SMALL SAMPLE BIAS AND ADJUSTMENT COSTS

The response of most stock variables (e.g., capital, housing, consumer durables, and prices) to exogenous impulses involves a dynamic-or ''short-run''-reaction, and a target-or ''long-run''-reaction. The difference between these two is typically attributed to some form of adjustment cost. In this paper I argue that the small sample problems of cointegrating procedures used to estimate the ''long''-run component are particularly severe when adjustment costs are important. More precisely, elasticity estimates will tend to be biased downward. I illustrate the empirical relevance of this by showing that the target elasticity of capital with respect to its cost is severely downward biased when estimated with conventional OLS cointegration procedures. Once this is corrected, the elasticity of the U.S. capital-output ratio to the cost of capital is found to be large and close to (minus) one.