Marginal Productivity Theory of Distribution: Definitions,

Assumptions, Explanation!
The oldest and most significant theory of factor pricing is the marginal
productivity theory. It is also known as Micro Theory of Factor
Pricing.
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.
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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
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“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. This implies that different units of factor of production
have the same efficiency. 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.
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:
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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:
It is assumed that the quantity of factors of production can be varied
i.e. their units can either be increased or decreased. Then the
remuneration of a factor becomes equal to its marginal productivity.
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 remuneration only in the long period.
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.
Analysis of Marginal Productivity Theory from the
Point of View of an Industry:
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 MRP 1. 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. DD 1 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. DD 1 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.
MRP curve is sloping down-ward. It cuts WW at point E which is the
equilibrium wage rate of Rs. 55. At point E, firm will demand only four
labourers. Thus, from the above, we can conclude that a factor is
demanded up to the limit where its marginal productivity is equal to
prevailing price.
Under perfect competition, in long period in the equilibrium position,
not only the marginal wages of a firm are equal to marginal revenue
productivity, even the average wages of the firm are equal to average
net revenue productivity as has been shown in Fig. 5. The fig. 5 shows
that at point ‘E’ marginal wages of labour are equal to marginal
revenue productivity and the firm employs OM number of workers. At
this point, even the average net revenue productivity is equal to
average wages. Thus firm earns only normal profit. If wage line shifts
from NN to N[N] then the demand for labour increases from OM to
OM1.

Determination of Factor Pricing under Imperfect

Competition:
Marginal productivity theory applies to the condition of perfect
competition. But in real life we face imperfect competition. Therefore,
economists like Robinson, Chamberlin have analyzed factor pricing
under imperfect competition. There are various firms under imperfect
competition. But here we shall analyze only Monopsony. Under
monopsony, there is perfect competition in product market.
Consequently MRP is equal to VMP. There is imperfect competition in
factor market.
It indicates that there is only one buyer of the factors. Therefore,
monopsony refers to a situation of market where only a single firm
provides employment to the factors. If the firm demands more factors,
factor price will go up and vice-versa. However, the determination of
factor price under monopsony can be explained with the help of Fig. 6.

In Fig. 6 number of labourers has been shown on X-axis and wages on

Y-axis. MW is marginal wage curve and ARP is the average wage
curve. MRP is the marginal revenue productivity curve and AW is the
average revenue productivity curve.
In the fig. 6 a monopsony will employ that number of labourers at
which their marginal wage is equal to MRP. In the fig. 6 firm is in
equilibrium at point E. Here, firm will employ ON labourers and they
will be paid wages equal to NF. In this way, ON labourers will get less
wages than their MRP i.e. EN. Monopsony firm will have EF profit per
labourer which arises due to exploitation of labourers. Total profit
SFWW’ is due to exploitation of labour.