Marginal Productivity Theory of Income Distribution Marginal Productivity

Marginal Productivity Theory of Income Distribution

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?

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

All Producers Face the Same Wage Rate Wage rate (a) Farmer Jones Wage rate Farmer Jones's VMPLwheat x MPL =P wheat Farmer Smith’s VMPLcorn = Pcorn x MPL corn wheat Market wage $200 rate (b) Farmer Smith $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.

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.

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.

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)

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?

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

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?

Equilibria in the Land Capital Markets (b) The Market for Capital (a) The Market for Land Rental rate SLand R* Land SCapital R* Capital D Land Q* Land Quantity Q* Capital Quantity

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

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%?

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?

Median Earnings by Gender and Ethnicity, 2006 Annual median earnings, 2006 $50, 000 $45, 722 45, 000 40, 000 35, 000 30, 000 $27, 337 $29, 166 $24, 893 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)

Earnings Differentials by Education, Gender, and Ethnicity Annual median earnings, 2006 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 African. American female Hispanic man Hispanic female

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

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

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

Size of the labor force, 2008

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

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

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

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.

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

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

Marginal Productivity Theory of Income Distribution Notes

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

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

All Producers Face the Same Wage Rate Wage rate (a) Farmer Jones Wage rate Farmer Jones's VMPLwheat x MPL =P wheat Farmer Smith’s VMPLcorn = Pcorn x MPL corn wheat Market wage $200 rate (b) Farmer Smith $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,

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.

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,

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

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?

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

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?

Equilibria in the Land Capital Markets (b) The Market for Capital (a) The Market for Land Rental rate SLand R* Land SCapital R* Capital D Land Q* Land Quantity Q* Capital Quantity

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

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%?

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?

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

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

Role of Productivity • High productivity is due to:

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.

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.

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 _____________________ – changes in ___________