Theories of Income Distribution
1. The Marginal Productivity Theory of Income Distribution
a. Marginal Productivity and Wage Inequality
i. 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.
ii. Three sources of wage differences
1. Compensating differentials
a. Across different types of jobs, wages are often higher or lower
depending on how attractive or unattractive the job is.
b. Example
i. 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.
c. For any particular job the marginal productivity theory holds
true.
i. For any worker in a given field they will be paid a wage
equal to the equilibrium value of the marginal product
of the last person in employed in the market.
2. Differences in Talent
a. People differ in their abilities: a high-ability person, by
producing a better product commands a higher price compared
to a lower-ability person, generates a higher value for the
marginal product.
i. Those differences in the MP translate into differences in
earning potential.
3. Differences in the quantity of human capital
a. Different people “embody” quiet different quantities of human
capital, and a person with more human capital typically
generates a higher value of the marginal product by producing
more or better products.
b. The most direct way to see the effect of human capital on
wages is to look at the relationship between education levels
and earnings.
c. Also formal education is not the only source of human capital;
on the job training and experience are also very important.
b. Market Power
i. Marginal productivity theory is based on the assumption that factor markets are
perfectly competitive.
ii. Not all markets are perfectly competitive though.
iii. One source of differences in wages between otherwise similar workers is unions.
1. These are organizations that try to raise wages and improve working
conditions for their members.
2. When successful unions replace one on one wage deals between
workers and employers with collective bargaining.
3. This leads to higher wages for those workers who are represented by
unions.
iv. Employers can sometimes organize to pay lower wages than would result from
competition
1. For example: Health care workers argue that HMOs engage in a
collective effort to hold down their wages.
v. Collective action, by either workers or by employers, is less common in the
United States than it used to be.
c. Efficiency Wages
i. This a type of incentive scheme used by employers to motivate workers to hard
work and to reduce worker turnover.
ii. Efficiency-wage model
1. Some employers pay an above-equilibrium wage as an incentive for
better performance and loyalty
d. Discrimination
i. Discrimination is not a natural part of market competition. The market actually
works against it.
ii. Two reasons why it can happen.
1. When labor markets don’t work well, employers may have the ability to
discriminate without hurting profits.
2. Discrimination has sometimes been institutionalized in government
policy.
e. Wage Disparities in Practice
2. Is the Marginal Productivity Theory of Income Distribution Really True?
a. Although the marginal productivity theory of income distribution is a well-established
part of economic theory, it is the source of some controversy.
i. Two objects to the theory
1. In the real world we see large disparities in income between workers
who, in the eyes of some observers, should receive the same payment.
a. Example: the average wages between men and women and
among various racial and ethnic groups.
2. Many people wrongly believe that the marginal productivity theory
gives a moral justification for the distribution of income, implying that
the existing distribution is fair and appropriate.
b. So Does Marginal Productivity Theory Work?
i. First it is not a perfect description of how factor incomes are determined but
that it works pretty well.
ii. By and large, in a modern economy with well-functioning labor markets, factors
of production are paid the equilibrium value of the marginal product.