Pattern of capital versus labor substitution

A business firm can use many different combinations of capital and labor in producing its product. Which combination will be chosen? This is a tricky question which we will try to address or attempt to answer. However before we can start to develop this theory it is important first to gain a better perspective of the facts that need to be addressed.

Capital/labor ratio measures the dollar amount of capital (plant and equipment) used in production relative to each employee hour of labor. The capital/labor ratio varies tremendously among industries. Petroleum refining and communications for example are highly capital intensive, while apparel and construction are quite labor intensive. One important reason for this difference is the technology of production. The current state of technology in petroleum refining requires it to be produced with large amounts of capital in the form of oil crackers and distillers. The production of a woman’s dress on the other hand requires large amounts of hand labor for cutting, stitching and fitting.

While technology places important constraints on the proportions of capital and labor used in production, it would be a mistake to conclude that a firm has no choice in this matter. In general quite the opposite is true. This is most starkly revealed by comparing how particular products are made in the United States relative to other countries, particularly developing countries where the cost of labor is much lower. Whether in a capital intensive industry such as petroleum refining or a labor industry such as apparel, producers in less developed countries adapt to the high costs of capital and low price of labor by conserving on the use of machinery and utilizing additional labor. Thus on a Chinese construction site bricks and dirt are carried by hand or pushcart, while in United States bulldozers and forklift trucks do the same tasks. Likewise cars produced in the United States are welded by robots, while cars produced in Mexico are welded by humans.

Since technology generally affords a firm a ‘menu of choice’ as to the proportion of capital and labor it uses, the exact proportion chosen will be significantly influenced by the relative prices of these two inputs. Over time wages in the United States have not seen significant rise than the cost of capital, causing firms to substitute capital for labor. This shift is clearly demonstrated in mining where the amount of capital per employee hour has receded.

This discussion points out two central issues that labor demand must address - first, what determines at a point in time the best mix of capital and labor in production and second how does this favorable mix of capital and labor change over times as wages and cost of capital change? What we know of MTA in this contract negotiation has embarked on the assault of our wages and our benefits in their desire to emulate the developing countries wages. However MTA put its head in the sand by ignoring the rising prices currently in New York. Maybe the MTA should be reminded of what the cost of Wonder Bread plus tax is.