chapter 19 factor markets and distribution of income
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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
1
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
3
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
5
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.
6
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
9
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
Quantity of labor (workers)
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.
Value of the Marginal Product
13
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
Quantity of labor (workers)
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
15
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
Quantity of labor (workers)
Quantity of labor (workers)
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
17
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
Profit-maximizing number of workers
Farmer Smith’sFarmer Jones's
wheat wheat
Wage rate
Quantity of labor (workers)
Quantity of labor (workers)
Profit-maximizing number of workers
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
19
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
Quantity of labor (workers)
Rental rate
20
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
21
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.
22
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?
23
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
25
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
27
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%.
29
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.
30
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.
32
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)
33
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
35
GLOBAL COMPARISON: THE OVERWORKED AMERICAN
36
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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