1. 1 of 48 WHAT YOU WILL LEARN IN THIS CHAPTER chapter: 20 >> Krugman/Wells ©2009  Worth Publishers Factor Markets and Distribution of Income

2. 2 of 48 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

3. 3 of 48  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 Economy’s Factors of Production

4. 4 of 48 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 The Factors of Production

5. 5 of 48 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.

6. 6 of 48 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 The Allocation of Resources

7. 7 of 48  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. Factor Incomes and the Distribution of Income

8. 8 of 48 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.

9. 9 of 48 ►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.

10. 10 of 48 ►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.

11. 11 of 48 Factor Distribution of Income in U.S. in 2007 Interest 5.4% Rent 0.6% Corporate profits 14.3% Proprietors’ income 9.3% Compensation of employees 70.4%

12. 12 of 48  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. Marginal Productivity and Factor Demand

13. 13 of 48 MPL 786543210 19 17 15 13 11 9 7 5 Marginal product of labor (bushels per worker) 786543210 100 80 60 40 20 Quantity of wheat (bushels) (a) Total Product(b) Marginal Product of Labor TP Quantity of labor (workers) The Production Function for George and Martha’s Farm Quantity of labor (workers)

14. 14 of 48  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

15. 15 of 48  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

16. 16 of 48 To maximize profit, George and Martha will employ workers up to the point at which, for the last worker employed, VMPL = W. Value of the Marginal Product

17. 17 of 48 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.

18. 18 of 48 The Value of the Marginal Product Curve Value of the marginal product value curve VMPL A 0 12348765 $400 300 200 100 Wage rate, VMPL Profit-maximizing number of workers Optimal point Market wage rate Quantity of labor (workers)

19. 19 of 48 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 Factor Demand Curve

20. 20 of 48 Shifts of the Value of the Marginal Product Curve A B 2085 $200 VMPL 1 2 A C 05 $200 VMPL 3 1 (a) An Increase in the Price of Wheat(b) A Decrease in the Price of Wheat Quantity of labor (workers) Wage rate Market wage rate

21. 21 of 48  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? The Marginal Productivity Theory of Income Distribution

22. 22 of 48 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.

23. 23 of 48 ►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.

24. 24 of 48 All Producers Face the Same Wage Rate 50 $200 Wage rate Market wage rate 7 $200 VMPL wheat VMPL corn VMPL wheat = P x MPL VMPL corn = P corn x MPL corn (a) Farmer Jones(b) Farmer Smith Profit-maximizing number of workers Farmer Smith’sFarmer Jones's wheat Wage rate Quantity of labor (workers) Profit-maximizing number of workers

25. 25 of 48  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

26. 26 of 48  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. Equilibrium in the Labor Market

27. 27 of 48 Equilibrium in the Labor Market Market Labor Supply Curve E Market Labor Demand Curve L* W* Equilibrium employment Equilibrium value of the marginal product of labor Quantity of labor (workers) Rental rate

28. 28 of 48  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? Is the Marginal Productivity Theory of Income Distribution Really True?

29. 29 of 48 Equilibria in the Land and Capital Markets Quantity (a) The Market for Land Quantity (b) The Market for Capital Rental rate D Land R* Capital S S Land D Capital Q* Land Q* Capital R* Land Rental rate

30. 30 of 48 Median Earnings by Gender and Ethnicity, 2006 Hispanic (male and female) African American (male and female) Female (all ethnicities) $45,722 $27,337 $24,893 $29,166 45,000 $50,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 White male Annual median earnings, 2006

31. 31 of 48  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. Marginal Productivity and Wage Inequality

32. 32 of 48  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. Marginal Productivity and Wage Inequality

33. 33 of 48 Earnings Differentials by Education, Gender, and Ethnicity White male $70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 Annual median earnings, 2006 White female African- American male No HS degreeHS degreeCollege degree African- American female Hispanic man Hispanic female

34. 34 of 48  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. Marginal Productivity and Wage Inequality

35. 35 of 48  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. Marginal Productivity and Wage Inequality

36. 36 of 48 ►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.

37. 37 of 48 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.

38. 38 of 48 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.

39. 39 of 48 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.

40. 40 of 48 The Individual Labor Supply Curve Individual labor supply curve 50400 $20 10 400 $20 10 30 (a) The Substitution Effect Dominates Quantity of leisure (hours) (b) The Income Effect Dominates Wage rate Quantity of leisure (hours)

41. 41 of 48 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.

42. 42 of 48 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

43. 43 of 48 ►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.

44. 44 of 48 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.

45. 45 of 48 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.

46. 46 of 48 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 efficiency- wage model, which arises from a type of market failure, shows how wage disparities can result from employers’ attempts to increase worker performance.

47. 47 of 48 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.

48. 48 of 48 The End of Chapter 20 Coming attraction: Chapter 21: Uncertainty, Risk and Private Information