Marginal Productivity AP Microeconomics Module 4 Dannie McKee, June 2013

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: 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

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.

Why Factor Prices Matter: 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

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.

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.

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.

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 MPL 7 8 6 5 4 3 2 1 19 17 15 13 11 9 Marginal product of labor (bushels per worker) 100 80 60 40 20 Quantity of wheat (bushels) (a) Total Product (b) Marginal Product of Labor TP Quantity of labor (workers) Panel (a) shows how the quantity of output of wheat on George and Martha’s farm depends on the number of workers employed. Panel (b) shows how the marginal product of labor depends on the number of workers employed.

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, for the last worker employed, VMPL = W.

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 This curve shows how the value of the marginal product of labor depends on the number of workers employed. It slopes downward because of diminishing returns to labor in production. To maximize profit, George and Martha choose the level of employment at which the value of the marginal product of labor is equal to the market wage rate. For example, at a wage rate of $200 the profit-maximizing level of employment is 5 workers, shown by point A. The value of the marginal product curve of a factor is the producer’s individual demand curve for that factor. Value of the marginal product value curve VMPL A 1 2 3 4 8 7 6 5 $400 300 200 100 Wage rate, VMPL Profit-maximizing number of workers Optimal point Market wage rate Quantity of labor (workers)

Poverty, Inequality, and Public Policy The welfare state is the collection of government programs designed to alleviate economic hardship. A government transfer is a government payment to an individual or to families—that provide financial aid to the poor, assistance to unemployed workers, guaranteed income for the elderly, and assistance in paying medical bills for those with large health care expenses.

The Logic of the Welfare State One major rationale for the welfare state is alleviating income inequality. A poverty program is a government program designed to aid the poor. A second major rationale for the welfare state is alleviating economic insecurity. A social insurance program is a government program designed to provide protection against unpredictable financial distress.

The Logic of the Welfare State These two rationales for the welfare state are closely related to the ability- to-pay principle (see Chapter 7). The ability-to-pay principle was used to justify progressive taxation.

The Logic of the Welfare State (continued) The ability-to-pay principle says that people with low incomes (for whom an additional dollar makes a big difference to their economic well-being) should pay a smaller fraction of their income in taxes than people with higher incomes (for whom an additional dollar makes much less difference). The same principle suggests that those with very low incomes should actually get money back from the tax system.

The Problem of Poverty The poverty threshold is the annual income below which a family is officially considered poor. The poverty rate is the percentage of the population with incomes below the poverty threshold. The following graph shows the U.S. poverty rate since 1959.

Trends in the U.S. Poverty Rate, 1959–2006 Year 2006 2000 1990 1980 1970 1959 25% 20 15 10 The poverty rate fell sharply from the 1960s to the early 1970s but has not shown a clear trend since then.

What Causes Poverty? Lack of education Lack of proficiency in English 83% “college premium” (2006) Lack of proficiency in English Racial and gender discrimination Bad luck

Consequences of Poverty The consequences of poverty include: lack of access to health care lack of access to affordable housing learning disabilities Children raised in severe poverty tend to suffer from lifelong learning disabilities.

Consequences of Poverty Poverty is self-perpetuating. The children of the poor start at such a disadvantage relative to other Americans that it’s very hard for them to achieve a better life.

Poor People in Rich Counties According to the relative definition of poverty (you’re poor if you have a low income compared with other people in your country), the United States has high poverty compared with other rich nations. According to absolute poverty (similar to the official U.S. poverty threshold), the U.S. is no longer the country with the highest poverty rate by this measure. The U.S. in second place. By either measure, the U.S. has a high poverty rate compared to other rich countries.

Economic Inequality Income in the United States is quite unequally distributed. The average income of the poorest fifth of families is less than a quarter of the average income of families in the middle. The richest fifth have an average income more than three times that of families in the middle. The incomes of the richest fifth of the population are, on average, about 15 times as high as those of the poorest fifth. The distribution of income in America has become more unequal since 1980.

Economic Inequality The Gini coefficient is a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles.

Summary of Welfare The welfare state absorbs a large share of government spending in all wealthy countries. Government transfers are the payments made by the government to individuals and families. Poverty programs alleviate income inequality by helping the poor; social insurance programs alleviate economic insecurity. The poverty threshold is adjusted according to the cost of living, but not according to the standard of living. The average American income has risen substantially over those 30 years. However, the poverty rate in the U.S.—the percentage of the population with an income below the poverty threshold—is no lower than it was 30 years ago. There are various causes of poverty: lack of education, the legacy of discrimination, and bad luck.

Summary of Welfare (continued) Median household income, the income of a family at the center of the income distribution, is a better indicator of the income of the typical household than mean household income because it is not distorted by the inclusion of a small number of very wealthy households. The Gini coefficient, a number that summarizes a country’s level of income inequality based on how unequally income is distributed across quintiles, is used to compare income inequality across countries.

Welfare Summary (Continued) Both means-tested and non-means-tested programs reduce poverty. The major in-kind benefits programs are Medicare and Medicaid, which pay for medical care. Due to concerns about the effects on incentives to work and on family cohesion, aid to poor families has become significantly less generous even as the negative income tax has become more generous. Social Security, the largest U.S. welfare state program, has significantly reduced poverty among the elderly. Unemployment insurance is also a key social insurance program.