1. Factor Markets and Distribution of Income
Chapter 19
Factor Markets and Distribution of Income

2. 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
WHAT YOU
WILL LEARN
IN THIS CHAPTER

3. 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? 3

4. The Factors of Production
Economists divide factors of production into four principal classes: 1) Land: a resource provided by nature 2) Labor: the work done by human beings 3) Physical capital: which consists of manufactured resources such as buildings, equipment, tools, and machines 4) Human capital: the improvement in labor created by education and knowledge that is embodied in the workforce 4

5. The Allocation of Resources
Factor prices play a key role in the allocation of resources among producers because of 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 5

6. 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%—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. 6

7. Factor Distribution of Income in U.S. in 2010
Interest
4.8%
Corporate profits
15.4%
Compensation of employees
68.0%
Rent
3.0%
Figure Caption: Figure 19-1: Factor Distribution of Income in the United States in 2010
In 2010, compensation of employees accounted for most income earned in the United States—about 68% 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 their labor and capital expended in their businesses.
Proprietors’ income
8.8%

8. 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. 8

9. The Production Function for George and Martha’s Farm
Quantity of wheat (bushels)
Marginal product of labor (bushels per worker)
(a) Total Product
(b) Marginal Product of Labor
100 TP 19 17 80 15 13 60 11 9 40 7 5 20
MPL
Figure Caption: Figure 19-2: The Production Function for George and Martha’s Farm
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. 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
Quantity of labor (workers)
Quantity of labor (workers)

10. 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. 10

11. 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. 11

12. Value of the Marginal Product
To maximize profit, George and Martha will employ workers up to the point at which VMPL = W for the last worker employed. 12

13. 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. 13

14. 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,
Figure Caption: Figure 19-3: 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.
100
VMPL 1 2 3 4 5 6 7 8
Quantity of labor (workers)
Profit-maximizing number of workers

15. 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 15

16. Shifts of the Value of the Marginal Product Curve
(a) An Increase in the Price of Wheat
(b) A Decrease in the Price of Wheat
Wage rate
Wage rate
Market wage rate A B C A
$200
$200
Figure Caption: Figure 19-4: Shifts of the Value of the Marginal Product Curve
Panel (a) shows the effect of an increase in the price of wheat on George and Martha’s demand for labor. The value of the marginal product of labor 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, shown by the movement from point A to point B. Panel (b) shows the effect of a decrease in the price of wheat. The value of the marginal product of labor curve shifts downward, from VMPL1 to VMPL3. At the market wage rate of $200, profit-maximizing employment falls from 5 workers to 2 workers, shown by the movement from point A to point C.
VMPL 1
VMPL
VMPL 2 3
VMPL 1 5 8 2 5
Quantity of labor (workers)
Quantity of labor (workers)

17. 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? 17

18. All Producers Face the Same Wage Rate
(a) Farmer Jones
(b) Farmer Smith
Wage rate
Wage rate
Farmer Jones's
VMPL
Farmer Smith’s
VMPL
wheat
corn
= P x
MPL
= P x
MPL
corn
wheat
wheat
corn
Market wage rate
$200
$200
VMPL
corn
Figure Caption: Figure 19-5: 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 so must 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.
VMPL
wheat 5
Quantity of labor (workers) 7
Quantity of labor (workers)
Profit-maximizing number of workers
Profit-maximizing number of workers

19. 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. 19

20. 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. 20

21. Equilibrium in the Labor Market
Rental rate
Market Labor Supply Curve
Equilibrium value of the marginal product of labor E W*
Figure Caption: Figure 19-6: 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.
Market Labor Demand Curve L*
Quantity of labor (workers)
Equilibrium employment

22. Equilibria in the Land and Capital Markets
Rental rate
Rental rate
(a) The Market for Land
(b) The Market for Capital S
Land R* S
Capital
Land R*
Capital D D
Land
Capital
Figure Caption: Figure 19-7: Equilibria in the Land and Capital Markets
Panel (a) illustrates equilibrium in the market for land; panel (b) illustrates equilibrium in the market for capital. The supply curve for land is relatively steep, reflecting the high cost of increasing the quantity of productive land. The supply curve for capital, in contrast, is relatively flat, due to the relatively high responsiveness of savings to changes in the rental rate for capital. The equilibrium rental rates for land and capital, as well as the equilibrium quantities transacted, are given by the intersections of the demand and supply curves. In a competitive land market, each unit of land will be paid the equilibrium value of the marginal product of land, R*Land. Likewise, in a competitive capital market, each unit of capital will be paid the equilibrium value of the marginal product of capital, R*Capital. Q* Q*
Land
Quantity
Capital
Quantity

23. 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? 23

24. Median Earnings by Gender and Ethnicity, 2010
Annual median earnings, 2010
$50,000
$46,815
45,000
40,000
35,000
30,000
$30,258
$30,455
$25,261
25,000
20,000
15,000
Figure Caption: Figure 19-8: Median Earnings by Gender and Ethnicity, 2010
The U.S. labor market continues to show large differences across workers according to gender and ethnicity. Women are paid substantially less than men; African-American and Hispanic workers are paid substantially less than White male workers.
10,000
5,000
White male
Female (all ethnicities)
African American (male and female)
Hispanic (male and female)

25. 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. 25

26. 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. 26

27. Earnings Differentials by Education, Gender, and Ethnicity
Annual median earnings, 2010
$70,000
No HS degree
HS degree
College degree
60,000
50,000
40,000
30,000
20,000
Figure Caption: Figure 19-9: Earnings Differentials by Education, Gender, and Ethnicity, 2010
It is clear 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. Other patterns are evident as well: for any given education level, White males earn more than every other group, and males earn more than females for any given ethnic group.
10,000
White male
White female
African-American male
African-American female
Hispanic man
Hispanic female

28. 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. 28

29. 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. 29

30. 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. 30

31. 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 upcoming graph, the individual labor supply curve shows how the quantity of labor supplied by an individual depends on that individual’s wage rate. 31

32. 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. 32

33. The Individual Labor Supply Curve
(a) The Substitution Effect Dominates
(b) The Income Effect Dominates
Wage rate
Wage rate
Individual labor supply curve
$20
$20 10 10
Figure Caption: Figure 19-11: The Individual Labor Supply Curve
When the substitution effect of a wage increase dominates the income effect, the individual labor supply curve slopes upward, 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. But when the income effect of a wage increase dominates the substitution effect, the individual labor supply curve slopes downward, as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30.
Individual labor supply curve 40 50 30 40
Quantity of leisure (hours)
Quantity of leisure (hours)

34. 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 34

35. Summary
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.
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.

36. Summary
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.

37. Summary
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.

38. Summary
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 efficiency-wage model, which arises from a type of market failure, shows how wage disparities can result from employers’ attempts to increase worker performance.

39. Summary
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.

40. Summary
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.

41. Key Terms Physical capital Unions Human capital Efficiency-wage model
Factor distribution of income
Time allocation
Value of the marginal product
Leisure
Individual labor supply curve
Value of the marginal product curve
Equilibrium value of the marginal product
Rental rate
Marginal productivity theory of income distribution
Compensating differentials