The Theory of Income Distribution

The theory of income distribution takes place within the context of the markets for FOPs or
factor markets.
Factor Markets
(Market of FOPs)

Demand Supply
(firms) (household)

FOP Factor price/cost/ Factor income / reward

Land Rent
Labour Wages
Capital Interest and Dividends
Enterprise Profit

NB: Factor income or rewards are earned by suppliers of FOPs (households) but represent
expenses or costs of production to the demanders of FOPs (firms).
The Labour Market
The labour market consist of the interaction between demand for labour (by firms) and the
supply of labour (by individuals or households).
The Demand for Labour ( D L ¿
The demand for labour and all other FOPs is described as a derived demand. This means that the
demand for FOPs is based on derived from the demand for the goods and services that FOPs can
produce or provide (and not really based on intrinsic value of the FOPs themselves), egs the
demand for teachers is based on the demand for education.
The D L refers to the amount or quantity of workers that firms are willing and able to employ or
hire at a given price (wage rate) and at a given time ceteris paribus. The D L is explained by the
Marginal Revenue Productivity (MRP) Theory.
MRP refers to the contribution of each extra or additional worker to the firm’s total revenue. In
other words, it measures how a firm’s revenue (TR) changes when it hires an additional unit of
labour. The MRP theory states that profit maximizing firms will hire workers up to the point
where the last worker contributes just as much to revenue (MRP) as he does to cost (MW).
According to the MRP therefore, the determination of income (wage) as well as determining
the quantity of workers to be hired (q L ) is based on MRP = MW.
Assumption of the MRP Theory
The labour market is assumed to be perfectly competitive:
 Many buyers (firms) and supplies (households) of labour.
 Workers are generally homogenous (all workers tend to have identical skills,
qualifications etc)
 Little or no barriers to entry and exit (it is relatively easy to enter and leave the labour
market.
 Firms are wage takers (firms do not have the ability to determine the wage rate but must
accept the wage as determined by the industry, egs sno cones and doubles workers,
janitors.
 There are no market imperfections facing the labour market. This means that there is no
trade union activity or government interventions etc which can influence wages.
 Firms are assumed to be profit maximiser.
 The product or service being produced or provided is sold in a PC product market.
No of Total Marginal Total Marginal Marginal
Workers Physical Physical Revenue Revenue Revenue
(Q L) Product Product (TR) (MR) Productivity
(TPP or Q) (MPP) (MRP)

0 0 0 (0*2)=0 0 0
1 12 (12-0/1- (12*2)=24 (24-0/12- (12*2)=24
0)=12 0)=2
2 22 (22-12/2- (22*2)=44 (44-24/22- (10*2)=20
1)=10 12)=2
3 28 (28-22/3- (28*2)=56 (56-44/28- (6*2)=12
2)=6 22)=2
4 33 5 66 (66-56/33- 10
28)=(10/5)=2
5 37 4 74 (74-66/37- 8
33)=2
6 40 3 80 (80-74/40- 6
37)=2
7 42 2 84 2 4

Assume P = $2
∆TPP ∆ TR
MPP= TR=P ×Q ( TPP ) MR= MRP=MPP × MR
∆ QL ∆ Q(TPP)

Assignment: Plot GRAPH of No. of workers (Q L) to Marginal Revenue Productivity (MRP)

(Q L) – x-axis
MRP – y-axis
Using MRP Theory to determine wage and employment level (PC Labour Market)

Wage level Determination

PC Firms operating in a PC labour market are wage takers. The firms therefore accepts the
equilibrium wage as determined by the industry based on the interaction between industry
demand and supply of labour. Furthermore, as firms operate in a PC labour market, they will not
increase wages in order to attract more households to supply their labour. This results in the firm
fixing a horizontal S L= AW =MW (because the firm can hire any number of workers at the same
wage rate).
Employment Level Determination
According to the MRP theory, the profit maximizing firm determines its employment level
where MRP = MW. At the accepted wage of W E , therefore firms will hire q L units of labour/
1

number of workers. At this point, the last worker hired contributes just as much to firm’s revenue
as he does to cost. If the firm hired fewer workers than q L (such as q L ¿ the last worker hired
1 2

would be contributing more to revenue than to cost. The firm would therefore continue to hire
more workers as long as this is happening. The firm would not hire workers beyond q L (such as
1

q L ¿ because the last worker hired would then contribute more to cost than to revenue.
3

A: MRP = W E∨ AW

B: MRP > W E∨ AW ∴ ↑Q L

C: MRP ¿ W E∨ AW ∴ ↓Q L
Why is the Firm’s MRP Curve the D L ?

Since the firm hires workers based on MRP = MW 1then it can be proven that the firm’s MRP
curve is in fact its demand curve for labour ( D L ¿ .This is because each point on the MRP curve
indicates the willingness of the firm to hire workers at each possible wage rate ( based on
equating MRP and MW).
Factors Affecting D L
Changes in the price of labour or wage rate (MW)

Changes in the wage rates will cause movements along D L :

A – B : ↑ W ( W 1−W 2) =¿ ↓ q L (q 1−q 2)

A – C : ↓ W ( W 1−W 2) =¿ ↑ q L (q 1−q 2)

Changes in MRP: (MRP = MPP × MR ¿