Marginal Productivity Theory

According to the marginal productivity theory of income distribution, every factor of production is paid the equilibrium marginal revenue product.

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 additional revenue generated by the last unit of that factor employed in the factor market as a whole—its equilibrium marginal revenue product. To understand why the marginal productivity theory of income distribution is important, look back at Figure 69.1, which shows the factor distribution of income in the United States, and ask yourself this question: who or what determined that labor would get 69.2% of total U.S. income? Why not 90% or 50%?

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 contribution to revenue made by the last unit of that factor hired. If a unit of labor is paid more than a unit of capital, it is because at the equilibrium quantity of each factor, the marginal revenue product of labor exceeds the marginal revenue 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, capital, and labor. For example, the market for computer programmers is different from the market for pastry chefs.

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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 marginal revenue product—the marginal revenue 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, and capital as well as the distribution of income among the factors of production. In Module 73 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 yearly revenue.

But there is a $67,000 difference between the salary paid to Hamill machinists and the revenue 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 revenue 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 marginal revenue 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 marginal revenue product. At Hamill, the machinists have job security and good benefits, which add to their salary. Including these benefits, machinists’ total compensation will be equal to the marginal revenue product of the last machinist employed.

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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 is now spending 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.