Marginal Productivity Theory of Income Distribution

1. Marginal Productivity Theory of Income Distribution

2. Marginal Productivity Theory of Income Distribution • Perfectly competitive factor markets maximize profit by hiring labor up to the point at which its value of the MP = P • What does this say about the labor’s share in the factor distribution of income?

3. Marginal Productivity Theory of Income Distribution • Labor market is in equilibrium • Number of workers that producers want to employ is = to the number of workers willing to work • All employers pay the same wage rate and each employer employs labor up to the point at which the MP of the last worker hired is equal to the market wage rate

4. All Producers Face the Same Wage Rate (a) Farmer Jones (b) Farmer Smith Wage rate Wage rate Farmer Jones's Farmer Smith’s VMPL VMPL corn wheat x x MPL MPL = P = P corn corn wheat wheat Market wage rate $200 $200 VMPL corn VMPL wheat 0 5 7 Quantity of labor (workers) Quantity of labor (workers) Profit-maximizing number of workers Profit-maximizing number of workers

5. 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.

6. Equilibrium in the Labor Market • 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.

7. Equilibrium in the Labor Market • It doesn’t matter where that additional unit is employed, since the value of the marginal product of labor (MPL) 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.

8. 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

9. 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?

10. Is the Marginal Productivity Theory of Income Distribution Really True? • If a farmer is considering whether to rent an additional acre of land for the next year, what does he consider? • Compare the cost of renting the extra acre of land to the value of the additional output generated by employing an additional acre (MP of an acre of land) • To maximize profit, the farmer must employ land up to the point at which the value of the MP of an acre of land is equal to the rental rate per acre

11. Is the Marginal Productivity Theory of Income Distribution Really True? • Farmers have to consider rental rate: a unit of land or capital is employed up to the point at which that unit’s value of the MP = to the rental rate over that time period • How is this determined, by equilibria in the land market and the capital market?

12. Equilibria in the Land and Capital Markets (b) The Market for Capital (a) The Market for Land Rental rate Rental rate S Land R* S Land Capital R* Capital D D Capital Land Q* Q* Quantity Quantity Capital Land

13. Marginal Productivity Theory of Income Distribution • Every factor of production is paid its equilibrium value of the marginal product

14. Marginal Productivity Theory of Income Distribution Who or what decides that labor would get 70.4% of total U.S. income, why not 90% or 50%?

15. Marginal Productivity Theory of Income Distribution • Wage rate earned by ALL workers in the economy is equal to the increase in the value of output generated by the last worker employed in the economy-wide labor market. • Is this theory true?

16. Median Earnings by Gender and Ethnicity, 2006 Annual median earnings, 2006 $50,000 $45,722 45,000 40,000 35,000 $29,166 30,000 $27,337 $24,893 25,000 20,000 15,000 10,000 5,000 0 Female (all ethnicities) African American (male and female) Hispanic (male and female) White male

17. Earnings Differentials by Education, Gender, and Ethnicity Annual median earnings, 2006 No HS degree HS degree College degree $70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 White male White female African-American male African-American female Hispanic female Hispanic man

18. Labor, Wages, and Earnings • Labor means: • Blue-and white-collar workers • Professional people • Owners of small businesses • Wages is the price employers pay for labor • Wage rate • Nominal wage • Real wage • Real wage depends on your nominal wage and the prices of the goods and services your purchase

20. Role of Productivity • The greater the productivity of labor, the greater is the demand for it • If the total supply of labor is fixed, then the stronger demand for labor, the higher is the average level of real wages

21. Role of Productivity • High productivity is due to: • Plentiful capital • Access to abundant natural resources • Advanced technology • Labor quality • Other factors

22. Size of the labor force, 2008

23. Average annual growth rates for the labor force, 1998-2008

24. Average annual growth rates for full-time and part-time employment, 1998-2008

25. Persons unemployed one year or longer as a percent of total unemployment, 2008

26. 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.

27. The Supply of Labor • 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.

29. The Individual Labor Supply Curve (b) The Income Effect Dominates (a) The Substitution Effect Dominates Wage rate Wage rate Individual labor supply curve $20 $20 10 10 Individual labor supply curve 0 40 50 0 30 40 Quantity of leisure (hours) Quantity of leisure (hours)

30. The Supply of Labor • 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: • changes in preferences and social norms • changes in population • changes in opportunities • changes in wealth

31. Marginal Productivity Theory of Income Distribution Notes

32. Marginal Productivity Theory of Income Distribution • What does this say about the labor’s share in the factor distribution of income?

33. Marginal Productivity Theory of Income Distribution • Labor market is in ______________ • Number of workers that producers want to employ is = to the number of workers willing to work • All employers pay the same wage rate and each employer employs labor up to the point at which the MP of the last worker hired is equal to the market wage rate

34. All Producers Face the Same Wage Rate (a) Farmer Jones (b) Farmer Smith Wage rate Wage rate Farmer Jones's Farmer Smith’s VMPL VMPL corn wheat x x MPL MPL = P = P corn corn wheat wheat Market wage rate $200 $200 VMPL corn VMPL wheat 0 5 7 Quantity of labor (workers) Quantity of labor (workers) Profit-maximizing number of workers Profit-maximizing number of workers

35. 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,

36. Equilibrium in the Labor Market • 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.

37. Equilibrium in the Labor Market • It doesn’t matter where that additional unit is employed, since the value of the marginal product of labor (MPL) is the same for all producers. • According to the marginal productivity theory of income distribution,

38. Equilibrium in the Labor Market Rental rate Market Labor Supply Curve E W* Market Labor Demand Curve L* Quantity of labor (workers)

39. 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?

40. Is the Marginal Productivity Theory of Income Distribution Really True? • If a farmer is considering whether to rent an additional acre of land for the next year, what does he consider? • Compare the cost of renting the extra acre of land to the value of the additional output generated by employing an additional acre (MP of an acre of land) • To maximize profit, the farmer must employ land up to the point at which the value of the MP of an acre of land is equal to the rental rate per acre

41. Is the Marginal Productivity Theory of Income Distribution Really True? • Farmers have to consider rental rate: • How is this determined, by equilibria in the land market and the capital market?

42. Equilibria in the Land and Capital Markets (b) The Market for Capital (a) The Market for Land Rental rate Rental rate S Land R* S Land Capital R* Capital D D Capital Land Q* Q* Quantity Quantity Capital Land

43. Marginal Productivity Theory of Income Distribution • Every factor of production is paid its equilibrium value of the marginal product

44. Marginal Productivity Theory of Income Distribution Who or what decides that labor would get 70.4% of total U.S. income, why not 90% or 50%?

45. Marginal Productivity Theory of Income Distribution • Wage rate earned by ALL workers in the economy is equal to the increase in the value of output generated by the last worker employed in the economy-wide labor market. • Is this theory true?

46. Labor, Wages, and Earnings • Labor means: • Wages is the price employers pay for labor • Real wage depends on your nominal wage and the prices of the goods and services your purchase

47. Role of Productivity • If the total supply of labor is fixed, then the stronger demand for labor, the higher is the average level of real wages

48. Role of Productivity • High productivity is due to:

49. 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.

50. The Supply of Labor • A rise in the wage rate causes both an income and a substitution effect on an individual’s labor supply. • _____________________of a higher wage rate induces longer work hours, other things equal. • This is countered by the ______________ : 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.