1.2 Module 41: Marginal Productivity Theory

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In the previous module we introduced the factor distribution of income. In this module, we will go a step further and explain how the marginal productivity theory of income distribution helps to explain how income is divided among factors of production in an economy. We will consider how the markets for factors of production are broken down. There are different markets for different types of factors. For example, there are different labor markets for different types of labor, such as for computer programmers, pastry chefs, and economists. Then, we look at the marginal productivity theory of income distribution and the extent to which it explains wage disparities between workers.

The Marginal Productivity Theory of Income Distribution

The marginal productivity theory of income distribution sums up what we have learned about payments to factors when goods markets and factor markets are perfectly competitive. According to this theory, each factor is paid the value of the output generated by the last unit of that factor employed in the factor market as a whole—its equilibrium value of the marginal product.

To understand why the marginal productivity theory of income distribution is important, look back at Figure 40-1, which shows the factor distribution of income in the United States in 2012, and ask yourself this question: who or what determined that labor would get 71% of total U.S. income? Why not 90% or 50%?

The U.S. labor market continues to show large differences across workers according to gender and ethnicity. Women are paid substantially less than men; African-American and Hispanic workers are paid substantially less than White male workers.

Source: U.S. Census Bureau

The answer, according to this theory, is that the division of income among the economy’s factors of production isn’t arbitrary: in the economy-wide factor market, the price paid for each factor is equal to the increase in the value of output generated by the last unit of that factor employed in the market. Therefore, if a unit of labor is paid more than a unit of capital, it is because at the equilibrium quantity of each factor, the value of the marginal product of labor exceeds the value of the marginal product of capital.

So far we have treated factor markets as if every unit of each factor were identical. That is, as if all land were identical, all labor were identical, and all capital were identical. But in reality factors differ considerably with respect to productivity. For instance, land resources differ in their ability to produce crops and workers have different skills and abilities.

Rather than thinking of one land market for all land resources in an economy, and similarly one capital market and one labor market, we can instead think of different markets for different types of land, physical capital, human capital, and labor. For example, the market for computer programmers is different from the market for pastry chefs.

When we consider that there are separate factor markets for different types of factors, the marginal productivity theory of income distribution still holds. That is, when the labor market for computer programmers is in equilibrium, the wage rate earned by all computer programmers is equal to the market’s equilibrium value of the marginal product—the value of the marginal product of the last computer programmer hired in that market.

The marginal productivity theory can explain the distribution of income among different types of land, labor, physical capital, and human capital as well as the distribution of income among the factors of production. Next we look more closely at the distribution of income between different types of labor and the extent to which the marginal productivity theory of income distribution explains differences in workers’ wages.

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Hamill Manufacturing of Pennsylvania makes precision components for military helicopters and nuclear submarines. Their highly skilled senior machinists are well paid compared to other workers in manufacturing, earning nearly $70,000 in 2011, excluding benefits. Like most skilled machinists in the United States, Hamill’s machinists are very productive: according to the U.S. Census Annual Survey of Manufacturers, in 2010 the average skilled machinist generated approximately $137,000 in value added.

But there is a $67,000 difference between the salary paid to Hamill machinists and the value added they generate. Does this mean that the marginal productivity theory of income distribution doesn’t hold? Doesn’t the theory imply that machinists should be paid $137,000, the average value added that each one generates?

The marginal productivity theory of income distribution holds for skilled machinists at Hamill Manufacturing.

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The answer is no, for two reasons. First, the $137,000 figure is averaged over all machinists currently employed. The theory says that machinists will be paid the value of the marginal product of the last machinist hired, and due to diminishing returns to labor, that value will be lower than the average over all machinists currently employed. Second, a worker’s equilibrium wage rate includes other costs, such as employee benefits, that have to be added to the $70,000 salary. The marginal productivity theory of income distribution says that workers are paid a wage rate, including all benefits, equal to the value of the marginal product.

You can see all these costs are present at Hamill. There the machinists have good benefits and job security, which add to their salary. Including these benefits, machinists’ total compensation will be equal to the value of the marginal product of the last machinist employed.

In Hamill’s case, there is yet another factor that explains the $67,000 gap: there are not enough machinists at the current wage rate. Although the company increased the number of employees from 85 in 2004 to 125 in 2011, they would like to hire more.

Why doesn’t Hamill raise its wages in order to attract more skilled machinists? The problem is that the work they do is so specialized that it is hard to hire from the outside, even when the company raises wages as an inducement. To address this problem, Hamill has spent a significant amount of money training each new hire, approximately $125,000 plus the cost of benefits per trainee. 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?

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 the United States 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 Disparities in Practice

Wage rates in the United States cover a very wide range. In 2012, hundreds of thousands of workers received the legal federal minimum of $7.25 per hour. At the other extreme, the chief executives of several companies were paid more than $100 million, which works out to $20,000 per hour even if they worked 100-hour weeks. 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 and ethnicity. Figure 41-1 compares annual median earnings in 2011 of workers age 25 or older classified by gender and ethnicity. As a group, White males had the highest earnings. Other data show that women (averaging across all ethnicities) earned only about 69% as much; African-American workers (male and female combined), only 69% as much; Hispanic workers (again, male and female combined), only 59% as much.

We are a nation founded on the belief that all men are created equal—and if the Constitution were rewritten today, we would say that all people are created equal. So why do they receive such unequal pay? Let’s start with the marginal productivity explanations, then look at other influences.

Marginal Productivity and Wage Inequality

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 unattractive 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 labor 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 throw passes like Tom Brady or hit tennis balls like Roger Federer. The same is true, though less obvious, in other fields of endeavor.

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 41-2 shows earnings differentials by gender, ethnicity, and three educational levels for people age 25 or older in 2010. As you can see, regardless of gender or ethnicity, higher education is associated with higher median earnings. For example, in 2010 White females with 9 to 12 years of schooling but without a high school diploma had median earnings 32% less than those with a high school diploma and 65% less than those with a college degree—and similar patterns exist for the other five groups. Additional data show that surgeons—an occupation that requires steady hands and many years of formal training—earned an average of $225,390 in 2010.

It is clear 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. Other patterns are evident as well: for any given education level, White males earn more than every other group, and males earn more than females for any given ethnic group.

Source: U.S. Census Bureau

Because even now men typically have had more years of education than women and Whites more years than non-Whites, differences in level of education are part of the explanation for the earnings differences shown in Figure 41-1.

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. Differences in job tenure and experience can partly explain one notable aspect of Figure 41-2: across all ethnicities, 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 non-White children typically 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 labor markets that are well described by marginal productivity theory (and would be consistent with the earnings differentials across ethnic groups shown in Figure 41-1). 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.

Market Power

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; now let’s touch briefly on the ways in which labor 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. Labor 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 2012 the median weekly earnings of union members in the United States were $943, compared with $742 for workers not represented by unions—a 27% difference.

Unions today have a fairly minor impact on wages compared to several decades ago.

AP Photo/Rick Bowner

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 health maintenance organizations (HMOs) 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 the modern United States? Several decades ago, when around 30% of American workers were union members, unions probably had a significant upward effect on wages. Today, however, most economists think unions exert a fairly minor influence. Union membership in the United States is relatively limited: in 2012, only 6.6% of the employees of private businesses were represented by unions.

Efficiency Wages

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 turnover. Suppose a worker performs a job that is extremely important but that the employer can observe how well the job is being performed only at infrequent intervals—say, serving as a caregiver for the employer’s child. 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.

The efficiency-wage model explains why we might observe wages offered above their equilibrium level. Like the price floors we studied in an earlier module—and, in particular, much like the minimum wage—this phenomenon leads to a surplus of labor in labor markets that are characterized by the efficiency-wage model. This surplus of labor 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.

Discrimination

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 labor 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 2011, with unemployment over 9%, the Equal Employment Opportunity Commission, the federal agency tasked with investigating employment discrimination charges, reported that the complaints from workers and job-seekers had hit an all-time high, the most logged in the agency’s 46-year history.

In the past, newspapers separated help-wanted ads by gender, as in this case, and by race.

Library of Congress Prints and Photographs Division, Washington DC (LCDIG-ppmsca-02927

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, at one time 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.

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. The deviations are important. But, by and large, in a modern economy with well-functioning labor 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.

Module 41 Review

Check Your Understanding

List three different economic concepts that explain wage differences when the marginal productivity theory of income distribution does not. Explain each.

PITFALLS: GETTING MARGINAL PRODUCTIVITY THEORY RIGHT

GETTING MARGINAL PRODUCTIVITY THEORY RIGHT

According to the marginal productivity theory, are workers paid a wage equal to the value of their own marginal product of labor?

No they are not. Remember 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. a 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. For an example, look back at Table 40-2 on p. 428. There, the first worker has a value of the marginal product of $380. It’s tempting to conclude that because that worker has a value of the marginal product of $380, he or she is paid $380 in equilibrium. But, that’s not the case. If the equilibrium value of the marginal product in the labor market is equal to $200, then all workers receive $200.

To learn more, see pages 432–433 and 436–437.