capital intensity increases, illustrating diminishing marginal returns to capital while holding output constant.^[21] Similarly, the marginal product of labor is \frac{\partial Q}{\partial L} = (1 - \alpha) \left( \frac{Q}{L} \right)^{1 - \rho}, ensuring that factor returns diminish individually even as the function exhibits constant returns to scale overall when normalized appropriately.^[21] In competitive markets, firms minimize costs subject to the CES production constraint, leading to a dual expenditure (cost) function that expresses the minimum cost C of producing output Q given factor prices w_K for capital and w_L for labor:

C(Q, w_K, w_L) = Q \left[ \alpha^{\sigma} w_K^{1 - \sigma} + (1 - \alpha)^{\sigma} w_L^{1 - \sigma} \right]^{1/(1 - \sigma)}.

^[22] The corresponding conditional factor demands, derived from this duality via Shephard's lemma, yield the capital-labor ratio

\frac{K}{L} = \left( \frac{\alpha}{1 - \alpha} \right)^{\sigma} \left( \frac{w_L}{w_K} \right)^{\sigma},

where these expressions reflect how factor proportions adjust to relative prices with elasticity \sigma. Absolute demands can be obtained by substituting the ratio back into the production function. This setup facilitates analysis of input responses to wage or rental rate changes in firm-level production decisions.^[23] The CES production function has been prominently applied in vintage capital models, where output depends on labor and multiple vintages of capital differentiated by embodied technology, often using a nested CES structure to capture putty-clay assumptions and investment irreversibilities.^[24] It also underpins analyses of biased technical change, allowing shifts in factor-augmenting productivity (e.g., labor-augmenting progress) to alter relative marginal products without varying the substitution elasticity, as seen in normalized CES variants that disentangle bias from substitution effects.^[25]

CES Utility Functions

In consumer theory, the constant elasticity of substitution (CES) utility function provides a flexible representation of preferences over multiple consumption goods, allowing for a constant parameter that governs the ease of substitution between them. This form captures how consumers trade off goods while maintaining consistent substitution behavior across consumption levels. The CES utility function was developed as part of the broader framework of additive preferences, where the direct utility is expressed in a form that ensures constant elasticity.^[15] The standard CES utility function for n goods c_1, \dots, c_n is given by

U(c_1, \dots, c_n) = \left( \sum_{i=1}^n \beta_i c_i^\rho \right)^{1/\rho},

where \beta_i > 0 are taste parameters reflecting relative preferences for each good (often normalized so that \sum \beta_i = 1), and \rho \leq 1 determines the curvature, with the elasticity of substitution defined as \sigma = \frac{1}{1 - \rho}. When \rho \to 0 (\sigma = 1), the function approaches the Cobb-Douglas form, exhibiting perfect substitutability in relative terms; as \rho \to -\infty (\sigma \to 0), it becomes Leontief, implying fixed proportions. This structure ensures homothetic preferences, meaning indifference curves are radial expansions of one another.^[15]^[6] Indifference curves derived from the CES utility function exhibit a marginal rate of substitution (MRS) between any two goods, say c_1 and c_2, that reflects the constant elasticity property. Specifically,

\text{MRS}_{12} = \frac{\partial U / \partial c_1}{\partial U / \partial c_2} = \frac{\beta_1}{\beta_2} \left( \frac{c_2}{c_1} \right)^{1 - \sigma}.

This expression shows that the MRS diminishes (or increases) at a constant rate determined by \sigma, leading to convex indifference curves for $0 < \sigma < \infty, analogous to isoquants in production but applied to consumer trade-offs. The curvature adjusts with \sigma: higher values allow smoother substitution, while lower values imply complementarity.^[26] From utility maximization subject to a budget constraint, CES preferences yield Marshallian demand functions where expenditure shares depend on relative prices and \sigma. A key implication is the form of Engel curves, which trace consumption as income varies. For \sigma = 1 (Cobb-Douglas case), these curves are linear in logarithms: \log x_i = \alpha_i + \log I + \sum \gamma_j \log p_j, where I is income, indicating constant budget shares and proportional consumption growth with income. For general \sigma, the curves remain homothetic but exhibit varying income elasticities, with unitary elasticity when \sigma = 1.^[27]^[28] CES utility functions are widely applied in macroeconomic models requiring homothetic preferences. In international trade, they underpin Armington aggregation, treating goods as differentiated by country of origin to model import demands with constant substitution elasticity, as formalized in early demand theory for spatially distinct products. In dynamic growth models, such as extensions of the neoclassical framework, CES utility ensures balanced growth paths by maintaining consistent consumption proportions over time and across agents.^[29]^[30]

Estimation and Modern Uses

Econometric Estimation Methods

Econometric estimation of the constant elasticity of substitution (CES) function typically involves nonlinear methods due to the functional form's inherent nonlinearity in parameters such as the substitution parameter ρ (where the elasticity of substitution σ = 1/(1 - ρ)) and the distribution parameter α. Nonlinear least squares (NLS) is a primary direct approach for estimating these parameters from production or utility data, minimizing the sum of squared residuals between observed outputs (or expenditures) and CES-predicted values. This method requires specifying the full CES equation and using optimization algorithms, such as gradient-based solvers or global search techniques, to handle multiple local minima; for instance, the R package micEconCES implements NLS alongside grid-search procedures to improve convergence and accuracy in estimating two-input CES functions.^[31]^[32] To address endogeneity issues, such as simultaneity between factor prices and quantities in production data, the generalized method of moments (GMM) is widely applied, particularly in panel data settings. GMM exploits orthogonality conditions between instruments (e.g., lagged variables or external shocks) and moment errors derived from the CES first-order conditions, allowing consistent estimation of ρ and α while controlling for unobserved heterogeneity and fixed effects. A pooled GMM estimator, for example, has been developed for firm-level panel data, using double differencing to eliminate firm-specific effects and incorporating supply-side assumptions to instrument endogenous prices, yielding unbiased σ estimates when time dimensions exceed 10 periods.^[33]^[25] Indirect inference methods provide an alternative by matching simulated moments from the CES model to empirical moments, such as factor income shares or partial elasticities, avoiding direct nonlinear optimization. These approaches estimate σ indirectly from regressions of logarithmic factor shares on relative factor prices, leveraging the CES property that share movements reflect substitution elasticities under competitive assumptions; for nested CES structures, two-step procedures first estimate relative elasticities via translog approximations before inferring overall σ.^[34]^[35]^[36] Estimation of CES parameters faces significant challenges, particularly identification issues when σ approaches limiting values like 0 (Leontief case) or infinity (linear case), where the functional form loses curvature and becomes indistinguishable from alternatives like Cobb-Douglas (σ = 1), leading to flat likelihood surfaces and imprecise estimates. Biased technical change further confounds identification by mimicking substitution effects, requiring normalization techniques or joint modeling of production and factor conditions to separate parameters. Reliable estimation demands substantial variation, either from long time-series to capture dynamics or cross-sectional heterogeneity across units, as aggregate data often suffer from simultaneity biases that underestimate σ.^[37]^[38]^[1]

Extensions and Limitations

One prominent extension of the standard CES function is the non-homothetic CES (NHCES), which relaxes the homotheticity assumption to allow the elasticity of substitution σ to vary with income levels or factor intensities, enabling better modeling of demand patterns where expenditure shares change systematically with income. This form was formalized by Sato, who derived conditions under which CES structures can exhibit non-homothetic properties while preserving the constant elasticity within subgroups of inputs.^[16] Blackorby, Primont, and Russell further extended this framework by integrating NHCES into duality theory, showing how such functions maintain separability and functional structure in production or utility contexts, facilitating aggregation across heterogeneous agents. Another key extension is the translog function, which serves as a local second-order approximation to the CES function and other forms, allowing the elasticity of substitution to vary flexibly across input levels without assuming constancy globally. Developed by Christensen, Jorgenson, and Lau, the translog specification uses a quadratic logarithmic form that approximates any twice-differentiable production or utility function around a reference point, making it particularly useful for empirical testing where σ may deviate from constancy in nonlinear ways. This approach addresses limitations in CES by capturing variable elasticities through higher-order terms, though it requires more parameters and data for estimation. Despite these extensions, the standard CES function's assumption of constant σ faces significant limitations, as it may fail to capture asymmetries in substitution patterns—such as differing responses to input price changes depending on the direction—or threshold effects where elasticity changes abruptly at certain input ratios. Empirical estimates of σ in CES models often cluster around 0.4 to 0.6 for aggregate capital-labor substitution but exhibit substantial variation by sector, underscoring the restrictive nature of uniformity across diverse economic contexts.^[12] Recent meta-analyses as of 2020 estimate the long-run aggregate elasticity in the range of 0.45 to 0.87.^[39] Basic estimation challenges, such as multicollinearity in factor shares, can exacerbate these issues when fitting constant σ models to heterogeneous data. As an alternative, the constant differences of elasticities of substitution (CDES) function, introduced by Hanoch, imposes structure where differences in pairwise elasticities remain fixed rather than the elasticities themselves, providing a globally regular non-homothetic form suitable for multi-input scenarios without the rigidity of constant σ. This specification has gained traction in trade and growth models requiring variable but structured substitution patterns.^[40]

References

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[12]
How constant is constant elasticity of substitution? Endogenous ...
With a growing elasticity of substitution, price signals of the same magnitude lead to larger demand shifts, increasing the effectiveness of climate policy and ...
[13]
The Origins of the CES Production Function - Duke University Press
Aug 1, 2020 · The CES production function was introduced to economics in the 1961 paper “Capital-Labor Substitution and Economic Efficiency,” by Kenneth Arrow, Hollis ...
[14]
Additive Preferences - jstor
This amounts to saying that the ratios between the income elasticities are constant, whereas under indirect addilog the differences are constant. For empirical ...
[15]
Homothetic and Non-Homothetic CES Production Functions - jstor
This article discusses homothetic and non-homothetic CES production functions, as by Ryuzo Sato in The American Economic Review.
[16]
The Homothetic Production Function - jstor
Scale and substitution properties are the key characteristics of a production function. Homogeneous functions are usually applied in empirical studies (see.
[17]
[PDF] Recent empirical studies of the CES and related production functions
Arrow, K. J., H. B. Chenery, B. S. Minhas, and R. M. Solow (1961),. "Capital-Labor Substitution and Economic Efficiency," Review of. Economics and Statistics ...
[18]
Constant Elasticity of Substitution Production Functions - jstor
Using the obvious duality of (1) and (5), one can show that a classical cost function can have all S.E.S. constant if and only if it satisfies the property (K) ...
[19]
[PDF] The CES Production Functions
The Case of Perfect Substitution (γ= 1): The function is. (2). Y = A [ θ aKK + (1-θ) aN N ]. The isoquants are straight lines for this production function. The ...
[20]
https://www.minneapolisfed.org/-/media/files/research/prescott/macro_theory/cesprodfn.pdf
[21]
Production Economics: A Dual Approach to Theory and Applications ...
Sep 12, 2011 · Production Economics: A Dual Approach to Theory and Applications Volume I: The Theory of Production. Melvyn Fuss and Daniel L. McFadden ...Missing: CES | Show results with:CES
[22]
[PDF] Identifying the elasticity of substitution with biased technical change
Only across production functions belonging to the same family does the following growth theoretic properties of the CES production hold. (Klump and de La ...
[23]
4.12 The CES Utility Function - EconGraphs
A more general way of modeling substitutability is via a constant elasticity of substitution (CES) utility function.Missing: definition | Show results with:definition
[24]
The Intuition of CES Utility - Economics Stack Exchange
May 12, 2021 · Most of the derivations can also be found in Houthakker (1960), "Additive Preferences". TLDR: If the utiltiy function is additively separable ...
[25]
Engel and Income Offer Curves: CES - EconGraphs
UTILITY FUNCTION. α = \alpha = α= u ( x 1 , x 2 ) = x 1 α ... INCOME OFFER CURVE. Show IOC \text{Show IOC} Show IOC. m m m, x 1 ∗ ...
[26]
[PDF] A Theory of Demand for Products Distinguished by Place of Production
A Theory of Demand for Products. Distinguished by Place of Production. Paul S. Armington *. I. Introduction and Summary. INTERNATIONAL TRADE flows are commonly ...
[27]
[PDF] Foundations of Neoclassical Growth - Princeton University
I take the domain of the utility function to be R+ rather than R, so that negative levels of consumption are not allowed. Even though some well-known economic ...
[28]
[PDF] Econometric Estimation of the "Constant Elasticity of Substitution ...
We discuss several existing approaches and propose a new grid-search approach for estimating the traditional CES function with two inputs as well as nested CES ...
[29]
[PDF] micEconCES: Analysis with the Constant Elasticity of Substitution ...
Estimate a Constant-Elasticity-of-Substitution (CES) function with two exogenous variables or a nested Constant-Elasticity-of-Substitution (CES) function ...
[30]
[PDF] Identifying the elasticity of substitution between capital and labour
We propose a pooled GMM (P-. GMM) estimator, examine its properties in a Monte Carlo study and apply it to a Norwegian sample of manufacturing firms. We ...
[31]
Alternative Methods of Estimating a CES Production Function ... - jstor
The current study began by estimating the elasticity of substitution using British inter-industry data. The values obtained by using the. "indirect" estimation ...
[32]
[PDF] On Estimation of the CES Production Function
If, however, the CES production function is generalized to allow for the possibility of non-constant returns to scale, this method of estimation is no longer ...
[33]
[PDF] Estimating elasticities of substitution with nested CES production ...
May 8, 2020 · The normalized CES production function: the- ory and empirics. J. Econ. Surv. 26 (5), 769–799. https://doi.org/10.1111/j.1467- · 6419.2012 ...
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AEA Web - American Economic Review - 100(4):1330 - Abstract
### Summary of Challenges and Methods for Estimating CES Elasticity of Substitution
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[PDF] [Sigma]: the long and short of it - EconStor
Sigma (σ) is the elasticity of substitution between capital and labor, important in economic growth, with estimates ranging from 0.40 to 0.60.
[36]
Two-Level Constant-Elasticity-of-Substitution Production Function1
K. Sato; A Two-Level Constant-Elasticity-of-Substitution Production Function1, The Review of Economic Studies, Volume 34, Issue 2, 1 April 1967, Pages 201–