Capital/Labor substitution, capital deepening, and FDI

Empirical Studies show that the elasticity of substitution between capital and labor is larger than one in developed countries but smaller in developing countries. This paper develops a production function which allows for this structure in the elasticity of substitution. The case of a falling real interest rate and capital deepening in the developed countries in the presence of FDI flows is analyzed. It is shown that this structure in the elasticity of substitution can be responsible for different types of relationships between the capital intensity of the developed country and the relative capital intensity of the developing country. They carry over to an first increasing and later eventually decreasing relationship between the capital intensity of the developed country and FDI profitability. (C) 2008 Elsevier Inc. All rights reserved.