Marginal Productivity and Income
The basic theory for resource markets is part of the
theory of the
firm. Key concepts are those of marginal
resource cost (MRC) and marginal
revenue product (MRP). A firm maximizes profit when it
sets MRC equal to MRP. Let us briefly review this
Firms buy resources or inputs when it is profitable to do so. A resource is valuable not because it directly satisfies some goal, but because it can indirectly satisfy a goal. Economists say that the demand for a resource is a derived demand. The demand for the resource is derived, or comes from, the demand for the goods and services that the resource produces. The benefit that a firm receives from an added input is the extra revenue it earns from selling production that the input adds. (Economists call this benefit the marginal revenue product, or MRP.)
Most inputs must be bought, hired, or rented. (Economists call the cost of an additional input the marginal resource cost, or MRC.) For a firm to make a profit from an added input, the additional revenue must exceed the additional cost. Economists take this commonsense idea and put it into economic jargon, saying that a firm should increase the use of an input if MRP exceeds MRC and reduce the use of an input when the MRC exceeds MRP. Therefore, when MRC equals MRC the firm should neither increase or decrease the input--it has found the profit-maximizing level.
To push the analysis further, assume that many firms buy
the resource and that none of these firms can noticeably
influence price in any market. This assumption that firms
takers means that marginal revenue equals price of
output, and that the marginal resource cost equals the price
of the resource. To make the following discussion less
abstract, suppose that the resource in question is hours of
labor, which means that the price in this market will be
With these assumptions, we get a diagram similar to that can be used to explain the technicalities of economic efficiency. On the left is Peter Milloy, a representative worker who
sells hours of unskilled labor. His supply curve is drawn so
that it slopes upward. But he is only one of a great many
workers selling in this market. To find the market supply
curve, one must add up all the hours of work that will be
offered at each wage.
On the right is Dynamic Enterprises, one of a great many
buyers of unskilled labor. Its demand curve will be the
downward-sloping part of its MRP curve. The MRP curve is the
demand curve for labor because this curve tells how valuable
another unit of the resource is to the firm. Hence, given a
wage, one can tell how much labor a firm demands by looking
at the MRP curve.
Dynamic Enterprises is only one of a great many buyers of
labor. To find the market demand, one must add up at each
wage the number of labor hours demanded by each firm. The
intersection of the market demand and market supply curve
gives the equilibrium wage--it will hire all workers who
contribute more to the firm than they cost.
This simple analysis develops what economists call the marginal productivity theory of wages: in a competitive market owners of resources tend to be paid their marginal contribution to output. An owner of a resource that adds a more valuable contribution to output is paid more than an owner of resource that adds a less valuable contribution. The key words here are "marginal" and
"adds." For example, garbage collectors perform a vital
service in large cities, and when they go on strike, people
are not only tremendously inconvenienced, but their health
may be threatened. The total value of the services of
garbage collectors is very high. But this high total value
does not mean that the value of another garbage collector is
high. If adding or removing one garbage collector changes
the value of garbage collection services little, his
marginal contribution will give a low wage in this market.
This analysis exactly parallels the diamond-water
The graphs above help illustrate changes that will raise or lower wages or other payments to inputs. The demand curve could shift because people value the output more. For
example, the high salaries of professional basketball
players are due to the popularity of basketball as a
spectator sport. A century ago, a man with the same
abilities of a Larry Bird or a Michael Jordan would have
earned a normal income because there was no demand for his
Increased productivity can also shift the demand curve. Industrialized societies has created a vast number of complex machines. Much of this capital is a substiture for unskilled physical labor but complements skilled intellectual labor. As a result, the rewards going to muscle power have fallen compared to the rewards going to brain power. Two hundred years, ago a strong but stupid man would probably have earned more than his smart but lame brother. Today, the results would probably be reversed.
The supply curve can also change, and as it does, so will
the income that the resource earns. A new discovery of metal
ore will reduce the value of known deposits. Increased
availability of education increases the numbers of doctors,
lawyers, teachers, and accountants. If demand for their
services does not change, their increased numbers will cause
their incomes to drop. People who want to control the wages
they earn have usually tried
to control the supply curve by limiting competition.
Real-world economies are not the same as abstract, theoretical economies. Real-world economies have factors other than productivity that determine income. For example, when people are engaged in what economists call rent seeking (something that does not exist in an ideal competitive economy), there may be a negative correlation between how much people earn and their socially useful productivity. However, even in theoretical market economies there are reasons, which will be discussed shortly, why income may not reflect marginal productivity.
But first we see how the marginal productivity argument that we have developed is key to explaining real wages.