The Determinants of Capital Intensity in Manufacturing: The Role of Factor Endowments and Factor Market Imperfections

In this study, we look at the determinants of industry-level capital intensities. Using cross-country data, we find that the most important determinant is a country’s factor endowment. In addition, we find that measures of labor regulation and financial development also matter: less restrictive labor regulations and greater financial development are associated with lower and higher capital-intensity, respectively. Furthermore, we establish that in developing countries less restrictive labor regulations are associated with lower capital-intensity especially in sectors that require more frequent labor adjustment. In addition, we find that hiring and firing regulations and centralized wage setting are key elements of labor regulation affecting capital-intensity. In a case study, we show that India, which has drawn attention for its stringent regulation of manufacturing labor markets, uses higher capital-intensities in manufacturing than countries at its level of development and with similar factor endowments. In a large proportion of industries, the gap between the actual capital-labor ratio used and the capital-labor ratio predicted using factor endowments narrows when we control for labor market rigidities and financial development. Our findings highlight the role played by factor market imperfections in determining capital-intensity in manufacturing. In particular, labor regulations can impose costs on labor use, thereby pushing firms towards greater capital intensity, in turn reducing labor demand and curtailing gains from trade based on factor-abundance driven comparative advantage.  The views presented here are those of the authors and not necessarily of the institutions they are affiliated with. † Corresponding author: Department of Economics, The Maxwell School of Citizenship and Public Affairs, Syracuse University, Eggers Hall, Syracuse, NY 13244, Email: [email protected]