Discussion Paper

No. 2011-9 | May 02, 2011
Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function

Abstract

The Cobb-Douglas function is today one of the most widely-adopted assumptions in economic modeling, yet both its theoretical and empirical basis have long been under question. The purpose of this paper is to build an alternative production function on neoclassical microfoundations to address these issues, and then test it empirically.
An analysis of annual U.S. data from 1949 to 2008 suggest the model explains nearly 85 percent of GDP fluctuations, and a nonnested model comparison test concludes that it is empirically more robust than the Cobb-Douglas. Furthermore, both contemporary and lagged aggregate capital are rejected as explanatory variables. This lends support to the old “Cambridge Critique”, which sustained that using valueweighted capital aggregates to explain production simply made no sense, and also strengthens the model in this paper for, unlike the Cobb-Douglas, it does not model installed capacity as aggregate capital, but as a sunk cost generating economic rents.
Taken at face value, these results not only pose a question on any macroeconomic model assuming a Cobb-Douglas function but also point towards an alternative interpretation of phenomena such as the way monetary policy impacts productivity. 

JEL Classification

E22 E23

Cite As

Eduard Gracia (2011). Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function. Economics Discussion Papers, No 2011-9, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2011-9

Assessment



Comments and Questions


Anonymous - Referee Report 1
August 01, 2011 - 09:30

see attached file


Eduard Gracia - Comments to Refereee Report 1
August 03, 2011 - 09:26

First of all I would like to thank the anonymous referee for his/her very helpful, thorough comments. Furthermore, I do agree with the recommendations made in the report. In hindsight I agree that the historical introduction, while probably suitable to another type of article, is too long for a technical ...[more]

... one - so I will be happy to shorten it. I also realize there is room for further improving the structure and mathematical notation of the analytical section to make it more accessible to the reader. I found in fact particularly refreshing the comment about not needing to justify the usage of continuous time: practitioners with a DSGE modelling background often find discrete time more comfortable, which forced me in the past to give long explanations in defence of continuous time analysis - but I totally agree that this should be unnecessary. In short, I really appreciate the referee's comments and I will be happy to address them in a revised version of the paper.


Anonymous - Referee Report 2
September 23, 2011 - 11:51

see attached file


Eduard Gracia - Reply to 2nd Referee
September 25, 2011 - 14:35

I would also like to thank the second referee for his/her very helpful comments. Unlike the first referral report, however, my reply to this one requires a more extensive note, which I have uploaded in pdf.


Eduard Gracia - Amendment of my earlier reply
September 30, 2011 - 11:58

Just a small amendment of my earlier reply to the 2nd referee's report. Recommendation number 3 states that the model in my paper is based on a closed economy, whereas the Cobb-Douglas function is not. My reply was that the model in the paper was not dependent on operating in ...[more]

... a closed economy either, and I assumed it would be a misunderstanding based on a comment on pg. 30 of the paper. Now I realize in Assumption 9 the word "closed economy" slipped in (although it was unnecessary), so I understand now this is a more likely source of the misinterpretation.

So, my mistake: I understand now the referee's comment in recommendation number 3, which I would be happy to correct in a revised version.