THIRD EDITION

ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells

Chapter 19
Factor Markets and Distribution of Income
 • How factors of production—resources
like land, labor, and both physical and
human capital—are traded in factor
markets, determining the factor
WHAT YOU distribution of income
WILL LEARN • How the demand for factors leads to the
marginal productivity theory of income
IN THIS distribution
CHAPTER • 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
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:

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
Pitfalls
What Is a Factor, Anyway?

• Imagine a business that produces shirts. The business will

make use of workers and machines—that is, 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.
Pitfalls
What Is a Factor, Anyway?

• The key distinction is that a factor of production earns

income from the selling of its services over and over again
but inputs cannot.

• A worker and a machine earn income over time, but inputs

like electricity or cloth are used up in the production process.
Once exhausted, they cannot be a source of future income
for the owner.
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
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.
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, describe a world in which
the leaders of society are land-owning aristocrats.
 Dickens’ novels, set 50 years later, describe a world in which
businessmen, especially factory owners, are in control.
FOR INQUIRING MINDS
The Factor Distribution of Income and Social Change in the
Industrial Revolution

• This shift reflects a dramatic transformation in the factor

distribution of income.
 The Industrial Revolution 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
period.
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 2010, compensation of employees accounted for most

income earned in the United States—about 68% of the total.
ECONOMICS IN ACTION
The Factor Distribution of Income in the United States

• 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—8.8% of the total—went to

individual owners of businesses as compensation for the
labor and capital expended in their businesses.
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.
Factor Distribution of Income in U.S. in 2010

Interest
4.8%

Corporate profits
15.4%

Compensation of employees

68.0%
Rent
3.0%

Proprietors’ income
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.
 The Production Function for George and Martha’s Farm
Quantity of Marginal
wheat (a) Total Product product of (b) Marginal Product of Labor
(bushels) labor
(bushels
per worker)

100 TP
19
17
80
15
13
60
11
9
40
7
5
20 MPL

0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity of labor (workers) Quantity of labor (workers)
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 VMPL = W for the last worker employed.
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
Wage rate,
VMPL

Optimal
point
$400

300

A
Market 200
wage rate Value of the
marginal product
value curve,
100 VMPL

0 1 2 3 4 5 6 7 8
Quantity of labor
Profit-maximizing (workers)
number of workers
Shifts of the Factor Demand Curve
What causes factor demand curves to shift?

There are three main causes:

1) Changes in prices of goods
2) Changes in supply of other factors
3) Changes in technology
 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 Wage
rate rate

Market A B C A
wage $200 $200
rate
VMPL
1
VMPL VMPL
2 3
VMPL
1
0 5 8 0 2 5
Quantity of labor Quantity of labor
(workers) (workers)
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?

 All Producers Face the Same Wage Rate

(a) Farmer Jones (b) Farmer Smith

Wage rate Wage rate

Farmer Jones's VMPLwheat Farmer Smith’s VMPLcorn

=P x MPL = Pcorn x MPL corn
wheat wheat

Market
wage $200 $200
rate

VMPL
corn

VMPL
wheat
0 5 Quantity of labor 7 Quantity of labor
(workers) (workers)
Profit-maximizing Profit-maximizing
number of workers number of workers
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 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
Rental rate

Market Labor
Supply Curve

Equilibrium E
value of the W*
marginal
product of
labor

Market Labor
Demand Curve

L* Quantity of labor (workers)

Equilibrium
employment
 Equilibria in the Land and Capital Markets
Rental Rental
(a) The Market for Land (b) The Market for Capital
rate rate
SLand

R* SCapital
Land
R* Capital

D Land D Capital

Q* Land Quantity Q* Capital Quantity

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.
ECONOMICS IN ACTION
Help Wanted!

 The highly skilled senior mechanists of Hamill Manufacturing

are well-paid compared with other workers in
manufacturing.

 Doesn’t the marginal productivity theory of income

distribution imply that the machinists should be paid the
revenue they generate?
ECONOMICS IN ACTION
Help Wanted!

 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.

 Also, 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 holds.
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?
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

10,000

5,000

0
White Female (all African Hispanic
male ethnicities) American (male and
(male and female)
female)
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.
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.
 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

10,000

0
White White African- African- Hispanic Hispanic
male female American American man female
male female
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.
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.

FOR INQUIRING MINDS
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.
FOR INQUIRING MINDS
The Economics of Apartheid

• 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.
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.
ECONOMICS IN ACTION
MARGINAL PRODUCTIVITY AND THE “1%”

• In the fall of 2011, many of the U.S. protestors adopted the

slogan “We are the 99%,” emphasizing the fact that the
incomes of the top 1% of the population had grown much
faster than those of most Americans.

• The CBO study on income inequality found that, between

1979 and 2007, the income of the median household,
adjusted for inflation, had risen 34.8%—but the average
income of the top 1% of households had risen 277.5%.
ECONOMICS IN ACTION
MARGINAL PRODUCTIVITY AND THE “1%”

• Why have the richest Americans been pulling away from the
rest?
 The causes are a source of considerable dispute and continuing
research.
 One thing is clear, however: this aspect of growing inequality
can’t be explained simply in terms of the growing demand for
highly educated labor.
ECONOMICS IN ACTION
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.
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
(a) The Substitution Effect Dominates (b) The Income Effect Dominates

Wage rate Wage rate

Individual labor
supply curve

$20 $20

10 10
Individual
labor supply
curve

0 40 50 0 30 40
Quantity of leisure Quantity of leisure
(hours) (hours)
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.
FOR INQUIRING MINDS
Why You Can’t Find a Cab When Its Raining

• 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.
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:

1) changes in preferences and social norms
2) changes in population
3) changes in opportunities
4) changes in wealth
GLOBAL COMPARISON: THE OVERWORKED AMERICAN
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.
ECONOMICS IN ACTION
The Decline of the Summer Job

• 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.
ECONOMICS IN ACTION
The Decline of the Summer Job

• 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.
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.
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.
Summary
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.
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.
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.
Summary
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.
Key Terms
• Physical capital • Unions
• Human capital • Efficiency-wage model
• Factor distribution of income • Time allocation
• Value of the marginal • Leisure
product • 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