Growth, Capital Shares, and a New Perspective on Production Functions

Standard growth theory implies that steady-state growth in the presence of exponential declines in the prices of computers and other capital equipment requires a Cobb-Douglas production function. Conventional wisdom holds that capital shares are relatively constant, so that the Cobb-Douglas approach might be a good way to model growth. Unfortunately, this conventional wisdom is misguided. Capital shares exhibit substantial trends and fluctuations in many countries and in many industries. Taken together, these facts represent a puzzle for growth theory. This paper resolves the puzzle by (a) presenting a production function that exhibits a short-run elasticity of substitution between capital and labor that is less than one and a long-run elasticity that is equal to one, and (b) providing microfoundations for why the production function might take the Cobb-Douglas form in the long run.