Advances in both cost-function analysis and in econometric theory now allow the estimation of cost functions that explicitly include adjustment costs for quasi-fixed factors. Pindyck and Rotemberg (1983) estimate a dynamic cost function for the U.S. manufacturing sector that includes adjustment costs for both capital and labor. Their results indicate that capital is costly to adjust, as expected, but that the cost of adjusting labor is insignificant. In this paper we use their model (hereafter the PR model) to estimate a dynamic cost function for a single industry so that we may examine adjustment costs for labor and capital at a lower level of aggregation.
We are particularly interested in the adjustment cost of labor. Finding that capital is costly to adjust, but that labor is not, is intuitively appealing for situations where firms are building new plants and increasing employment over time. But it seems likely that these results will be different if large, permanent reductions in employment are occurring: the cost of adjusting the labor stock will increase if job security provisions are included in worker contracts and if more white collar workers, who may be more expensive to lay off , l are included among the terminations. Indeed, our results indicate that for at least one declining industry, the cost of adjusting labor may be more important than the aggregate estimates suggest.
We also make a preliminary attempt at evaluating the importance of the specification of the adjustment cost equations. Adjustment costs are usually modeled as a function of absolute changes in factors, largely because this specification is analytically tractable. But it has been suggested that adjustment costs are arguably more closely related to the size of the relative change in factor usage (Gould [1968]). Because the latter specification can be easily accommodated within the PR model framework, we are able to investigate this possibility.
We estimate a cost function for the U.S. steel industry using annual industry data from the years 1954-1985. This industry seems likely to exhibit high labor-adjustment costs because blue-collar workers are unionized and because large numbers of both blue and white-collar workers have been permanently laid off by steel firms, particularly during the later years of the sample.
The industry's capital adjustment costs, on the other hand, may or may not differ from those experienced by the manufacturing sector as a whole. The sample period includes years when the industry was still expanding its capacity (mostly the 1950s), years when industry investment was largely devoted to capital deepening (the 1960s), and years when industry capacity peaked and began to decline (the 1970s). Also, the industry has a history of maintaining excess capacity, a practice that could bias adjustment cost estimates. Our difficulty in estimating the cost of adjusting the capital stock during this period suggests that a more sophisticated model of capital stock adjustment than is generally employed may be necessary.
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