CHAPTER 12
Factor Markets and the
Distribution of Income
PowerPoint® Slides
by Can Erbil and Gustavo Indart
© 2005 Worth Publishers
Slide 12-1
What You Will Learn in this Chapter:




How factors of production—resources like land, labour, and
both physical capital and human capital—are traded in
factor markets, determining the factor distribution of
income
How the demand for factors leads to the marginal
productivity theory of income distribution
Sources of wage disparities and the role of discrimination
The way in which a worker’s decision about time allocation
gives rise to labour supply
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Slide 12-2
The Economy’s Factors of Production
 A factor of production is any resource that is used by
firms to produce goods and services, items that are
consumed by households
 Factors of production are bought and sold in factor
markets, and the prices in factor markets are known
as factor prices
 What are these factors of production, and why do
factor prices matter?
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Slide 12-3
The Factors of Production
Economists divide factors of production into four
principal classes:
 Land
 Labour
 Physical capital - consists of manufactured
resources such as buildings and machines
 Human capital - is the improvement in labour
created by education and knowledge that is
embodied in the workforce
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Slide 12-4
Why Factor Prices Matter:
The Allocation of Resources
Factor prices play a key role in the allocation of
resources among producers due to two features
that make these markets special:
 Demand for the factor is derived from the
firm’s output choice
 Factor markets are where most of us get the
largest shares of our income
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Slide 12-5
Factor Incomes and the
Distribution of Income
The
factor distribution of income is the division
of total income among labour, land, and capital
Factor
prices, which are set in factor markets,
determine the factor distribution of income
Labour
receives the bulk of the income in the
modern Canadian economy —between 66 and 75
percent over the past 45 years
Although
the exact share is not directly measurable,
much of what is called compensation of employees is
a return to human capital
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Slide 12-6
Factor Distribution of Income in
Canada in 2003
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Slide 12-7
Marginal Productivity and Factor
Demand
All
economic decisions are about comparing costs
and benefits. For a producer, it could be deciding
whether to hire an additional worker…
 But what is the marginal benefit of that
worker?
will use the production function, which relates
inputs to output to answer that question
We
We
will assume throughout this chapter that all
producers are price-takers—they operate in a
perfectly competitive industry
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Slide 12-8
The Production Function for George and
Martha’s Farm
Panel (a) uses the total product curve to show how total wheat
production depends on the number of workers employed on the farm.
Panel (b) shows how the marginal product of labour, the increase in
output from employing one more worker, depends on the number of
workers employed.
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Slide 12-9
Value of the Marginal Product
What
is George and Martha’s optimal number of
workers? That is, how many workers should they
employ to maximize profit?
 As we know from earlier chapters, a price-taking
firm’s profit is maximized by producing the
quantity of output at which the marginal cost of
the last unit produced is equal to the market
price
Once
we determine the optimal quantity of output,
we can go back to the production function and find
the optimal number of workers
 There is also an alternative approach based on
the value of the marginal product…
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Slide 12-10
Value of the Marginal Product
The value of the marginal product of a factor
is the value of the additional output generated by
employing one more unit of that factor

The value of the marginal product of labour
is:
VMPL = P × MPL

The general rule is that a profit-maximizing, pricetaking producer employs each factor of production
up to the point at which the value of the marginal

product of the last unit of the factor employed is
equal to that factor’s price
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Slide 12-11
Value of the Marginal Product
To maximize profit, George and Martha will employ
workers up to the point at which, for the last worker
employed, VMPL = W.
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Slide 12-12
The Value
of the
Marginal
Product
Curve
VMPL shows how the value of the marginal product of labour depends on
the number of workers employed. It is downward sloping due to
diminishing returns to labour in production. To maximize profit, George and
Martha choose the level of employment at which the value of the marginal
product of labour is equal to the market wage rate (at a wage rate of $200
the profit-maximizing level of employment is 5 workers).
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Slide 12-13
Shifts of the Factor Demand
Curve

What causes factor demand curves to shift?

There are three main causes:
 Changes in prices of goods
 Changes in supply of other factors
 Changes in technology
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Slide 12-14
Shifts of the Value of the Marginal
Product Curve
Panel (b)
(a) shows the effect of a rise
fall in
in the
the price
price of
of wheat.
wheat on
TheGeorge
value of
and
the
Martha’s demand
marginal
product curve
for labour.
shiftsThe
downward,
value of from
the marginal
VMPL1 toproduct
VMPL3.curve
At theshifts
upward,wage
market
from rate
VMPL
of1 $200,
to VMPL
profit-maximizing
2. If the marketemployment
wage rate remains
falls from
at $200,
5
profit maximizing
workers
to 2 workers
employment
(A  C). rises from 5 workers to 8 workers (A  B).
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Slide 12-15
The Marginal Productivity
Theory of Income Distribution
We have learned that when the markets for goods
and services and the factor markets are perfectly
competitive, factors of production will be employed
up to the point at which their value of the marginal
product is equal to their price.
What does this say about the factor distribution of
income?
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Slide 12-16
All Producers Face the Same Wage Rate
Although Farmer Jones grows wheat and Farmer Smith grows corn, they
both compete in the same market for labour and must therefore pay the
same wage rate, $200. Each producer hires labour up to the point at
which VMPL = $200: 5 workers for Jones, 7 workers for Smith.
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Slide 12-17
Equilibrium in the Labour Market
Each firm will hire labour up to the point at which
the value of the marginal product of labour is equal to
the equilibrium wage rate

This means that, in equilibrium, the marginal
product of labour will be the same for all employers

So the equilibrium (or market) wage rate is equal to
the equilibrium value of the marginal product
of labour—the additional value produced by the last
unit of labour employed in the labour market as a
whole

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Slide 12-18
Equilibrium in the Labour Market
It doesn’t matter where that additional unit is
employed, since VMPL is the same for all producers

The theory that each factor is paid the value of the
output generated by the last unit employed in the
factor market as a whole is known as the marginal
productivity theory of income distribution

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Slide 12-19
Equilibrium in
the Labour
Market
The market labour
demand curve is the
horizontal sum of the
individual labour
demand curves of all
producers. Here the
equilibrium wage rate is
W*, the equilibrium
employment level is L*,
and every producer
hires labour up to the
point at which VMPL =
W*.
So, labour is paid its equilibrium value of the marginal product, the value of
the marginal product of the last worker hired in the labour market as a
whole.
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Slide 12-20
Is the Marginal Productivity
Theory of Income Distribution
Really True?
There are some issues open to debate about the
marginal productivity theory of income
distribution:
 Do the wage differences really reflect
differences in marginal productivity, or is
something else going on?
 What factors might account for these
disparities and are any of these explanations
consistent with the marginal productivity theory
of income distribution?
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Slide 12-21
Earnings Differential by Gender and
Ethnicity, Canada, 2000
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Slide 12-22
Marginal Productivity and Wage
Inequality
Compensating differentials are wage differences
across jobs that reflect the fact that some jobs are less
pleasant than others

Compensating differentials, as well as differences in the
values of the marginal products of workers that arise from
differences in talent, job experience, and human capital,
account for some wage disparities

It is clear from the following graph that, regardless of
gender, education pays: those with a university degree
earn more than those without one, although not all
degrees increase earnings equally

It is also clear from the following graph that for any
given education level, males earn more than females

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Slide 12-23
Earnings Differentials by Education and
Gender, Canada, 2000
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Slide 12-24
Marginal Productivity and Wage
Inequality
Market power, in the form of unions or collective
action by employers, as well as the efficiency-wage
model, also explain how some wage disparities arise

Unions are organizations of workers that try to raise
wages and improve working conditions for their members

According to the efficiency-wage model, some
employers pay an above equilibrium wage as an incentive
for better performance

Discrimination has historically been a major factor in
wage disparities. Market competition tends to work
against discrimination

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Slide 12-25
The Supply of Labour
Work versus Leisure
Decisions about labour supply result from decisions
about time allocation: how many hours to spend
on different activities

Leisure is time available for purposes other than
earning money to buy marketed goods

In the following graph, the individual labour
supply curve shows how the quantity of labour
supplied by an individual depends on that individual’s
wage rate

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Slide 12-26
The Supply of Labour
A rise in the wage rate causes both an income and a
substitution effect on an individual’s labour supply

 The substitution effect of a higher wage rate
induces longer work hours, other things equal
 This is countered by the income effect: higher
income leads to a higher demand for leisure, a
normal good
If the income effect dominates, a rise in the wage
rate can actually cause the individual labour supply
curve to slope the “wrong” way: downward

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Slide 12-27
The Individual Labour Supply Curve
When the substitution effect of a wage
increase dominates the income effect,
the individual labour supply curve is
upward sloping as in panel (a). Here a
rise in the wage rate from $10 to $20
per hour increases the number of hours
worked from 40 to 50.
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But when the income effect of a wage
increase dominates the substitution
effect, the individual labour supply
curve is downward sloping as in panel
(b). Here the same rise in the wage
rate reduces the number of hours
worked from 40 to 30.
Slide 12-28
Shifts of the Labour Supply Curve
The market labour supply curve is the horizontal
sum of the individual 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
changes in wealth
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Slide 12-29
The End of Chapter 12
Coming Attraction:
Chapter 13:
Efficiency and Equity
© 2005 Worth Publishers
Slide 12-30