Theories of Income Distribution Micro: Econ: 37 73 Module Theories of Income Distribution KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: Labor market applications of the marginal productivity theory of income distribution. Sources of wage disparities, including the role of discrimination. The purpose of this module is to shed light on what the marginal productivity theory of income distribution says, or doesn’t say, about why some workers earn higher wages than other workers.

The Marginal productivity Theory of Income Distribution According to MP theory, the division of income among factors of production is determined by MP Can we use MP theory to explain why some workers are paid more than others? According to the marginal productivity theory of income distribution, the division of income among the economy’s factors of production is determined by each factor’s marginal productivity at the market equilibrium.   But what about the distribution of income for different types of labor within the broader labor market? Can we use this theory to explain why some workers are paid more than others?

Marginal Productivity and Wage Inequality Compensating differentials Differences in talent Human capital When we look at two different people who are paid differently, we see wage inequality. Much of this wage inequality can be attributed to factors that are consistent with the marginal productivity theory of income distribution.   Three possible explanations. 1. Compensating Differentials A police officer in Chicago (population 2.85 million) earns a higher salary than a police officer in Hanover, Indiana (population 3,790). They perform essentially the same tasks and have similar training, but the officer in Chicago is compensated for a more dangerous environment. This is a compensating differential. Note: Some workers, if they work a late-night shift (the graveyard shift) will receive a higher wage than a worker who works the normal daytime shift. This is another form of compensating differential. 2. Differences in Talent There are plenty of good examples of how a more talented worker does (and should) earn more than a less talented person in the same occupation. A very skillful chef will earn more than a chef who isn’t quite as talented. A future Hall of Fame baseball pitcher will earn more than another pitcher who is barely holding onto his roster spot. A great novelist sells more books, and earns more money, than a less skilled writer. 3. Differences in Human Capital Human capital refers to the accumulated education, experience and training possessed by an individual. Some individuals receive higher wages because they have acquired more human capital than some of their co-workers. More human capital is usually associated with more productivity and thus a higher wage. For example, a high school teacher with a Masters in Education will receive a higher salary than a colleague who has not received that degree. These three explanations for wage inequality are consistent with the marginal productivity theory of income distribution, but even if we account for them, there are still unexplained differences between the wages of two individuals whom we might expect to receive identical wages.

Other Sources of Wage inequality Market Power Efficiency Wages Discrimination -Market Power A union is an organization that represents a group of workers. The union collectively bargains with employers on behalf of the membership. This means that the union and the employers will negotiate wages, benefits, and working conditions and, once a contract is agreed upon, the contract holds both parties to the terms of the contract.   Union membership in the U.S. has declined since the 1960s and today about 7% of private-sector employees are represented by unions. Declining membership has meant that the ability to greatly increase wages (like Ricardo’s) above the non-union level has weakened. -Efficiency Wages An efficiency wage is when an employer pays a wage above the competitive level as an incentive for workers to be more productive and to reduce employee turnover. This can emerge when it’s not very easy to directly observe the worker’s performance and it is costly for an employer to retrain new workers. Paying a higher wage makes sense for the employer because the worker doesn’t want to quit and lose this high-wage job and this reduces the constant need to spend money training new employees. An efficiency wage works like a price floor and creates a surplus of workers who wish to have an efficiency-wage job. Because there is a surplus of others out there, those fortunate enough to have the job will work hard not to lose it. Thus there is a wage disparity between those who have the efficiency-wage job, and those who, with the same skills and credentials, wish they had it. -Discrimination Basic supply and demand theories predict that the labor market itself, not government regulation or lawsuits, will fix this form of discrimination. Though the competitive market should eliminate wage discrimination, it still exists in labor markets around the world. This would tend to cast doubt on the assumption of competitive labor markets. An alternative explanation for persistent wage discrimination is that minorities do not have equal access to the education and training that provide desirable characteristics to the labor market. Or that there exists many employers in the majority group that simply have such a strong dislike of the minority groups that they will continue to pay higher wages to workers that they like, even if it is not the profit-maximizing decision to do so.

Is the MP Theory Really True? Objections to MP theory Evidence Fairness Does MP Theory work? There are two main objections to the theory. Suppose we observe two groups of workers, group X and Y, and they appear to have very similar traits, occupations, and human capital. Yet average wages in group X are greater than average wages in group Y. Are we to assume that workers in group X are, on average, more productive than workers in group Y? This is hard for many researchers to conclude. Some people look at the current distribution of income in society and conclude that this distribution is fair. The moral justification for this distribution of income is that some people in society or just that much more productive than the others. If you don’t see the distribution of income as fair, then you must reject the marginal productivity theory itself. So Does Marginal Productivity Theory Work?   Yes and no. For the most part, I think we can agree that an employer would not willingly pay you a wage that is higher than your marginal revenue product. And this would imply that any two people of equal productivity should receive the same wage. However we are not naïve enough to believe that this is always true and many people believe that the current distribution of income is unfair and not entirely attributable to vast differences in productivity.