ritics of capitalism have raised many objections to the market economy. For example, Marxists
claim that workers are systematically exploited because they are paid less than the full value of their labor. Meanwhile, progressives typically believe that the rich should "give back to the community" that has showered such blessings and privilege upon them.
To be sure, an economist who wishes to defend the virtues of laissez-faire capitalism has well-honed responses to such critiques. Regarding worker pay, it is literally textbook economics to show that so long as there is competition among firms, workers will tend to be paid the "value of their marginal product," meaning that there is a definite sense in which workers are paid the "full value" of their labor. When it comes to the rich "giving back," the economist might point to all of the staples of modern life—such as the automobile, telephone, Walmart, and iPhone—that were developed by pioneering entrepreneurs. In a voluntary market setting, the way to get rich is to serve the masses. Indeed, there is a definite sense in which someone's income is a measure of how much the person has already "given to the community."
"Suppose that an incredibly productive person decides to drop out of the workforce altogether. Should the rest of society even care, or is it all a wash?"
These objections, and the corresponding responses, are typical. And yet, doesn't it seem that there is at least a tension between them? If it's true that a worker gets paid an amount just equal to what he or she adds to total economic output, then how can there be any surplus left over to benefit the masses? In particular, suppose that an incredibly productive person decides to drop out of the workforce altogether. Should the rest of society even care, or is it all a wash?
It turns out that there's no contradiction between these principles: Even though a worker is paid the value of his or her marginal product, it is still true that the rest of society benefits from the worker's contribution to the economy. And look at it another way: If highly productive workers were suddenly to become monks, the rest of us would be materially poorer, even though those workers were paid the value of their marginal product before becoming monks. In this essay, I'll reconcile the apparent tension between these two standard principles, by explaining first the role of specialization and then the distinction between inframarginal and marginal units.
Labor Becomes More Productive With Cooperation (and Specialization)
So, how can it be true that a new worker reaps the "full value" of his contribution to output, while, at the same time, other people in society are also richer because the new worker came on the scene? I can illustrate the possibility first with a very simple example. Then I'll generalize to incorporate the standard treatment in economics classes.
Imagine a man who initially thinks he's alone on a tropical island. He would like to gather coconuts from a tree, but he has no ladder or other tools, and so it takes him one hour to retrieve 10 coconuts.
Later, the man is elated to discover a second person on the island. The two men are identical in their abilities at retrieving coconuts. However, by working in tandem (perhaps taking turns standing on each other's shoulders), the two men can gather 30 coconuts in an hour. If they split the yield evenly, each man enjoys 15 coconuts per hour, which is a 50% increase in the physical yield of their labor time compared to the situation in which they each work in isolation.
In this simple example, note that neither man is exploiting the other; since they are identical workers, they share the total output evenly. Yet the first man benefits greatly from the existence of the other (and vice versa).
More generally, the productivity of labor increases with specialization. As the population grows, people can focus on more narrowly defined tasks: some produce only dental services; others grow food; others build houses; and so on. Even though each person might "take out" from total output exactly what he or she "put in," the rest of society can still benefit from the cooperation of new workers because the enhanced division of labor means that everybody else is able to "put in"—and, hence, "take out"—that much more. In other words, when a new worker enters the economy, the rest of us can benefit not because we skim some off the top of what he adds, but because his or her cooperation makes us more productive.
That's how the society as a whole benefits, but we can also see the same phenomenon from the perspective of the individual worker. The man who finds himself suddenly stranded on a tropical island—even if it were richly endowed with natural resources—would suffer a tremendous drop in his standard of living and would be very eager to restore contact with the rest of humanity. This observation does not mean that the man must, therefore, be "exploiting" everybody else or "drawing out more than his fair share" when rejoining society. For example, a brain surgeon stranded on a tropical island is not very productive, but she can greatly contribute to total output when working in tandem with other specialized workers and equipment.
To reiterate, human labor is far more physically productive when people specialize in particular tasks and then trade their respective outputs. This is one of the reasons that productive workers can make everyone else richer, even if they are paid the "full value" of their own contributions.
Marginal Productivity Theory: Does Labor Get Paid Its "Full Value"?
Thus far, we have seen that the increased output due to the division of labor is one of the reasons that the rest of society might benefit from a new worker, even if that worker is paid exactly what he or she added. However, another concept explains why society benefits even though individual workers are treated fairly. This second principle is the distinction between inframarginal and marginal units, but to understand its significance, we should first review what economists mean when they say that workers are paid according to their "marginal productivity."
Table 1 presents hypothetical production figures for a bubble gum factory.
Table 1: Total Packs of Bubble Gum Produced in Factory By Varying Levels of Workers
As the table indicates, if no workers show up at the factory, then output is zero. If just one worker shows up, then 100 packs of gum are produced. If two workers show up, then 180 packs are produced, and so on.
Now suppose that in equilibrium in this market, the factory hires five workers. In this case, what is the "marginal product" of the fifth worker? As the table indicates, the fifth worker is boosting production by 9 packs of gum per hour. This is because total output is 250 packs of gum with the original four workers, while total output jumps up to 259 packs of gum (per hour) when the fifth worker joins the crew. If we suppose that bubble gum sells for $1 per pack, then this fifth worker increases revenue to the factory owner by $9 per hour.
Economists generally agree that so long as the labor market is competitive, the owner of the factory will end up paying the fifth worker (close to) the value of his marginal product—i.e., $9 per hour. The reasoning is straightforward: If there are comparable firms competing with our hypothetical factory, then they would profit by bidding away the worker if he were not being paid the value of his marginal product. For example, if the factory tried to pay the worker only $8 per hour, then a competitor could offer the worker $8.25 per hour and still pocket a net 75 cents per hour gain from the move. The only logical stopping point for this process is when each worker (not just "the fifth") is paid the value of his or her marginal product.
At this point, it is crucial to understand that all of the workers are paid the same wage rate because (by assumption) they are all interchangeable. In other words, if any single one of the five workers decided to call in sick or to quit, then total factory output would drop by only 9 packs of gum per hour. This is because the remaining four workers would rearrange their activities in order to yield the maximum output possible with four workers. It wouldn't matter if the "first" worker were the one who got sick or quit; the others would simply take over the relevant tasks.
With the terminology defined, we can see the importance of the inframarginal/marginal distinction. Look again at Table 1. All five of the workers are paid $9 per hour, but only the marginal product of the fifth worker is 9 packs of gum. The marginal product is higher for the first four workers.
In particular, even though the owner of the factory is paying the workers "the full value" of their output—in the sense that each worker is paid according to his or her marginal product—the factory owner would, nonetheless, be devastated if all five of the workers called in sick or quit. This is because at full capacity, the factory churns out $259 worth of bubble gum per hour, while paying the workers a total of 5 × $9 = $45 per hour in wages. So if these five workers decided to become monks, we can see quite clearly that "the rest of society" would suffer. The "rest of society" in this case would include not just the factory owner—who might not be earning much of a profit at all, considering all of his expenses beyond just labor costs—but also the owners of land and the machinery used in the factory, as well as the consumers who buy bubble gum.
It's worth exploring the consumers' perspective more deeply. The inframarginal principle applies not just to the productivity of labor, but also carries over into what economists call "consumer surplus." In our example, where bubble gum sells for $1 per pack—at which point we can imagine that the factory owner is "just breaking even" on the margin, considering all of his costs of production, and consumers think that last pack of gum they purchase is "just barely worth" the $1 price—the consumers of bubble gum benefit from the existence of this market. Even though some avid bubble gum chewers might have been willing to pay up to, say, $10 for their first pack of gum, in equilibrium, they can buy many packs of gum for $1 each. This is yet another way of seeing that the "rest of society" would be hurt if the workers stopped going to the bubble gum factory, even though we assumed they were being paid the full value of their marginal product.
I have demonstrated in this section that a factory owner benefits from the ability to hire many workers, even though he is paying the workers "fair" wages according to their marginal productivity. By the same token, consumers benefit from the ability to buy many products, even though they are paying the sellers the "fair" price equal to the marginal cost of the items. To understand how this is all possible, I considered the distinction between the inframarginal and marginal units of analysis.
In order to defuse typical critiques of the capitalist system, economists often argue that workers are paid a wage equal to the value of their contribution to output. Yet economists also argue that the rest of society benefits materially from the role that high-income individuals play in the economy. At first glance, it appears that these two claims are contradictory. However, once we appreciate the higher productivity under the division of labor and the distinction between inframarginal and marginal units, we see that the two claims are compatible.
Specifically, when we add new workers (especially very productive ones) to the existing population, they allow for an enhanced division of labor, which makes everyone more productive. Therefore, even if everyone "takes out" from the economic pie exactly what he or she "put in," the addition of new workers can make everybody better off. Beyond this consideration, we must also appreciate that saying a worker gets paid according to her productivity is a statement about the margin, but not about the earlier (inframarginal) units. So yes, if any particular farmer suddenly vanished, that wouldn't affect the rest of society very much. But if all the farmers suddenly vanished, the rest of society would suffer greatly.
Other economists have tried to quantify the gains from innovation to various groups in society, but in this article, I have used simple examples to illustrate the basic principle: Even if every participant in the economy is paid "fairly," according to how much he or she "put in," the rest of society can also gain from the participation of others. Although at first paradoxical, this is a beautiful result that should foster peace and cooperation among humanity.
Indeed, Nobel laureate Paul Krugman has been making this argument—namely, that we have no need to be grateful to very productive entrepreneurs for "adding" to the economy, because they are already paid according to their contributions—for years. See for example his recent blog post, "Why Do You Care How Much Other People Work? Revisited", New York Times blog, September 25, 2017, and five years ago he spelled out the position quite clearly in his post "What You Add Is What You Get", New York Times blog, July 9, 2012.
I write that society might benefit from a new worker because the increased division of labor must be offset by the limited amount of land and other fixed factors of production. Although it is clear that a global population of 100 people would correspond to a much lower standard of living, on the other hand a global population (with current technology and resources) of, say, 100 quadrillion people would also spell misery.
Some purists stress that all exchanges in the marketplace involve a gain to both parties. In other words, even "on the margin," in the real world an employer strictly benefits from hiring that last unit of labor-time, while the worker also strictly benefits from selling that last unit of leisure. However, because my point in the text is to focus on the huge range of inframarginal units, we don't need to argue about the knife-edge case of the actual margin.
Strictly speaking, if the addition of the fifth worker involves greater use of other inputs (such as the plastic used to make the wrappers for the packs of gum), then the firm's marginal costs rise by more than the fifth employee's wages, and so the factory owner will pay the worker according to only the increment in total net income (neglecting labor costs), not the full increase in gross revenues.
Robert P. Murphy is Research Assistant Professor with the Free Market Institute at Texas Tech University. He is the author of Choice: Cooperation, Enterprise, and Human Action
(Independent Institute, 2015).
For more articles by Robert P. Murphy, see the Archive