Question

Describe how the neoclassical economists determined the shares of income accruing to each factor of production. How did neoclassical economists view the distribution of income in light of their model? Did they see exploitation?

Answer 1

First of all let us understand the term "Distribution" In economics, distribution is the way total output, income, or wealth is distributed among individuals or among the factors of production (such as labour, land, and capital). In general theory and the national income and product accounts, each unit of output corresponds to a unit of income.

One use of national accounts is for classifying factor incomes and measuring their respective shares, as in national Income. But, where focus is on income of persons or households, adjustments to the national accounts or other data sources are frequently used. Here, interest is often on the fraction of income going to the top (or bottom) x percent of households, the next x percent, and so forth (defined by equally spaced cut points, say quintiles), and on the factors that might affect them (globalization, tax policy, technology, etc.).

Now, go for Neoclassical theory.

In neoclassical economics, the supply and demand of each factor of production interact in factor markets to determine equilibrium output, income, and the income distribution. Factor demand in turn incorporates the marginal-productivity relationship of that factor in the output market.

Analysis applies to not only capital and land but the distribution of income in labor markets.^[7]

The neoclassical growth model provides an account of how the distribution of income between capital and labor is determined in competitive markets at the macroeconomic level over time with technological change and changes in the size of the capital stock and labor force. More recent developments of the distinction between human capital and physical capital and between social capital and personal capital have deepened analysis of distribution.

In Economics Factors of production are what is used in the production process to produce output—that is, finished goods and services. The utilized amounts of the various inputs determine the quantity of output according to the relationship called the production function. There are three basic resources or factors of production: land, labor, and capital. The factors are also frequently labeled "producer goods or services" to distinguish them from the goods or services purchased by consumers, which are frequently labeled "consumer goods". here are two types of factors: primary and secondary. The previously mentioned primary factors are land, labor, and capital goods. Materials and energy are considered secondary factors in classical economics because they are obtained from land, labor, and capital. The primary factors facilitate production but neither becomes part of the product (as with raw materials) nor becomes significantly transformed by the production process (as with fuel used to power machinery). Land includes not only the site of production but also natural resources above or below the soil. Recent usage has distinguished human capital (the stock of knowledge in the labor force) from labor. Entrepreneurship is also sometimes considered a factor of production. Sometimes the overall state of technology is described as a factor of production. The number and definition of factors vary, depending on theoretical purpose, empirical emphasis, or school of economics.

The basic idea in neoclassical distribution theory is that incomes are earned in the production of goods and services and that the value of the productive factor reflects its contribution to the total product. Though this fundamental truth was already recognized at the beginning of the 19th century (by the French economist J.B. Say, ), its development was impeded by the difficulty of separating the contributions of the various inputs. To a degree they are all necessary for the final result: without labour there will be no product at all, and without capital total output will be minimal. This difficulty was solved by J.B. Clark (c. 1900) with his theory of marginal products. The marginal product of an input, say labour, is defined as the extra output that results from adding one unit of the input to the existing combination of productive factors. Clark pointed out that in an optimum situation the wage rate would equal the marginal product of labour, while the rate of interest would equal the marginal product of capital. The mechanism tending to produce this optimum begins with the profit-maximizing businessman, who will hire more labour when the wage rate is less than the marginal product of additional workers and who will employ more capital when the rate of interest is lower than the marginal product of capital. In this view, the value of the final output is separated (imputed) by the marginal products, which can also be interpreted as the productive contributions of the various inputs. The prices of the factors of production are determined by supply and demand, while the demand for a factor is derived from the demand of the final good it helps to produce. The word derived has a special significance since in mathematics the term refers to the curvature of a function, and indeed the marginal product is the (partial) derivative of the production function.

One of the great advantages of the neoclassical, or marginalist, theory of distribution is that it treats wages, interest, and land rents in the same way, unlike the older theories that gave diverging explanations. (Profits, however, do not fit so smoothly into the neoclassical system.) A second advantage of the neoclassical theory is its integration with the theory of production. A third advantage lies in its elegance: the neoclassical theory of distributive shares lends itself to a relatively simple mathematical statement.

Now let us see the criticism of this theory. Neoclassical theory assumes that the total product Q is exactly exhausted when the factors of production have received their marginal products.This relationship is only true if the production function satisfies the condition that when L and K are multiplied by a given constant then Q will increase correspondingly. In economics this is known as constant returns to scale. If an increase in the scale of production were to increase overall productivity, there would be too little product to remunerate all factors according to their marginal productivities; likewise, under diminishing returns to scale, the product would be more than enough to remunerate all factors according to their marginal productivities.

Research has indicated that for countries as a whole the assumption of constant returns to scale is not unrealistic. For particular industries, however, it does not hold; in some cases increasing returns can be expected, and in others decreasing returns. This situation means that the neoclassical theory furnishes at best only a rough explanation of reality.

Now let us see the returns to the factors of production in Neo classical theory [Share of income to each factor of production]:

The demand side of the markets for productive factors is explained in large degree by the theory of marginal productivity, but the supply side requires a separate explanation, which differs for land, labour, and capital.

Rent : The supply of land is unique in being rather inelastic; that is, an increase in rent does not necessarily increase the amount of available land. Landowners as a group receive what is left over after the other factors of production are paid. In this sense, rent is a residual, and a good deal of the history of the theory of distribution is concerned with the issue whether rent should be regarded as part of the cost of production or not (as in Ricardo’s famous dictum that the price of corn is not high because of the rent of land but that land has a rent because the price of corn is high). But inelasticity of supply is not characteristic only of land; special kinds of labour and the size of the total labour force also tend to be unresponsive to variations in wages. The Ricardian issue, moreover, was important in the context of an agrarian society; it lacks significance now, when land has so many different uses.

Wages: In analyzing the earnings of labour, it is necessary to take account of the imperfections of the labour market and the actions of trade unions. Imperfections in the market make for a certain amount of indeterminacy in which considerations of fairness, equity, and tradition play a part. These affect the structure of wages—i.e., the relationships between wages for various kinds of labour and various skills. Therefore one cannot say that the income difference between a carpenter and a physician, or between a bank clerk and a truck driver, is completely determined by marginal productivity, although it is true that in the long run the wage structure is influenced by supply and demand.

The role of the trade unions has been a subject of much debate. The naive view that unions can raise wages by their efforts irrespective of market forces is, of course, incorrect. In any particular industry, exaggerated wage claims may lead to a loss of employment; this is generally recognized by union leaders. The opposite view, that trade unions cannot influence wages at all (unless they alter the basic relationship between supply and demand for labour), is held by a number of economists with respect to the real wage level of the economy as a whole. They agree that unions may push up the money wage level, especially in a tight labour market, but argue that this will lead to higher prices and so the real wage rate for the economy as a whole will not be increased accordingly. These economists also point out that high wages tend to encourage substitution of capital for labour (the cornerstone of neoclassical theory). These factors do indeed operate to check the power of trade unions, although the extreme position that the unions have no power at all against the iron laws of the market system is untenable. It is safe to say that basic economic forces do far more to determine labour’s share than do the policies of the unions. The main function of the unions lies rather in modifying the wage structure; they are able to raise the bargaining power of weak groups of workers and prevent them from lagging behind the others.

Interest and Profit: The earnings of capital are determined by various factors. Capital stems from two sources: from saving (by households, financial institutions, and businesses) and from the creation of money by the banks. The creation of money depresses the rate of interest below what may be called its natural rate. At this lower rate, businessmen will invest more, the capital stock will increase, and the marginal productivity of capital will decline. Although this chain of reactions has drawn the attention of monetary theorists, its impact on income distribution is probably not very important, at least not in the long run. There are also other factors, such as government borrowing, that may affect the distribution of income; it is difficult to say in what direction. The basic and predominant determinant is marginal productivity: the continuous accumulation of capital depresses the rate of interest.

One type of earning that is not explained by the neoclassical theory of distribution is profit, a circumstance that is especially awkward because profits form a substantial part of national income (20–25 percent); they are an important incentive to production and risk taking as well as being an important source of funds for investment. The reason for the failure to explain profit lies in the essentially static character of the neoclassical theory and in its preoccupation with perfect competition. Under such assumptions, profit tends to disappear. In the real world, which is not static and where competition does not conform to the theoretical assumptions, profit may be explained by five causes. One is uncertainty. An essential characteristic of business enterprise is that not all future developments can be foreseen or insured against. Frank H. Knight (1921) introduced the distinction between risk, which can be insured for and thus treated as a regular cost of production, and uncertainty, which cannot. In a free enterprise economy, the willingness to cope with the uninsurable has to be remunerated, and thus it is a factor of production. A second way of accounting for profits is to explain them as a premium for introducing new technology or for producing more efficiently than one’s competitors. This dynamic element in profits was stressed by Joseph Schumpeter (1911). In this view, prices are determined by the level of costs in the least progressive firms; the firm that introduces a new product or a new method will benefit from lower costs than its competitors. A third source of profits is monopoly and related forms of market power, whether deliberate as with cartels and other restrictive practices or arising from the industrial structure itself. Some economists have developed theories in which the main influence determining distributive shares is the relative “degree of monopoly” exerted by various factors of production, but this seems a bit one-sided. A fourth source of profits is sudden shifts in demand for a given product—so-called windfall profits, which may be accompanied by losses elsewhere. Finally, there are profits arising from general increases in total demand caused by a certain kind of inflationary process when costs, especially wages, lag behind rising prices. Such is not always the case in modern inflations.

Now, we will see the dynamic influences on distribution: Neoclassical theory throws light upon the long-run changes in distribution of income. It fails to take account of the short-run impact of business fluctuations, of inflation and deflation, of rapidly rising prices. This failure is an omission, though it is true that distributive shares do not fluctuate as much as employment, prices, and the state of business generally. This lagging in the behaviour of shares can be understood by remembering that they are determined by the quotient of the real remuneration of the factor and its productivity; both variables move, according to marginal productivity theory, in the same direction. Yet inflation and deflation do have a certain impact upon distribution: if purchasing power shrinks, profits are the first income category to suffer; next come wages, particularly through the effects of unemployment. In a depression, the recipients of fixed money incomes (such as interest and pensions) gain from lower prices. In an inflation the opposite happens.

The traditional inflationary sequence was that as prices rose, profits would increase, with wages lagging behind; this would tend to diminish the share of labour in the national income. Experience since World War II, however, has been different; in many countries wage levels tended to run ahead in the inflationary spiral and profits lagged behind, although most entrepreneurs eventually succeeded in shifting the burden of wage inflation onto the consumers. The result of the postwar inflation was a slight acceleration of the increase in the share of labour, while the shares of capital and land decreased faster than they would have in the absence of inflation. Profits as a whole held their own. The struggle among the various participants in the economic process no doubt added fuel to the inflationary fires.

Now, let us see the influence on Technology: Another dynamic influence is technological progress. The concept of the production function assumes a constant technology. But in reality the growth of production is much less the consequence of increased quantities of labour and capital than of improvements in their quality. This element in increased production is distributed in a way not fully explained by neoclassical theory. Part of the change in distribution that is caused by technological progress can be analyzed as resulting from changes in the elasticities of production.

If goes up, technological change is said to be “capital-using,” and the share of capital will increase. This is what, in fact, may have happened; the change in technology has offset, though it has not neutralized, the decline in the share of capital caused by the employment of a higher amount of capital per worker. But another part of the fruits of technological progress is garnered by profit receivers, probably quite a substantial part. Businessmen who are quick innovators make high profits; in a rapidly changing society, profits tend to be high, a circumstance that is fortunate because profits are the mainspring of economic change. The high rate of growth experienced by the post-World War I Western world stemmed from this profit-innovation-profit nexus.

Last but not least let us understand now Personal income and Neoclassical theory.

The neoclassical theory endeavours to explain the prices of productive factors and the distributive shares received by them. It does not come to grips with a third category of distribution, that of personal income, which is much more affected by institutional arrangements and by characteristics of the social structure. Profits in particular may be shared in various ways: they may accrue to stockholders, to workers, to management, or to the government; or they may be retained in the corporation. What happens depends on dividend policy, tax policy, and the existence of profit-sharing arrangements with workers. Neoclassical theory has little to say on these matters or on the fact that in present-day capitalist society the managers of big business are virtually in a position to fix their own personal incomes. Managers have so much power vis-à-vis the stockholders and their total share of profits is so relatively little that their ability to pay themselves high salaries is limited only by the conventions of the business world. These high incomes cannot be explained by the categories of the neoclassical theory, and they do not constitute an argument against the theory. They may well argue for changes in society’s institutions, but that is a matter on which the neoclassical theory of distribution does not pontificate. A great deal of change could occur in the legal and social order without any disturbance to the theory.