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.2.2 PERFORMANCE The function of a market system is to provide the information and incentives that will result in the allocation of relatively scarce resources and goods to their highest valued use within a social system. From an equity perspective we tend to believe that anyone who uses or consumes a good should bear the opportunity costs that result from that use. The price should equal the marginal cost. Rational consumers will buy goods so long as their marginal benefits are greater than or equal to the price they pay. Sellers will produce and offer goods for sale so long as the marginal cost of producing the goods is less than the price they can get. The optimal allocation of resources is characterized by the simple equation: MB = P = MC Long run equilibrium in purely competitive markets is the ideal and provides the benchmark for market performance. As market power is 266 13.2.2 Performance increased the price tends to rise above the MC suggesting less than an optimal allocation. When price is greater than MC, it should be considered as evidence that something may be amiss. It does not mean that it must be corrected. Just as a body temperature of 99.80 suggests a problem it does not mean you should be taking an antibiotic or undergoing surgery. In a market the price may exceed the MC but the cost of correcting the problem may exceed the benefits of the correction. 267 14 Markets for Inputs and Distribution of Income 14 MARKETS FOR INPUTS AND DISTRIBUTION OF INCOME The factor markets allocate the factors of production among the various producers/sellers. In a market economy, the inputs [land ®, labor (L), capital (K) and entrepreneurial ability] are owned by individual agents who make decisions about the amount of each input they want to supply. The decisions of the producers determine the demand for the inputs. Remember that the decisions of the producers reflects the preferences and ability In the goods markets, each individual consumer will maximize their utility MU X P X = MUY PY = ⋯ = MU N P N when:, subject to: P X Q X + P Y QY + ⋯ + P N Q N ≤ BUDGET This is an equilibrium condition. The consumer cannot alter their expenditure and improve their welfare or increase their utility. Income (budget), preferences (MUN) and the relative prices determine the outcomes. The market demand reflects these conditions to the market. The demand function is a schedule of the maximum price (reservation price) that buyers are willing and able to pay for a schedule
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of quantities of a good in a given period of time (ut), ceteris paribus. The supply function in the market reflects the opportunity cost or producing each unit of output. It can be defined as the minimum price (reservation price) that the seller will accept for each unit of output. Market equilibrium is determined by the interaction of the buyers and sellers. 268 14 Markets for Inputs and Distribution of Income The equilibrium of the buyers and market equilibrium depends on the income of the buyers. The way in which income is distributed in a system determines the allocation decisions. The judgment about the criteria used to distribute income has both an ethical and efficiency dimension. In most social groups, it is considered desirable that income be distributed in proportion to the contributions to the achievement of objectives. Clearly, most societies make exceptions: most societies refuse to let individuals who are incapable of making contributions do without resources and goods to support life. In industrial societies there is a range of judgments regarding what things should be provided. At one extreme few resources are provided. At the other extreme a higher level of comfort is considered appropriate. From an efficiency perspective, each factor should receive a share of income in proportion to the factor’s contribution to the value of the output. John Bates Clark (1847-1938) was one of the architects of the “marginal productivity theory of income distribution.” In concept the idea is simple, in practice it is difficult to measure the contributions of each factor to the production process. The production process was described by a production function. In its simplistic form it is: Q = f(labor, kaptial, land, technology,... ) The marginal product of each factor describes the contribution of each factor to the production of the output. The marginal product of a factor can be described as: MP F ≡ ΔQ ΔF, the change in output (Q ) caused by a change in F ( the factor ) With the use of calculus the marginal products of a set of inputs can be described as partial derivatives. Given a production function: 269 Q = ALa Kb, the marginal products of the factors is: 14 Markets for Inputs and Distribution of Income MP L = MP = AαL α−1 K β = AL α K β−1 If the marginal products are known and the relative prices of goods in the markets reflect the values of the outputs, the value of each factors contribution can be calculated as the product of MPF and the price of the output. The marginal productivity
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theory of income distribution suggests that the income share each factor of production should receive is determined by the marginal product of the input and the price of the output. The change in the value of the output associated with a change in an input is called the value of marginal product (VMP) or the marginal revenue product (MRP). Originally the VMP was used to describe the demand for an input into production process for a purely competitive firm and the MRP was used to describe the demand for an input used to produce a product where market power (a negatively sloped product demand) existed. Most texts currently use MRP as a generic term that covers both VMP and MRP. 14.1 A. THE DEMAND FOR INPUTS The demand for a factor of production is a derived demand. You do not have a direct demand for an auto mechanic: rather you have a demand for an automobile that functions properly. The demand for the mechanic is a derived demand. You probably do not have a demand for 2X4’s (they really aren’t 2” by 4”), you have a demand for a house that is constructed with the lumber. The demand for an input is determined by the relative value of the good produced and the productivity of the input. 270 14.1 A. The Demand for Inputs The demand for an input can be derived by using the production function (the MP for an input) and the price of the good. The marginal revenue product is shown in Table IX.1. Table IX.1 shows a short run production function. Capital is fixed at 4 units. As labor is added, the output (Q or TP) increases at an increasing rate. In this example the marginal product of labor (MPL) declines from the first unit. This makes the MRPL or demand for labor less messy. The constant price at all levels of output (PX = $11 at all output levels) is the result of the firm being in a purely competitive market: the demand faced by the firm is perfectly elastic. The marginal revenue product is a measure of the value of the output that is attributable to each unit of the input. The first unit of labor “produces “ 8 units of output (MPL = 8). These 8 units of output can be sold for $88 (PX=$11, MPL1= 8: so PX*MPL= 8*11=88). The maximum that an employer would be willing to pay the first unit
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of labor would be $88. The MRP of the second worker is $77. The second worker produces 7 units of output valued at $11 each. 271 14.1 A. The Demand for Inputs Table XI.1 Short Run Demand for Labor in Pure Competition Kaptial (fixed) Labor (L) Q, TP MPL Product price, PX (MPL)PX MRPL 15 21 26 30 33 35 36 36 11 $11 $11 $11 $11 $11 $11 $11 $11 $11 $88 $77 $66 $55 $44 $33 $22 $11 $0 The MRP of each unit of input is the maximum an employer would be willing to pay each unit of input and can be interpreted as a demand function. Notice that if 35 units could be sold, 7 units of labor would be hired. The MRP L7 is $22. The maximum the employer would be willing to pay the 7th unit of labor is The MRP is the maximum the employer will pay each unit of labour in a given period of time given the productivity (MP) and the price of the output (PX). At a wage of WR, the firm will hire N workers. All N workers are paid the same wage rate; i.e. there is no price discrimination. The wage bill or expense is shown as area 0NRWR, measure by NWR. the producer surplus is area WRRA. The producer surplus is not the same as profit. The payment to the fixed factor must be subtracted from the producer surplus to calculate profit. $ (Wage) A WR R 0 N Figure IX.1 272 MRPL L/ut 14.1 A. The Demand for Inputs $22. Wage/price discrimination is technically illegal, all workers are paid $22. The employer gains $66 on the first unit of labor ($88-$22), $55 on the second, $44 on the third, $33 on the forth, $22 on the fifth, $11 on the sixth and nothing on the seventh. This is shown graphically in Figure IX.1 The MRP of an input used by a firm with market power (a negatively sloped demand for it output) is shown in Table IX.2. Short Run Demand for Labor For Firm in Imperfect Competition or Monopoly Table XI.2 Kapital (fixed) Labor (L) Q, TP MPL Product price, PX 15 21 26 30 33 35 36 36 13 $
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11 $10 $9 $8 $7 $6 $6 $6 $6.00 (MPL)PX MRPL $91 $70 $53 $39.00 $28 $19 $12 $6 $0 Note that the only difference in Table IX.1 and IX.2 is that he price of the output must be decreased if more units are to be sold. This makes the demand for the input relatively more inelastic. 273 14.1 A. The Demand for Inputs $ WH WR H 0 B G J Figure IX.2 L/ut 14.1.1 SUPPLY OF INPUTS The individual agent who owns the input will decide how much of a factor they want to offer for sale at each price offered for the input. A worker must decide how many units of labor (hours, days, weeks, years, etc) they will offer for sale at each possible wage rate. The supply of labor is a function of the wage rate, the value of leisure, alternatives available, taxes and other circumstances. Generally it is believed that more labor will be offered for sale at higher wage rates, up to a point. Owners of other factors of production (land, capital, entrepreneurial ability) make decisions that determine the supply functions of those factors. Figure IX.2 illustrates several possible supply functions. The segment HGB is one possibility, it represents a supply where the worker is willing to offer more labor at higher wage rates. The maximum labor that will be offered for sale is at point B. At a wage rates higher than W H, the supplier substitutes leisure for income and offers less labor for sale as the 274 wage increases. Another possibility is a supply of labor that is represented by segment WRGB. A horizontal segment at the prevailing wage rate is caused by a worker or workers who refuse to work at any wage that is less than the 14.1.1 Supply of Inputs prevailing wage, WR. 14.1.2 MARKET FOR INPUTS The market for an input includes all potential buyers and sellers of an input. The demand reflects the decisions of the buyers of the inputs and is based on the MRP for the factor. $ W H W R W L The supply function represents the decisions of w H the factor owners to supply the input at various prices. Figure IX.3 represents a market for labor. MRP B S G MRP MRP 1 0 F T J L/ut Figure IX.3 represents the demand and S is the supply of L
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. The market equilibrium occurs at point G where the quantity of labor offered for sale is equal to the quantity of labor that is demanded at a the wage rate WR. J units of labor are hired. An increase in the productivity of labor or the price of the good produced (PX) will increase the demand (MRP). A decrease in productivity or PX will shift the MRP to the left (MRP1). If worker are unwilling to work for less than the market wage, WR, the supply is represented by line WRGB. The level of 275 14.1.2 Market for Inputs employment would fall to F units of labor. If HGB were the relevant supply, unemployment would fall to T units and the wage would fall to WL. If the MRP increased so the wage rate exceeded WH, workers would supply a smaller quantity of labor in a given period of time. 14.1.3 INCOME DISTRIBUTION Income distribution can be described as a functional or personal distribution. The functional distribution of income describes the allocation of income among the factors of production. The distribution of income among the members of society, individuals and families, is called the personal distribution of income. Adam Smith, David Ricardo, Karl Marx and other early economists were primarily concerned about the distribution of income among social classes that were partially based on economic criteria. During the feudal era labor (serfs) and land owners (aristocracy and church) were the important factors of production. Generally, the social classes were the serfs, aristocracy and clergy. Economic behavior was coordinated by a complex set of social institutions that were based on deontological ethics (duty). Reciprocity and command were the primary organizing mechanisms. Markets existed and were used in many cases. Market towns and fairs were used to allocate some goods while labor, land and many goods were allocated through obligations specified by tradition and command. The personal distribution of income describes the allocation of income among economic agents. In most modern, industrial societies, markets are the primary organizing institution of economic processes. Markets determine the allocation of income as well as the allocation of scarce resources. Other social 276 institutions such as welfare and philanthropy play a minor role in the personal distribution of income. 14.1.3 Income Distribution Irvin Tucker (microE CONOMICS for Today, South-Western 2000, p 283) shows the distribution of income based on the head of household. His data is based on the Census data and is shown in Table IX.3. Income Distribution Based on
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Head of Household - 1997 Table IX.3 Irvin Tucker, microE CONOMICS for Today, South-Western 2000, p 283 Characteristic By Head of Median Income Household All Families Male Female Age 25-34 Age 65+ Head non High School Grad Head High School Grad Head with Bachelor’s degree $44,568 $32,960 $21,023 $39,979 $30,660 $25,465 $40,040 $67,230 The information in Table IX.3 poses several issues. When considering income distribution by age of household, there is a “life cycle” of a person’s earnings and needs that should be considered. It should be noted that the distribution of wealth and income are two related but different problems. Another issue is the role of education and training. Disease and the industrial revolution significantly altered the social classes and the distribution of income. Technological change is a fundamental feature of modern industrial societies and will change the nature and role of education and training in the distribution of income. 277 14.1.3 Income Distribution A “Lorenz Curve” can also describe the personal distribution of income. A Lorenz curve can be used to show either the distribution of income or wealth and can be applied to the world, a country or a sub category of individuals (the military, lawyers, or... ). A Lorenz curve plots the cumulative proportion of income units and cumulative proportion of income received when income units are arrayed from lowest to highest. The data for a Lorenz curve is shown in Table IX.4. (Irvin Tucker, microE CONOMICS for Today, South-Western 2000, p 282) The income distribution is arrayed from lowest to highest. The data in Table IX.4 suggest that the income distribution became more equal from 1929 to 1970 and less equal from 1970 to 1997. The trends in income distribution are subject to controversy. There are many forces that influence income distribution. It is highly unlikely that the MRP is the single determinate of the income share received by a factor or individual who owns the factor. Political forces, technological change, tradition, law and a variety of other forces influence the distribution of income. Discrimination by gender or race are hotly debated issues. 278 14.1.3 Income Distribution Table IX.4 Income Distribution Among Families 1929-1997 % Families Lowest 20% 1929 3.5 Second Lowest 20% Middle 20% Second highest 20% 0% 9.0 % 13. 8%
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19. 3% 1970 5.5 % 12. 3.5 % 12. 5% 2% 26. 17. 3% 6% 45. 23. 6% 8% 5.5 % 17. 7% 35. 3% 59. 1% 1997 4.2 % 9.9 % 15. 7% 23. 0% 4.2 % 14. 1% 29. 8% 52. 8% Highest 20% 54. 100 40. 100 47. 100 Highest 5% 4% 30 % % Cumu lative 9% 15. 6% % Cumul ative 2% 20. 7% % Cumul ative A Lorenz curve is usually shown as plots of the cumulative proportion of income units and cumulative proportion of income received when income units are arrayed from lowest to highest. In Figure IX.4 data from 1929, 1970 and 1997 are compared to an equal income distribution. An equal income distribution is shown as a diagonal line AB. The further the Lorenz curve deviates from the diagonal, the more unequal the distribution of income. 279 100% B 14.1.3 Income Distribution 50% Equal Distribu tion of Income 1970 1929 Unequal distribution of Income 1997 50% 100% Cumulative % of Families Figure IX.4 280 15 Property Rights and Markets 15 PROPERTY RIGHTS AND MARKETS The optimal solution to the allocation problem requires the participants to have accurate information about the marginal costs and marginal benefits associated with specific alternatives. Most of Neoclassical microeconomics is a story about the way market exchange reveals, communicates and uses individual evaluations about marginal benefits (MB) and marginal costs (MC). The information about MC and MB revealed by market exchanges (like all information) is never perfect. Problems arise when exchange is not voluntary and property rights are attenuated. Pure competition is one way to ensure that no one buyer or seller has the ability to alter the outcome of market exchanges and the information revealed in prices. The existence of market power allows a buyer or seller to influence the outcome of a market exchange and distort the information about MB and MC. Attenuated or weakened property rights also may distort information about MB and/or MC and result in an allocation that is less than optimal. “Nonattenuated” or strong private property rights have three important characteristics: exclusive, enforceable, and transferable. 15.1 PRIVATE PROPERTY RIGHTS Private property rights have three important characteristics that contribute to the efficient functioning of the market: exclusivity,
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enforceability and transferability. A lack of any one of these characteristics will distort market exchanges and result in less than optimal results. Furuboton and Pejovich define property rights as: Property rights are understood as sanctioned behavioral relations among men [sic] that arise from the existence of goods and pertain to their use. These relations specify the norms of behavior with respect to goods 281 15.1 Private Property Rights that each and every person must observe in his daily interactions with other persons, or bear the cost of non-observance. The term “good” is used here for anything that yields utility or satisfaction to a person. Thus, and this point is important, the concept of property rights in the context of the new approach applies to all scarce goods. The concept encompasses both the rights over material things (to sell my typewriter) as well as ‘human’ rights (the right to vote, publish etcetera). The prevailing system of property rights in the community is, them, the sum of economic and social relations with respect to scarce resources in which individuals stand to each other. [Eriik Furuboton and Svetozar, Cambridge, Mass.: Ballenger, 1974, Pejovich, The Economics of p 3] Property Rights This definition implies that an individual has a bundle of rights or claims empowering him or her to control the outcome of specific events or alternatives. Secondly, it implies these claims are sanctioned by social institutions and are social in character. Private property rights implies that the individual has the power to determine the use of an economic “good” and incurs all benefits and cost associated with that use. 15.2 TRANSFERABILITY Clearly a good must have property rights that can be transferable before it can be exchanged in a market. In some cases it may be physically impossible to transfer a property right (I cannot buy some one else’s good health or height or athletic skills). In other cases it may be illegal to transfer or acquire the property rights to a good (I cannot legally sell my kidney in the US or UK). In cases where it is technically possible to transfer a property right but illegal, a “black market” may emerge. Part of the cost of acquiring or selling a good is the risk an punishment of violating the law. There is a large literature on the economics of crime not addressed here. 15.3 ENFORCEABILITY Property rights can be enforced in formal or informal ways. Both Adam Smith and Karl Marx believed
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