Introduction to Economics

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1 Introduction to Economics ECONOMICS Chapter 5 Factor of Production Markets and Income Distribution

2 contents Demand and Supply of the Factors of Production Equilibrium in the Labor Market Capital Market Profit Problem of Income Distribution Measurement of the Degree of Inequality Problem of Poverty Redistributive Policy

3 5.1 Demand and Supply of the Factors of Production characteristics of the factor of production market - household(consumer) supplier, firm demander households determine the supply of the factors of production with a view to utility maximization firms determine the demand for the factors of production with a view to profit maximization - prices of the factors of production have a close relation with the distribution of income the level of wage determines laborers income

4 5.1 Demand and Supply of the Factors of Production Demand for the Factors of Production demand for the factors of production - derived demand demand for the factors of production is derived from the demand for commodities - demand for the factors of production determined in the context of profit maximization - value of marginal product, VMPL additional revenue by adding one more unit of a certain factor of production

5 5.1 Demand and Supply of the Factors of Production Demand for the Factors of Production demand for labor A firm employs labor up to the level where the marginal revenue product of labor is equal to wage rate VMPL = w profit maximized when this condition is met marginal revenue product of labor curve is demand curve for labor

6 5.1 Demand and Supply of the Factors of Production Demand for Labor Curve

7 5.1 Demand and Supply of the Factors of Production Supply of the Factors of Production - decision process differs depending on which factor of production is considered ex) supply of labor a consumer allocates his time between work and leisure to maximize his utility the decision of how many hours he/she will work is the result of this choice assumption : a consumer can freely choose how many hours he/she will work

8 5.1 Demand and Supply of the Factors of Production Supply of Labor a change in wage rate means a change in the price of labor(or leisure) so its effect on the supply of labor can be analyzed in the framework of substitution effect and income effect substitution effect - a rise in wage rate leisure becomes more expensive in a relative sense an increase in the supply of labor income effect - a rise in wage rate an increase in consumer s real income an increase in the supply of labor (leisure is a normal good)

9 5.1 Demand and Supply of the Factors of Production Labor Supply Curve

10 5.2 Equilibrium in the Labor Market an equilibrium of the factor of production market is reached at the intersection of demand and supply curves just like the commodity market when the price of a certain factor of production is determined in the market, the income of those who supply it is determined at the same time theory of income distribution in case of labor market, wage rate and the level of employment are determined income of those who supply labor determined

11 5.2 Equilibrium in the Labor Market Equilibrium in the Labor Market

12 5.2 Equilibrium in the Labor Market Skilled Labor and Unskilled Labor in general, wages of skilled laborers are higher than those of unskilled laborers unskilled laborers can be transformed into skilled laborers through human investment human investment education or on-the-job training which contributes to an increase in labor productivity human capital theory views that the accumulation of human capital is as important as the accumulation of physical capital

13 5.2 Equilibrium in the Labor Market Discrimination in the Labor Market discrimination based on age, sex, race reasons for discrimination prejudice, lack of information if discrimination continues for a long time, the need for discrimination disappears those who are discriminated against do not have the incentive to get education or on-the-job training to improve productivity at this stage, they get bad treatment not because of discrimination but because of low productivity

14 5.3 Capital Market Capital the word capital is used in many different ways it could mean the money invested to a firm in economics, capital means structures, machinery, equipment and inventories utilized in production process strictly speaking capital goods

15 5.3 Capital Market Characteristics of Capital labor and land are called primary factors of production since they can be used directly without going through production process but capital is a produced factor of production it has durability and is an input and an output at the same time we should distinguish between capital and capital service what is used in production process is capital service, not capital itself the value of a capital good goes down as time goes by depreciation

16 5.3 Capital Market Accumulation of Capital capital accumulation means sacrifice of present consumption in order to get more future consumption closely related to savings capital is accumulated by investments investments affect present and future consumption the level of consumption goes down immediately after an investment, but it goes up rapidly thereafter too much capital accumulation is not desirable since it demands too much sacrifice in present consumption

17 5.3 Capital Market Effect of Investment on Consumption Level

18 5.3 Capital Market Contents of Capital capital stock three kinds of capital goods - a total amount of capital existing in one country - includes all the things that are not consumed to be used in the production of other commodities (1) structure : plants, houses, bridges (2) equipment : machines, tools, vehicles, computers (3) inventory : inventory of inputs or outputs

19 5.4 Profit sources of profit - profit is a reward to entrepreneurial efforts - entrepreneurial efforts vision or creativity which introduces new ideas to business innovation and risk bearing

20 5.4 Profit Sources of Profit innovation risk bearing - introduction of new products, finding ways to cut costs dramatically etc. - J. Schumpeter : profit is a reward to those who innovate - a premium is needed to induce someone to bear risks monopoly power - monopoly power is another source of profit - undesirable because it causes inefficient allocation of resources

21 5.4 Profit Roles Profit Plays driving force of a capitalist economy government policy profit is a driving force of the dynamic progress of a capitalist economy - firms pursue innovation with an expectation of profit - raises efficiency in allocation processes - should encourage genuine entrepreneurial efforts with tax and financial policies

22 5.5 Problem of Income Distribution importance of equitable distribution of income - for maximum economic welfare, productive resources should be efficiently allocated first of all - but efficient allocation is not a sufficient condition for maximum welfare - equitable distribution of income is also important the problem of equity is closely related to value judgments objective discussion of distribution related issues difficult economists pay relatively little attention to these issues

23 5.5 Problem of Income Distribution Functional Distribution of Income and Size Distribution of Income two kinds of income distribution - functional distribution of income how national income is divided among different factors of production? theoretical approach possible Thomas Piketty s Capital in the 21 Century - size distribution of income how income is distributed among different income classes? theoretical approach difficult

24 5.6 Measurement of the Degree of Inequality equity equality - a complicated concept related to value judgments - even the concept of equality could be different from just equal division of income inequality index - measures how far is the actual state of income distribution from the state of equal division - implicitly assumes that the state of equal division is equitable

25 5.6 Measurement of the Degree of Inequality Deciles Distribution Ratio income decile - income classes each of which consists of 10% of people from the poorest 10% to the richest 10% decile distribution ratio - the share of income of the poorest 40% divided by the share of income of the richest 20% - smaller value more equal

26 5.6 Measurement of the Degree of Inequality Lorenz curve Lorenz curve % of households on the horizontal axis and % of income they receive on the vertical axis shape of the curve diagonal line absolute equality red lines absolute inequality we can compare the states of income distribution by looking at the locations of the curves closer to the diagonal line more equal but Lorenz curves should not intersect each other for comparison to be possible

27 5.6 Measurement of the Degree of Inequality Lorenz curve

28 5.6 Measurement of the Degree of Inequality Gini Coefficient Gini Gini = + coefficient perfect equality : Gini = 0 perfect inequality : Gini = 1 Gini coefficient ranges from 0 to 1, and a higher value indicates a more unequal state limit of Gini coefficient - qualitative aspects of distribution are not considered

29 5.6 Measurement of the Degree of Inequality Lorenz Curve and Gini Coefficient

30 5.7 Problem of Poverty definition of poverty - poverty a universal phenomenon which exists always and everywhere the perception of poverty differs depending on situations - poverty line a dividing line between the poor and the nonpoor difficult to figure out the minimum cost of living on objective grounds

31 5.7 Problem of Poverty Minimum Cost of Living (1) Rowntree method : absolute and objective basis how much money is necessary to purchase basic necessities? minimum cost of living absolute level of minimum consumption for survival difficult to know how much is necessary for survival in a social sense (2) Leyden method : absolute and subjective basis survey results calculates the minimum cost of living based on subjective evaluation

32 5.7 Problem of Poverty Minimum Cost of Living (3) a certain proportion of average income or median income - minimum cost of living in a relative sense a certain percentage of average income or median income is set as poverty line - the relative aspects of poverty even though basic necessities are guaranteed, some may feel he/she is poor if all the people around him/her are much better-off

33 5.7 Problem of Poverty Measurement of the Degree of Poverty head-count ratio - number of poor people / whole population - treat all the poor equally even though the degree of poverty differs widely poverty gap - how much the actual income is lower than the poverty line? poverty index - reflects the complicated nature of poverty ex) Sen index

34 5.8 Redistributive Policy examples of redistributive policies (1) progressive tax system tax system with progressivity makes the distribution of after-tax income more equal but it cannot increase incomes of the poor (2) negative income tax instead of collecting tax, government gives subsidies to people whose income fall below a certain level (3) social welfare system

35 5.8 Redistributive Policy Negative Income Tax

36 5.8 Redistributive Policy Social Welfare System social welfare system consists of social insurance system and public assistance system (1) social insurance system national pension, national health insurance, unemployment insurance limited redistributive effects (2) public assistance system government pays subsidies to the poor to support their living strong redistributive effects, but may foster dependent attitudes

37 5.8 Redistributive Policy Problems of Redistributive Policies cannot eradicate poverty may be the cause of inefficiency poor people may show the tendency to depend on social support welfare disease some points out that redistributive policies provide the incentive to fail ultimate goals of redistributive policies induce people to get out of poverty by their own efforts

38 E C O N O M I C S THANK YOU

Microeconomics: MIE1102

Microeconomics: MIE1102 TEXT CHAPTERS TOPICS 1, 2 ECONOMICS, ECONOMIC SYSTEMS, MARKET ECONOMY 3 DEMAND AND SUPPLY. MARKET EQUILIBRIUM 4 ELASTICITY OF DEMAND AND SUPPLY 5 DEMAND & CONSUMER BEHAVIOR 6 PRODUCTION FUNCTION 7 COSTS