Marginal Productivity Theory of Income Distribution

Marginal Productivity Theory of Marginal Productivity Theory of Income DistributionIncome Distribution


• Perfectly competitive factor markets Perfectly competitive factor markets maximize profit by hiring labor up to the maximize profit by hiring labor up to the point at which its value of the MP = Ppoint at which its value of the MP = P

• What does this say about the labor’s What does this say about the labor’s share in the factor distribution of share in the factor distribution of income?income?


• Labor market is in equilibriumLabor market is in equilibrium

• Number of workers that producers want to Number of workers that producers want to employ is = to the number of workers willing employ is = to the number of workers willing to workto work

• All employers pay the same wage rate and All employers pay the same wage rate and each employer employs labor up to the point each employer employs labor up to the point at which the MP of the last worker hired is at which the MP of the last worker hired is equal to the market wage rateequal to the market wage rate

All Producers Face the Same Wage Rate 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)



Equilibrium in the Labor MarketEquilibrium in the Labor Market

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

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


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


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

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


Market Labor Supply Curve

E

Market Labor Demand Curve

L*

W*

Equilibrium employment

Equilibrium value of the marginal product of labor


Rental rate

Is the Marginal Productivity Theory of Is the Marginal Productivity Theory of Income Distribution Really True?Income Distribution Really True?

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

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

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


• If a farmer is considering whether to rent an If a farmer is considering whether to rent an additional acre of land for the next year, additional acre of land for the next year, what does he consider?what does he consider?– Compare the cost of renting the extra acre of Compare the cost of renting the extra acre of

land to the value of the additional output land to the value of the additional output generated by employing an additional acre (MP generated by employing an additional acre (MP of an acre of land)of an acre of land)

– To maximize profit, the farmer must employ land To maximize profit, the farmer must employ land up to the point at which the value of the MP of up to the point at which the value of the MP of an acre of land is equal to the rental rate per acrean acre of land is equal to the rental rate per acre


• Farmers have to consider rental rate: a unit Farmers have to consider rental rate: a unit of land or capital is employed up to the point of land or capital is employed up to the point at which that unit’s value of the MP = to the at which that unit’s value of the MP = to the rental rate over that time periodrental rate over that time period

• How is this determined, by equilibria in the How is this determined, by equilibria in the land market and the capital market?land market and the capital market?

Equilibria in the Land and Capital Markets Equilibria in the Land and Capital Markets

Quantity

(a) The Market for Land

Quantity

(b) The Market for Capital

Rental rate

DLand

R*Capital

SCapital

SLand

DCapital

Q*Land Q*Capital

R*Land

Rental rate


• Every factor of production is paid its Every factor of production is paid its equilibrium value of the marginal equilibrium value of the marginal productproduct


Who or what Who or what decides that decides that

labor would get labor would get 70.4% of total 70.4% of total U.S. income, U.S. income,

why not 90% or why not 90% or 50%?50%?


• Wage rate earned by ALL workers in the Wage rate earned by ALL workers in the economy is equal to the increase in the value economy is equal to the increase in the value of output generated by the last worker of output generated by the last worker employed in the economy-wide labor employed in the economy-wide labor market.market.

• Is this theory true?Is this theory true?

Median Earnings by Gender and Ethnicity, 2006Median Earnings by Gender and Ethnicity, 2006

Hispanic (male and female)

African American (male and female)

Female (all ethnicities)

$45,722

$27,337$24,893

$29,166

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, 2006

Earnings Differentials by Education, Gender, and EthnicityEarnings 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, 2006

White female

African-American male

No HS degree HS degree College degree

African-American female

Hispanic man

Hispanic female

Labor, Wages, and EarningsLabor, Wages, and Earnings• Labor means:Labor means:– Blue-and white-collar workersBlue-and white-collar workers– Professional peopleProfessional people– Owners of small businessesOwners of small businesses

• Wages is the price employers pay for laborWages is the price employers pay for labor– Wage rateWage rate– Nominal wageNominal wage– Real wageReal wage

• Real wage depends on your nominal wage and Real wage depends on your nominal wage and the prices of the goods and services your the prices of the goods and services your purchasepurchase

Role of ProductivityRole of Productivity

• The greater the productivity of labor, the The greater the productivity of labor, the greater is the demand for itgreater is the demand for it

• If the total supply of labor is fixed, then the If the total supply of labor is fixed, then the stronger demand for labor, the higher is the stronger demand for labor, the higher is the average level of real wagesaverage level of real wages


• High productivity is due to:High productivity is due to:–Plentiful capitalPlentiful capital–Access to abundant natural resourcesAccess to abundant natural resources–Advanced technologyAdvanced technology–Labor qualityLabor quality–Other factorsOther factors

Size of the Size of the labor labor force, force, 20082008

Average Average annual annual growth growth rates rates

for the for the labor labor force, force,

1998-20081998-2008

Average Average annual annual

growth rates growth rates for full-time for full-time

and part-time and part-time employment, employment,

1998-20081998-2008

Persons Persons unemployed unemployed

one year one year or longer or longer

as a percent of as a percent of total total

unemployment, unemployment, 20082008

The Supply of LaborThe Supply of Labor

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

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


• A rise in the wage rate causes both an income and a A rise in the wage rate causes both an income and a substitution effect on an individual’s labor supply. substitution effect on an individual’s labor supply.

– The substitution effect of a higher wage rate induces The substitution effect of a higher wage rate induces longer work hours, other things equal. longer work hours, other things equal.

– This is countered by the income effect: higher income This is countered by the income effect: higher income leads to a higher demand for leisure, a normal good. leads to a higher demand for leisure, a normal good.

• If the income effect dominates, a rise in the wage rate If the income effect dominates, a rise in the wage rate can actually cause the individual labor supply curve to can actually cause the individual labor supply curve to slope the “wrong” way: downward.slope the “wrong” way: downward.

The Individual Labor Supply CurveThe 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)


• The market labor supply curve is the The market labor supply curve is the horizontal sum of the individual supply curves horizontal sum of the individual supply curves of all workers in that market. of all workers in that market.

• It shifts for four main reasons: It shifts for four main reasons: –changes in preferences and social normschanges in preferences and social norms–changes in populationchanges in population–changes in opportunitieschanges in opportunities–changes in wealthchanges in wealth

Marginal Productivity Theory of Marginal Productivity Theory of Income Distribution NotesIncome Distribution Notes


• What does this say about the labor’s What does this say about the labor’s share in the factor distribution of share in the factor distribution of income?income?


• Labor market is in ______________Labor market is in ______________

• Number of workers that producers want to Number of workers that producers want to employ is = to the number of workers willing employ is = to the number of workers willing to workto work

• All employers pay the same wage rate and All employers pay the same wage rate and each employer employs labor up to the point each employer employs labor up to the point at which the MP of the last worker hired is at which the MP of the last worker hired is equal to the market wage rateequal to the market wage rate

All Producers Face the Same Wage Rate 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 Each firm will hire labor up to the point at which the value of the marginal at which the value of the marginal product of labor is equal to the product of labor is equal to the equilibrium wage rate. equilibrium wage rate.

This means that, in equilibrium, This means that, in equilibrium,


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


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

According to the marginal productivity theory According to the marginal productivity theory of income distribution, of income distribution,


Market Labor Supply Curve

E

Market Labor Demand Curve

L*

W*


Rental rate


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

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

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


• If a farmer is considering whether to rent an If a farmer is considering whether to rent an additional acre of land for the next year, additional acre of land for the next year, what does he consider?what does he consider?– Compare the cost of renting the extra acre of Compare the cost of renting the extra acre of

land to the value of the additional output land to the value of the additional output generated by employing an additional acre (MP generated by employing an additional acre (MP of an acre of land)of an acre of land)

– To maximize profit, the farmer must employ land To maximize profit, the farmer must employ land up to the point at which the value of the MP of up to the point at which the value of the MP of an acre of land is equal to the rental rate per acrean acre of land is equal to the rental rate per acre


• Farmers have to consider rental rate:Farmers have to consider rental rate:

• How is this determined, by equilibria in the How is this determined, by equilibria in the land market and the capital market?land market and the capital market?

Equilibria in the Land and Capital Markets Equilibria in the Land and Capital Markets

Quantity

(a) The Market for Land

Quantity

(b) The Market for Capital

Rental rate

DLand

R*Capital

SCapital

SLand

DCapital

Q*Land Q*Capital

R*Land

Rental rate


• Every factor of production is paid its Every factor of production is paid its equilibrium value of the marginal equilibrium value of the marginal productproduct


Who or what Who or what decides that decides that

labor would get labor would get 70.4% of total 70.4% of total U.S. income, U.S. income,

why not 90% or why not 90% or 50%?50%?


• Wage rate earned by ALL workers in the Wage rate earned by ALL workers in the economy is equal to the increase in the value economy is equal to the increase in the value of output generated by the last worker of output generated by the last worker employed in the economy-wide labor employed in the economy-wide labor market.market.

• Is this theory true?Is this theory true?

Labor, Wages, and EarningsLabor, Wages, and Earnings

• Labor means:Labor means:

• Wages is the price employers pay for laborWages is the price employers pay for labor

• Real wage depends on your nominal wage and the Real wage depends on your nominal wage and the prices of the goods and services your purchaseprices of the goods and services your purchase


• If the total supply of labor is fixed, then the If the total supply of labor is fixed, then the stronger demand for labor, the higher is the stronger demand for labor, the higher is the average level of real wagesaverage level of real wages


• High productivity is due to:High productivity is due to:


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

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


• A rise in the wage rate causes both an income and a A rise in the wage rate causes both an income and a substitution effect on an individual’s labor supply. substitution effect on an individual’s labor supply.

– _____________________of a higher wage rate induces _____________________of a higher wage rate induces longer work hours, other things equal. longer work hours, other things equal.

– This is countered by the ______________ : higher income This is countered by the ______________ : higher income leads to a higher demand for leisure, a normal good. leads to a higher demand for leisure, a normal good.

• If the income effect dominates, a rise in the wage rate If the income effect dominates, a rise in the wage rate can actually cause the individual labor supply curve to can actually cause the individual labor supply curve to slope the “wrong” way: downward.slope the “wrong” way: downward.


• The market labor supply curve is the The market labor supply curve is the horizontal sum of the individual supply curves horizontal sum of the individual supply curves of all workers in that market. of all workers in that market.

• It shifts for four main reasons: It shifts for four main reasons: –changes in __________________________changes in __________________________–changes in _____________________changes in _____________________–changes in _____________________changes in _____________________–changes in _____________________changes in _____________________

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Marginal Productivity Theory of Income Distribution

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