The Marginal Productivity Theory

The marginal productivity theory is primarily concerned with what determines the demand for factors of production. It shows that, under perfect competition, an employer will always pay a reward to a factor equal to the value of its contribution to the product. Its most serious weaknesses are that in the real world perfect competition seldom prevails and that it tends to ignore the supply side. Nevertheless, it does give precision to what determines the demand for a factor, and thus some examination of the theory is a necessary preliminary to a more detailed discussion of the rewards of individual factors in the real world. It is a general theory applying to all factors of production. Illustration, however, is usually in terms of labour and wages, and we shall adopt this practice.

The marginal productivity theory of distri­bution, as developed by J. B. Clark, at the end of the 19th century, provides a general explanation of how the price (of the earnings) of a factor of production is determined.

In other words, it suggests some broad principles regarding the distribution of the national income among the four factors of production.

According to this theory, the price (or the earnings) of a factor tends to equal the value of its marginal product. Thus, rent is equal to the value of the marginal product (VMP) of land; wages are equal to the VMP of labour and so on. The neo-classical economists have applied the same principle of profit maximisation (MC = MR) to determine the factor price. Just as an entrepreneur maximises his total profits by equating MC and MR, he also maximises profits by equating the marginal product of each factor with its marginal cost.

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

1. Perfect competition in both product and factor markets:

Firstly, the theory assumes the perfect competition in both product and factor markets. It means that both the price of the product and the price of the factor (say, labour) remains unchanged.

2. Operation of the law of diminishing returns:

Secondly, the theory assumes that the marginal product of a factor would diminish as additional units of the factor are employed while keeping other factors constant.

3. Homogeneity and divisibility of the factor:

Thirdly, all the units of a factor are assumed to be divisible and homogeneous. It means that a factor can be divided into small units and each unit of it will be of the same kind and of the same quality.

4. Operation of the law of substitution:

Fourthly, the theory assumes the possibility of the substitution of different factors. It means that the factors like labour, capital and others can be freely and easily substituted for one another. For example, land can be substituted by labour and labour by capital.

5. Profit maximisation:

Fifthly, the employer is assumed to employ the different factors in such a way and in such a proportion that he gets the maximum profits. This can be achieved by employing each factor up to that level at which the price of each is equal to the value of its marginal product.

6. Full employment of factors:

Sixthly, the theory assumes full employment for factors. Otherwise each factor cannot be paid in accordance with its marginal product. If some units of a particular factor remain unemployed, they would be then willing to accept the employment at a price less than the value of their marginal product.

7. Exhaustion of the total product:

Finally, the theory assumes that the payment to each factor according to its marginal productivity completely exhausts the total product, leaving neither a surplus nor a deficit at the end.

 MPP:

The first is marginal physical product of a factor. The marginal physical product (MPP) of a factor, say, of labour, is the increase in the total product of the firm as additional workers are employed by it.

VMP:

The second concept is value of marginal product. If we multiply the MPP of a factor by the price of the product, we would get the value of the marginal product (VMP) of that factor.

MRP:

The third concept is marginal revenue product (MRP). Under perfect competition, the VMP of the factor is equal to its marginal revenue product (MRP), which is the addition to the total revenue when more and more units of a factor are added to the fixed amount of other factors, or MRP = MPP x MR under perfect competition. It is simply MPP multiplied by constant price, as P = MR. [VMP of a factor = MPP of the factor x price of the product per unit, and MRP of a factor=MPP of the factor x MR under perfect competition. So under perfect competition VMP of a factor = MRP of that factor.]

The theory states that the firm employs each factor up to that number where its price is equal to its VMP. Thus, wages tend to be equal to the VMP of labor; interest is equal to VMP of capital and so on. By equating VMP of each factor with its cost a profit- seeking firm maximizes its total profits. Let us illustrate the theory with reference to the determination of the price of labor, i.e., wages.

Let us suppose that the price of the product is Rs. 5 (constant) and the wages per unit of labour are Rs. 200 (constant). As the number of factors other than labour remains unchanged, wages represent the marginal cost (MC).