Distribution of Income and Factor Pricing
The Distribution of Income and Factor Pricing domain tests how rent, wages, interest and profit are determined. The core idea is that factor prices are derived from productivity and are shaped by market conditions and institutions.
Core rules and concepts
- Factor demand is a derived demand: labour is demanded for the goods it helps produce.
- Marginal productivity theory says a factor is paid according to its marginal revenue product (MRP = MR × MP) under competitive conditions.
- Rent is payment for land use. Ricardo treated rent as a surplus from differences in fertility; modern theory links rent to scarcity and transfer earnings.
- Wages are determined by labour demand and supply; collective bargaining and minimum-wage laws can alter outcomes.
- Interest rewards waiting or capital use; profit is the residual reward for enterprise and risk-bearing.
- Transfer earnings are what a factor could earn in its next best use; economic rent is payment above transfer earnings.
Worked example
A worker produces 10 extra units per day, each selling for ₹20, so MRP = ₹200. If the wage is ₹150, hiring adds ₹50 to revenue after wage cost. In a competitive market the worker can command up to ₹200. If a union raises the wage to ₹220, the employer will not hire unless productivity rises. This links MRP, wage and employment.
Traps that cost marks
Do not confuse economic rent with contractual house rent. Do not treat normal profit as a surplus above cost; it is included in cost. Do not say all wages are equal: skill, risk, training and bargaining power create differences.