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date: 11 July 2020

Abstract and Keywords

The aggregate production function, one of the most widely used concepts in macroeconomics, is also the one whose theoretical rationale is perhaps the most suspect. The aggregate production function is one where output has to be a value, rather than a physical, measure, regardless of the precise unit of observation, whether, for example, it is for the firm or an individual industry. The value measure has to be used because of the heterogeneity of output and capital, such as value added or gross output in the case of output. These constant price measures are not physical quantities. This chapter shows that the specifications of all aggregate production functions, using value data, are nothing more than approximations to an accounting identity. After describing the accounting identity and the Cobb-Douglas production function, the chapter demonstrates that the results of the estimation of production functions that find increasing returns to scale and externalities are simply due to misspecification of the underlying identity, and that the estimated biased coefficients may actually be predicted in advance.

Keywords: aggregate production function, output, capital, accounting identity, Cobb-Douglas production function, returns to scale, externalities, macroeconomics, value added, physical quantities

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