Restating the Neoclassical Theory of Factor Income Distribution

 The Gini Coefficient measures the equality of incomes of the population in an economy. As shown in the image below the % cumulative population is marked on the x-axis and the corresponding cumulative incomes are marked on the y-axis. The red curve showing actual distribution of incomes is called Lorenzo curve and the distance between the line of equality and Lorenzo curve is measured by the Gini coefficient. A score closer to 0 indicates perfect equality whereas a score of 100 indicates perfect inequality.

This is a list of 100+ countries sorted by Gini coefficient sourced from https://knoema.com/atlas/ranks/GINI-index

It is not surprising for us to note that many of the developing countries are facing high degree of inequality whereas some of the Western European and Scandinavian countries have better income equality. The income inequality in United States is close to that of Uganda and Mongolia!

The Neoclassical Theory

The traditional neoclassical theory states that factor incomes are determined based on the productivity of the factor and supply of factor. In the figure below assuming that labor is the only variable factor and all other factors are fixed the income of the labor depends on the interaction between the supply of labor and the marginal productivity of labor.

In the figure above, we can see clearly that the total marginal product of labor represented by DOSE is way higher than ONES which is the actual wage earned by the labor. Free markets and movement of labor ensure that wages paid to any individual is equal to the marginal product of labor which is the equilibrium wage rate. Moreover a very large number of people are dependent on this chunk of factor income. The rent triangle NDE is the compensation to other factors of production that includes land, capital and organization which is distributed among a smaller group of individuals.

In the wake of global income inequality it is high time for us to redefine/restate our theories of income distribution. At the same time, we need to protect the spirit of capitalism - the incentive for initiative - the invisible hand which propels an individual to undertake risk which benefits the society as a whole.

Given below is the figure which restates the neoclassical theory. The incomes earned by labor are higher (represented by OJKES) in the restated figure when compared to the previous figure.

The super normal profits enjoyed by the risk taking entrepreneur/organization remain more or less the same - the redistribution would not change things around much. But from a labor perspective, it makes a huge difference. The entrepreneur still remains the hero in this model as romanticized by Joseph Schumpeter.

This redistribution of factor incomes can be achieved by way of minimum wages, labor participation in equity, differential taxation and income support schemes etc.

Let us hope that these next couple of decades bring prosperity and happiness across income groups!