Uncertainty and capacity constraints: reconsidering the aggregate production function

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 ustained 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.