Factor Markets and the Distribution of Income

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?

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 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

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 that all producers are price-takers—they operate in a perfectly competitive industry.

The Production Function for George and Martha’s Farm Panel (a) uses the total product curve to show how total wheat production depends on the number of workers employed on the farm; panel (b) shows how the marginal product of labor, the increase in output from employing one more worker, 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 value of the additional 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 VMPL shows how the value of the marginal product of labor depends on the number of workers employed. It is downward sloping due to 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 (at a wage rate of $200 the profit-maximizing level of employment is 5 workers).

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

Shifts of the Value of the Marginal Product Curve Panel (b) shows the effect of a fall in the price of wheat. The value of the marginal product curve shifts downward, from VMPL1 to VMPL3. At the market wage rate of $200, profit-maximizing employment falls from 5 workers to 2 workers (A  C). Panel (a) shows the effect of a rise in the price of wheat on George and Martha’s demand for labor. The value of the marginal product curve shifts upward, from VMPL1 to VMPL2. If the market wage rate remains at $200, profit maximizing employment rises from 5 workers to 8 workers (A  B).

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 their 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 Although Farmer Jones grows wheat and Farmer Smith grows corn, they both compete in the same market for labor and must therefore pay the same wage rate, $200. Each producer hires labor up to the point at which VMPL = $200: 5 workers for Jones, 7 workers for Smith.

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 VMPL is the same for all producers. The theory that each factor is paid the value of the output generated by the last unit employed in the factor market as a whole is known as the marginal productivity theory of income distribution.

Equilibrium in the Labor Market The market labor demand curve is the horizontal sum of the individual labor demand curves of all producers. Here the equilibrium wage rate is W*, the equilibrium employment level is L*, and every producer hires labor up to the point at which VMPL = W*. So, labor is paid its equilibrium value of the marginal product, the value of the marginal product of the last worker hired in the labor market as a whole.

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. 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…

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. According to the efficiency-wage model, some employers pay an above equilibrium wage as an incentive for better performance.

The Supply of Labor Work Versus Leisure 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.

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 But when the income effect of a wage increase dominates the substitution effect, the individual labor supply curve is downward sloping as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30. When the substitution effect of a wage increase dominates the income effect, the individual labor supply curve is upward sloping as in panel (a). Here a rise in the wage rate from $10 to $20 per hour increases the number of hours worked from 40 to 50.

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, and changes in wealth.

Rent, Interest, and Profit

What is land? Economic rent Are prices high because rents are high, or are rents high because prices are high? What is capital? How is the interest rate determined? The net productivity of capital The capitalization of assets The present value of future income How are profits determined? Theories of profit

What Is Rent? What is land? Land is a resource or a factor of production The owner of land is paid rent for allowing its use in the production process The amount of rent paid for a piece of land is based on the supply of and the demand for land

What Is Land? Land is land How land is used depends on its location, its fertility, and whether it possesses any valuable minerals Sometimes we confuse land with what is built on it Land with an apartment building on it will rent for more than a vacant lot However in economic terms we pay rent on the land itself

How Does One Piece of Land Differ From Another? A plot of land may have a few alternative uses If it is used at all, it will be used by the highest bidder – the one willing to pay the most for it The basic way one piece of land differs from another is location An acre of land in the middle of a desert is worth a lot less than an acre of land in a metropolitan area

How Is the Supply of Land Arrived at? In economics we say the supply of land is fixed We can make more efficient use of land We represent the supply of land as a vertical line

How Is the Demand for Land Derived? The demand for land, like the demand for labor and capital, is derived from a firm’s MRP (Marginal Revenue Product) curve The land will go to the highest bidder The demand curve for land slopes downward to the right because its marginal physical product declines with output (due to diminishing returns) If the firm is an imperfect competitor, it must lower price to increase sales, thereby further depressing MRP as output expands

Determination of Rent The demand for rent is the MRP schedule of the highest bidder for a specific piece of land. The supply of land is fixed, so its supply curve is perfectly inelastic. The rent, like the price of anything else, is set by supply and demand

Increase in Demand for Land Since the supply of land is perfectly inelastic, an increase in demand is reflected entirely in an increase in price (and not an increase in the quantity of land).

Economic Rent Economic rent is payment in excess of what people would be willing to accept Rent paid to landlords (exclusive of any payment for buildings and property improvement ) is, by definition, economic rent

Are Prices High Because Rents Are High, or Are Rents High Because Prices Are High? High rents don’t cause high prices Desirable locations attract many prosperous renters, who bid up rents because they believe they will get a lot of business Rents are high because the demand for the final product(s) – and consequently the derived demand – is high If low rents lead to low prices stores (with low rent) would have lower prices, but they have higher prices

Capital What is capital Capital consists of office buildings, factories, stores, machinery and equipment, computer systems, and other synthetic goods used in the production process When we invest we are spending money on new capital The stock of capital increases by means of a flow of investment Say you have a capital stock of four machines. You buy two more. That’s your investment for the year. Now you have a capital stock of six machines

How Is the Interest Rate Determined? The interest rate is determined by the demand for loanable funds and the supply of loanable funds The supply of loanable funds (or savings) slopes upward to the right because the amount of money people save is somewhat responsive to interest rates

Interest Rates and Consumer Loans High interest rates deter borrowing for consumer loans Banks arguably charge too much on credit card loans Should this justify a legal ceiling (usury laws) on the interest that may be charged on these and other loans?

Usury Laws Usury laws place limits on how much interest may be charged Usury laws are price ceilings because they prevent the interest rates from rising to their equilibrium level This creates a shortage of loanable funds

Usury Laws How do usury laws hurt borrowers? Since usury laws create a shortage of loanable funds, the funds that are available go to the most creditworthy individuals and businesses first Borrowers with poor credit ratings are completely left out These borrowers are left with consumer finance companies that may not be subject to usury laws This means that if they can find money to borrow they will end up paying much higher interest rates than without usury laws

Interest Rate Ceiling Shortage of $350 billion

Determination of the Level of Investment Net Productivity of Capital The net productivity of capital is, in effect, a firm’s MRP schedule. In this case, given this firm’s net productivity of capital, it would borrow $40 million if the interest rate were 10 percent. The lower the interest rate, the more that would be borrowed and invested

The Net Productivity of Capital Economist have developed the concept of net productivity of capital, which translates into the expected profit rate Subtract all cost (including an allowance for a normal profit) from sales. This give us the dollar value of net productivity Assuming this value is positive, we divide it by capital cost to give us the net productivity of capital, which we express as a percentage

The Net Productivity of Capital Find the net productivity of capital if sales = $150,000; labor cost = $30,000; raw materials = $10,000; fuel and maintenance = $5,000; normal profit = $5,000; and capital cost = $80,000 Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity $130,000 $ 20,000 Labor cost $30,000 Raw materials 10,000 Fuel and Maintenance 5,000 Normal Profit 5,000 Capital cost 80,000 Total Cost $130,000

The Net Productivity of Capital Find the net productivity of capital is sales = $150,000; labor cost = $30,000; Raw materials = $10,000; Fuel and maintenance = $5,000; Normal profit = $5,000; and Capital Cost = $80,000 ( are included in Total Cost) Sales $ 150,000 - Total Cost ________ x Dollar value of net productivity $ 130,000 $ 20,000 Dollar value of net productivity ($20,000) ----------------------------------------------------- = Net productivity of capital (25 percent) Capital cost ($80,000) You would invest right up the point (or just short of the point) at which the interest rate equals the net productivity of capital

The Capitalization of Assets The capitalization of assets is just an alternate way of dealing with capital investment This concept enables a business firm to make a decision about purchasing a capital asset To make this decision a firm needs to know what is the value of that asset To do this the firm must also know what the current interest rate is

Value of Asset How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%?

Value of Asset How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%? Annual income from asset Value of asset = --------------------------------------------- Interest rate

Value of Asset How much is the value of a building that provides an annual income of $200 when the going rate of interest is 8%? Annual income from asset $200 Value of asset = --------------------------------------------- = ----------------- = $2,500 Interest rate .08 If the interest rate rises, the value of an asset falls. If the interest rate falls, the value of an asset rises.

The Present Value of Future Income A dollar today is worth more than a dollar in the future Because of inflation Because the dollar can be lent out to earn interest

The Present Value of Future Income r = the interest rate; n = the number of years 1 Present value of a dollar received n years from now = ---------------------- n (1 + r)

The Present Value of Future Income If the interest rate were 5%, how much would a dollar received one year from now be worth today? 1 Present value of a dollar received n years from now = ------------------------------------- n (1 + r) 1 = -------------------------------- 1 (1 + .05) r = the interest rate; n = the number of years

The Present Value of Future Income If the interest rate were 5%, how much would a dollar deceived one year from now be worth today? 1 Present value of a dollar received n years from now = --------------------- n (1 + r) 1 = ------------------------ 1 (1 + .05) 1 = ------------------------- 1.05 = 95.24 cents r = the interest rate; n = the number of years

The Present Value of Future Income What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5%. Work out to the nearest cent 1 Present value of a dollar received n years from now = ------------------- n (1 + r) r = the interest rate; n = the number of years

The Present Value of Future Income What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5%. Work out to the nearest cent 1 Present value of a dollar received n years from now = ------------------------------------- n (1 + r) 1 = $1,000 X -------------------------------- 3 (1.05) r = the interest rate; n = the number of years

The Present Value of Future Income What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5%. Work out to the nearest cent 1 Present value of a dollar received n years from now = ------------------------------------- n (1 + r) 1 = $1,000 X ------------------------------- (1.05) 3 1 = $1,000 X ---------------------------------- 1.157625 r = the interest rate; n = the number of years

The Present Value of Future Income What is the present value of $1,000 that will be paid to you in three years if the interest rate is 5%. Work out to the nearest cent 1 Present value of a dollar received n years from now = -------------------------- n (1 + r) 1 = $1,000 X ------------------------------ (1.05) 3 1 = $,1000 X ---------------------------------- 1.157625 = $1,000 X .863838 = $863.84 r = the interest rate; n = the number of years

How Are Profits Determined? Economist treat profits as a residual left to the entrepreneur after rent, interest, and wages have been paid One could argue that because these three resource payments are determined by supply and demand, then what is left over, profits, are indirectly determined by supply and demand

Theories of Profiting The Entrepreneur as a Risk Taker The Entrepreneur as an Innovator The Entrepreneur as a Monopolist The Entrepreneur as an Exploiter of Labor

The Entrepreneur as a Risk Taker The entrepreneur is indeed a risk taker Starting a business is a risky endeavor Most new businesses fail in the first five years Why then do people start a new business? If they succeed they will get a high rate of return

The Entrepreneur as an Innovator An innovation is not an invention An invention is a new idea, a new product, or a new way of producing things An innovation is the act of putting the invention to practical use Innovation is what entrepreneurs do

The Entrepreneur as a Monopolist Monopolist and oligopolist make profits (economic) because of a shortage of competition If this shortage of competition is due to hard work, foresight, and innovation, one could hardly complain of the evils of big business The shortage of competition is due to “natural scarcities” If this shortage of competition is due to “contrived scarcities” and the business restricts output so it can make monopoly profits, that is another story

The Entrepreneur as an Exploiter of Labor Karl Marx based his theory of profits on the supposition that the capitalist exploits the worker by taking the surplus value of the worker’s labor (profits) and using this to buy more capital to be able to exploit even more workers Marx sees the capitalist’s role as that of exploiting the employees