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A firm's output is given by the Cobb-Douglas production function $$Y_t=X_tK_t^{\alpha_K} L_t^{\alpha_L}$$ where $\alpha_K\approx\frac{1}{3}$ is the capital share and $\alpha_L$ the labor share.


Question: By optimizing labor, is it possible to arrive at a profit function like $\Pi_t=Z_tK_t^\gamma$ which only depends on capial? I think the answer involves $\gamma=\frac{\alpha_K}{1-\alpha_L}$.


The firm's profit is output minus wage costs,$$\Pi_t=Y_t-wL_t$$ Assume labor is frictionless. Choosing $w$ to maximize profits and solving the FOC gives $w^*_t=\alpha_LX_tK_t^{\alpha_K} L_t^{\alpha_L-1}=\alpha_L\frac{Y_t}{L_t}$, which is the marginal product of labor. Thus, $$\Pi_t=(1-\alpha_L) Y_t=(1-\alpha_L) X_tK_t^{\alpha_K} L_t^{1-\alpha_L}$$But that is still not the answer to my question.

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  • $\begingroup$ Hi! Can you please explain what you mean by "homogeneous profit function"? Also, what do you mean when you write that $\gamma$ is "typically" close to one? In your example it is one half? Finally, why is capital free, how come your company does not pay interest? $\endgroup$
    – Giskard
    Jan 1 at 12:46
  • $\begingroup$ Hi @Giskard I am looking into investment theory. The key choice variable is (physical) investment while labor doesn't feature in the models. The models often start with $\Pi=ZK^\gamma$ (where $\gamma$ is calibrated to values around 0.9) and go on to impose capital investment frictions and study firm dynamics. Some papers state that $\Pi=ZK^\gamma$ can actually be derived from a Cobb Douglas production function by optimizing over (frictionless) labor but I have never seen that written out. $\endgroup$
    – Alex
    Jan 1 at 13:37
  • $\begingroup$ What is $Z_t$? and why do you not include cost of capital in the profit function? $\endgroup$
    – Pekisch
    Jan 1 at 23:07

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