Abstract. This study provides a theoretical framework for implicitly accounting for adjustment costs in differential systems of factor demand relationships. Differential factor demand relationships, as they are represented by parameters of the cost function, are generally assumed to be linear in the parameters in the existing empirical literature. I argue that this linearity might not always hold because firms may incur adjustment costs that are inherent in the act of adjusting the mix of inputs applied in the underlying production technologies. Implications of convex and nonconvex adjustment costs for estimating differential systems as well as price and substitution elasticities are explored.

Keywords: differential factor demand systems, adjustment costs, threshold nonlinearities, factor price elasticities, factor substitution elasticities.