The Marginal Productivity Theory of Income Distribution
According to the marginal productivity theory of income distribution, every factor of production is paid its equilibrium value of the marginal product.
So we have learned that when the markets for goods and services and the factor markets are perfectly competitive, a factor of production will be employed up to the point at which its value of the marginal product is equal to its market equilibrium price. That is, it will be paid its equilibrium value of the marginal product. What does this say about the factor distribution of income? It leads us to the marginal productivity theory of income distribution, which says that 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—
To understand why the marginal productivity theory of income distribution is important, look back at Figure 19-1, which shows the factor distribution of income in the United States, and ask yourself this question: who or what decided that labor would get 66% of total U.S. income? Why not 90% or 50%?
PITFALLS: GETTING MARGINAL PRODUCTIVITY THEORY RIGHT
GETTING MARGINAL PRODUCTIVITY THEORY RIGHT
It’s important to be careful about what the marginal productivity theory of income distribution says: it says that all units of a factor get paid the factor’s equilibrium value of the marginal product—
The most 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. In looking at Table 19-2, you might be tempted to think that because the first worker has a value of the marginal product of $380, that worker is paid $380 in equilibrium. Not so: if the equilibrium value of the marginal product in the labor market is equal to $200, then all workers receive $200.
The answer, according to the marginal productivity theory of income distribution, is that the division of income among the economy’s factors of production isn’t arbitrary: it is determined by each factor’s marginal productivity at the economy’s equilibrium. The wage rate earned by all workers in the economy is equal to the increase in the value of output generated by the last worker employed in the economy-
Here we have assumed that all workers are of the same ability. (Similarly, we’ve assumed that all units of land and capital are equally productive.) But in reality workers differ considerably in ability.
Rather than thinking of one labor market for all workers in the economy, we can instead think of different markets for different types of workers, where workers are of equivalent ability within each market. For example, the market for computer programmers is different from the market for pastry chefs.
In the market for computer programmers, all participants are assumed to have equal ability; likewise for the market for pastry chefs. In this scenario, 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—
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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 2013, 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 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 124 in 2013, 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 $130,000 plus the cost of benefits per trainee. (Unfortunately, training new hires has left Hamill vulnerable to poaching, which occurs when other companies that haven’t incurred the cost of training lure employees away by offering higher wages.) In the end, it does appear that the marginal productivity theory of income distribution holds.
Quick Review
In a perfectly competitive market economy, the price of the good multiplied by the marginal product of labor is equal to the value of the marginal product of labor: VMPL = P × MPL. A profit-
maximizing producer hires labor up to the point at which the value of the marginal product of labor is equal to the wage rate: VMPL = W. The value of the marginal product curve of labor slopes downward due to diminishing returns to labor in production. The market demand curve for labor is the horizontal sum of all the individual demand curves of producers in that market. It shifts for three reasons: changes in output price, changes in the supply of other factors, and technological progress.
As in the case of labor, producers will employ land or capital until the point at which its value of the marginal product is equal to its rental rate. According to the marginal productivity theory of income distribution, in a perfectly competitive economy each factor of production is paid its equilibrium value of the marginal product.
19-2
Question 19.2
In the following cases, state the direction of the shift of the demand curve for labor and what will happen, other things equal, to the market equilibrium wage rate and quantity of labor employed as a result.
Service industries, such as retailing and banking, experience an increase in demand. These industries use relatively more labor than nonservice industries.
Due to overfishing, there is a fall in the amount of fish caught per day by commercial fishers; this decrease affects their demand for workers.
Question 19.3
Explain the following statement: “When firms in different industries all compete for the same workers, then the value of the marginal product of the last worker hired will be equal across all firms regardless of whether they are in different industries.”
Solutions appear at back of book.