Transcript 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.

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 income
2. How the demand for factors leads to the marginal
productivity theory of income distribution
3. An understanding of the sources of wage
disparities and the role of discrimination
4. The way in which a worker’s decision about time
allocation gives rise to labor supply
1
The Economy’s Factors of Production
 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 Production
Economists divide factors of production into four principal classes:
1) Land: a resource provided by nature
2) Labor: the work done by human beings
3) Physical capital: which consists of manufactured resources such as
buildings, equipment, tools, and machines
4) Human capital: the improvement in labor created by education and
knowledge that is embodied in the workforce
Pitfalls
What 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.
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The Allocation of Resources
 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.
FOR INQUIRING MINDS
The 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 ACTION
The 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
Interest
4.8%
Corporate profits
15.4%
Compensation of employees
68.0%
Rent
3.0%
Proprietors’ income
8.8%
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Marginal Productivity and Factor Demand
 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 pricetakers—they operate in a perfectly competitive industry.
The Production Function for George and Martha’s Farm
Quantity of
wheat
(bushels)
Marginal
product of
labor
(bushels
per worker)
(a) Total Product
TP
100
19
17
15
13
11
9
7
5
80
60
40
20
0
(b) Marginal Product of Labor
1
2
3
4 5 6
7 8
Quantity of labor (workers)
0
MPL
1
2
3
4
5
6
7
8
Quantity of labor (workers)
9
Value of the Marginal Product
 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.
Value of the Marginal Product
To maximize profit, George and Martha will employ workers up to the point at
which VMPL = W for the last worker employed.
The Value of the Marginal Product Curve
Wage rate,
VMPL
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.
Optimal
point
$400
300
A
Market 200
wage rate
Value of the
marginal product
value curve,
VMPL
100
0
1
2
3
4
5
6
Profit-maximizing
number of workers
7
8
Quantity of labor
(workers)
13
Shifts of the Factor Demand Curve
 What causes factor demand curves to shift?
There are three main causes:
1) Changes in prices of goods
2) Changes in supply of other factors
3) Changes in technology
Shifts of the Value of the Marginal Product Curve
(a) An Increase in the Price of Wheat
Wage
rate
(b) A Decrease in the Price of Wheat
Wage
rate
Market
wage $200
rate
A
C
B
A
$200
VMPL
VMPL
VMPL
2
VMPL
1
0
5
8
0
Quantity of labor
(workers)
2
1
3
5
Quantity of labor
(workers)
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The Marginal Productivity Theory of Income Distribution
 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?
All Producers Face the Same Wage Rate
(a) Farmer Jones
(b) Farmer Smith
Wage rate
Wage rate
Farmer Smith’s VMPLcorn
= Pcorn x MPL corn
Farmer Jones's VMPLwheat
x MPL
=P
wheat
wheat
Market
wage $200
rate
$200
VMPL
corn
VMPL
wheat
0
5
Profit-maximizing
number of workers
Quantity of labor
(workers)
7
Quantity of labor
(workers)
Profit-maximizing
number of workers
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Equilibrium in the Labor Market
 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
Rental rate
Market Labor
Supply Curve
Equilibrium
value of the
marginal
product of
labor
E
W*
Market Labor
Demand Curve
L*
Quantity of labor (workers)
Equilibrium
employment
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Equilibria in the Land and Capital Markets
Rental
rate
Rental
(a) The Market for Land
rate
(b) The Market for Capital
SLand
SCapital
R*
Land
R* Capital
D Capital
D Land
Q* Land
Quantity
Q* Capital
Quantity
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Pitfalls
Getting 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 ACTION
Help 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
Annual median
earnings, 2010
$50,000
$46,815
45,000
40,000
35,000
30,000
$30,455
$30,258
$25,261
25,000
20,000
15,000
10,000
5,000
0
White
male
Female (all
ethnicities)
African
American
(male and
female)
Hispanic
(male and
female)
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Marginal Productivity and Wage Inequality
 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.
Earnings Differentials by Education, Gender, and Ethnicity
Annual median
earnings, 2010
No HS degree
$70,000
HS degree
College degree
60,000
50,000
40,000
30,000
20,000
10,000
0
White
male
White
female
AfricanAmerican
male
AfricanAmerican
female
Hispanic
man
Hispanic
female
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Marginal Productivity and Wage Inequality
 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.
FOR INQUIRING MINDS
The 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.
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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 ACTION
MARGINAL 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%.
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
30
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.
The Individual Labor Supply Curve
(a) The Substitution Effect Dominates
Wage rate
(b) The Income Effect Dominates
Wage rate
Individual labor
supply curve
$20
$20
10
10
Individual
labor supply
curve
0
40
50
Quantity of leisure
(hours)
0
30
40
Quantity of leisure
(hours)
32
FOR INQUIRING MINDS
Why 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.
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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 norms
2) changes in population
3) changes in opportunities
4) changes in wealth
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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