Azharuddin Ansari, Economics, Faculty of Law, Jamia Millia Islamia

Economics I
Jamia Millia Islamia
Unit 2

Marginal Productivity Theory of Distribution

It was propounded by the German economist T.H. Von Thunen. But later on many economists
like Karl Mcnger, Walras, Wickstcad, Edgeworth and Clark etc. contributed for the
development of this theory.

According to this theory, remuneration of cache factor of production tends to be equal to its
marginal productivity.

Marginal productivity is the addition that the use of one extra unit of the factor makes to the
total production. So long as the marginal cost of a factor is less than the marginal
productivity, the entrepreneur will go on employing more and more units of the factors. He
will stop giving further employment as soon as the marginal productivity of the factor is
equal to the marginal cost of the factors.

Definitions:
“The distribution of income of society is controlled by a natural law, if it worked without
friction, would give to every agent of production the amount of wealth which that agent
creates.” -J.B. Clark

“The marginal productivity theory contends that in equilibrium each productive agent will be
rewarded in accordance with its marginal productivity.” -Mark Blaug

“The marginal productivity theory of income distribution states that in the long run under
perfect competition, factors of production would tend to receive a real rate of return which
was exactly equal to their marginal productivity.” –Liebhafasky
Assumptions of the Theory:

The main assumptions of the theory are as under:

1. Perfect Competition:

The marginal productivity theory rests upon the fundamental assumption of perfect
competition. This is because it cannot take into account unequal bargaining power between
the buyers and the sellers.

2. Homogeneous Factors:

This theory assumes that units of a factor of production are homogeneous in nature. This
implies that different units of factor of production have the same efficiency and had a same
features. Thus, the productivity of all workers offering the particular type of labour is the
same.

3. Rational Behaviour:

The theory assumes that every producer desires to reap maximum profits. This is because the
organizer is a rational person and he so combines the different factors of production in such a
way that marginal productivity from a unit of money is the same in the case of every factor of
production.

4. Perfect Substitutability:

The theory is also based upon the assumption of perfect substitution not only between the
different units of the same factor but also between the different units of various factors of
production.

5. Perfect Mobility:

The theory assumes that both labour and capital are perfectly mobile between industries and
localities. In the absence of this assumption the factor rewards could never tend to be equal as
between different regions or employments.

6. Interchangeability:

It implies that all units of a factor are equally efficient and interchangeable. This is because
different units of a factor of production are homogeneous, since they are of the same
efficiency, they can be employed inter-changeable, and e.g., whether we employ the fourth
man or the fifth man, his productivity shall be the same.

4. Perfect Substitutability:

The theory is also based upon the assumption of perfect substitution not only between the
different units of the same factor but also between the different units of various factors of
production.

5. Perfect Mobility:

The theory assumes that both labour and capital are perfectly mobile between industries and
localities. In the absence of this assumption the factor rewards could never tend to be equal as
between different regions or employments.

6. Interchangeability:

It implies that all units of a factor are equally efficient and interchangeable. This is because
different units of a factor of production are homogeneous, since they are of the same
efficiency, they can be employed inter-changeable, and e.g., whether we employ the fourth
man or the fifth man, his productivity shall be the same.

7. Perfect Adaptability:

The theory takes for granted that various factors of production are perfectly adaptable as
between different occupations.

8. Knowledge about Marginal Productivity:

Both producers and owners of factors of production have means of knowing the value of
factor’s marginal product.

9. Full Employment:

It is assumed that various factors of production are fully employed with the exception of
those who seek a wage above the value of their marginal product.

10. Law of Variable Proportions:

The law of variable proportions is applicable in the economy.

11. The Amount of Factors of Production should be Capable of being Varied:

12. The Law of Diminishing Marginal Returns:

It means that as units of a factor of production are increased the marginal productivity goes
on diminishing.

13. Long-Run Analysis:

Marginal productivity theory of distribution seeks to explain determination of a factor’s

Explanation of the Theory:

The marginal productivity theory states that under perfect competition, price of each factor of
production will be equal to its marginal productivity. The price of the factor is determined by
the industry. The firm will employ that number of a given factor at which price is equal to its
marginal productivity. Thus, for industry, it is a theory of factor pricing while for a firm it is a
factor demand theory.

Under the conditions of perfect competition, price of each factor of production is determined
by the equality of demand and supply. As the theory assumes that there exists full
employment in the economy, therefore, supply of the factor is assumed to be constant. So,
factor price is determined by its demand which itself is determined by the marginal
productivity. Thus, under such conditions, it becomes essential to throw light on the demand
curve or marginal productivity curve of an industry.

As the industry consists of a group of many firms, accordingly, its demand curve can be
drawn with the demand curves of all the firms in the industry. Moreover, marginal revenue
productivity of a factor constitutes its demand curve. It is only due to this reason that a firm’s
demand or labour depends on its marginal revenue productivity. A firm will employ that
number of labourers at which their marginal revenue productivity is equal to the prevailing
wage rate.
Fig. 2 shows that at wage rate OP1, the demand for labour is ON1 and

marginal revenue productivity curve is MRP1. If wage rate falls to OP, firms will increase
production by demanding more labour. In such a situation the price of the commodity will fall
and marginal revenue productivity curve will also shift to MRP2.

At OP wages, the demand for labour will increase to ON. DD1 is the firm’s demand curve for
labour. The summation of demand of all the firms shows demand curve of an industry. Since
the number of firms is not constant under perfectly competitive market, it is not possible to
estimate the summation of demand curves of all firms. However, one thing is certain that is
the demand curve of industry also slopes downward from left to right. The point where
demand for and supply of a factor are equal will determine the factor price for the industry.
This theory assumes the supply of a factor to be fixed.
Thus factor price is determined by the demand for factor i.e. factor price will be equal to the
marginal revenue productivity. It has been shown by Fig. 3. In the Fig. 3, number of labour
has been taken on OX axis whereas wages and MRP have been taken on OY axis. DD1 is the
industry’s demand curve for labour. This is also the Marginal Revenue Productivity curve.

Factor Price (OW) = Marginal Revenue Productivity MRP.

Thus under perfect competition, factor price is determined by the industry and firm demands
units of a factor at this price.

Analysis of Marginal Productivity Theory from the Point of View of Firm:

Under perfect competition, number of firms is very large. No single firm can influence the
market price of a factor of production. Every firm acts as a price taker and not a price maker.
Therefore, it has to accept the prevailing price. No employer would like to pay more than
what others are paying. In other words, a firm will employ that number of a factor at which
its price is equal to the value of marginal productivity. Therefore, from the point of view of a
firm, the theory indicates how many units of a factor it should demand.

It is due to this reason that it is also called Theory of Factor Demand. Other things remaining
the same, as more and more labourers are employed by a firm, its marginal physical
productivity goes or- diminishing. As price under perfect competition remains constant, so
when marginal physical productivity of labour goes on diminishing, marginal revenue
productivity will also go on diminishing. Therefore, in order to get the equilibrium position, a
firm will employ labourers up to a point where their respective marginal revenue productivity
is equal to their wage rate.

Table 2 indicates that wage rate of labour is Rs. 55 per labourers. Price of the product
produced by the labourer is Rs. 5 per unit. Now, when a firm employs one labourer, his
marginal physical productivity is 20 units. By multiplying the MPP with price of the product
we get marginal revenue productivity. Here, it is Rs. 100 for the first labour. The marginal
revenue productivity of second labourer is Rs. 85 and of third labourer it is Rs. 70.

The marginal revenue productivity of fourth labourer is Rs. 55 which is equal to wage rate.
The firm will earn maximum profits if it employs up to the fourth labourer. If the firm
employs fifth labourer, it will have to suffer losses of Rs. 15. Therefore, to get maximum
profits, a firm will employ a factor upto a point where MRP is equal to price.

In Fig. 4 number of labourers has been measured on OX-axis and wage rate on Y-axis. MRP
is marginal revenue productivity curve and WW is the wage rate prevailing in the market.
Since, under perfect competition wage rate will remain constant that is why WW wage line is
parallel to OX-axis.