The economy’s
income is distributed in the markets for the factors of
production. The three most important factors of production
are labour, land and capital.
The demand for factors, such as labour, is a derived demand that comes
from firms that use the factors to produce goods and
services. Competitive, profit-maximizing firms hire each factor up to
the point at which the value of the marginal product of
the factor equals its price.
The supply of labour arises from individuals’ trade-off between work
and leisure. An upward sloping labour supply curve means that people respond to an increase
in the wage by enjoying less leisure and working more hours.
The price paid to each factor adjusts to balance the supply and demand
for that factor. Because factor demand reflects the value of the marginal product of
that factor, in equilibrium each factor is compensated according to its marginal
contribution to the production of goods and services.
Because factors of production are used together, the marginal
product of any one factor depends on the quantities of all factors
that are available. As a result, a change in the supply of
one factor alters the equilibrium earnings of all the factors.
Workers earn different wages for many reasons. To some extent, wage
differentials compensate workers for job attributes. Other things equal,
workers in hard, unpleasant jobs get paid more than workers in easy, pleasant
jobs.
Workers with more human capital get paid more than workers with
less human capital. The return to accumulating human capital is high and has increased over the
past two decades.
Although years of education, experience and job characteristics
affect earnings as theory predicts, there is much variation in earnings
that cannot be explained by things that economists can measure. The unexplained
variation in earnings is largely attributable to natural ability,
effort and chance.
Some economists have suggested that more educated workers earn
higher wages not because education raises productivity but because workers with
high natural ability use education as a way to signal their high ability
to employers. If this signalling theory is correct, then increasing the
educational attainment of all workers would not raise the overall level of
wages.
Wages are sometimes pushed above the level that brings supply and
demand into balance. Three reasons for above-equilibrium wages are minimum wage laws,
unions and efficiency wages.
Some differences in earnings are attributable to discrimination
on the basis of race, sex or other factors. Measuring the amount of
discrimination is difficult, however, because one must correct
for differences in human capital and job characteristics.
Competitive markets tend to limit the impact of discrimination
on wages. If the wages of a group of workers are lower than those
of another group for reasons not related to marginal productivity,
then non-discriminatory firms will be more profitable than discriminatory firms.
Profit-maximizing behaviour, therefore, can reduce discriminatory wage
differentials. Discrimination persists in competitive markets, however, if
customers are willing to pay more to discriminatory firms or if the
government passes laws requiring firms to discriminate.
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