1. © 2005 Worth Publishers Slide 12-1 CHAPTER 12 Factor Markets and the Distribution of Income PowerPoint® Slides by Can Erbil and Gustavo Indart © 2005 Worth Publishers, all rights reserved

2. © 2005 Worth Publishers Slide 12-2 What You Will Learn in this Chapter: How factors of production—resources like land, labour, and both physical capital 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 Sources of wage disparities and the role of discrimination The way in which a worker’s decision about time allocation gives rise to labour supply

3. © 2005 Worth Publishers Slide 12-3  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. © 2005 Worth Publishers Slide 12-4 Economists divide factors of production into four principal classes:  Land  Labour  Physical capital - consists of manufactured resources such as buildings and machines  Human capital - is the improvement in labour created by education and knowledge that is embodied in the workforce The Factors of Production

5. © 2005 Worth Publishers Slide 12-5 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 is derived from the firm’s output choice  Factor markets are where most of us get the largest shares of our income Why Factor Prices Matter: The Allocation of Resources

6. © 2005 Worth Publishers Slide 12-6 The factor distribution of income is the division of total income among labour, land, and capital Factor prices, which are set in factor markets, determine the factor distribution of income Labour receives the bulk of the income in the modern Canadian economy —between 66 and 75 percent over the past 45 years 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

7. © 2005 Worth Publishers Slide 12-7 Factor Distribution of Income in Canada in 2003

8. © 2005 Worth Publishers Slide 12-8 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

9. © 2005 Worth Publishers Slide 12-9 Panel (a) uses the total product curve to show how total wheat production depends on the number of workers employed on the farm. Panel (b) shows how the marginal product of labour, the increase in output from employing one more worker, depends on the number of workers employed. The Production Function for George and Martha’s Farm

10. © 2005 Worth Publishers Slide 12-10 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

11. © 2005 Worth Publishers Slide 12-11 Value of the Marginal Product The value of the marginal product of a factor is the value of the additional output generated by employing one more unit of that factor The value of the marginal product of labour is: 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

12. © 2005 Worth Publishers Slide 12-12 Value of the Marginal Product To maximize profit, George and Martha will employ workers up to the point at which, for the last worker employed, VMPL = W.

13. © 2005 Worth Publishers Slide 12-13 VMPL shows how the value of the marginal product of labour depends on the number of workers employed. It is downward sloping due to diminishing returns to labour in production. To maximize profit, George and Martha choose the level of employment at which the value of the marginal product of labour is equal to the market wage rate (at a wage rate of $200 the profit-maximizing level of employment is 5 workers). The Value of the Marginal Product Curve

14. © 2005 Worth Publishers Slide 12-14 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. © 2005 Worth Publishers Slide 12-15 Shifts of the Value of the Marginal Product Curve Panel (a) shows the effect of a rise in the price of wheat on George and Martha’s demand for labour. The value of the marginal product 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 (A  B). Panel (b) shows the effect of a fall in the price of wheat. The value of the marginal product curve shifts downward, from VMPL 1 to VMPL 3. At the market wage rate of $200, profit-maximizing employment falls from 5 workers to 2 workers (A  C).

16. © 2005 Worth Publishers Slide 12-16 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 their value of the marginal product is equal to their price. What does this say about the factor distribution of income?

17. © 2005 Worth Publishers Slide 12-17 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 labour and must therefore pay the same wage rate, $200. Each producer hires labour up to the point at which VMPL = $200: 5 workers for Jones, 7 workers for Smith.

18. © 2005 Worth Publishers Slide 12-18 Equilibrium in the Labour Market Each firm will hire labour up to the point at which the value of the marginal product of labour is equal to the equilibrium wage rate This means that, in equilibrium, the marginal product of labour 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 labour—the additional value produced by the last unit of labour employed in the labour market as a whole

19. © 2005 Worth Publishers Slide 12-19 Equilibrium in the Labour Market It doesn’t matter where that additional unit is employed, since VMPL is the same for all producers The theory that each factor is paid the value of the output generated by the last unit employed in the factor market as a whole is known as the marginal productivity theory of income distribution

20. © 2005 Worth Publishers Slide 12-20 Equilibrium in the Labour Market So, labour is paid its equilibrium value of the marginal product, the value of the marginal product of the last worker hired in the labour market as a whole. The market labour demand curve is the horizontal sum of the individual labour demand curves of all producers. Here the equilibrium wage rate is W*, the equilibrium employment level is L*, and every producer hires labour up to the point at which VMPL = W*.

21. © 2005 Worth Publishers Slide 12-21 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?

22. © 2005 Worth Publishers Slide 12-22 Earnings Differential by Gender and Ethnicity, Canada, 2000

23. © 2005 Worth Publishers Slide 12-23 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 It is clear from the following graph that, regardless of gender, education pays: those with a university degree earn more than those without one, although not all degrees increase earnings equally It is also clear from the following graph that for any given education level, males earn more than females Marginal Productivity and Wage Inequality

24. © 2005 Worth Publishers Slide 12-24 Earnings Differentials by Education and Gender, Canada, 2000

25. © 2005 Worth Publishers Slide 12-25 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 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

26. © 2005 Worth Publishers Slide 12-26 The Supply of Labour Work versus Leisure Decisions about labour 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 labour supply curve shows how the quantity of labour supplied by an individual depends on that individual’s wage rate

27. © 2005 Worth Publishers Slide 12-27 The Supply of Labour A rise in the wage rate causes both an income and a substitution effect on an individual’s labour 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 labour supply curve to slope the “wrong” way: downward

28. © 2005 Worth Publishers Slide 12-28 When the substitution effect of a wage increase dominates the income effect, the individual labour supply curve is upward sloping 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. The Individual Labour Supply Curve But when the income effect of a wage increase dominates the substitution effect, the individual labour supply curve is downward sloping as in panel (b). Here the same rise in the wage rate reduces the number of hours worked from 40 to 30.

29. © 2005 Worth Publishers Slide 12-29 Shifts of the Labour Supply Curve The market labour 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

30. © 2005 Worth Publishers Slide 12-30 The End of Chapter 12 Coming Attraction: Chapter 13: Efficiency and Equity