Two Trees and Two Fruits

Abstract

I examine how substitutabilities across industry goods affect expected returns of industries. In an endowment economy where two industries produce different goods, I show that an expanding industry demands relatively lower (higher) expected returns if the substitutability between the two goods is low (high). I test these predictions using the nondurable and service industries. The substitutability between nondurables and services is very low in the data. Consistent with the model, the observed relative expected returns of the service industry decrease as the service industry grows. When calibrated, the model successfully explains the long-run movements in the relative expected returns between the two industries.

Keywords: two trees, two fruits, industry returns, substitutability, structural change, nondurable industry, service industry

JEL Classification: G00, G12