PG Semester 1 Micro Economics Shika Ramesh

MODULE – 4: THEORIES ON DISTRIBUTION

“Distribution’ refers to the sharing of the wealth that is produced among the different factors
of production. In the modern time, the production of goods and services is a joint operation.
All the different factors of production, that is, land, labour, capital and enterprise are
combined together in productive activity. Productive activity is, thus, the result of the joint
effort of these four factors of production which work collectively to produce more wealth.
These factors need to be paid or rewarded for their services, in the form of rent, interest,
wages and profits, for producing the wealth. The manner in which the payments are made to
these factors of production comes under the study of ‘distribution’. The ‘theory of
distribution’ determines the price to be paid for each factor and the ‘theory of pricing’
determines the price paid to each commodity.

The theory of distribution has two types of income distribution:

1. Functional Distribution: Functional distribution refers to the distinct share of the national
income received by the people as a reward for the unique functions rendered by them through
their productive services. These shares are commonly described as wages, rent, interest and
profits in the aggregate production. This distribution explains how the rent is determined for
land, how wages and salaries are fixed for labour, interest on capital and profit for the
entrepreneurs.

2. Personal Distribution: Personal distribution refers to the given amount of wealth and
income received by individuals in a society through their economic efforts, that is,
individual’s personal earnings of income through various sources.

The concept of equality and inequality of income distribution and social justice is basically
concerned with the personal distribution of income. Taxation measures are designed to
influence personal distribution of income and wealth in a community. The theory of
distribution deals with functional distribution and not with personal distribution of income. It
seeks to explain the principles governing the determination of factor rewards like - rent,
wages, interest and profits, that is, how prices of the factors of production are set.

Concepts of Factor Productivity

There are two main concepts relating to factor productivity:

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1. Physical productivity: When the productivity of any factor is expressed in terms of

goods and services, it is called physical productivity. It is further divided into average
and marginal physical productivity.
 Average Physical Productivity (APP): APP is the physical units produced per
unit of the variable factor. It is arrived at by dividing total physical productivity
𝑇𝑃𝑃
(TPP) by the number of units of the variable factor employed (N), i.e. 𝐴𝑃𝑃 = .
𝑁

 Marginal Physical Productivity (MPP): MPP is the addition made to total output
by employing an additional unit of a variable factor. MPP = TPPn – TPPn-1
 Value of Marginal Physical Productivity (VMPP): The value of marginal
physical productivity (or product) is obtained by multiplying MPP with the price
(Average Revenue (AR)) of the product. VMPP or VMP = MPP × Price (AR)
2. Revenue productivity: When the productivity of a factor is expressed in terms of
money, it is called revenue productivity. It is further divided into average and marginal
revenue productivity.
 Average Revenue Productivity (ARP): ARP is the revenue obtained per unit of
the factor employed. It is obtained by dividing total revenue productivity (TRP) by
𝑇𝑅𝑃
the total number of units of the factor employed (N) i.e. 𝐴𝑅𝑃 = . It is also
𝑁

obtained by multiplying APP with the price of the product, i.e., ARP = APP x Price
(AR).
 Marginal Revenue Productivity (MRP): MRP is the addition made to total
revenue productivity by employing one more unit of a variable factor, i.e., MRP =
TRPn – TRPn-1.

Under perfect competition, the VMP of the factor is equal to its marginal revenue product
(MRP). VMP of a factor = MPP of the factor × price of the product per unit, and MRP of a
factor = MPP of the factor × MR under perfect competition. So under perfect competition,
VMP of a factor = MRP of that factor.

Relation between ARP and MRP

There is a definite relation between ARP and MRP curves

which is based on the law of variable proportions. Both
ARP and MRP curves are inverted U-shape.

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1. When the ARP curve rises, the MRP curve is above it.
2. When the ARP curve is at its maximum, at point M, the MRP curve cuts it from above.
3. When the ARP curve falls, the MRP curve is below it and falls steeply.

Concepts of Factor Cost

The total cost of a factor (TFC) is the expenditure incurred by a firm in hiring or buying that
factor. It is further divided into average and marginal factor cost.

1. Average Factor Cost (AFC): AFC is the per-unit cost of the variable factor
employed by a firm. It is obtained by dividing total factor cost by the units of the
𝑇𝐹𝐶
factor employed, i.e., 𝐴𝐹𝐶 = .
units of factor employed

2. Marginal Factor Cost (MFC): It is the addition to the total factor cost by hiring or
purchasing an extra unit of that factor. MFC = TFCn – TFCn-1

4.1 Marginal Productivity Theory (MPT) of Distribution

The theory was propounded by John Bates Clark, Stanley Jevons, Leon Walras and J.R.
Hicks. But the basis of this theory was provided by J.B Clark in his work “The Distribution
of Wealth” in 1899.

Assumptions of Marginal Productivity Theory

The marginal productivity theory of distribution is based on the following assumptions:

1. There is perfect competition, both in the product market as well as in the factor
market.
2. The technological change is constant.
3. All units of a factor should be perfectly homogeneous, that is, they should be of equal
efficiency. This means that all units of a factor should receive the same price. The
homogeneity of factors should imply that they are perfect substitutes of each other.
4. The firm aims at maximisation of profit. Therefore, it should seek and observe the
most efficient allocation of resources.
5. The economy as a whole should operate at the full employment level.
6. There should be perfect mobility of factors of production.
7. There should not be any government intervention in the fixation of factor price, such
as minimum wage legislation or price control etc.

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8. The theory essentially considers long-run analysis in order to prove that the price of a
factor will tend to be equal to both average and marginal productivity.

In a perfectly competitive factor market, a firm can buy any number of units of factors of
production, at the prevailing market price. Now, the question is: given the price of a factor,
how much of each factor will the firm employ. According to this theory, an entrepreneur or a
firm will employ a factor at a given price till its marginal productivity tends to be equal to its
price. It, thus, follows that the reward (price) of a factor tends to be equal to its marginal
productivity. As long as the marginal productivity of a factor is greater than its price, the
employer would use more and more units of the factor. The marginal productivity, after a
certain stage would tend to diminish because of the operation of the law of diminishing
marginal returns. This can be explained with the help of the following example.

Price Wage Net returns from

No. of VMP
TPP MPP per unit Rate (in additional labour
labour (in Rs.)
(in Rs.) Rs.) (in Rs.)
1 10 10 2 20 12 8
2 24 14 2 28 12 16
3 40 16 2 32 12 20
4 50 10 2 20 12 8
5 56 6 2 12 12 0
6 56 0 2 0 12 -12

It is seen in the above table that in the beginning, producer employs the first labourer. With
the 1st labourer, total product is 10, marginal product is also 10. It is assumed that the price
per unit of output is Rs 2 and the wage rate of the labour is constant at Rs 12. Thus, by
employing the first labourer, producer gets Rs 8 as net return. Therefore, he adds 2nd and 3rd
labourer and gets Rs 16 and Rs 20 as net return respectively. But when he employs 5th
labourer, the total output is at its maximum of 56 units and the value of MP and the wage rate
to be paid is Rs 12 (equal) and the net returns from the additional labourer is zero. In this
way, with the 5th labourer, the marginal productivity of labour and wages becomes equal. The
rational producer or firm will not add new labourer now because this is the optimum level for
maximum profit for the firm. If the firm adds additional labourer, the net returns will become
negative from that labourer.

In short, the marginal productivity theory states that the remuneration paid to each factor will
be at that point where marginal productivity of a factor is equal to the value of the output
produced by that factor. When total product is distributed in accordance with the marginal
productivity of each factor, the total product gets exhausted. This is called as the ‘Adding-Up

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problem’ or the ‘Product Exhaustion problem’. No producer would employ a factor once its
productivity is less than the remuneration paid for it. If a producer does so, then, the returns
diminish, cost exceeds revenue and the firm incur losses. The point at which marginal
productivity equals the remuneration paid to the factor, is the point where profits will be the
maximum.

In the diagram, it is assumed that the

factor employed is labour or capital.
The MP curve shows how the
marginal productivity of labour or
capital has a tendency to come down,
as more and more units of labour or
capital are employed. For instance, in the case of labour (Figure A), when the units employed
becomes OL, the prevailing wage rate OB is reached. If more labour is employed beyond OL,
marginal productivity will go beyond OB wage rate and the producer would incur losses.
Thus, the employer would be maximising his profits when OL labour is employed at OB
wages. Similar is the case with marginal productivity of capital (Figure B).

It can be expressed as:

[𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡] = [𝑐𝑜𝑠𝑡 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟] + [𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙] or [P . Q] = [w . L] + [r . K]

Where ‘w’ is the share of wages to labour and ‘r’ is the share of interest to capital. As per
MPT theory, the factor shares must add up to one or unity. Thus, dividing the above by [P.Q],
we get,
𝑤.𝐿 𝑟.𝐾
1= +
𝑃.𝑄 𝑃.𝑄

The value of the product must be exhausted by the factor payments. If the physical output
(TPP) is exhausted by paying each factor its MPP, i.e. if

Q = (MPPL) . L + (MPPK) . K

where MPP is the marginal physical product and L and K are the number of labourers and
capital employed. If P is multiplied in the above equation, we get,

P . Q = (MPPL . P) . L + (MPPK . P) . K

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where (MPPL . P) is the VMP of labour, (MPPK . P) is the VMP of capital and (P . Q) is the
value of output. Hence, it can be seen that the factors are paid rewards (price) equal to their
VMP and thus, the total factor rewards will exhaust the total value of the product.

In the diagram, WW is the wage line indicating the constant

rate of wages at each level of employment in a perfectly
competitive market (AW = MW. Here, AW is average wage
and MW is marginal wage). The VMP curve shows the value
of marginal product of labour and it goes downwards from
left to right indicating diminishing MP of labour. The figure
shows that the firm employs OL number of labourers because
by doing so it equates the MRP of labour with the wage ratio and makes optimum purchase
of labour.

Criticisms

The MPT has been criticised by J.M Keynes, Taussig and Davenport as follows:

1. Perfect competition and full employment situations are unrealistic in the real world.
2. Factors of production are immobile.
3. Factors are never homogenous.
4. Factors are employed in accordance to their requirement.
5. The theory ignores the role of trade unions and collective bargaining to raise wages.

Solution to Marginal Productivity Theory

1. Euler’s Theorem: Wicksteed applied a mathematical proposition called Euler’s theorem

to prove the MPT theory that the total product will get exhausted when the factors are paid
rewards equal to their marginal productivity. However, Euler’s theorem, named after the
mathematician Leonhard Euler, states that this is only true if the production function is linear
homogeneous of degree one which implies constant returns to scale. A production function is
said to show constant returns to scale, if output increases by 1% in response to 1% rise in all
inputs (output increases proportionately with increase in inputs). According to Euler’s
theorem, the production function with constant returns to scale can be written as:

𝜕𝑄 𝜕𝑄 𝜕𝑄 𝜕𝑄
Q= 𝜕𝐿
.𝐿 + 𝜕𝐾
.𝐾 where 𝜕𝐿
= MPPL and 𝜕𝐾 = MPPK

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Thus, the MPT satisfies the ‘adding-up’ condition, [share of labour] + [share of capital] = 1.

Proof of Euler’s Theorem

A production function, Q = f (L, K) is a homogenous function of degree v, if

f(λL, λK) = λv. f (L, K)

Differentiating with respect to λ,

∂f ∂f
L. ∂L + K. ∂K = v. λv-1 . f (L, K)

With constant returns to scale, v is equal to one, thus,

L. (MPPL) + K . (MPPK) = f (L, K)

Given Q = f (L, K), we get,

L. (MPPL) + K . (MPPK) = Q

Multiplying the above equation with P,

L . (MPPL . P) + K . (MPPK . P) = P . Q

Hence, it is proved that the payment of factors according to their VMP exhausts the value of
output and the share of the factors adds up to unity in the case of constant returns to scale. If
the production function shows decreasing returns to scale, then, factor payment is less than
total output. In the case of increasing returns to scale, total factor payment is more than the
total output. Hence, product exhaustion theorem is only consistent with constant returns to
scale production function.

2. Wicksteed and Walras: They showed that the assumption of a homogeneous production
function is not necessary for the fulfilment of the postulates of the marginal productivity
theory. Their proof implies that, regardless of the production function, if factors are paid the
value of their marginal physical product, then, total factor payments will exactly exhaust the
total value of the product in the long-run competitive equilibrium.

In the long run, firms produce at the minimum point of their U-shaped LAC curve and
therefore, the requirements of the Euler’s theorem hold. The Clark-Wicksteed-Walras proof
holds only for the values of the variables in the long-run equilibrium. Furthermore, it holds

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for all types of production functions and hence it shows that product exhaustion is not a
characteristic of the special case of the linear homogeneous production function.

The figure shows the product of a single firm. The

MPPL curve shows the marginal physical product of labour.
Assume that the firm employs OL workers and a unit of
land. The total product of each firm is the area OMEL. If
each worker is given his marginal physical product, then,
the ‘physical’ wage would be OA = LE and the total wages
would be OAEL (shaded area in the figure). In other words,
the area OAEL is the total marginal physical product paid to labour or the share of labour (in
physical units) in the total output of the firm. The remaining (physical) product AME is the
rent of the fixed factor, that is, land. This residual rent is the total marginal product of land,
that is, the share of land in output.

4.2 Macro Theories of Distribution

1. Ricardo’s Theory of Distribution: Ricardo’s theory of distribution is based on his

principle of differential rent. He explained the theory of distribution in his book, “On the
Principles of Political Economy and Taxation” in 1817. The main assumptions are:

 All land is used for the production of  All workers are paid a subsistence wage
corn  Supply price of labour is given and
 Law of diminishing returns operates constant
 Supply of land is fixed  Demand for labour depends upon
 Demand for corn is perfectly inelastic capital accumulation
 Labour and capital are variable inputs  Capital accumulation results from profit
 State of technical knowledge is given  There is perfect competition.

The Ricardian model is based on the interrelation of three groups in the economy. They are
landlords, capitalists and labourers among whom the entire produce of land is distributed for
the production of corn. Given the total output of corn, the share of each factor can be
determined.

Rent is that portion of the produce of the earth which is paid to the landlord for the use of
original and indestructible powers of the soil. It is the difference between average and
marginal product of labour. If all the land had the same properties of unlimited supply and

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uniformity in quality, no charge would make for its use. The wage rate is determined by wage
fund divided by the number of workers employed at the subsistence level. Profit is the
difference between the MP of labour and the wage rate. According to the model, out of the
total corn produced, rent has the first right and the residual is distributed between wage and
profit while interest is included in profit.

In the figure, AP and MP curve represent average

product and the marginal product of labour. The X-
axis represents number of labourers and Y-axis Rent

represents the production of corn. The share of labour,

Profits
according to Ricardo, is determined by the
subsistence wage. OW is the subsistence wage per
labourer who needs a minimum of OW amount of Wages

corn for his subsistence. The wage bill (= wage level

× amount of labour) is OWLM (share of labour in M1

total output) at the subsistence level. OM labour is employed and OQRM corn is produced in
total. Share of rent is PQRT (difference between average and marginal product of labour, that
is, RM – TM = RT). Total profits are WPTL (difference between the MP of labour and the
subsistence wage, that is, TM – LM = TL). Profits equal the total product (OQRM) minus
rent (PQRT) minus wage bill (OWLM). Algebraically,

WPTL = OQRM – (PQRT + OWLM)

WPTL = OQRM – PQRT – OWLM

Total output increases with economic development which leads to an increase in wage fund
(or share of wages or total wage bill) leading to an increase in the amount of labourers. More
labourers gets subsistence wages which leads to increase in population. This leads to increase
in the demand for corn which also raises the price of corn. Thus, when OM1 labour is
employed, the total output increases to OABM1. As population increases, inferior grade lands
are cultivated to meet the rising demand for corn. Rents on superior grade of land increases
and absorb a greater share of the output produced on these lands. But here, the distribution of
the share of wages and rent squeezes out the profits. In short, the share of rent has increased
at the expense of profits (no profits). According to Ricardo, there is a natural tendency for the
profit rate to fall in the economy so that the country ultimately reaches the stationary state. In

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this state, capital accumulation stops, population does not grow, the wage rate is at the
subsistence level, rent is high and economic progress stops.

2. Marx’s Theory of Distribution: Karl Marx, the father of scientific socialism, is a great
thinker of history. He is regarded as the father of history who predicted the decline of
capitalism and the start of socialism. The Marxian analysis is the greatest and the most
penetrating examination of the process of economic development. Marxian economic theory
of growth is based on certain assumptions:

1. There are two principal classes in 5. Capital is of two types: constant capital
society – Bourgeoisie (The Haves- and variable capital.
capitalists) and Proletariat (The Have-nots-
6. Capitalists exploit the workers.
workers).
7. Labour is homogenous and perfectly
2. Wages of the workers are determined at
mobile.
a subsistence level of living.
8. Perfect competition in the economy.
3. Labour theory of value holds good.
Thus, labour is the main source of value 9. National income is distributed between
generation. wages and profits.

4. Factors of production are owned by the

capitalists.

Marx’s theory is based on the analysis of surplus-value of labour and is an adaptation of

Ricardo’s ‘surplus principle’. The value of labour is the amount of labour that it takes to
produce the means of subsistence necessary for the maintenance of the labourer. If a labourer
works for 10-hours a day, but it takes him only 6-hour labour to produce goods to cover his
subsistence, he will be paid wages equal to 6-hours’ labour. The difference worth 4-hours’
labour goes into the pockets of the capitalists in the form of net profits, rent and interest.
Marx calls this unpaid work as “surplus value” (s) (degree of exploitation of labour by the
capitalists) and the extra labour for which the labour receives nothing is “surplus labour”. The
capitalists save the surplus value, reinvest it in acquiring large stock of capital (capital
accumulation). Thus, the higher the rate of surplus-value, the higher the degree of
exploitation of the labour by the capitalists.

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Profits are also determined by the amount of capital. For understanding this, Marx separated
capital into two:

1. Constant capital (c): It refers to the circulating capital such as raw materials, machines
etc. which directly assist in labour productivity.
2. Variable capital (v): It is the capital devoted to the purchase of labour power in the
form of wages.

Thus, the total value of the product (y) can be written as, y = c + v + s where ‘y’ is output, ‘c’
constant capital, ‘v’ variable capital and ‘s’ is the surplus value. It is the variable capital
which is the main source of surplus value while the value of machines is gradually passed on
to the product. The ratio of constant capital to variable capital (c / v) is termed as the “organic
composition of capital” (which can be viewed as a sort of capital-labour ratio). For Marx,
only labour produces surplus value. Thus, Marx called the ratio of surplus labour to variable
capital, s / v, as the ‘exploitation rate’. According to Marx, profit is the converted form of
surplus value which is accumulated by the capitalists without paying remuneration to the
workers. The influence of technical progress generally increases the organic composition of
capital and lowers the rate of profits (r).

One of the consequences of capital accumulation is the concentration of capital in big

enterprises. Competition among capitalists force them to cheapen their products. This can be
done by introducing labour-saving machines which increases labour productivity. Those
capitalists who are unable to replace labour by machines are “squeezed out” and their
enterprises are taken over by big capitalists. Capital accumulation involves increase in
constant capital and decline in variable capital. This process of replacing labour by machines
creates an “industrial reserve army” which increases as capitalism develops. The larger the
industrial reserve army, the worse are the conditions of the employed workers, since the
capitalists can dismiss dissatisfied and troublesome workers. They are also able to cut down
wages to a semi-starvation level. This is the law of ‘increasing misery of the masses’ under
capitalism. But when the capitalists is replacing the workers by machines, there is a continual
reduction of surplus value. Marx believes that technological progress tends to increase the
organic composition of capital. Since the rate of profit is inversely related to the organic
composition of capital, the profits tends to decline with capital accumulation. Marx denoted it
as,
𝑠
𝑟= × 100
𝑐+𝑣
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It indicates that the rate of profit r varies inversely with the organic composition of capital (c /
v) and varies directly with the rate of surplus value. Therefore, the rate of profit (r) rises with
the rate of surplus value s / v and falls with the organic composition of capital c / v. This is
Marx’s law of ‘falling tendency of the rate of profit’. In other words, it may be stated that to
increase the surplus value, the capitalists try to increase the labour productivity via increased
application of machinery and equipment which changes the organic composition of capital
(more constant capital and less variable capital). As a result, the rate of profit (from
exploiting labourers (surplus value)) fall.

The Marxian analysis is based on the assumption

that as the capitalists employ more capital, they
keep the labour supply constant. In the diagram, x-
axis represents the amount of capital and y-axis P
represents the total output. The total product curve
OP rises at an increasing rate up to point A and
thereafter, at a decreasing rate. This means that
given the labour supply as constant, the law of
diminishing returns starts operating after point A with respect to the use of capital. The
constant wage rate is shown by the horizontal line TW which reflects constant labour supply
with increasing use of capital. A tangent line TT1 is drawn at point A from where a
perpendicular line AK1 cuts TW line at S1. Similarly, another line TT2 is drawn from point T
which intersects the total product curve at point B from which a perpendicular line BK2 cuts
TW line at S2. Now, when OK1 quantity of capital is used on machines, the total output is
equal to AK1 and the entrepreneurs earn AS1 total profits and the profit rate is AS1/TS1. If
entrepreneurs employ more capital than OK1 in the expectation of earning more profits, the
total profits decline from AS1 to BS2 and the profit rate also falls to BS2/TS2. Thus, with the
use of more capital on machines, the profit rate falls.

3. Kalecki’s Theory of Distribution: Michal Kalecki explains in his “Essays on the Theory
of Economic Fluctuations” that the distribution of national income into wages and profits
depends on the degree of monopoly (control) in the economy. The higher the degree of
monopoly, the higher will be the mark-up (profit margin which is calculated as
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒−𝐶𝑜𝑠𝑡 𝑃𝑟𝑖𝑐𝑒
× 100) of prices over direct costs (including labour costs), the lower
𝐶𝑜𝑠𝑡 𝑃𝑟𝑖𝑐𝑒

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will be the share of wages in national output. A lower share of wages implies a higher share
of capital income for the white-collar workers of the industry.

𝑝−𝑚
Kalecki applied Lerner’s microeconomic degree of monopoly1 [ where p = price and m =
𝑝

marginal cost] to the macro level by estimating the average degree of monopoly of all
individuals enterprises in the economy. In Kalecki’s formulation of the ‘degree of monopoly
power’, marginal cost ‘m’ includes cost of labour, which includes only wages of manual
labour, and the cost of raw materials per unit of output. (p - m) indicates income per unit of
output of the capitalist class which is inclusive of entrepreneurial profits and aggregate
overhead costs (interest, depreciation and salaries).

Assumptions

In order to explain the determination of the distributive shares of capitalist class and labour
class in national income, following assumptions has been made by Kalecki:

1. MC = AC of manual labour and raw materials (in the short-run) to a certain point
corresponding to ‘practical capacity’. Practical capacity is the maximum capacity for
all practical purposes. If from the maximum capacity, capacity lost due to operating
interruptions such as breakdowns or repairs, delays in supply of raw materials, waits,
time lost etc. is deducted, the balance is the practical capacity.
2. In the real world, output of the firm is below the practical capacity. Thus, he assumes
the existence of excess capacity in the economy.

With these assumptions, Kalecki explains his theory as follows:

Lerner’s index of the degree of monopoly of a single firm is given by,

𝑝−𝑚
µ= 𝑝

1
Lerner’s degree of monopoly power depends upon the numerical coefficient of the price elasticity of demand
for a monopolist’s product. It means less elastic is the demand for a product, the more would be the degree of
monopoly power and vice-versa. The monopolist is the sole seller in the market for his product and hence, he
possess a monopoly power in the market. According to Prof. Lerner, degree of monopoly power in perfect
competition is zero since p = AR = MR = MC or p = MC. In a monopoly market, degree of monopoly power is
positive since p = AR > MR = MC or p > MC. Therefore, Lerner’s index of monopoly power is (p – MC/ p)
which is zero in perfect competition and positive in the case of a monopoly.

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which explains the ratio of the difference between price (p) and marginal cost (m), and µ is
the degree of monopoly. Since Kalecki assumes MC = AC in the short run, therefore, in the
above formula, MC can be substituted with AC denoted as ‘a’ and thus,

𝑝−𝑎
µ= or p µ = (p – a)
𝑝

Here, (p – a) is the difference between price of the product and AC on manual labour and raw
materials per unit of output. Thus, (p – a) is inclusive of entrepreneurial profits (price of the
product is the revenue of the firm, thus, revenue minus average cost) and aggregate overhead
costs and therefore, represents gross capitalist income per unit of output. The total gross
capitalist income of a firm for the total output is obtained by multiplying both sides of the
above equation by ‘x’ which is the total production of the firm, i.e.,

x .p .µ = x (p – a)

where x (p – a) is the gross capitalist income of a single firm from the total output produced.
To obtain the gross capitalist income of all the firms, that is, the gross capitalist income of the
country, the gross capitalist income of all firms are summed up as,

∑ x .p .µ = ∑ x (p – a) (1)

where ∑ x (p – a) is the gross capitalist income of all the firms and ∑ x . p is the aggregate
turnover of the economy denoted by ‘T’, that is, the total value of the output of all goods
produced and sold in the economy. Thus,

T=∑x.p

Dividing equation (1) by the aggregate turnover T, we obtain,

∑ 𝑥𝑝 𝜇 ∑ 𝑥 (𝑝 − 𝑎)
=
𝑇 𝑇

Since T = ∑ x . p,

∑ 𝑥𝑝 𝜇 ∑ 𝑥 (𝑝−𝑎)
∑ 𝑥𝑝
=
𝑇

∑ 𝑥𝑝 𝜇
Where is the weighted average of the micro degree of monopoly µ or macro degree of
∑ 𝑥𝑝

monopoly µ̅. Thus,

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PG Semester 1 Micro Economics Shika Ramesh

∑ 𝑥 (𝑝−𝑎)
𝜇̅ = (2)
𝑇

Gross Capitalist Income

which represents that the macro degree of monopoly = .
Aggregate Turnover

Equation (2) shows that the relative share of gross capitalist income and salaries in the
aggregate turnover is equal to the average degree of monopoly. Given the cost of raw
materials, which are included in ‘a’, the increase in average degree of monopoly power 𝜇̅ will
cause the share of gross capitalist income or profits to rise at the expense of labour share or
wages. Thus, according to Kalecki, the distribution of the output of the industry into wages
and profit is determined by the degree of monopoly power.

Labour’s Share in National Income and Degree of Monopoly

Kalecki showed the dependence of labour’s share in national income on the macro degree of
monopoly in the economy as follows:

If A is the national income and W is the total wage bill, then, A – W represents the gross
capitalist’s income which is also equal to ∑ x (p – a). Hence, substituting the same in
equation (2), we get,

𝐴−𝑊
𝜇̅ =
𝑇

Multiplying both sides by 𝑇⁄𝑊 (aggregate turnover to wage ratio), we get,

𝑇 𝐴−𝑊 𝑇
𝜇̅ . = .
𝑊 𝑇 𝑊

𝑇 𝐴−𝑊
𝜇̅ . =
𝑊 𝑊

𝑇 𝐴 𝑊 𝐴
𝜇̅ . = - = 𝑊−1
𝑊 𝑊 𝑊

𝐴 𝑇
= 1 + 𝜇̅ .
𝑊 𝑊

Writing the reciprocal of the above equation,

𝑊 1
= 𝑇 (3)
𝐴 1 + 𝜇̅ .
𝑊

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PG Semester 1 Micro Economics Shika Ramesh

𝑊 𝑊𝑎𝑔𝑒𝑠
Equation (3) shows that , that is, , represents the relative share of wages in
𝐴 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
𝑇
national income and is inversely related to the degree of monopoly power 𝜇̅ and . It means
𝑊
an increase in the degree of monopoly power will reduce the relative share of wages and also
𝑇 𝑇
increases (since W is in the denominator, increases) since this raises prices in relation to
𝑊 𝑊
𝑇
wages. can also change due to change in the price of basic raw materials in relation to
𝑊
wage costs in the industries.

4. Kaldor’s Theory of Distribution: Keynes never formulated a theory of distribution. The

credit of developing the ‘Keynesian Theory of Distribution’ goes to Prof. Kaldor, who stated
that the principle of the multiplier (change in income to change in investment) could be used
for the determination of the relation between profits and wages. Kaldor also divides the
national income into wages (share of labour class) and profits (share of property owning
class). Profits are the income of the property owning class which includes ordinary profits,
rent and interest. Wages comprises of salaries as well.

Assumptions

1. There is a state of full employment so that total output or income (Y) is given.
2. National income or output consists of wages (W) and profits (P) only.
3. The marginal propensity to consume (MPC) of workers is greater than that of the
capitalists and the marginal propensity to save (MPS) of workers is less than that of
the capitalists.
4. The investment-output ratio (I/Y) is an independent variable
5. Elements of imperfect competition or monopoly power exists

Suppose W stands for aggregate wages and P for aggregate profits. Thus, national income Y
is,
Y=W+P

Since Kaldor assumes full employment, S = I. Hence, taking Sw as aggregate savings out of
wages (APS) and Sp as aggregate savings out of profits (APS), we have the aggregate savings
as the sum of aggregate savings from wages and profits which is written as,
S = Sw + Sp

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PG Semester 1 Micro Economics Shika Ramesh

Investment assumed as given and assuming simple proportional savings function, Sw = SwW
and Sp = SpP, we obtain the equation,

I = SpP + SwW

I = SpP + Sw (Y – P) since [W = Y – P]

I = SpP + SwY – SwP

I = (Sp – Sw) P + SwY

Thus, dividing both sides by national income (Y), we have the ratio of investment to national
income (multiplier),

𝐼 (𝑆𝑝−𝑆𝑤)𝑃+𝑆𝑤𝑌
= or
𝑌 𝑌

𝐼 𝑃
𝑌
= (𝑆𝑝 − 𝑆𝑤) 𝑌 + 𝑆𝑤 (1)

From (1), the ratio of profit to national income 𝑃⁄𝑌 can be derived as,

𝑃 𝐼
(𝑆𝑝 − 𝑆𝑤) = − 𝑆𝑤 (2)
𝑌 𝑌

Dividing both sides of equation (2) by (Sp – Sw), we get,

𝑃 𝐼 1 𝑆𝑤
= . −
𝑌 𝑌 𝑆𝑝 − 𝑆𝑤 𝑆𝑝 − 𝑆𝑤

Thus, given the marginal propensity to save of the wage-earners (workers) and the capitalists,
the share of profits in national income depends on the ratio of investment to total output. If
there is an increase in investment – income ratio (𝐼⁄𝑌), it will result in an increase in the

share of profits to national income 𝑃⁄𝑌 as long as Sp and Sw are constant and Sp > Sw.

The crucial aspect of Kaldor’s theorem is that the share of profits in the total income 𝑃⁄𝑌 is a

function of the investment-income ratio 𝐼⁄𝑌. Under full employment (I = S), an increase in

investment must bring about an increase in both the ratio of investment to income 𝐼⁄𝑌 and

also an increase in the savings income ratio 𝑆⁄𝑌. This is necessary if equilibrium at a higher
level of real investment is to be obtained. If the saving-income ratio did not rise, the result

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PG Semester 1 Micro Economics Shika Ramesh

would be a continuous upward movement of the general level of prices. The heart of Kaldor’s
theory lies in his demonstration that “shift in the distribution of income is essential to bring
about the higher-saving income ratio, which is the necessary condition for a continued full
employment equilibrium with a higher absolute level of investment in real terms. This is
illustrated below:

In the figure, a direct relationship between 𝑃⁄𝑌 and 𝐼⁄𝑌 is assumed. The ratio of investment
to income depends upon exogenous (outside) factors and is assumed as independent
altogether. Since, propensities to save for the two income classes differ, that is, MPS of the
workers is less than the MPS of the capitalists (as in the assumption), the MPS out of profits
are more than the MPS out of wage income. According to Kaldor, the assumption of Sp > Sw
is a necessary condition for both stability in the entire system along with the assumption of an
increase in the share of profits when the investment-income ratio rises.

Given the full employment level of income Yo,

the saving-income ratio and the investment-
income ratio are 𝑆⁄𝑌𝑜 and 𝐼⁄𝑌𝑜, respectively.
The economy is in equilibrium with a fixed
profit-income ratio given by the vertical line NN.
If there is an increase in income, the 𝑆⁄𝑌𝑜 and
𝐼⁄ functions shifts upwards to 𝑆⁄ and 𝐼⁄
𝑌𝑜 𝑌1 𝑌1
(from point E0 to E1). But the share of profits in
national income remain constant, as given by the line NN. In case 𝐼⁄𝑌𝑜 alone shifts up, the
𝑆⁄ level remaining the same, there would be inflationary rise of prices. This would raise
𝑌𝑜
the profit-income ratio 𝑃⁄𝑌, assuming Sp > Sw, and thus, pushes up the saving-income

function to 𝑆⁄𝑌1 to ensure equilibrium at full employment. If this smooth movement between
𝐼⁄ with 𝑆⁄ persists, the system will sustain itself at full employment and the equilibrium
𝑌 𝑌
share of profit to income will remain constant.

The underlying idea is that with fixed level of real income (assumption of full employment),
the only way in which it is possible to bring about an increase in 𝑆⁄𝑌 for the entire economy
is either through a rise in the propensity to save itself, which has been ruled out by Kaldor
through his assumption that Sp and Sw are constant, or through a shift in the distribution of

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PG Semester 1 Micro Economics Shika Ramesh

real income from low saving groups to the high saving groups. The mechanism which brings
about the redistribution of income in favour of the profit share whenever there is a rise in the
investment-income ratio is essentially that of the price level. The increase in investment
expenditure under full employment conditions, leads initially to a general rise in prices. But
wages cannot rise as fast and as much as the rise in prices.

The failure of money wages to keep pace with the rise in prices will reduce real income of
wage earners and it will increase the profit margins of entrepreneurs. Since the MPS of the
entrepreneurs is, on average, higher than that of wage earners, the inflation-induced shifts in
the distribution of real income in favour of profits will increase the overall level of real
saving in the economy. This process will continue until the saving-income ratio 𝑆⁄𝑌 is once

again in equilibrium with the investment income ratio 𝐼⁄𝑌. Thus, it is quite clear that the
assumption of Sp > Sw is of crucial importance in the Kaldor’s model. In the absence of this
assumption, the real 𝑆⁄𝑌 will not rise irrespective of any change in the distribution of income.
Consequently, the system may remain unstable.

**********

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