Chapter 19
Factor Markets and Distribution of Income
WHAT YOU
WILL LEARN
IN THIS
CHAPTER
• 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
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
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.
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%
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
price-takers—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)
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
• 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.
The Value of the Marginal Product Curve
Wage rate,
VMPL
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)
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)
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
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.
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.
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*
Equilibrium
employment
Quantity of labor (workers)
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
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?
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)
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.
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.
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
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.
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.
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.
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.
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.
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)
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
Summary
1. There are markets for factors of production, including
labor, land, and both physical capital and human capital.
These markets determine the factor distribution of
income.
2. Profit-maximizing price-taking producers will employ a
factor up to the point at which its price is equal to its value
of the marginal product—the marginal product of the
factor multiplied by the price of the output it produces.
The value of the marginal product curve is therefore the
individual price-taking producer’s demand curve for a
factor.
Summary
3. The market demand curve for labor is the horizontal sum of
the individual demand curves of producers in that market.
It shifts for three main reasons: changes in output price,
changes in the supply of other factors, and technological
changes.
Summary
4. When a competitive labor market is in equilibrium, the
market wage is equal to the equilibrium value of the
marginal product of labor, the additional value produced
by the last worker hired in the labor market as a whole.
This insight leads to the marginal productivity theory of
income distribution, according to which each factor is paid
the value of the marginal product of the last unit of that
factor employed in the factor market as a whole.
Summary
5. Large disparities in wages raise questions about the validity
of the marginal productivity theory of income distribution.
Many disparities can be explained by compensating
differentials and by differences in talent, job experience,
and human capital across workers.
Market interference in the form of unions and collective
action by employers also creates wage disparities.
The efficiency-wage model, which arises from a type of
market failure, shows how wage disparities can result from
employers’ attempts to increase worker performance.
Summary
6. Labor supply is the result of decisions about time
allocation, where each worker faces a trade-off between
leisure and work.
An increase in the hourly wage rate tends to increase work
hours via the substitution effect but to reduce work hours
via the income effect.
If the net result is that a worker increases the quantity of
labor supplied in response to a higher wage, the individual
labor supply curve slopes upward.
Summary
7. The market labor supply curve is the horizontal sum of the
individual labor 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, and changes in wealth.
Key Terms
•
•
•
•
•
•
•
•
•
Physical capital
•
Human capital
•
Factor distribution of income •
Value of the marginal
•
product
•
Value of the marginal
product curve
Equilibrium value of the
marginal product
Rental rate
Marginal productivity theory
of income distribution
Compensating differentials
Unions
Efficiency-wage model
Time allocation
Leisure
Individual labor supply curve