- Study Guide (Course-wide Content)
A. Income and Wealth
- Distribution theory is concerned with the basic question of for whom economic goods are to be produced. In examining how the different factors of production—land, labor, and capital—get priced in the market, distribution theory considers how supplies and demands for these factors are linked and how they determine all kinds of wages, rents, interest rates, and profits.
- Income refers to the total receipts or cash earned by a person or household during a given time period (usually a year). Income consists of labor earnings, property income, and government transfer payments.
- National income consists of the labor earnings and property income generated by the economy in a year. Government takes a share of that national income in the form of taxes and gives back part of what it collects as transfer payments. The post-tax personal income of an individual includes the returns on all the factors of production—labor and property—that the individual owns, plus transfer payments from the government, less taxes.
- Wealth consists of the net dollar value of assets owned at a given point in time. Wealth is a stock, while income is a flow per unit of time. A household's wealth includes its tangible items such as houses and its financial holdings such as bonds. Items that are of value are called assets, while those that are owed are called liabilities. The difference between total assets and total liabilities is called wealth or net worth.
- To understand the pricing of different factors of production, we must analyze the theory of production and the derived demand for factors. The demand for inputs is a derived demand: we demand pizza ovens not for their own sake but for the pizzas that they can produce for consumers. Factor demand curves are derived from demand curves for final products. An upward shift in the final demand curve causes a similar upward shift in the derived factor demand curve; greater inelasticity in commodity demand produces greater inelasticity of derived factor demand.
- We met in earlier chapters the concepts of the production function and marginal products. The demand for a factor is drawn from its marginal revenue product (MRP), which is defined as the extra revenue earned from employing an extra unit of a factor. In any market, MRP of a factor equals the marginal revenue earned by the sale of an additional unit of the product times the marginal product of the factor (MRP = MR x MP). For competitive firms, because price equals marginal revenue, this simplifies to MRP = P x MP.
- A firm maximizes profits (and minimizes costs) when it sets the MRP of each factor equal to that factor's marginal cost, which is the factor's price. This can be stated equivalently as a condition in which the MRP per dollar of input is equalized for each input. This must hold in equilibrium because a profit-maximizing employer will hire any factor up to the point where the factor's marginal product will return in dollars of marginal revenue just what the factor costs.
- To obtain the market demand for a factor, we add horizontally all firms' demand curves. This, along with the particular factor's own supply curve, determines the supply-and-demand equilibrium. At the market price for the factor of production, the amounts demanded and supplied will be exactly equal—only at equilibrium will the factor price have no tendency to change.
- The marginal-productivity theory of income distribution analyzes the way total national income gets distributed among the different factors. Competition of numerous landowners and laborers drives factor prices to equal their marginal products. That process will allocate exactly 100 percent of the product. Any factor, not just labor alone, can be the varying factor. Because each unit of the factor gets paid only the MP of the last unit hired, there is a residual surplus of output left over from the MPs of early inputs. This residual is exactly equal to the incomes of the other factors under marginal productivity pricing. Hence, the marginal-productivity theory of distribution, though simplified, is a logically complete picture of the distribution of income under perfect competition.
- Even though a competitive economy may squeeze the maximum amount of bread out of its available resources, one major reservation about a market economy remains. We have no reason to think that incomes will be fairly distributed under laissez-faire capitalism. Market incomes might produce acceptable differences or enormous disparities in income and wealth that persist for generations.