This paper reevaluates the longstanding debate on capital-labor substitution by examining the role of external inputs: raw materials, intermediate goods and services, imports, offshoring. Both a meta-analysis (analyzing existing estimates of substitution) and direct estimation (using U.S. data for 1963-2016) indicate that external inputs disproportionately displace labor. These findings imply (1) that the capital-labor ratio responds 40-80% more strongly to the price of labor than to the price of capital, (2) that value added cannot be modeled separably from gross output, and (3) that historical disagreements regarding substitution can be recast as an omitted variable bias involving external inputs.

Aggregate productivity suffers when workers and machines are not matched with their most productive uses. This paper builds a model that features industry-specific markups, industry-specific returns to scale, and establishment-specific distortions and uses it to measure the extent of this misallocation in the economy. Applying the model to restricted U.S. Census microdata on the manufacturing sector suggests that misallocation declined by 13% between 1982 and 2007. The finding of declining misallocation starkly contrasts with the 29% increase implied by the widely used assumptions that all establishments charge the same markup and have constant returns to scale.