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.