The Marginal Productivity Theory of Income Distribution

AP® Exam Tip

Be prepared to identify and explain sources of income inequality for the AP® exam.

According to the marginal productivity theory of income distribution, the division of income among the economy’s factors of production is determined by each factor’s marginal revenue product at the market equilibrium. If we consider an economy-wide factor market, the price paid for all factors in the economy is equal to the increase in revenue generated by the last unit of the factor employed in the market. But what about the distribution of income among different labor markets and workers? Does the marginal productivity theory of income distribution help to explain why some workers earn more than others?

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.

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Compensating differentials are wage differences across jobs that reflect the fact that some jobs are less pleasant or more dangerous than others.

The 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 in unpleasant or dangerous jobs receive a higher wage than workers in jobs that require the same skill, training, and effort but lack the unpleasant or dangerous qualities. For example, truckers who haul hazardous chemicals are paid more than truckers who haul bread. For any particular job, the marginal productivity theory of income distribution generally holds true. For example, hazardous-load truckers are paid a wage equal to the equilibrium marginal revenue product of those truckers, which is the contribution to revenue of the last person employed in the 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 high-ability person, by producing a better product that commands a higher price compared to a lower-ability person, generates a higher marginal revenue product. And these differences in the marginal revenue 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 control a soccer ball like Lionel Messi or hit a tennis ball like Serena Williams. The same is true, though less obvious, in other fields of endeavor.

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Arthur S. Aubry/Photodisc/Getty Images

A third, 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 more human capital typically generates a higher marginal revenue product by producing more or better products. So differences in human capital account for substantial differences in wages. People with high levels of human capital, such as 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 education levels and earnings. Figure 73.1 shows earnings differentials by gender, ethnicity, and three education levels for people 25 years or older in 2013. As you can see, regardless of gender or ethnicity, higher education is associated with higher median earnings. For example, in 2013 white females with 9 to 12 years of schooling but without a high school diploma had median earnings 31% less than those with a high school diploma and 61% 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 $233,150 in 2013.

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Figure 73.1: Earnings Differentials by Education, Gender, and Ethnicity, 2013It 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: Bureau of Labor Statistics.

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

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 2006 National Science Foundation report on earnings differences between male and female scientists and engineers. The study was motivated by concerns over the male–female earnings gap: the median salary for women in science and engineering is about 24% less than the median salary for men. The study found that, on average, women in these occupations are younger than men and have considerably less experience than their male counterparts. This difference in age and experience, according to the study, explained most of the earnings differential. Differences in job tenure and experience can partly explain one notable aspect of Figure 73.1: that, across all ethnicities, women’s median earnings are less than men’s median earnings for any given education level.

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, and 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 earnings consistent with the earnings differentials across ethnic groups shown in Figure 73.1). 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

AP® Exam Tip

Unions act like single sellers of labor. Through collective bargaining, they represent all the workers, making them a monopoly.

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?

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Union members rally to demand higher wages.
STEPHANE DE SAKUTIN/AFP/Getty Images

We studied markets that are not perfectly competitive in previous modules; now let’s touch briefly on the ways in which labor markets may deviate from the competitive assumption.

Unions are organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively.

One undoubted source of differences in wages among otherwise similar workers is unions—organizations that try to raise wages and improve working conditions for their members. Labor unions, when successful, replace one-on-one wage deals between workers and employers with “collective bargaining,” in which the employer negotiates wages with union representatives. Without question, this leads to higher wages for those workers who are represented by unions. In 2013, the median weekly earnings of union members in the United States were $950, compared with $750 for workers not represented by unions—about a 26% difference.

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Just as workers can sometimes organize to demand 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.

Collective action, either by workers or by employers, is less common in the United States than it used to be. Several decades ago, approximately 30% of U.S. workers were union members. Today, however, union membership in the United States is relatively limited: 6.7% of the employees of private businesses are represented by unions. And although there are fields like health care in which a few large firms account for a sizable share of employment in certain geographical areas, the sheer size of the U.S. labor market and the ease with which most workers can move in search of higher-paying jobs probably mean that concerted efforts to hold wages below the unrestrained market equilibrium level rarely occur and even more rarely succeed.

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 worker 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. This would be true, for example, for childcare providers. 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 childcare provider 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.

According to the efficiency-wage model, some employers pay an above-equilibrium wage as an incentive for better performance and loyalty.

The efficiency-wage model explains why we may observe wages offered above their equilibrium level. Like the price floors we studied in Module 8—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 find work. As a result, two workers with exactly the same profile—the same skills and job history—may earn different 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 above-equilibrium wages to motivate their employees, leading to an inefficient outcome.

Discrimination

It is an 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.

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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 research published in the American Economic Review, two economists, Marianne Bertrand and Sendhil Mullainathan, documented discrimination in hiring by sending fictitious résumés 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 has made it easier to maintain discrimination against market pressure. 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. The following FYI 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 Economics of Apartheid

The Republic of South Africa is the richest nation in Africa, but it also has a harsh political history. Until the peaceful transition to majority rule in 1994, the country was controlled by its White minority, Afrikaners, the descendants of European (mainly Dutch) immigrants. This minority imposed an economic system known as apartheid, which overwhelmingly favored White interests over those of native Africans and other groups considered “non-White,” such as Asians.

The origins of apartheid go back to the early years of the twentieth century, when large numbers of White farmers began moving into South Africa’s growing cities. There they discovered, to their horror, that they did not automatically earn higher wages than other races. But they had the right to vote—and non-Whites did not. And so the South African government instituted “job-reservation” laws designed to ensure that only Whites got jobs that paid well. The government also set about creating jobs for Whites in government-owned industries. As Allister Sparks notes in The Mind of South Africa (1990), in its efforts to provide high-paying jobs for Whites, the country “eventually acquired the largest amount of nationalized industry of any country outside the Communist bloc.”

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William Foley/The LIFE Images Collection/Getty Images

In other words, racial discrimination was possible because it was backed by the power of the government, which prevented markets from following their natural course. A postscript: in 1994, in one of the political miracles of modern times, the White regime ceded power and South Africa became a full-fledged democracy. Apartheid was abolished. Unfortunately, large racial differences in earnings remain. The main reason is that apartheid created huge disparities in human capital, which will persist for many years to come.

Wage Disparities in Practice

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Wage rates in the United States cover a very wide range. In 2014, 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 for the year, which works out to $20,000 per hour even if they worked 100-hour weeks. Leaving out these extremes, there is still a huge range of wage rates. Are people really that different in their marginal productivities? Do workers really differ that much in their value to firms?

A particular source of concern is the existence of systematic wage differences across gender and ethnicity. Figure 73.2 compares annual median earnings in 2013 of workers 25 years or older classified by gender and ethnicity. As a group, White males had the highest earnings. Women (averaging across all ethnicities) earned only about 79% as much; African-American workers (male and female combined) only 71% as much; and Hispanic workers only 65% as much.

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Figure 73.2: Median Earnings by Gender and Ethnicity, 2013The 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: Bureau of Labor Statistics.

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? The pay differences may involve some differences in marginal productivity, but we also must allow for the possibility of other influences.