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# Constant elasticity of substitution

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 Title: Constant elasticity of substitution Author: World Heritage Encyclopedia Language: English Subject: Collection: Publisher: World Heritage Encyclopedia Publication Date:

### Constant elasticity of substitution

Constant elasticity of substitution (CES), in economics, is a property of some production functions and utility functions.

Specifically, it arises in a particular type of aggregator function which combines two or more types of consumption, or two or more types of productive inputs into an aggregate quantity. This aggregator function exhibits constant elasticity of substitution.

## Contents

• CES production function 1
• CES utility function 2
• References 3

## CES production function

The CES [3][4]

Q = F \cdot \left(a \cdot K^r+(1-a) \cdot L^r\right)^{\frac{1}{r}}

where

• Q = Quantity of output
• F = Factor productivity
• a = Share parameter
• K, L = Quantities of primary production factors (Capital and Labor)
• r = {\frac{(s-1)}{s}}
• s = {\frac{1}{(1-r)}} = Elasticity of substitution.

As its name suggests, the CES production function exhibits constant elasticity of substitution between capital and labor. Leontief, linear and Cobb–Douglas production functions are special cases of the CES production function. That is, if r=1 we have a linear or perfect substitutes production function; if r approaches zero in the limit, we get the Cobb–Douglas production function; and, as r approaches negative infinity we get the Leontief or perfect complements production function. The general form of the CES production function, with n inputs, is:[5]

Q = F \cdot \left[\sum_{i=1}^n a_{i}X_{i}^{r}\ \right]^{\frac{1}{r}}

where

• Q = Quantity of output
• F = Factor productivity
• a_{i} = Share parameter of input i, \sum_{i=1}^n a_{i} = 1
• X_i = Quantities of factors of production (i = 1,2...n)
• s=\frac{1}{1-r} = Elasticity of substitution.

Extending the CES (Solow) form to accommodate multiple factors of production creates some problems, however. There is no completely general way to do this. Uzawa showed the only possible n-factor production functions (n>2) with constant partial elasticities of substitution require either that all elasticities between pairs of factors be identical, or if any differ, these all must equal each other and all remaining elasticities must be unity.[6] This is true for any production function. This means the use of the CES form for more than 2 factors will generally mean that there is not constant elasticity of substitution among all factors.

Nested CES functions are commonly found in partial equilibrium and general equilibrium models. Different nests (levels) allow for the introduction of the appropriate elasticity of substitution.

## CES utility function

The same functional form arises as a utility function in consumer theory. For example, if there exist n types of consumption goods c_i, then aggregate consumption C could be defined using the CES aggregator:

C = \left[\sum_{i=1}^n a_{i}^{\frac{1}{s}}c_{i}^{\frac{(s-1)}{s}}\ \right]^{\frac{s}{(s-1)}}

Here again, the coefficients a_i are share parameters, and s is the elasticity of substitution. Therefore the consumption goods c_i are perfect substitutes when s approaches infinity and perfect complements when s approaches zero. The CES aggregator is also sometimes called the Armington aggregator, which was discussed by Armington (1969).[7]

A CES utility function is one of the cases considered by Dixit and Stiglitz in their study of optimal product diversity in a context of monopolistic competition.[8]

A CES indirect utility function is considered by Baltas (2001) to derive a utility-consistent brand demand system. The brand-level model is subsequently extended to allow the joint determination of brand demand and category expenditure. Category demand is determined endogenously by a multi-category CES indirect utility function encapsulating consumer preferences over brands and product categories in a large simultaneous system. It is also shown that CES preferences are self-dual and that primal and dual CES preferences yield systems of indifference curves that may exhibit any degree of convexity. [9]

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