Theories of Income Distribution

1. The Marginal Productivity Theory of Income Distribution

a. Marginal Productivity and Wage Inequalityi. 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 differences1. 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▫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.1. 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 Talenta. 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 capitala. 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 Poweri. Marginal productivity theory is based on

the assumption that factor markets are perfectly competitive.

ii. Not all markets are perfectly competitive though.

ii. One source of differences in wages between otherwise similar workers is unions.

a. These are organizations that try to raise wages and improve working conditions for their members.

b. When successful unions replace one on one wage deals between workers and employers with collective bargaining.

c. 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 Wagesi. This a type of incentive scheme used by

employers to motivate workers to hard work and to reduce worker turnover.

ii. Efficiency-wage model1. Some employers pay an above-equilibrium

wage as an incentive for better performance and loyalty

d. Discriminationi. 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.