THIRD EDITION
ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells
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
Pitfalls
What 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.
Pitfalls
What Is a Factor, Anyway?
• 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.
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.
FOR INQUIRING MINDS
The 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.
FOR INQUIRING MINDS
The Factor Distribution of Income and Social Change in the
Industrial Revolution
• 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.
ECONOMICS IN ACTION
The 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.
ECONOMICS IN ACTION
The Factor Distribution of Income in the United States
•
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.
ECONOMICS IN ACTION
The Factor Distribution of Income in the United States
•
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.
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
Pitfalls
Getting 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 ACTION
Help 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?
ECONOMICS IN ACTION
Help Wanted!

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.

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?
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.
FOR INQUIRING MINDS
The 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.
FOR INQUIRING MINDS
The Economics of Apartheid
•
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 ACTION
MARGINAL 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%.
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.
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.
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)
FOR INQUIRING MINDS
Why 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.
FOR INQUIRING MINDS
Why You Can’t Find a Cab When Its Raining
• 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 norms
2) changes in population
3) changes in opportunities
4) changes in wealth
GLOBAL COMPARISON: THE OVERWORKED AMERICAN
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.
ECONOMICS IN ACTION
The Decline of the Summer Job
•
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.
ECONOMICS IN ACTION
The Decline of the Summer Job
•
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.
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