Notes 4---Estimating a Cobb Douglas Production Function

1.

The Cobb Douglas Production Function

Suppose the Cobb-Douglas production function describes how a particular economy's output
level Y is determined from the inputs L and K:
(1)

Y ( L, K ) ALa1 K a2 ,

A>0, 0 < a1 < 1, 0 < a2 < 1

The variables A, a1, and a2 describe the economy's technology. The variable A can be thought of as the
general level of technology. The production function indicates that an increase in the parameter A---a
technological improvement---will increase output. The technological parameters a1 and a2 measure the
respective contributions of L and K to the production process, as will now be shown more carefully.
For this Cobb-Douglas production function, the marginal product of labor can be calculated as
(2)

YL

Y
Y ( L, K ) a1 ALa 1 K a .

L L
1

L
a1 ALa1 1K a2
L
ALLa1 1K a 2
a1
,
L

a1

ALa1 K a 2
L

which means

Y
Y
a1
L
L
The quantity Y/L is the average product of labor. Thus, we see that the marginal product of labor Y/L
and the average product of labor Y/L are each measures of labor productivity, and the last equation
indicates the two are related.
In fact, rearranging the last equation, we find that the parameter a1 is given by the ratio of the
marginal product to the average product:

(4)

Y
a1 L .
Y
L

The ratio of the marginal product to the average product defines the elasticity of output with respect to
labor input. An elasticity always gives the percentage change in one variable divided by the percentage
change in another variable. By rearranging the right side of the last equation, we see this more clearly:

(5)

Y s Y s
L Y s %OUTPUT
L
Ys
%LABOR
L

If a1 > 1, then a given percentage change in labor would generate a larger percentage change in output.
The term elastic is used to describe the responsiveness of output to labor input in this case. If a1 < 1, then
a given percentage change in labor would generate a smaller percentage change in output. The term
inelastic is used to describe the lack responsiveness of output to labor input in this case. If the
production process exhibits diminishing returns relative to labor, then a1 < 1 must hold.
The marginal product of labor decreases and the employment level increases whenever
diminishing returns is present. Mathematically, the rate of change in the marginal product is found by
taking the derivative of the marginal product function with respect to the employment level L. For the
Cobb-Douglas production function the rate of change in the marginal product is:
(6)

[YL ]

a1 ALa 1 K a
L
L
1

a1[a1 1] ALa1 2 K a 2 .
As long as a1 < 1 in the Cobb-Douglas production function, the derivative (6) is negative. This is
equivalent to assuming diminishing returns. That is, a1 < 1 indicates that the marginal product of labor
decreases as the employment level increases.
2.

Estimating the Cobb Douglas Production Function

By applying econometric tools to our Cobb-Douglas production function, we can try to obtain
estimates of the parameters A, a1, and a2. In fact, this is a classic econometric problem.
Our production function indicates the output level Y depends upon employment L and capital K. By
gathering data on output, employment, and capital stock, we could regress Y on L and K. However, such
a regression would not be consistent with the Cobb Douglass production function relationship, but rather
would be consistent with the linear production function relationship
(7)

Y a1 L a2 K

The regression would provide us with estimates of a1 and a 2 . The estimate of a1 would be the
estimate of the marginal product of labor for the linear production function (7). Notice this estimate
would be a constant, meaning production does not exhibit diminishing returns. Indeed, the linear
production function (7) indicates marginal labor productivity cannot decrease as employment increase,
nor increase. The same is true with the marginal productivity of capital. Moreover, the level of capital
does not impact labor productivity in the linear production function (7) as it does in the Cobb Douglas
production function (7). Economists have long favored using the Cobb-Douglas production function
over the linear production function because the Cobb Douglas allows for diminishing returns and because
it allows the level of one input (e.g., capital) to affect the productivity of another input (e.g., labor).

In the Cobb-Douglas production function Y ALa1 K a2 , there is a nonlinear relationship between

the inputs L and K and the output Y, and the two input interact. To estimate the parameters a1 , a 2 , and
A , the nonlinear Cobb Douglas must be linearized. This is possible, which is another reason why the
Cobb-Douglas is so attractive. Taking the natural log of both sides of Y ALa1 K a2 , we obtain
(8)

ln(Y ) ln( A) a1 ln( L) a2 ln( K ) .

Using available data, we can take the natural log of each data series to create variables that are in
the log levels rather than the levels. Regression the ln(Y ) on the ln(L) and the ln(K ) , we obtain
(9)

ln(Y ) 7.08

0.94 ln( L)

(0.69)*** (0.012)***

0.51ln( K ) ,

R2=.9975

(0.07)***

Notice that the estimates, while significant, are not entirely sensible. The 0.94 estimate for a1 indicates
that a 10 percent increase in the employment leads to a 9.4 percent increase in the output level, which
implies there is diminishing returns to labor. Similarly, the 0.51 estimate for a2 indicates that a 10 percent
increase in the capital leads to a 5.1 percent increase in the output level, which implies there is
diminishing returns to capital. However, the sum a1 a 2 0.94 0.51 1.45 is greater than one,
which implies production exhibits increasing returns to scale. Increasing returns to scale means a
proportionate increase in all inputs leads to a more than proportional increase the output. For example,
doubling all inputs would lead to more than a doubling of output. In this case, a1 a 2 1.45 indicates a
one hundred percent increase in (or doubling of) the inputs leads to a 145 percent increase in the output
level. With constant technology, it is difficult to conceive how output could more than double from a
doubling of the inputs.
One problem with the regression (9) and production function (1) is there is an implicit assumption that
the level of technology A is fixed over time. Yet, in the real world, we would expect that the level of
technology changes. We can allow for technical change, using the same production function, by
differentiating (8) with respect to time, assuming the technology level A is not constant but rather is time
dependent. Doing so, we obtain
(10)

1 dY 1 dA
1 dL
1 dK
.

a1
a2
Y dt
A dt
L dt
K dt

Recognizing [1 / Y ][dY / dt ] is the growth rate of Y, we can define a new variable g Y for the growth rate
of Y. Similarly, we can define the variables g A , g L , and g K for the growth rates of technology, labor,
and capital, and we can rewrite (10) as
(11) g Y g A a1 g L a 2 g K
Whereas the level of technology was assumed constant in the model (8), it is the growth rate of
technology that is assumed constant in the model (11), if we regress the growth rate of output on the
growth rates of employment and capital. Doing so, we obtain
(12) g Y 0.018
(.002)***

0.38 g L
(.090)***

0.28 g K , R 2 .8687

(0.032)***

Equation (12) indicates that the average growth rate for technology (average of the variable g A ) is
0.018=1.8% per year. Using the rule of 72, this implies the level of technology (level of knowledge
imbedded in production processes) doubles every 40 years or so. The estimates a1 0.38 and
a 2 0.28 are the estimated elasticities for labor and capital. These estimates indicate that a 10%
increase in employment will increase output by 3.8 percent, while a 10% increase in capital will increase
output by 2.8%. That is, both labor and capital obey the law of diminishing returns. Because
a1 a 2 0.66 , we find that doubling both labor and capital will increase output by 66%.
Growth Accounting involves explaining the growth rate of output from the growth of factor inputs
and from technology. Using available data on employment and capital, the average annual growth rates
for the variables g L and g K are 1.76% and 3.12%. Entering these growth rates into equation (12), we
obtain

0.018
(13) g Y
100%
53.7%

0.38(.0176 )

20.2%

0.28(.0312 )
26.2%

Combining the numbers on the right side of (13), we obtain 0.033=3.33%. This is the estimate from the
model for the growth rate of output. Because of the nature of regression, which best fits the model to the
data, this estimate is exactly equal to the actual growth rate for output over the period. Underneath
equation (13), the percentage contribution of each input to the growth rate of output is shown, as is the
percentage contribution of technological improvement. Our estimates indicate technological
improvement makes the most significant contribution to economic growth, at 53.7%, followed by capital
growth at 26.2% and finally by labor growth.
The growth rate of output per laborer is one measure of the average standard of living, and it is
equal to g Y g L . Subtracting g L from both sides of (11), we obtain

g Y g L g A 1 a1 g L a 2 g K . Entering the estimates obtained from the regression (12), we obtain

(14) g Y g L .018 1 0.38 (0.0176 )

100%
114.2% -70.0%

0.28(0.0312 )
55.7%

Combining the numbers on the right side of (14), we obtain 0.0156=1.56%. The accounting in (14)
indicates that employment growth, because of diminishing returns, reduces the average standard of living,
while technological improvement and capital growth enhance it. If there were no employment growth
(i.e., g L 0 ), then output growth per laborer would be g Y g L .018 0.28 (0.0312 ) 2.67 % .
Labor growth diminishes this by 1 0.38 (0.0176 ) 0.0109 1.09 % . Using the rule of 72, we can
gain perspective on what employment growth is actually costing us. At 1.56% growth, the average
standard of living actually doubles in about 46 years. If employment did not increase, so output per
worker grew at 2.67%, then the standard of living would double about every 27 years.

The following figure presents two models of the real gross domestic product growth rate, and
their associated forecasts. Model 1 is the best fit model (12), where the growth rates for used in the
forecast are g L , and g K are obtained from best fit polynomial models, with dummy variables to control
for unusual negative growth rate periods. Model 2 is constructed by taking the best fit model (12) and
using the average growth rates of 1.76% and 3.12%. for g L , and g K . This second model yields a
forecast of 3.33% per year for real GDP out into the indefinite future. In contrast, model 1 yields a

forecast that starts with a 3.67% prediction, which then decreases gradually to a 3.32% prediction 20
years later. The reason for the higher initial growth rate forecast in model 1 is that using a dummy
variable to treat negative growth rates as unusual increases the average growth rate of the factor (labor or
capital) going into the forecast. The reason for the decreasing growth rate in model 1 is that the best fit
model for capital indicates that the growth rate for capital will decrease over time, which then causes a
decrease in output. One might suspect the growth rate for output to be between these two forecasts.
U.S. Rate of Economic Growth
(Growth Rate of Real Gross Domestic Product )
10.0%

Percent change from previous

year

8.0%

6.0%

4.0%

2.0%

0.0%
1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

-2.0%

Actual

Model 1

Model 2

-4.0%