Factor Markets and the Distribution of Income

• Module 40: Factor Markets
• Module 41: Marginal Productivity Theory
• Module 42: The Market for Labor

THE VALUE OF A DEGREE

Does higher education pay? Yes, it does: in the modern economy, employers are willing to pay a premium for workers with more education. And the size of that premium has increased a lot over the last few decades. Back in 1973 workers with advanced degrees, such as law degrees or MBAs, earned only 76% more than those who had only graduated from high school. By 2011, the premium for an advanced degree had risen to over 225%.

Who decided that the wages of workers with advanced degrees would rise so much compared with those of high school grads? The answer, of course, is that nobody decided it. Wage rates are prices, the prices of different kinds of labor; and they are decided, like other prices, by supply and demand.

Still, there is a qualitative difference between the wage rate of high school grads and the price of used textbooks: the wage rate isn’t the price of a good, it’s the price of a factor of production. And although markets for factors of production are in many ways similar to those for goods, there are also some important differences.

In this section, we examine factor markets, the markets in which the factors of production such as labor, land, and capital are traded. Factor markets, like markets for goods and services, play a crucial role in the economy: they allocate productive resources to producers and help ensure those resources are used efficiently.

This section begins by describing the major factors of production. Then we consider the demand for factors of production, which leads us to a crucial insight: the marginal productivity theory of income distribution. We then consider some challenges to the marginal productivity theory. The section concludes with a discussion of the supply of the most important factor, labor.