chapter:

1. chapter: 20 >> Factor Markets and Distribution of Income Krugman/Wells Economics ©2009  Worth Publishers

2. 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 • How the demand for factors leads to the marginal productivity theory of income distribution • An understanding of the sources of wage disparities and the role of discrimination • The way in which a worker’s decision about time allocation gives rise to labor supply

3. 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 Economy’s Factors of Production

4. Economists divide factors of production into four principal classes: Land: a resource provided by nature Labor: the work done by human beings Physical capital: which consists of manufactured resources such as buildings, equipment, tools and machines Human capital: the improvement in labor created by education and knowledge that is embodied in the workforce The Factors of Production

5. Why Factor Prices Matter: The Allocationof Resources Factor prices play a key role in the allocation of resources among producers due to 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

6. 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 percent—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. Factor Incomes and the Distribution of Income

7. Factor Distribution of Income in U.S. in 2007 Interest 5.4% Corporate profits 14.3% Compensation of employees 70.4% Rent 0.6% Proprietors’ income 9.3%

8. 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. The Production Function for George and Martha’s Farm (a) Total Product (b) Marginal Product of Labor Quantity of wheat (bushels) Marginal product of labor (bushels per worker) 100 TP 19 17 80 15 13 60 11 9 40 7 5 20 MPL 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 Quantity of labor (workers) Quantity of labor (workers)

10. 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. Value of the Marginal Product

11. 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.

12. Value of the Marginal Product

13. The Value of the Marginal Product Curve 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.

14. The Value of the Marginal Product Curve Wage rate, VMPL Optimal point $400 300 A Market wage rate 200 Value of the marginal product value curve 100 VMPL 0 1 2 3 4 5 6 7 8 Quantity of labor (workers) Profit-maximizing number of workers

15. Shifts of the Factor Demand Curve • What causes factor demand curves to shift? • There are three main causes: • Changes in prices of goods • Changes in supply of other factors • Changes in technology

16. Shifts of the Value of the Marginal Product Curve (a) An Increase in the Price of Wheat (b) A Decrease in the Price of Wheat Wage rate Wage rate C A A B Market wage rate $200 $200 VMPL 1 VMPL VMPL 3 2 VMPL 1 0 5 8 0 2 5 Quantity of labor (workers) Quantity of labor (workers)

17. 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?

18. 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

19. 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.

20. Equilibrium in the Labor Market • 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.

21. 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

22. 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. 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

24. 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

25. 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.

26. Marginal Productivity and Wage Inequality • 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.

27. 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

28. 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.

29. Marginal Productivity and Wage Inequality • 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.

30. 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.

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

32. 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.

33. 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)

34. 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: changes in preferences and social norms changes in population changes in opportunities changes in wealth

35. There aremarkets for factors of production, including labor, land,and both physical capital and human capital.Thesemarkets determine the factor distribution of income. • Profit-maximizing price-taking producers will employ afactor up to the point at which its price is equal to itsvalue of the marginal product—the marginal productof the factor multiplied by the price of the output it produces.The value of the marginal product curve istherefore the individual price-taking producer’s demandcurve for a factor.

36. The market demand curve for labor is the horizontal sumof the individual demand curves of producers in thatmarket. It shifts for three main reasons: changes in outputprice, changes in the supply of other factors, andtechnological changes. • When a competitive labor market is in equilibrium, themarket wage is equal to the equilibrium value of themarginal product of labor, the additional value producedby the last worker hired in the labor market as awhole. This insightleads to the marginal productivity theory of incomedistribution,according to which each factor is paid thevalue of the marginal product of the last unit of that factoremployed in the factor market as a whole.

37. Large disparities in wages raise questions about thevalidity of the marginal productivity theory of incomedistribution. Many disparities can be explained bycompensating differentials and by differences intalent, job experience, and human capital across workers.Market interference in the form of unions and collectiveaction by employers also creates wage disparities. Theefficiency-wage model, which arises from a type ofmarket failure, shows how wage disparities can resultfrom employers’ attempts to increase worker performance.

38. Labor supply is the result of decisions about timeallocation,where each worker faces a trade-off betweenleisure and work. An increase in the hourly wage ratetends to increase work hours via the substitution effectbut to reduce work hours via the income effect. If the netresult is that a worker increases the quantity of laborsupplied in response to a higher wage, the individuallabor supply curve slopes upward. • The market labor supply curve is the horizontal sum of theindividual labor supply curves of all workers in that market.It shifts for four main reasons: changes in preferencesand social norms, changes in population, changes inopportunities, and changes in wealth.