Capital-labor substitution and misallocation

We explore the role of the elasticity of substitution between capital and labor (σ) in misallocation of resources. We show, both analytically and empirically using the cross-country firm level survey data, that the extent of misallocation is substantially large for low σ compared to the Cobb-Douglas value of one that the extant literature invariably assumes. When σ is low, dispersion in marginal products of capital across firms will be larger for given dispersion in capital-labor ratios because marginal product now declines more rapidly with increasing capital. The extent of misallocation is even larger when σ varies across firms. Given the overwhelming evidence that σ