The Price of Capital, Factor Substitutability and Corporate Profits

Technical progress has contributed to a steady decline in the relative price of new capital goods and at the same time facilitated the substitutability between phys ical capital and labor in output production. This paper studies the quantitative implications that these two changes have for the level and the variability of firms' prots, the capital-to-labor ratio, and also for labor market outcomes when profits arise from rents paid to quasi-fixed factors of production. We embed a CES production function into a model of capital accumulation and competitive search in the labor market, allowing firms to increase their size by hiring multiple workers. We use our model to disentangle the effects of the decline in the relative price of capital and increased factor substitutability. Our analysis identies each of these two changes as important drivers of the empirically observed rise in the capital- to-labor ratio and in the level and variability of firms' prots. Their overall effect on wages, employment, and the labor share of income is inconclusive, since their respective impact on each of these variables goes in the opposite direction.