SFB 303 Discussion Paper No. B - 066

Author: Weissenberger, Edgar, Gerd Müller-Brockhausen, and Heinz Welsch
Title: A Factor Demand Model with Quasi-Fixed Factors and Rational Expectations
Abstract: The introduction of quasi-fixed factors in factor demand models has been very popular in recent empirical demand studies. These studies can be grouped into two categories. The first is flexible functional form models that permit quite general substitution possibilities but impose the static expectations assumption about prices and output (see for example Berndt, Fuss and Waverman (1980) or Morrison and Berndt (1981)). The second puts the emphasis on expectations formation with only rudimentary treatment of the technological structure (the prototype in this category is Sargent (1978)). The main finding of these studies is that one has to distinguish short-run and long-run adjustment and that the assumption of all factors being variable represents a gross violation of the data.
In a recent study Pindyck and Rotemberg (1983) estimate a dynamic factor demand model under the assumption of rational expectations by estimating the Euler equations directly. They do not, however, utilize an explicit solution to their model, nor do they test the validity of the restrictions implied by the rational expectations hypothesis (hereafter REH). In a footnote Pindyck and Rotemberg point out that the test of the overidentifying restrictions indicates rejection of their model. It is well-known that the stochastic error of a first order optimality condition will typically exhibit serial correlation rendering OLS estimates inconsistent (for example see Muellbauer and Winter (1980)). Sargan (1982) has pointed out that the efficiency of instrumental variable estimates from such equations is doubtful. We believe that this justifies yet another empirical study on factor demand. The advantage of our method over that of Pindyck and Rotemberg is that we are able to estimate the explicit solutions jointly with the stochastic processes of the informational variables, subject to the cross- equation REH-restrictions.
Creation-Date: February 1986
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