Factor Markets and Income Distribution
O
Oiyo Contributor
Chapter 6: Factor Markets and Income Distribution
In contrast to the product markets we have discussed so far, in factor markets, households are the suppliers and firms are the demanders.
1. Demand for Production Factors
A firm’s demand for production factors is a Derived Demand that arises from the demand for the goods those factors produce.
(1) Determination of Labor Demand (In Perfect Competition)
- Value of Marginal Product (VMP): The increase in total revenue from hiring one additional unit of labor ().
- Equilibrium Condition: (where w is the wage).
- A firm hires labor up to the point where the wage equals the value of the marginal product of labor.
2. Supply of Labor (The Household’s Choice)
Labor supply is a matter of choosing between leisure and income.
- Substitution Effect: As wages rise, the opportunity cost of leisure increases, leading individuals to decrease leisure and increase labor.
- Income Effect: As wages rise, real income increases, leading individuals to consume more leisure (a normal good) and decrease labor.
- Backward-Bending Labor Supply Curve: A phenomenon where labor supply actually decreases as wages rise above a certain level, because the income effect outweighs the substitution effect.
3. Measuring Income Distribution
Key indicators used to measure the degree of income inequality in a society.
| Indicator | Description | Characteristics |
|---|---|---|
| Lorenz Curve | Represents the relationship between the cumulative percentage of the population and the cumulative percentage of income. | Closer to the diagonal line means more equal. |
| Gini Coefficient | A numerical value derived from the Lorenz curve (0 to 1). | Closer to 0 is more equal, closer to 1 is more unequal. |
| Decile Dispersion Ratio | Ratio of the income of the bottom 40% to the top 20%. | Larger value means more equal. |
4. Income Redistribution Policies
Governments intervene to mitigate inequality arising from the market.
- Progressive Tax: Applying higher tax rates to higher income levels.
- Public Assistance/Social Security: Providing livelihood support or insurance to the socially vulnerable.
- Negative Income Tax: A system where those below a certain income level receive subsidies instead of paying taxes.
Key Checklist
- What two values does a firm compare when deciding whether to hire additional labor? (Answer: VMP and Wage)
- Why might labor supply decrease when wages rise? (Answer: Income effect is larger than Substitution effect)
- Between a society with a Gini coefficient of 0.2 and one with 0.5, which is more equal? (Answer: 0.2)
- What is the Gini coefficient if the Lorenz curve coincides with the diagonal line? (Answer: 0)
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