Shouldn't EVERY Factor of Production Get Paid Its Marginal Product?

Shouldn't EVERY Factor of Production Get Paid Its Marginal Product?
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A popular Marxist slogan is that the workers should be paid the “full value of their product.” Ironically, Austrian economists have no problem with the motto, it’s just that Karl Marx and his disciples failed to see that market forces generate this outcome. In particular, Marx relied on an exploitation theory of interest, in which the capitalists skimmed their net returns off the top of what “labor” produced; Eugen von Böhm-Bawerk exploded that line of reasoning. Once we take into account the fact that present goods are subjectively more valuable than future goods, we see that the workers are indeed paid the “full value of their product.”

In the discussion of Thomas Piketty’s Capital in the Twenty-First Century, these old debates over income distribution have returned. I want to point out one major problem in the handling of so-called “labor productivity,” which is actually quite misleading.

People who want to challenge the free-market economist’s claim that workers tend to be paid wages according to their marginal product will often produce charts like this one, taken from a Bureau of Labor Statistics essay:

Prod vs Compensation

Thus it appears that since the early 1970s, a widening gap opened up between “labor productivity” and real hourly compensation. I have seen many people refer to such diagrams or statistics in order to “prove” that free-market economists are simply ignorant of the facts when they claim that workers tend to be paid in accordance with what they bring to the table for their employers.

Now we have to ask ourselves: Could this standard interpretation possibly be correct? Is it really the case, for example, that by 2010, workers were producing 6 units of output but only being paid a little more than 5.6? Wouldn’t that open up a big profit opportunity for some employer to expand his or her pool of workers, by paying (say) 5.7? Of course one might say that it would be hard for any old entrepreneur to do this, but on the margin, wouldn’t the established employers expand their use of labor, if it indeed is being significantly underpaid?

Or, whatever reason the critic gives for why such an arbitrage opportunity does not currently exist, does that mean employers on average were losing money hand over fist on their workers from 1947 through the 1970s? Why were the employers back then so stupid?

Another quick point is that the above chart dovetails nicely with David Howden’s thoughts about “income inequality,” the (allegedly) scary stats for which often start in the early 1970s. There was indeed a major change in the U.S. financial system in the early 1970s, but it’s not the route progressives want to take when complaining about the deteriorating position of the middle class.

But so far I’ve been skipping the main point: The fundamental problem with the chart above is that it confuses most people. “Productivity” in the chart refers to total output per man-hour of labor. In other words, take real GDP and divide by the total number of hours that people worked in a year, and that’s “productivity” for that year.

People often assume that this number ought to correspond to “average wages paid to workers” for that year, in a fair system. But hold on a second. What about the owners of natural resources and capital goods? Should they get paid nothing for their contributions to total output? The workers didn’t crank out cars in the factories working with their bare hands, after all.

Let me put it another way. I could produce a chart like the above with two lines, one plotting “Land productivity” (which measured total GDP divided by the number of acres of land used in production) and the other showing “Real rent paid to landowners.” Or, I could make one line “Machine productivity” (total GDP divided by the number of machine-hours used) and the other “Real rent paid to machine owners.” In a just society, would all of these graphs have to show overlapping lines for 50 years straight? Wouldn’t that be an amazing coincidence?

In case the reader is confused, let me clarify things: In a competitive market economy, there is a tendency for workers, landowners, and the owners of capital goods to be paid in accordance with the marginal product of their inputs. That is not the same thing as saying each should be paid in accordance with total output divided by its class’s number of units. It can’t mean that: If workers (say) got paid according to “labor productivity” the way it’s calculated by the BLS, then all output would go to workers and none would be left for the owners of other inputs.

Some people might respond, “Good! Why should ‘unearned’ income go to these fat cat exploiters? Only the workers truly contribute!” Yet this statement is simply incorrect, from an engineering perspective. The workers by themselves are actually quite unproductive; raw labor power, lacking natural resources and capital goods, can produce massages, vocal performances, and stand-up comedy routines, but that’s about it (ignore the issue of standing ground).

Ethically, it’s not obvious why people who channel their productive efforts into the construction of capital goods shouldn’t be allowed to charge “what the market will bear” for the services they provide. Nobody is sticking a gun to anyone’s head in the process; the owners of capital goods earn rental payments because use of the capital goods expands output.

For those comfortable with the mathematics of formal economic models, at my personal blog I walk through a numerical example of the Solow growth model to make these points explicit. Intuitively speaking, as people continue to save and invest in excess of physical depreciation, the stockpile of capital goods accumulates. Done wisely, this activity augments the physical productivity of labor in the future, raising real wage rates. Absent odd theoretical cases where the machines are robot-like and totally displace human labor, the process of capital accumulation leads to rising absolute worker compensation and quite possibly even higher relative earnings, compared to the owners of capital goods.

In conclusion, the apparent divergence between “labor productivity” and “real labor compensation” does NOT invalidate marginal productivity theory. It merely shows that there are factors besides labor in the production process.

  • Michael Tontchev

    If that works for you, great. But there's no guarantee such labor contracts would work for everyone. Not only that, but what about uncertainty in the business climate? If the employer has a poor year (as some major firms had during the depression), should the workers all get 0 income for the year?

    If what you claim works in your experience was a general rule of business, they would teach it at business school and it would likely already be standard practice (since it appears that it is profit-maximizing).

Profile photo of Robert P. Murphy

Robert P. Murphy is the Senior Economist at the Institute for Energy Research, and a Senior Fellow with the Fraser Institute. He holds a PhD in economics from New York University. Murphy is the author of Choice: Cooperation, Enterprise, and Human Action (Independent Institute, 2015) as well as numerous other books and hundreds of articles.

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