Internal Adjustment Costs of Firm-Specific Factors and the Neoclassical Theory of the Firm

Abstract

This paper considers the consequences of a two-sector vertically-integrated model of firms producing output using firm-specific capital with a second sector producing firm-specific capital by adapting raw capital purchased in the market. Analysts rarely observe each sector separately. Aggregating over both sectors produces short-run and long-run factor demand functions that appear to be perverse, but when disaggregated obey standard neoclassical properties. Adjustment costs create the appearance of static inefficiency in the presence of dynamic efficiency.

Keywords: adjustment costs, factor demand, frontier production theory, firm-specific capital

JEL Classification: D21,E13,L11