SUMMARY

1. Just as there are markets for goods and services, there are markets for factors of production, including labor, land, and both physical capital and human capital. These markets determine the factor distribution of income.

2. Profit-maximizing price-taking producers will employ a factor up to the point at which its price is equal to its value of the marginal product—the marginal product of the factor multiplied by the price of the output it produces. The value of the marginal product curve is therefore the individual price-taking producer’s demand curve for a factor.

3. The market demand curve for labor is the horizontal sum of the individual demand curves of producers in that market. It shifts for three main reasons: changes in output price, changes in the supply of other factors, and technological changes.

4. When a competitive labor market is in equilibrium, the market wage is equal to the equilibrium value of the marginal product of labor, the additional value produced by the last worker hired in the labor market as a whole. The same principle applies to other factors of production: the rental rate of land or capital is equal to the equilibrium value of the marginal products. This insight leads to the marginal productivity theory of income distribution, according to which each factor is paid the value of the marginal product of the last unit of that factor employed in the factor market as a whole.

5. Large disparities in wages raise questions about the validity of the marginal productivity theory of income distribution. Many disparities can be explained by compensating differentials and by differences in talent, job experience, job status, and human capital across workers. Market interference in the forms of unions and collective action by employers also creates wage disparities. The efficiency-wage model, which arises from a type of market failure, shows how wage disparities can result from employers’ attempts to increase worker performance. Free markets tend to diminish discrimination, but discrimination remains a real source of wage disparity, especially through its effects on human capital acquisition. Discrimination is typically maintained either through problems in labor markets or (historically) through institutionalization in government policies.

6. Labor supply is the result of decisions about time allocation, where each worker faces a trade-off between leisure and work. An increase in the hourly wage rate tends to increase work hours via the substitution effect but to reduce work hours via the income effect. If the net result is that a worker increases the quantity of labor supplied in response to a higher wage, the individual labor supply curve slopes upward. If the net result is that a worker reduces work hours, the individual labor supply curve—unlike supply curves for goods and services—slopes downward.

7. The market labor supply curve is the horizontal sum of the individual labor supply curves of all workers in that market. It shifts for four main reasons: changes in preferences and social norms, changes in population, changes in opportunities, and changes in wealth.