Lecture 11. Income Distribution Theory
Recommended reading : 【Macroeconomics】 Microeconomics Table of Contents
1. Factor markets (general)
2. Labor market
3. Capital market
1. Factor markets (general)
⑴ Background
① Goods market : households are the demand side; firms are the supply side
② Factor market : firms are the demand side; households are the supply side
③ Directly connected to the neoclassical theory of income distribution
⑵ Demand for factors of production
① Interpretation 1. It has the character of derived demand
○ Meaning : demand for factors is derived from demand for goods (MC)
○ Dividing a factor’s price by its marginal product has the meaning of marginal cost (MC)
② Interpretation 2. In a neoclassical perfectly competitive market, price represents marginal product : because marginal revenue product is 0
○ A perfectly competitive firm’s labor demand is determined where the nominal wage equals the value of the marginal product of labor
○ Marginal revenue product (marginal revenue product; MRP) : the additional revenue generated by hiring one more worker
○ Value of marginal product (value of marginal product; VMP) : the factor’s marginal product multiplied by the output’s market price
○ (Note) You can understand VMP as MRP under perfect competition
○ Price of labor = value of the marginal product of labor (where w denotes the nominal wage)
○ Price of capital = value of the marginal product of capital (where v denotes nominal rent)
③ Labor demand curve
○ Assumption : labor is the only variable input
○ Downward-sloping : because the law of diminishing marginal product is assumed
○ Factors that increase labor demand○ Increase in demand for the product
○ Increase in the productivity of a factor of production
○ Increase in the price of an input that is a substitute
○ Decrease in the price of an input that is a complement
○ Increase in the number of producers
○ (Note) Capital input can either increase or decrease labor demand
○ Price elasticity of labor demand : also known as the Hicks–Marshall laws of derived demand
○ Faster diminishing marginal product ↑ → labor demand curve becomes steeper → elasticity ↓
○ Greater substitutability with other inputs ↑ → employment changes more → elasticity ↑
○ Labor’s share in total cost ↑ → employment changes more easily and by a larger amount → elasticity ↑
○ Price elasticity of demand for the product ↑ → since labor demand is derived demand, elasticity ↑
○ Elasticity of capital supply ↑ → elasticity ↑
⑶ Supply of factors of production
① Supply of labor : the neoclassical interpretation from consumer theory (choice between labor and leisure) in the Consumer Theory section
○ Assumption : workers can freely choose their working hours
○ Objective function : for utility function u, leisure L, and income/budget M
○ Constraint : for labor H, leisure L, and income/budget M
○ Substitution effect : wage rate ↑ → opportunity cost of leisure ↑ → leisure consumption ↓ → labor supply ↑
○ Income effect : wage rate ↑ → leisure consumption ↑ (leisure is a normal good) → labor supply ↓
○ Early on, the substitution effect dominates; later, the income effect dominates, producing a backward-bending (backward-bending) shape
○ In the backward-bending segment, the wage elasticity of labor supply is negative
○ (Note) If leisure is an inferior good, the backward-bending pattern does not appear
○ (Note) Non-labor income generates only the income effect → labor supply decreases
Figure. 1. Labor supply curve
② Supply of capital
③ Supply of land
○ The supply of land is perceived as almost fixed
○ The supply of land for a specific use can be elastic (e.g., land for housing)
⑷ Equilibrium in the factor market
Figure. 2. Equilibrium in the factor market
① Determination of employment and wages
○ Employment and wages are determined by equilibrium between the product market (demand side) and the factor market (supply side)
○ (Note) As in the figure above, the backward-bending portion is sometimes omitted
○ Because the equilibrium price is directly linked to consumers’ income, this is also called income distribution theory
○ Reasons why the price of the same factor differs across markets
② When an imperfectly competitive market becomes a perfectly competitive market
○ Equilibrium employment and the equilibrium wage increase
③ Economic rent and transfer earnings
Figure. 3. The concept of transfer earnings and rent
○ Transfer earning : the opportunity cost of the factor supplier
○ The area below the supply curve
○ (Comment) Similar to “cost”
○ Economic rent : the extra payment made because a factor’s supply is inelastic
○ Also called unearned income : corresponds to producer surplus in the goods market
○ In other words, the portion of a payment that exceeds transfer earnings is called economic rent
○ The more inelastic labor supply is, the larger the share of economic rent in total compensation
○ Example 1. Famous entertainers, athletes
○ Example 2. Activities where medical or bar associations restrict the number of new license holders
○ Example 3. Lobbying to obtain government permits/authorizations
○ (Comment) Similar to producer surplus
○ Quasi-rent
○ Compensation for factors whose supply is fixed in the short run, such as capital equipment
○ That is, it has the nature of rent in the short run but the nature of transfer earnings in the long run
⑸ Monopsony and bilateral monopoly
① Monopsony
○ Definition : a market with many suppliers but only one buyer
○ Hard to find in goods markets; mainly observed in factor markets
○ Causes : extremely specialized factors, local/regional characteristics
○ Marginal factor cost curve (marginal factor cost curve) : the additional expenditure when purchasing the last unit of a factor
○ Condition : marginal factor cost = value of marginal product
Figure. 4. Monopsony vs. perfect competition
○ Lc : employment under perfect competition
○ wc : factor price (wage) under perfect competition
○ Lm : employment under monopsony
○ wm : factor price (wage) under monopsony
○ Compared with perfect competition, monopsony yields a lower factor price and a smaller employment level
○ The difference between wc and wm is called monopsonistic exploitation
② Bilateral monopoly (bilateral monopoly; BM)
Figure. 5. Bilateral monopoly market
○ Lc : employment under perfect competition
○ wc : factor price (wage) under perfect competition
○ LM : employment under supply monopoly
○ wM : factor price (wage) under supply monopoly
○ Lm : employment under monopsony
○ wm : factor price (wage) under monopsony
○ In a bilateral monopoly, each side has monopoly power and their preferred outcomes conflict
○ Ultimately, the outcome depends on which side has greater bargaining power
2. Labor market: focusing on why wage differentials arise
⑴ When the labor market is perfectly competitive
① Productivity differences among workers
② Differences in job amenities or risk : wage differentials here are called compensating wage differentials
⑵ When the labor market is imperfectly competitive
① Temporary disequilibrium in the market
② Seniority-based pay
③ Imperfect information
④ Social discrimination
⑶ Skilled labor vs. unskilled labor
① The demand curve for skilled labor lies above that for unskilled labor (∵ higher marginal productivity)
② The supply curve for skilled labor lies above that for unskilled labor (∵ higher cost of skill acquisition)
③ Dual labor market theory○ Primary labor market : managerial jobs, professional jobs, skilled craft jobs, etc.
○ Secondary labor market : simple laborers, domestic helpers, etc.
○ (Comment) Think of the primary market as the “first string” / better-positioned workers
⑷ Human capital theory : those who receive education have higher productivity than those who do not, so they will earn higher wages
⑸ Signaling theory : education is merely a device to distinguish capable from less capable people; raising education levels is unrelated to wage increases
⑹ Efficiency wage theory : a strategy of paying higher-than-industry wages so that workers exert maximum productivity
⑺ Labor unions
① Objectives of labor unions : increase wage income, improve working conditions, stabilize employment
② Outcomes○ It is difficult to achieve wage increases without sacrificing employment
○ Wages may fall in sectors where unions are not formed
③ Factors that limit union power
○ Supply-side factors : for low-wage labor where non-union workers can easily supply labor, the relevant union’s power weakens
○ Demand-side factors : substituting labor with machines, reducing output to cut staff, weak product demand
⑻ Discrimination in the labor market : racial discrimination, gender discrimination, etc.
① 1st. Discrimination restricts women’s employment in the high-skill labor market
② 2nd. With reduced supply in the high-skill market, women’s wages rise
③ 3rd. With increased supply in the ordinary-skill market, women’s wages fall
④ 4th. If this discrimination persists, it is used as “evidence” to justify discrimination and thereby intensifies it
⑤ Policy 1. Principle of equal pay
⑥ Policy 2. Principle of comparable worth
⑦ Policy 3. Natural selection : discriminatory firms exclude highly productive people and are therefore selected out over time
⑧ Why discrimination persists○ Discriminated workers actually have lower productivity
○ Deep-rooted prejudice makes fair employment policies difficult to implement
3. Capital market
⑴ Concept of capital
① Primary factors of production : labor and land can be used immediately without an additional production process
② Produced factors of production : capital must be produced through a production process
③ Capital goods : machines or equipment used in production○ Depreciation : as capital goods are used, their value declines
④ Capital services : services obtained by using capital goods for a period of time
○ The supply curve of capital services is upward sloping
⑵ The investment decision process
① Present value : the value of future revenues or costs evaluated in today’s terms
② Discount rate : the rate used to discount future amounts into present value
③ If present value ＞ investment cost : invest
④ If present value ＜ investment cost : do not invest
⑶ Determination of the interest rate
① Why there are multiple interest rates in reality
○ Risk
○ Lending period
○ Administrative costs
○ Tax treatment
Input: 2020.11.10 23:15