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WHAT YOU WILL LEARN IN THIS
CHAPTER
chapter:
20
>> Factor Markets and
Distribution of Income
Krugman/Wells
©2009  Worth Publishers
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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
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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?
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The Factors of Production
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
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PITFALLS
What is a Factor, Anyway?




Imagine a business that produces shirts. The business will
make use of workers and machines—that is, of 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.
The key distinction is that a factor of production earns
income from the selling of its services over and over again
but input cannot.
A worker and a machine earn income over time, but input
like electricity or cloth are used up in the production process.
Once exhausted, they cannot be a source of future income
for the owner.
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The Allocation of 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
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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 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.
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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, describes a world in which the
leaders of society are land-owning aristocrats.
Dickens’ novels describe a world in which businessmen, especially
factory owners, are in control.
This shift reflects a dramatic transformation in the factor
distribution of income. The Industrial Revolution, which took
place between the late eighteenth and the mid-nineteenth
centuries, 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
time period.
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►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 2007, compensation of employees accounted for most
income earned in the United States—about 70% of the total.
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—9.3% of the total—went to
individual owners of businesses as compensation for the labor
and capital expended in their businesses.
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►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.
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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%
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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.
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The Production Function for George and Martha’s Farm
(a) Total Product
Quantity of
wheat
(bushels)
(b) Marginal Product of Labor
Marginal
product of
labor
(bushels
per worker)
100
TP
19
17
15
13
11
9
7
5
80
60
40
20
0
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)
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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…
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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, pricetaking 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.
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Value of the Marginal Product
To maximize profit, George and Martha will employ workers up to the point at
which, for the last worker employed, VMPL = W.
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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.
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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
0
VMPL
1
2
3
4
5
6
Profit-maximizing
number of workers
7
8
Quantity of labor
(workers)
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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
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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)
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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?
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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.
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►ECONOMICS IN ACTION
Help Wanted!
 The highly-skilled senior mechanists of Hamill Manufacturing
are well-paid compared to other workers in manufacturing.
 Doesn’t the marginal productivity theory of income
distribution imply that the machinists should be paid the
revenue they generate?
 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.
 Secondly, 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 does hold.
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All Producers Face the Same Wage Rate
Wage rate
(a) Farmer Jones
Wage rate
Farmer Smith’s VMPLcorn
= Pcorn x MPL corn
Farmer Jones's VMPLwheat
x MPL
=P
wheat
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
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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.
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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.
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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
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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?
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Equilibria in the Land and Capital Markets
(b) The Market for Capital
(a) The Market for Land
Rental
rate
Rental
rate
SLand
R* Land
SCapital
R* Capital
D Capital
D Land
Q* Land
Quantity
Q* Capital
Quantity
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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)
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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.
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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.
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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
AfricanAmerican
male
AfricanAmerican
female
Hispanic
man
Hispanic
female
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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.
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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.
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►ECONOMICS IN ACTION
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. The
government also created jobs for whites in government
industries.
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.
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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.
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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.
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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.
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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
Quantity of leisure (hours)
0
30
40
Quantity of leisure (hours)
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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.
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.
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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
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►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.
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.
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.
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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.
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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.
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.
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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 efficiencywage model, which arises from a type of market failure,
shows how wage disparities can result from employers’
attempts to increase worker performance.
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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.
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.
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The End of Chapter 20
Coming attraction:
Chapter 21:
Uncertainty, Risk and
Private Information
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