# Marginal productivity, wages, and profits in neoclassical economics

In neoclassical economics a worker is paid the marginal product of what they produce. If this is true then what is the source of profits?

• Do you mean profits in the economic sense (rents over opportunity cost) or in the accounting sense (profits in balance sheets)? – luchonacho Aug 14 '17 at 7:58
• This post might be of interest to you. – luchonacho Aug 14 '17 at 8:04

Recall the profit function.

$$\pi=pf(x)-wx$$

where $x$ is a set of inputs, and $w$ is a set of input prices.

A firm is profit maximizing when $MC=MR$ or in a competitive case where $MC=p$. If a worker is paid his marginal product (where $MPL=w$) we only pay what he produces.

If marginal cost is constant and marginal revenues are constant across all production sets, then the firms profits will be zero.

However if there are diminishing returns from the inputs then every worker is paid less, thus allowing for profits to exist in the short run.

Bottom line: In the short run, through the diminishing returns from labor that profit for the firm comes into existence.

In the long run however, new firms enter capturing more and more of the profits until they are reduced to zero.

• In a Cobb-Douglas with constant returns to scale there are diminishing returns to factors of production, and perfect competition will still render profits to zero (factor/output prices will adjust). I think the answer is incorrect. Check this post. – luchonacho Aug 14 '17 at 8:03
• @luchonacho from what I understand In our case the marginal cost from labor is $w$, it is reduced via diminishing returns. A firm does not have to produce where $pf(x)-wx=0$ unless market price is reduced to its break-even point. Since $w$ exhibits diminishing returns we end up with $MPL_1>MPL_2$ thus reducing input prices across all of the same input. Please let me know if I'm wrong. – EconJohn Aug 14 '17 at 17:17
• For an exogenous $p$, in the short-term, firms might have profits. But under the assumption of competitive markets, new firms will enter, expanding supply and therefore reducing $p$. This occur until $p$ is at the breakeven point, when there are no profits. My conflict is with the phrase "if there are diminishing returns from the inputs then every worker is paid less, thus allowing for profits to exist." That might be true in the short run, but not in the long run. – luchonacho Aug 14 '17 at 17:28
• @luchonacho so its an argument between long run and short run. should preface the answer as in the short run? – EconJohn Aug 14 '17 at 17:29
• The OP is not precise at all on what s/he mean by anything, so that clarification would be helpful. – luchonacho Aug 14 '17 at 17:32

Consider it intuitively. If each agent is paid the marginal product of what they contribute, then supposedly, the firm will also provide some value to a good or service that they will find a return on.

For someone like taxi cab drivers, they probably contribute most of the value of the service, (and pay for their own gas, upkeep, etc.). They end up getting paid close to the full value of the service, while the firm collects rents other ways. But if you are a car salesman, when you make a sale, you don't get paid the full value of the car that you sell. That's because sure, your labor contributed to the value of the sale, but so did the people keeping up the floor room, the advertising, etc. So everyone contributes some value to the firm, and presumably the firm itself will do so. The firm in this case may have put up financing for the dealership and taken on the cost of sifting through the labor market. So presumably the individuals in the firm will receive "profits" for these efforts as well.

Keep in mind that when we talk about zero economic profit in neoclassical economics, this does not preclude accounting profits.

• "If each agent is paid the marginal product of what they contribute, then supposedly, the firm will also provide some value to a good or service that they will find a return on." In the common case of competitive markets, firms paying MP mean indifference between producing or not (zero economic profit). If by return you mean "accounting return", then the same is true if they are not paid their marginal product, of if they have negative economic profits but positive accounting ones. Thus this phrase does not help to understand the issue. – luchonacho Aug 15 '17 at 15:20
• If the user is asking for why " " "profits" " " exist in the model and the answer is that they simply don't, then there is no " " "issue" " ". But obviously profits are conceptualized in the neoclassical model because profits exist in real life, and things like imperfect competition even in a neoclassical model can cause economic profits. There is no reason to restrict ourselves to a narrow intuition about perfect competition. – Kitsune Cavalry Aug 15 '17 at 15:48
• So in my particular case, I take a more intuitive approach by saying that "wages" (marginal product) a firm owner like a small business owner or other such firm would make, are what a layman would consider "profits." And this could be the source of confusion that some people may have, that is helpful to flesh out. – Kitsune Cavalry Aug 15 '17 at 15:51