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

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.