Although the marginal productivity theory of income distribution is a well-established part of economic theory, closely linked to the analysis of markets in general, it is a source of some controversy. There are two main objections to it.

First, in the real world we see large disparities in income between factors of production that, in the eyes of some observers, should receive the same payment. Perhaps the most conspicuous examples in Canada are the large differences in the average wages between women and men and among various racial and ethnic groups. Do these wage differences really reflect differences in marginal productivity, or is something else going on?

Second, many people wrongly believe that the marginal productivity theory of income distribution gives a moral justification for the distribution of income,implying that the existing distribution is fair and appropriate. This misconception sometimes leads other people, who believe that the current distribution of income is unfair, to reject marginal productivity theory.

To address these controversies, we’ll start by looking at income disparities across gender and ethnic groups. Then we’ll ask what factors might account for these disparities and whether these explanations are consistent with the marginal productivity theory of income distribution.

Wage rates in Canada cover a very wide range. In 2014, hundreds of thousands of workers received the legal minimum wage, a rate that varies from $11 per hour in Nunavut and Ontario to $9.95 per hour in Alberta. The average minimum wage worker earns less than $22 000 per year if they are able to get 40 hours of work per week. At the other extreme, the chief executives of two dozen companies were paid more than $10 million, which works out to more than $27 000 per day even if they worked all 365 days of the year. Even leaving out these extremes, there is a huge range of wage rates. Are people really that different in their marginal productivities?

A particular source of concern is the existence of systematic wage differences across gender, ethnicity, and immigration status. Figure 19-8 compares annual median earnings in 2010 of workers age 15 or older classified by gender and ethnicity. As a group, males (averaging across all ethnicities and places of birth) had the highest earnings. Other data show that women (averaging across all ethnicities and places of birth) earned only about 71% as much; treaty Indian workers (male and female combined), only 59% as much; workers who immigrated between 2001 and 2009 (again, male and female combined), only 67% as much; visible minority workers (averaging across places of birth and gender) earned only about 75% as much.

We are a nation founded on the belief that every individual is equal before and under the law and has the right to the equal protection and equal benefit of the law without discrimination. So why do workers receive such unequal pay? Let’s start with the marginal productivity explanations, and then look at other influences.

A large part of the observed inequality in wages can be explained by considerations that are consistent with the marginal productivity theory of income distribution. In particular, there are three well-understood sources of wage differences across occupations and individuals.

First is the existence of compensating differentials: across different types of jobs, wages are often higher or lower depending on how attractive or unattrac-tive the job is. Workers with unpleasant or dangerous jobs demand a higher wage in comparison to workers with jobs that require the same skill and effort but lack the unpleasant or dangerous qualities. For example, truckers who haul hazardous loads are paid more than truckers who haul non-hazardous loads. But for any given job, the marginal productivity theory of income distribution generally holds true. For example, hazardous-load truckers are paid a wage equal to the equilibrium value of the marginal product of the last person employed in the labour market for hazardous-load truckers.

A second reason for wage inequality that is clearly consistent with marginal productivity theory is differences in talent. People differ in their abilities: a higher-ability person, by producing a better product that commands a higher price compared to a lower-ability person, generates a higher value of the marginal product. And these differences in the value of the marginal product translate into differences in earning potential. We all know that this is true in sports: practice is important, but 99.99% (at least) of the population just doesn’t have what it takes to skate and score goals like Sidney Crosby or hit tennis balls like Rafael Nadal or Milos Raonic. The same is true, though less obvious, in other fields of endeavour.

A third and very important reason for wage differences is differences in the quantity of human capital. Recall that human capital—education and training—is at least as important in the modern economy as physical capital in the form of buildings and machines. Different people “embody” quite different quantities of human capital, and a person with a higher quantity of human capital typically generates a higher value of the marginal product by producing a product that commands a higher price. So differences in human capital account for substantial differences in wages. People with high levels of human capital, such as skilled surgeons or engineers, generally receive high wages.

The most direct way to see the effect of human capital on wages is to look at the relationship between educational levels and earnings. Figure 19-9 shows earnings differentials by gender and four educational levels for people aged 15 or older in 2010. As you can see, regardless of gender, higher education is associated with higher median earnings. For example, in 2010 females without a high school diploma had median earnings 37% less than those with a high school diploma and 59% less than those with a post-secondary degree or diploma below a bachelor’s degree—and similar patterns exist for males. Additional data show that specialist physicians and judges—occupations that require many years of formal training—earned median employment income of $126 119 and $228 104, respectively, in 2010.

Because men typically have had more years of education than women, differences in levels of education are part of the explanation for the earnings differences shown in Figure 19-8.

It’s also important to realize that formal education is not the only source of human capital; on-the-job training and experience are also very important. This point was highlighted by a 2010 Library of Parliament Background Paper. The study was motivated by concerns over the presence of a male–female earnings gap despite the fact that women have caught up with men in terms of both labour force participation and education attainment. The study showed that the average hourly wage of women between the ages of 25 and 54 was 15% below that of their male counterparts. Indeed, the gender wage gap varies across occupations: the female-to-male earnings ratio ranges from 70% for occupations unique to primary industry to 99% for occupations in art, culture, recreation, and sport.

Table 19-3 shows the average hourly wage and the female-to-male earnings ratios for selected occupations described in the report. The report suggests that job and demographic characteristics are the contributing factors to these wage gaps. For example, the expectation that women will take on greater household responsibilities related to raising children tends to reduce their working hours and/or lead to interruptions in their participation in the labour market, which has adverse impact on their job experience and the training they receive. The report points out that women represented two-thirds of the workers in 13 of the 20 lowest paid occupations in the country, while men were the majority in only 3 of these 20 occupations. Gender differences in job tenure and experience can partly explain one notable aspect of Figure 19-9: women’s median earnings are less than men’s median earnings for any given education level.

But it’s also important to emphasize that earnings differences arising from differences in human capital are not necessarily “fair.” A society in which Aboriginal and immigrant children often receive a poor education because they live in underfunded school districts, then go on to earn low wages because they are poorly educated, may have labour markets that are well described by marginal productivity theory (and would be consistent with the earnings differentials across ethnic groups shown in Figure 19-8). Yet many people would still consider the resulting distribution of income unfair.

Still, many observers think that actual wage differentials cannot be entirely explained by compensating differentials, differences in talent, and differences in human capital. They believe that market power, efficiency wages, and discrimination also play an important role. We will examine these forces next.

The marginal productivity theory of income distribution is based on the assumption that factor markets are perfectly competitive. In such markets we can expect workers to be paid the equilibrium value of their marginal product, regardless of who they are. But how valid is this assumption?

We studied markets that are not perfectly competitive in Chapters 13, 14, and 15; now let’s touch briefly on the ways in which labour markets may deviate from the competitive assumption.

One undoubted source of differences in wages between otherwise similar workers is the role of unions—organizations that try to raise wages and improve working conditions for their members. Labour unions, when they are successful, replace one-on-one wage deals between workers and employers with collective bargaining, in which the employer must negotiate wages with union representatives. Without question, this leads to higher wages for those workers who are represented by unions. In early 2014 the median weekly earnings of union members in Canada were $992.40, compared with $760 for workers not represented by unions—a nearly 34% difference.

Just as workers can sometimes organize to extract higher wages than they would otherwise receive, employers can sometimes organize to pay lower wages than would result from competition. For example, health care workers—doctors, nurses, and so on—sometimes argue that provincial health ministries and hospitals are engaged in a collective effort to hold down their wages.

How much does collective action, either by workers or by employers, affect wages in Canada now? Canada’s unionization rates have remained relatively stable in the past few decades, falling only from 34% in 1997 to 31.2% in 2013. So unlike the United States, where less than 7% of private sector employees were unionized in 2010, unions in Canada still exert a significant upward effect on wages. In 2013 about 58% of all unionized employees worked in the public sector, balancing the market power governments possesses as employers. However, with deregulation, outsourcing, and globalization, the power of unions has eroded slightly, especially their bargaining power over wages. Nonetheless, they still play an important role in the negotiations of job security, better working conditions, and benefits for their members.

A second source of wage inequality is the phenomenon of efficiency wages—a type of incentive scheme used by employers to motivate workers to work hard and to reduce worker turnover. Suppose a worker performs a job that is extremely important—say, serving as a caregiver for the employer’s child—but that the employer can observe how well the job is being performed only at infrequent intervals. Then it often makes sense for the employer to pay more than the worker could earn in an alternative job—that is, more than the equilibrium wage. Why? Because earning a premium makes losing this job and having to take the alternative job quite costly for the worker.

So a worker who happens to be observed performing poorly and is therefore fired is now worse off for having to accept a lower-paying job. The threat of losing a job that pays a premium motivates the worker to perform well and avoid being fired. Likewise, paying a premium also reduces worker turnover—the frequency with which an employee leaves a job voluntarily. Despite the fact that it may take no more effort and skill to be a child’s caregiver than to be an office worker, efficiency wages show why it often makes economic sense for a parent to pay a caregiver more than the equilibrium wage of an office worker.

The efficiency-wage model explains why we might observe wages offered above their equilibrium level. Like the price floors we studied in Chapter 5—and, in particular, much like the minimum wage—this phenomenon leads to a surplus of labour in labour markets that are characterized by the efficiency-wage model. This surplus of labour translates into unemployment—some workers are actively searching for a high-paying efficiency-wage job but are unable to get one, and other more fortunate but no more deserving workers are able to acquire one.

As a result, two workers with exactly the same profile—the same skills and same job history—may earn unequal wages: the worker who is lucky enough to get an efficiency-wage job earns more than the worker who gets a standard job (or who remains unemployed while searching for a higher-paying job). Efficiency wages are a response to a type of market failure that arises from the fact that some employees don’t always perform as well as they should and are able to hide that fact. As a result, employers use nonequilibrium wages in order to motivate their employees, leading to an inefficient outcome.

It is a real and ugly fact that throughout history there has been discrimination against workers who are considered to be of the wrong race, ethnicity, gender, or other characteristics. How does this fit into our economic models?

The main insight economic analysis offers is that discrimination is not a natural consequence of market competition. On the contrary, market forces tend to work against discrimination. To see why, consider the incentives that would exist if social convention dictated that women be paid, say, 30% less than men with equivalent qualifications and experience. A company whose management was itself unbiased would then be able to reduce its costs by hiring women rather than men—and such companies would have an advantage over other companies that hired men despite their higher cost. The result would be to create an excess demand for female workers, which would tend to drive up their wages.

But if market competition works against discrimination, how is it that so much discrimination has taken place? The answer is twofold. First, when labour markets don’t work well, employers may have the ability to discriminate without hurting their profits. For example, market interferences (such as unions or minimum-wage laws) or market failures (such as efficiency wages) can lead to wages that are above their equilibrium levels. In these cases, there are more job applicants than there are jobs, leaving employers free to discriminate among applicants. In 2012, with unemployment over 7%, the Canadian Human Rights Commission, the federal agency tasked with investigating discrimination charges in the federal government and federally regulated industries (e.g., banking, transportation, and communication), reported that the complaints from workers and jobseekers had hit an all-time high, the most logged in the agency’s 35-year history.

In research published in the American Economic Review, two economists, Marianne Bertrand and Sendhil Mullainathan, documented discrimination in hiring by sending fictitious resumés to prospective employers on a random basis. Applicants with “white-sounding” names such as Emily Walsh were 50% more likely to be contacted than applicants with “African-American-sounding” names such as Lakisha Washington. Also, applicants with white-sounding names and good credentials were much more likely to be contacted than those without such credentials. By contrast, potential employers seemed to ignore the credentials of applicants with African-American-sounding names.

Second, discrimination has sometimes been institutionalized in government policy. This institutionalization of discrimination has made it easier to maintain it against market pressure, and historically it is the form that discrimination has typically taken. For example, in Canada in the late 1800s and early 1900s, Asians faced immigration barriers (including exclusion from entry) and laws restricting the jobs they could have and forcing their wages to be less than what other employees earned. In the United States, African-Americans were barred from attending “whites-only” public schools and universities in many parts of the country and forced to attend inferior schools. Although market competition tends to work against current discrimination, it is not a remedy for past discrimination, which typically has had an impact on the education and experience of its victims and thereby reduces their income. The preceding For Inquiring Minds illustrates the way in which government policy enforced discrimination in the world’s most famous racist regime, that of the former government of South Africa.

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. The deviations are important. But, by and large, in a modern economy with well-functioning labour markets, factors of production are paid the equilibrium value of the marginal product—the value of the marginal product of the last unit employed in the market as a whole.

It’s important to emphasize, once again, that this does not mean that the factor distribution of income is morally justified.