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 ''s hort-run''-reaction, and a target-or ''long-run''-reaction. The differ ence between these two is typically attributed to some form of adjustm ent cost. In this paper I argue that the small sample problems of coin tegrating procedures used to estimate the ''long''-run component are p articularly severe when adjustment costs are important. More precisely , elasticity estimates will tend to be biased downward. I illustrate t he empirical relevance of this by showing that the target elasticity o f capital with respect to its cost is severely downward biased when es timated with conventional OLS cointegration procedures. Once this is c orrected, the elasticity of the U.S. capital-output ratio to the cost of capital is found to be large and close to (minus) one.