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The Cobb-Douglas Production Function

© 1999 P. LeBel
Production functions are central to the determination of the efficient allocation of resources. At the
individual firm level, production functions enable a decision-maker to determine the optimal combination
of inputs that should be used to produce a given level of output at the lowest cost. When taken together
with a firm's profit-maximizing output decision, production functions enable firm's to achieve both technical
(or least cost) and allocative (optimal output) efficiency. In turn, technical and allocative efficiency are
essential conditions for competitive markets to achieve an economically efficient allocation of resources.
Of the many types of production functions, one of the most widespread functions has been the Cobb-Douglas
production function, after Charles W. Cobb and Paul H. Douglas, "A Theory of Production", American
Economic Review, XVIIII (Supplement, 1938), pp. 139-156. While the Cobb-Douglas production
function is limited to a unitary elasticity of substitution, it does provide for direct estimates of the optimal
expenditure proportions on production inputs, given a budget constraint and relative input prices.

A. Consider the following empirical data:


Real Gross Product, Man Days, Real Capital Input in the Agricultural Sector of Taiwan, 1958-1972
Source: Damodar Gujurati, Basic Econometrics, 2nd edition. (New York: McGraw-Hill, 1988), p. 191

Table 1
Year GDP Labor Capital
1958 16,607.70 275.50 17,803.70
1959 17,511.30 274.40 18,096.80
1960 20,171.20 269.70 18,271.80
1961 20,932.90 267.00 19,167.30
1962 20,406.00 267.80 19,647.60
1963 20,831.60 275.00 20,803.50
1964 24,806.30 283.00 22,076.60
1965 26,465.80 300.70 23,445.20
1966 27,403.00 307.50 24,939.00
1967 28,628.70 303.70 26,713.70
1968 29,904.50 304.70 29,957.80
1969 27,508.20 298.60 31,585.90
1970 29,035.50 295.50 33,474.50
1971 29,281.50 299.00 34,821.80
1972 31,535.80 288.10 41,794.30

B. To estimate the output elasticities in a Cobb-Douglas function of the form Q =AX2a X3b
first calculate the logarithm (or ln) of each variable in tabular form

Table 2
Ln GDP Ln Labor Ln Capital
1958 9.7176 5.6186 9.7872
1959 9.7706 5.6146 9.8035
1960 9.9120 5.5973 9.8131
1961 9.9491 5.5872 9.8610
1962 9.9236 5.5902 9.8857
1963 9.9442 5.6168 9.9429
1964 10.1189 5.6454 10.0023
1965 10.1836 5.7061 10.0624
1966 10.2184 5.7285 10.1242
1967 10.2622 5.7160 10.1929
1968 10.3058 5.7193 10.3075
1969 10.2222 5.6991 10.3605
1970 10.2763 5.6887 10.4185
1971 10.2847 5.7004 10.4580
1972 10.3589 5.6633 10.6405

C. Then, using ordinary least squares regression, estimate the coefficients of X2 and X3, with Q as
the dependent variable. Output statistics will include the following:

Table 3
SUMMARY OUTPUT

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Ln GDP
Regression Statistics
Multiple R 0.9429
R Square 0.8890
Adjusted R Square 0.8705
Standard Error 0.0748
Observations 15
ANOVA
df SS MS F Significance F
Regression 2 0.5380 0.2690 48.0688 0.0000
Residual 12 0.0672 0.0056
Total 14 0.6052
CoefficientsStandard Error t Stat P-value Lower 95% Upper 95%Lower 95.0%Upper 95.0%
Intercept -3.3385 2.4495 -1.3629 0.1979 -8.6755 1.9986 -8.6755 1.9986
Ln Labor 1.4988 0.5398 2.7765 0.0168 0.3226 2.6749 0.3226 2.6749
Ln Capital 0.4899 0.1020 4.8005 0.0004 0.2675 0.7122 0.2675 0.7122

D. The econometric equation will thus be reported as:

Ln A Ln X2 Ln X3
Ln Q = -3.3385 1.4988 0.4899
2.7765 4.8005 (t)
R^2 = 0.8890
R^2 (adj.) = 0.8705 = 1 - (1-R^2)*(N-1)/(N-k)
df = 14
F = 48.069

E. Taking the antilogarithm of the intercept and placing the regession coefficients as exponents
in the original function yields the estimated form of the Cobb-Douglas production function:

1.4988 0.4899
Q= 0.035 X2 X3

F. Testing for the presence or absence of economies of scale involves simple addition
of the input exponents (or output elasticities) to see if they are less than, equal to, or greater than one:

Since a + b= 1.9886 there are i increasing returns to scale.

1.4988 0.4899
Example: Q= 0.035 X2 X3
100 100 336.80
and by doubling inputs: 200 200 1336.64 = 296.86%

G. Deriving the optimal input combination requires information on the output elasticities, the state
of technology (or the A parameter) the price of each input, and the level of income, all of which
are reformulated as a Lagrangian constrained optimization problem.

H. Solution and simulation of a Lagrangian constrained optimization problem:


(You might want to split your screen into two windows, with the simulation control panel at the top and
Figure 2 in the bottom window to see the immediate result of a change in any parameter on the
corresponding technical efficiency optimum input combination).

Constrained Optimization Simulation Control Panel


Technical Change
Given: 0.2000 0.8000 Disembodied Embodied
(X X3 ) B
Q= 1.0000 2 A a a+B Scalar
Base 1.00 0.2000 0.8000 1.0000
Simulation 1.00 0.2000 0.8000 1.0000
Neutral Scalar Test values 0.2400 0.9600 1.2000
Optimization: Base Simulation: Optimal Solutions:

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X X
Given: Income $200.00 $200.00 Q 2 3
Pr X2 $10.00 $10.00 12.13 4.00 16.00 Base
Pr X3 $10.00 $10.00 12.13 4.00 16.00 Simulation
Relative Change: 0.0% 0.00% 0.00%

Before we derive the optimal input combination, we can first portray the production surface as:

Table 4
X
1 2 3 4 5 6 7 8
1 1.52 2.64 3.65 4.59 5.49 6.36 7.19 8.00
2 1.48 2.57 3.55 4.47 5.35 6.19 7.00 7.79
3 1.43 2.49 3.45 4.34 5.19 6.00 6.79 7.55
Y 4 1.38 2.40 3.32 4.18 5.00 5.79 6.54 7.28
5 1.32 2.30 3.18 4.00 4.78 5.53 6.26 6.96
6 1.25 2.17 3.00 3.78 4.51 5.22 5.91 6.58
7 1.15 2.00 2.77 3.48 4.16 4.82 5.45 6.06
8 1.00 1.74 2.41 3.03 3.62 4.19 4.74 5.28

Figure 1

Cobb-Douglas Production Possibilities

8.00

6.00

4.00

2.00

0.00
8
7
6
5
4
3
2
1

I. The Lagrangian constrained optimization problem is formulated as:

0.2000 0.8000
1 Max L = 1.000 (X2 X3 ) + l (10.00 X2 + 10.00 X3 -200.00)

2 Solving for optimal values of each input, X2 and X3, requires taking the first
partial derivative of the Lagrangian function for each variable and setting it equal to zero:

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-0.8000 0.8000
2.a dL/dX2 = 0.2000 X2 X3 + l 10.00 =0

0.2000 -0.2000
2.b d L/d X3 = 0.8000 X2 X3 + l 10.00 =0

2.c dL/dl = 10.00 X2 + 10.00 X3 -200.00 =0

3 Next, set the first two derivative equations equal to lambda:

-0.8000 0.8000
3.a -l = 0.02 (X2 X3 )

0.2000 -0.2000
3.b -l = 0.0800 (X2 X3 )

4 Setting both expressions equal to each other to eliminate lambda yields:

-0.8000 0.8000 0.2000 -0.2000


0.02 (X2 X3 ) = 0.0800 (X2 X3 )

5 Next, take the expressions in equation four and multiply each by a simplifying constant to
eliminate one unknown:

0.8000 0.2000 -0.8000 0.8000 0.8000 0.2000 0.2000


(X2 X3 ) 0.02 (X2 X3 ) = (X2 X3 ) + 0.0800 (X2

Thus:
5.a 0.02 X3 = 0.0800 X2 and:

5.bX3 = 4.00 X2

Substituting this optimal input ratio into the budget constraint yields:

6 X + X =
(10.00) 2 (10.00)x (4.00) 2 200

Thus, (50.00) X2 = 200

6.a and the optimal quantity of X2 = 4.00 which when substituted into the budget constraint yields

(10.00)x (4.00) + (10.00) X3 = 200

Thus, (10.00) X3 = 160.00

6.b and the optimal quantity of X3 = 16.00

7 From the optimal input quantities we derive the optimal level of input expenditures as:

PrX X Opt.Q Total


i i

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X Exps = (10.00)x (4.00)= $40.00
2

X Exps = (10.00)x (16.00)= $160.00


3

8 We can also compare these expenditures in relation to the proportional values of the output elasticities:

Optimal Expenditure Proportions:


Shares: OutputElast. Output elasticity shares:
X2 $40.00 0.2000 0.2000 0.2000 = elasticity of X2 divided by sum of output elasticities
X3 $160.00 0.8000 0.8000 0.8000 = elasticity of X3 divided by sum of output elasticities
Total $200.00 1.0000 1.0000 1.0000

Thus, optimal expenditure proportions can be derived in either of two ways:


One is to derive the optimal input combinations from the Lagrangian constrained optimization formulation
and derive the corresponding expenditures.
The other, non-calculus based solution is to add the sum of the two output elasticities and calculate
the proportional share of each elasticity out of the total output elasticity.

9 Verification that the constrained input combination is optimal.


Verifying that one has an optimal input combination requires that the ratio of each marginal production
to its corresponding intput price be equal for all pairwise sets of inputs. First we calculate the marginal
product of each input as the first partial derivative of the production function.

-0.8000 0.8000 -0.8000 0.8000

dQ/dX2 = =
9.a 0.6063 (0.20)x X2 X3 = (0.20)x (4.00)x (16.00)

0.2000 -0.2000 0.2000 -0.2000

9.b dQ/dX3 = 0.6063 = (0.80)x X2 X3 = (0.80)x (4.00)x (16.00)

10 Then we compute the ratio of each marginal product, or partial derivative, to its corresponding input price:

10.a (MP/P) = 0.6063 = 0.06063


X2 10

10.b (MP/P) = 0.6063 = 0.06063


X 10 Q.E.D.
3

Figure 2
Graphing Functions Data:
X factor X X' Base Budget Base Q Sim Q
Cobb-Douglas
1.00 0 Production
0.00 Function
20.00 20.00
1 1.00 19.00 19.00 22.63 22.63
25.00 2 2.00 18.00 18.00 19.03 19.03
3 3.00 17.00 17.00 17.19 17.19
4 4.00 16.00 16.00 16.00 16.00
5 5.00 15.00 15.00 15.13 15.13
20.00 6 6.00 14.00 14.00 14.46 14.46
7 7.00 13.00 13.00 13.91 13.91
8 8.00 12.00 12.00 13.45 13.45
9 9.00 11.00 11.00 13.06 13.06
15.00 10 10.00 10.00 10.00 12.72 12.72
11 11.00 9.00 9.00 12.42 12.42
12 12.00 8.00 8.00 12.16 12.16
13 13.00 7.00 7.00 11.92 11.92
10.00 14 14.00 6.00 6.00 11.70 11.70
15 15.00 5.00 5.00 11.50 11.50
16 16.00 4.00 4.00 11.31 11.31
17 17.00 3.00 3.00 11.14 11.14
5.00
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0.00
10.00

5.00
18 18.00 2.00 2.00 10.99 10.99
19 19.00 1.00 1.00 10.84 10.84
20 20.00 0.00 0.00 10.70 10.70
0.00

Base Budget Base Q Sim Q

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uglas

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95.0%

one:

p and

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-0.2000
X3 )

raint yields:

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cities:

asticities
asticities

mulation

ction
rginal

ut price:

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