Chapter 19 Factor Markets and Distribution of Income

1. How factors of production—resources like land, labor, and both physical and human capital—are traded in factor markets, determining the factor distribution of income2. How the demand for factors leads to the marginal productivity theory of income distribution3. An understanding of the sources of wage disparities and the role of discrimination4. The way in which a worker’s decision about time allocation gives rise to labor supply

Chapter 19Factor Markets and Distribution of Income

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A factor of production is any resource that is used by firms to produce goods and services, items that are consumed by households.

Factors of production are bought and sold in factor markets, and the prices in factor markets are known as factor prices.

What are these factors of production, and why do factor prices matter?

The Factors of ProductionEconomists divide factors of production into four principal classes:

1) Land: a resource provided by nature2) Labor: the work done by human beings3) Physical capital: which consists of manufactured resources such as

buildings, equipment, tools, and machines4) Human capital: the improvement in labor created by education and

knowledge that is embodied in the workforce

The Economy’s Factors of Production

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PitfallsWhat Is a Factor, Anyway? Imagine a business that produces shirts. The business will make use of

workers and machines—that is, labor and capital. But it will also use other inputs, such as electricity and cloth. Are all of these inputs factors of production?

No. Labor and capital are factors of production, but cloth and electricity are not.

The key distinction is that a factor of production earns income from the selling of its services over and over again but inputs cannot.

A worker and a machine earn income over time, but inputs like electricity or cloth are used up in the production process. Once exhausted, they cannot be a source of future income for the owner.

Factor prices play a key role in the allocation of resources among producers because of two features that make these markets special:• Demand for the factor, which is derived from the firm’s output choice• Factor markets are where most of us get the largest shares of our

income

Factor Incomes and the Distribution of Income The factor distribution of income is the division of total income among

labor, land, and capital. Factor prices, which are set in factor markets, determine the factor

distribution of income. Labor receives the bulk—more than 70%—of the income in the modern

U.S. economy. Although the exact share is not directly measurable, much of what is

called compensation of employees is a return to human capital.

The Allocation of Resources

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FOR INQUIRING MINDSThe Factor Distribution of Income and Social Change in the Industrial Revolution Novels by Jane Austen and Charles Dickens seem to be describing quite

different societies. Austen’s novels, set around 1800, describe a world in which the

leaders of society are land-owning aristocrats. Dickens’ novels, set 50 years later, describe a world in which

businessmen, especially factory owners, are in control. This shift reflects a dramatic transformation in the factor distribution of

income. The Industrial Revolution changed England from a mainly

agricultural country to an urbanized and industrial one.

The share of national income from land fell from 20% to 9%, but that from capital rose from 35% to 44% during the same period.

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ECONOMICS IN ACTIONThe Factor Distribution of Income in the United States In the United States, payments to labor account for most of the

economy’s total income. In 2010, compensation of employees accounted for most income

earned in the United States—about 68% of the total. Most of the remainder—consisting of earnings paid in the form of

interest, corporate profits, and rent—went to owners of physical capital.

Finally, proprietors’ income—8.8% of the total—went to individual owners of businesses as compensation for the labor and capital expended in their businesses.

What we call compensation of employees is really a return on human capital. A surgeon isn’t just applying the services of a pair of ordinary hands. He is also supplying the result of many years and thousands of dollars invested in training and experience.

Economists believe that human capital has become the most important factor of production in modern economies.

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Factor Distribution of Income in U.S. in 2010

Interest4.8%

Rent3.0%

Corporate profits15.4%

Proprietors’ income8.8%

Compensation of employees

68.0%

All economic decisions are about comparing costs and benefits. For a producer, it could be deciding whether to hire an additional worker.

But what is the marginal benefit of that worker?

We will use the production function, which relates inputs to output to answer that question.

We will assume throughout this chapter that all producers are price-takers—they operate in a perfectly competitive industry.

Marginal Productivity and Factor Demand

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MPL

7 86543210

1917151311975

Marginal product of

labor (bushels

per worker)

7 86543210

100

80

60

40

20

Quantity of wheat

(bushels)(a) Total Product (b) Marginal Product of Labor

TP

Quantity of labor (workers)

The Production Function for George and Martha’s Farm


What is George and Martha’s optimal number of workers? That is, how many workers should they employ to maximize profit?

As we know from earlier chapters, a price-taking firm’s profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price.

Once we determine the optimal quantity of output, we can go back to the production function and find the optimal number of workers.

There is also an alternative approach based on the value of the marginal product.

Value of the Marginal Product

The value of the marginal product of a factor is the extra value of output generated by employing one more unit of that factor.

Value of the marginal product of labor = VMPL = P × MPL

The general rule is that a profit-maximizing, price-taking producer employs each factor of production up to the point at which the value of the marginal product of the last unit of the factor employed is equal to that factor’s price.


To maximize profit, George and Martha will employ workers up to the point at which VMPL = W for the last worker employed.


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The Value of the Marginal Product Curve

Value of the marginal product

value curve,VMPL

A

0 1 2 3 4 8765

$400

300

200

100

Wage rate, VMPL

Profit-maximizing number of workers

Optimal point

Market wage rate


The value of the marginal product curve of a factor shows how the value of the marginal product of that factor depends on the quantity of the factor employed.

What causes factor demand curves to shift?

There are three main causes:1) Changes in prices of goods2) Changes in supply of other factors3) Changes in technology

Shifts of the Factor Demand Curve

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Shifts of the Value of the Marginal Product Curve

A B

20 85

$200

VMPL1VMPL2

AC

0 5

$200

VMPL3

VMPL1

(a) An Increase in the Price of Wheat (b) A Decrease in the Price of Wheat



Wage rate

Wage rate

Market wage rate

We have learned that when the markets for goods and services and the factor markets are perfectly competitive, factors of production will be employed up to the point at which the value of the marginal product is equal to their price.

What does this say about the factor distribution of income?

The Marginal Productivity Theory of Income Distribution

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All Producers Face the Same Wage Rate

50

$200

Wage rate

Market wage rate

7

$200

VMPLwheat

VMPLcorn

VMPL wheat= P x MPL

VMPLcorn= Pcorn x MPL corn

(a) Farmer Jones (b) Farmer Smith


Farmer Smith’sFarmer Jones's

wheat wheat

Wage rate




Each firm will hire labor up to the point at which the value of the marginal product of labor is equal to the equilibrium wage rate.

This means that, in equilibrium, the marginal product of labor will be the same for all employers.

So, the equilibrium (or market) wage rate is equal to the equilibrium value of the marginal product of labor—the additional value produced by the last unit of labor employed in the labor market as a whole.

It doesn’t matter where that additional unit is employed, since the value of the marginal product of labor (VMPL) is the same for all producers.

According to the marginal productivity theory of income distribution, every factor of production is paid its equilibrium value of the marginal product.

Equilibrium in the Labor Market

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Equilibrium in the Labor Market

Market Labor Supply Curve

E

Market Labor Demand Curve

L*

W*

Equilibrium employment

Equilibrium value of

the marginal

product of labor


Rental rate

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Equilibria in the Land and Capital Markets

Quantity

(a) The Market for Land

Quantity

(b) The Market for CapitalRental rate

DLand

R*Capital

SCapital

SLand

DCapital

Q*Land Q*Capital

R*Land

Rental rate

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PitfallsGetting Marginal Productivity Right The most common source of error is to forget that the relevant value of the

marginal product is the equilibrium value, not the value of the marginal products you calculate on the way to equilibrium.

It’s important to be careful about what the marginal productivity theory of income distribution says: All units of a factor get paid the factor’s equilibrium value of the marginal

product—the additional value produced by the last unit of the factor employed.

ECONOMICS IN ACTIONHelp Wanted! The highly skilled senior mechanists of Hamill Manufacturing are well-paid

compared with other workers in manufacturing.

Doesn’t the marginal productivity theory of income distribution imply that the machinists should be paid the revenue they generate?

No. The theory says that they will be paid the value of the marginal product of the last machinist hired, and due to diminishing returns of labor, that value will be lower than the overall average.

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ECONOMICS IN ACTION

Also, a worker’s equilibrium wage rate includes other benefits such as job security, training new hires, etc., so in the end, it does appear that the marginal productivity theory of income distribution holds.

Is the Marginal Productivity Theory of Income Distribution Really True?

There are some issues open to debate about the marginal productivity theory of income distribution:

Do the wage differences really reflect differences in marginal productivity, or is something else going on?

What factors might account for these disparities, and are any of these explanations consistent with the marginal productivity theory of income distribution?

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Median Earnings by Gender and Ethnicity, 2010

Hispanic (male and female)

African American (male and female)

Female (all ethnicities)

$46,815

$30,455$25,261

$30,258

45,000

$50,000

40,000

35,000

30,000

25,000

20,000

15,000

10,000

5,000

0White male

Annual median

earnings, 2010

Compensating differentials are wage differences across jobs that reflect the fact that some jobs are less pleasant than others.

Compensating differentials—as well as differences in the values of the marginal products of workers that arise from differences in talent, job experience, and human capital—account for some wage disparities.

It is clear from the following graph that, regardless of gender or ethnicity, education pays.

Those with a high school diploma earn more than those without one, and those with a college degree earn substantially more than those with only a high school diploma.

Marginal Productivity and Wage Inequality

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Earnings Differentials by Education, Gender, and Ethnicity

White male

$70,000

60,000

50,000

40,000

30,000

20,000

10,000

0

Annual median

earnings, 2010

White female

African-American

male

No HS degree HS degree College degree

African-American

female

Hispanic man

Hispanic female

Market power, in the form of unions or collective action by employers, as well as the efficiency-wage model, also explain how some wage disparities arise.

Unions are organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively.

According to the efficiency-wage model, some employers pay an above equilibrium wage as an incentive for better performance.

Discrimination has historically been a major factor in wage disparities.

Market competition tends to work against discrimination.

Marginal Productivity and Wage Inequality

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FOR INQUIRING MINDSThe Economics of Apartheid Until the peaceful transition to majority rule in 1994, the Republic of

South Africa was controlled by its white minority, which imposed an economic system known as Apartheid. This system overwhelmingly favored white interests over those of

native Africans and other “non-White” groups.

The government instituted “job reservation” laws that ensured that only whites got jobs that paid well.

In 1994, Apartheid was abolished.

Unfortunately, large racial differences in earnings remain. Apartheid created huge disparities in human capital, which will persist for many years to come.

So Does Marginal Productivity Theory Work?

The main conclusion you should draw from this discussion is that the marginal productivity theory of income distribution is not a perfect description of how factor incomes are determined, but that it works pretty well.

It’s important to emphasize that this does not mean that the factor distribution of income is morally justified.

ECONOMICS IN ACTIONMARGINAL PRODUCTIVITY AND THE “1%” In the fall of 2011, many of the U.S. protestors adopted the slogan “We

are the 99%,” emphasizing the fact that the incomes of the top 1% of the population had grown much faster than those of most Americans.

The CBO study on income inequality found that, between 1979 and 2007, the income of the median household, adjusted for inflation, had risen 34.8%—but the average income of the top 1% of households had risen 277.5%.

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ECONOMICS IN ACTION

MARGINAL PRODUCTIVITY AND THE “1%”

Why have the richest Americans been pulling away from the rest? The causes are a source of considerable dispute and continuing

research. One thing is clear, however: this aspect of growing inequality can’t

be explained simply in terms of the growing demand for highly educated labor.

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ECONOMICS IN ACTION

The Supply of Labor

Decisions about labor supply result from decisions about time allocation: how many hours to spend on different activities.

Leisure is time available for purposes other than earning money to buy marketed goods.

In the upcoming graph, the individual labor supply curve shows how the quantity of labor supplied by an individual depends on that individual’s wage rate.

A rise in the wage rate causes both an income and a substitution effect on an individual’s labor supply. The substitution effect of a higher wage rate induces longer work

hours, other things equal. This is countered by the income effect: higher income leads to a

higher demand for leisure, a normal good. If the income effect dominates, a rise in the wage rate can actually

cause the individual labor supply curve to slope the “wrong” way: downward.

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The Individual Labor Supply Curve

Individual labor supply

curve

Individual labor supply

curve

50400

$20

10

400

$20

10

30

(a) The Substitution Effect Dominates

Quantity of leisure (hours)

(b) The Income Effect Dominates

Wage rate Wage rate

Quantity of leisure (hours)

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FOR INQUIRING MINDSWhy You Can’t Find a Cab When Its Raining According to a study published in the Quarterly Journal of Economics,

cab drivers go home early when it’s raining. The hourly wage rate of a taxi driver depends on the weather.

When it’s raining, drivers earn more per hour. It seems that the income effect of this higher wage rate outweighs

the substitution effect. However, if drivers thought in terms of the long run, they would realize

that rainy days and nice days tend to average out, implying that their high incomes on a rainy day don’t really affect their long-run income very much.

The study seems to show clear evidence of a labor supply curve that slopes downward instead of upward, thanks to income effects.

Shifts of the Labor Supply Curve The market labor supply curve is the horizontal sum of the individual

supply curves of all workers in that market.

It shifts for four main reasons: 1) changes in preferences and social norms2) changes in population3) changes in opportunities4) changes in wealth

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GLOBAL COMPARISON: THE OVERWORKED AMERICAN

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ECONOMICS IN ACTION

The Decline of the Summer Job Come summertime, resort towns along the New Jersey shore find

themselves facing a recurring annual problem: a serious shortage of lifeguards. In recent years, a growing number of young Americans have chosen

not to take summer jobs. One explanation for the decline is that more students feel they should

devote their summers to additional study. Another important factor is increasing household affluence, which has

resulted in many teenagers no longer feeling the pressure to contribute to household finances by taking summer jobs. The income effect has led to a reduced labor supply.

Another factor points to the substitution effect: increased competition from immigrants, who are now taking on the teenagers’ jobs, such as delivering pizzas and mowing lawns.

This has led to a decline in wages so teenagers forgo summer work and consume leisure instead.

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Chapter 19 Factor Markets and Distribution of Income