Aggregation in Production Functions: What Applied Economists should Know

<quotation> There is no subject so old that something new cannot be said about it. <source>(Dostoevsky)</source> </quotation> <quotation> Glendower: I can call spirits from the vasty deep Hotspur: Why, so can I, or so can any man; But will they come when you do call for them? <source>(Shakespeare, Henry IV, Part I, Act III, Scene I)</source> </quotation> This paper surveys the theoretical literature on aggregation of production functions. The objective is to make neoclassical economists aware of the insurmountable aggregation problems and their implications. We refer to both the Cambridge capital controversies and the aggregation conditions. The most salient results are summarized, and the problems that economists should be aware of from incorrect aggregation are discussed. The most important conclusion is that the conditions under which a well-behaved aggregate production function can be derived from micro production functions are so stringent that it is difficult to believe that actual economies satisfy them. Therefore, aggregate production functions do not have a sound theoretical foundation. For practical purposes this means that while generating GDP, for example, as the sum of the components of aggregate demand (or through the production or income sides of the economy) is correct, thinking of GDP as GDP=F(K, L), where K and L are aggregates of capital and labor, respectively, and F(•) is a well-defined neoclassical function, is most likely incorrect. Likewise, thinking of aggregate investment as a well-defined addition to 'capital' in production is also a mistake. The paper evaluates the standard reasons given by economists for continuing to use aggregate production functions in theoretical and applied work, and concludes that none of them provides a valid argument. Copyright Blackwell Publishing Ltd 2003.