MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION:

1. The market price for a factor of production is determined by the supply and demand for that factor.

2. Demand for a factor of production is derived from the demand for the things it helps produce.

3. Demand by a firm for a factor of production is the marginal productivity schedule of the factor.

4. Cost-minimizing firms will hire factors of production until the cost of hiring an additional unit of the factor,
the marginal factor cost, equals the revenue gained from selling the additional output created by using that additional unit of the factor,
the Value of Marginal Product or Marginal Revenue Product.

       Marginal Factor Cost = Marginal Revenue Product

In the example below, we see the marginal physical product of labor in a model with one fixed factor of production, land.
Assume that the output, corn, and the input, labor, are both bought and sold in perfectly competitive markets.
This means that the farm is a perfectly competitive firm in the corn market, and that each laborer is a perfectly competitive seller
in the market for labor.

The firm is the perfectly competitive seller in the corn market, and a perfectly competitive buyer in the labor market.
 
 

Total Physical Product
Land
Labor
Average Physical Product
Marginal Physical Product
0 Bushels
5 Acres
0
 
 
 
 
 
 
10
10 Bushels
5 Acres
1
10
 
 
 
 
 
15
25 Bushels
5 Acres
2
12.5
 
 
 
 
 
12
37 Bushels
5 Acres
3
12.3
 
 
 
 
 
10
47 Bushels 
5 Acres
4
11.7
 
 
 
 
 
8
55 Bushels
5 Acres
5
11
 
 
 
 
 
5
60 Bushels
5 Acres
6
10
 
 
 
 
 
2
62 Bushels
5 Acres
7
8.9
 
 
 
 
 
1
63 Bushels
5 Acres
8
7.9
 
 

If the wage, measured in bushels of corn, is 10 bushels per worker, then the equilibrium number of workers hired will be 4,
as seen in the supply and demand graph for labor by this farm.  The marginal physcial product curve is the demand curve for
labor by the farmer.  The flat supply curve of labor is what the farmer sees as the labor supply curve in this
perfectly competitive market for labor.

The firm will minimize its costs of production by hiring workers until the cost of hiring an additional worker is equal to the
additional output that last worker hired generates:

Wage in Bu of corn = Marginal Physical Product of last worker hired. [or, Real wage = MPP]

If we had a money economy, then the cost minimization condition is that the cost of hiring an additional worker equals the additional revenue the last worker hired generates. Suppose the price of a bushel of corn is $20. Assume the money wage is $100 per growing season.

Then, the cost minimizing situation occurs when: Money Wage = Marginal Physical Product*Marginal Revenue from selling additional corn produced. [or, w = MPP*MR]

Since the corn producer sells in a perfectly competitive market, P = MR.

Our condition becomes: Money wage = MPP*Price of corn
                                                $100 = MPP*$20 ==> Hire 6 workers, since MPP of sixth worker is 5 bushels.

The graph is similar to that above, but marginal revenue product will be the demand curve, instead
of marginal physical product.
 

Distribution and value theory rests on three points:

1. Technology defines the production function.

2. The demand for factors of production are derived from the goods those factors produce.

3. Relative factor supplies, in conjunction with factor demand, determines factor price.

Profit maximizing firms demand factors of production because these factors enable the firm to produce a good individuals want to buy.

If a firm is maximizing profits, in perfect competition, it will find Q to set P = MC.

Thus, for a firm using multiple variable inputs, the cost-minimizing and profit conditions together imply:

MPP1/W1 = MPP2/W2 = ..... = 1/MR = 1/MC

If this condition holds, factors are hired efficiently, resources are allocated efficiently, costs are minimized, and profits are maximized.

But, in long-run equilibrium, those Max Profits will be ZERO. For a price taking firm, buying inputs in perfectly competitive markets, P=MR, we have;

Money wage = Price of Firm's output * marginal physical product

w = Price of output*Marginal Physical Prodcut or w = MRP  [Money wage = Marginal Revenue Product.]

For a price setting firm, buying inputs in a perfectly competitive market: w = MR*MPP = MRP

Demand for labor will shift if:

1. Demand for producers output changes
2. New technology is introduced
3. Variations in use of other factors occurs.
4. Amount of human capital in the labor force changes.

Elasticity of demand for labor depends on:

1. Elasticity of demand for the good labor produces. The more elastic the demand for the output, the more elastic the demand for labor.

2. Proportion of labor cost to total cost. The demand for labor is more elastic, ceteris paribus, then labor's share of total costs is higher.

3. Ease of substitution of other factors of production for labor. The easier it is to substitute other inputs for labor, the greater is the elasticity of demand for both inputs.

Labor supply depends on:

1. Labor force participation rates

2. Number of hours people are willing to work

3. Value of human capital, i.e., skill, education and training of work force.

Labor supply exhibits a purchasing power effects and a substitution effect when wages change. Higher wages mean work is substituted for leisure.
But, higher wages mean that each hour worked brings the worker more purchasing power per hour worked.

If liesure is a normal good, higher wages will also make workers want to work less.

If substutition effect > purchasing power effect, labor supply slopes upward.

If substitution effect < purchasing power effect, labor supply slopes downward--> Backward bending supply of labor.

This is true for an individuals labor supply, not for the market supply of labor curve.  It is assumed that the backward-bends average out in the end.

Demand for labor represents marginal benefits society receives from addtional employment.

Supply of labor represents marginal costs to society from using those resources.
 

HUMAN CAPITAL: Capabilities of an individual

1. Education improves capabilities of a worker and has beneficial external effects for society.

2. Training gives benefits to the individual. It may be specific or general, i.e..., cannot be taken with the worker from where he or she learned it, or it can be taken away. Turnover and quit rates are negatively correlated with specific training.
Firms want to keep the workers they have trained. Firms that invest in their workers will pay high wages and have benefits packages for them, to keep them from leaving for other jobs.
 
MONOPSONIST:  SOLE BUYER IN THE MARKET

A firm that is a monopsonist in the market for labot is the only buyer of labor.

Monopsony power causes the marginal factor cost (MFC) to be larger than the wage.  This is analogous to the effect a monopolist has on marginal revenue and price in an output market.
 
 

MP of labor
Output in Bushels
Workers per season
Wages per worker per season
Total Labor Cost
Marginal Factor Cost = DTLC/DWorkers
 
150
1
$225
$225
 
125
 
 
 
 
$325
 
275
2
$275
$550
 
100
 
 
 
 
$500
 
375
3
$350
$1050
 
75
 
 
 
 
$750
 
450
4
$450
$1800
 
50
 
 
 
 
$1075
 
500
5
$575
$2875
 
 

If Money Wage = $375 per season, PC = $5/BU, then a monopsonistic buyer of labor will force a reduction in employment.

Note, if perfect competition in labor market,

            Money Wage = MRP  when 4 workers hired:

                 $375 = $5 * 75

With monopsony:

                 MFC = MRP   is cost minimization rule.

                 $500 = $500 when 3 workers hired.

How are factors of production distributed to competing uses?:

1. Equal net advantage:  input owners will sell factors to industry with highest net advantage, considering monetary and non-monetary rewards vs. costs.  {College professors are paid less than private sector Ph.D.'s}

2.  Factor mobility:  If a factor will move from one use to anoter for a small change in incentives or pay, it is highly mobile.  LAbor within a geographic area is more mobile than it is across areas.
     Labor is immobile across many occupations:  engineers, lawyers, doctors, trained technicians.
 
     Labor mobility:

     a.  Increases as time lengthens.
     b.  Easier between jobs in same area.
     c.  Easy for jobs in same occupation
     d.  Education provides "upward" mobility.
     e.  New job opportunities raise mobility.
     f.  Barriers to entry restrict mobility

3.  Factor Price differentials:  Why do some types of labor get paid more than others?

   a.  Dynamic differentials:  Disequilibrium as market adjusts.  Electrical engineers make more than civil engineers, until cupply catches up with demand.

   b.  Equilibrium differentials:  Casued by differences in the types of training and skill individuals possess, and the demand for their services.

     1.  Different skill levels are paid differently because skill is rare with regard to demand for it.
     2.  Compensate different costs of acquiring skills.
     3.  Differentials may reflect non-monetary compensation.
         {Professors}
 

ECONOMIC RENT: See graph for examples

Transfer Earnings:  amount a factor must earn to keep it from moving to another use; opportunity cost of alternative use.

Pure Economic Rent:  Amount that is in excess of transfer earnings.

Factors in fixed supply earn only pure economic rent.

Idea was stated by David Ricardo in discussing the Corn Laws:  He realized that land had no where to go if demand rose and fell for its output.  Its opportunity costs were "zero", since farm land was farm land, and of no other use, in his view.

Henry George:  1886 ran for Mayor of NYC.  Advocated "single tax" on land, since land was perfectly inelastic in supply.  Taxing land will cause no waste, and no escape of the tax.  Landlords would bear whole tax burden.