3-2 How Is National Income Distributed

to the Factors of Production?

As we discussed in Chapter 2, the total output of an economy equals its
total income. Because the factors of production and the production
function together determine the total output of goods and services, they
also determine national income. The circular flow diagram in Figure 3-1
shows that this national income flows from firms to households through
the markets for the factors of production.

In this section, we continue to develop our model of the economy by

discussing how these factor markets work. Economists have long studied
factor markets to understand the distribution of income. For example, Karl
Marx, the noted nineteenth-century economist, spent much time trying to
explain the incomes of capital and labour. The political philosophy of
communism was in part based on Marx’s now-discredited theory.

Here we examine the modern theory of how national income is divided

among the factors of production. It is based on the classical (eighteenth-
century) idea that prices adjust to balance supply and demand, applied
here to the markets for the factors of production, together with the more
recent (nineteenth-century) idea that the demand for each factor of
production depends on the marginal productivity of that factor. This
theory, called the neoclassical theory of distribution, is accepted by most
economists today as the best place to start in understanding how the
economy’s income is distributed from firms to households.