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Marginal Productivity Theory

This document provides an overview of the marginal productivity theory of distribution. It begins by defining the theory and its key assumptions, such as perfect competition, diminishing returns, factor substitutability, and profit maximization. It then explains the concepts of marginal physical product, value of marginal product, and marginal revenue product. The essence of the theory is that firms will employ factors up to the point where their price equals their value of marginal product. This is demonstrated with an example and diagram. Finally, the document discusses some common criticisms of the theory, such as its assumptions of perfect competition and full employment being unrealistic.

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534 views5 pages

Marginal Productivity Theory

This document provides an overview of the marginal productivity theory of distribution. It begins by defining the theory and its key assumptions, such as perfect competition, diminishing returns, factor substitutability, and profit maximization. It then explains the concepts of marginal physical product, value of marginal product, and marginal revenue product. The essence of the theory is that firms will employ factors up to the point where their price equals their value of marginal product. This is demonstrated with an example and diagram. Finally, the document discusses some common criticisms of the theory, such as its assumptions of perfect competition and full employment being unrealistic.

Uploaded by

Pranjal Bari
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Dr.

Anjali Prasad Topic:-Marginal Productivity Theory


Department of Economics Class:-BA Part 1 Hons.
TPS College, Patna

The Marginal Productivity Theory of


Distribution (With Diagram)

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.

Assumptions of the Theory:


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.

Some Key Concepts:


The theory is also based on key certain concepts.

These are the following:


1. 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.
2. 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.

3. 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 Essence of the Theory:


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 labour; interest is equal to
VMP of capital and so on. By equating VMP of each factor with its cost a profit- seeking
firm maximises its total profits. Let us illustrate the theory with reference to the
determination of the price of labour, 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 remain
unchanged, wages represent the marginal cost (MC).

Table 12.1: Calculation of MPP, VMP and MRP of a Variable Factor (Labour)

Table 12.1 shows that at 2 or 3 labourers, the VMP or MRP of labour is greater than
wages; so the firm can earn more profits by employing an additional labour. But at 5 or
6 labourers, the VMP or MRP of labour is less than wages, so it would reduce the
number of labourers. But when it employs 4 labourers, the wage rate (Rs. 20) becomes
equal to the VMP or MRP of labour (also Rs. 20). Here the firm gets the maximum
profits because its marginal cost of labour (or marginal wage Rs. 12) is equal to its
marginal revenue (VMP or MRP, Rs. 20).

Thus, under the assumption of perfect competition a firm employs a factor up to that
number at which the price of the factor is just equal to the value of the marginal product
(=MRP of the factor). In the same way it can be shown that rent is equal to the VMP of
land, interest is equal to the VMP of capital, and so forth.

The theory may now be illustrated diagrammatically. See Fig. 12.2. Here WW is the
wage line indicating the constant rate of wages at each level of employment (AW = MW.
Here AW is average wage and MW is marginal wage). The VMP line shows the value of
marginal product curve of labour, and it goes downwards from left to right indicating
diminishing MPP of labour. Fig. 12.2 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 of the Theory:


The marginal productivity theory of distribution has been subjected to a
number of criticisms:
1. In determination of marginal product:
Firstly, main product is a joint product— produced by all the factors jointly. Hence the
marginal product of any particular factor (say, land or labour) cannot be separately
determined. As William Petty pointed out as early in 1662: Labour is the father and
active principle of wealth, as lands are the mother.
2. Unrealistic:
It is also shown that the employment of one additional unit of a factor may cause an
improvement in the whole of organisation in which case the MPP of the variable factors
may increase. In such circumstances, if the factor is paid in accordance with the VMP,
the total product will get exhausted before the distribution is completed. This is absurd.
We cannot think of such a situation in reality.

3. Market imperfection:
The theory assumes the existence of perfect competition, which is rarely found in the
real world. But E. Chamberlin has shown that the theory can also be applied in the case
of monopoly and imperfect competition, where the marginal price of a factor would be
equal to its MRP (not to its VMP).

4. Full employment:
Again, the assumption of full employment is also unrealistic. Full employment is also a
myth, not a reflection of reality.

5. Difficulties of factor substitution:


W. W. Leontief, the Nobel economist, denies the possibility of free substitution of the
factors always owing to the technical conditions of production. In some products
process, one factor cannot be substituted by another. Moreover organisation or
entrepreneurship is a specific factor which cannot be substituted by any other factor.

6. Emphasis on the demand side only:


The theory is one-sided as it ignores the supply side of a factor; it has emphasised only
the demand side i.e., the employer’s side, hi the opinion of Samuelson, the marginal
productivity theory is simply a theory of one aspect of the demand for productive
services by the firm.

7. Inhuman theory:
Finally, the theory is often described as ‘inhuman’ as it treats human and non-human
factors in the same way for the determination of factor prices.

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