The marginal productivity theory of distribution determines the prices of factors of production. This theory states that a factor of production is paid price equal to its marginal product. For example a laborer gets his wage according its marginal product. He is rewarded on the basis of contribution he makes the total output.
Factors of production are demanded because they have productivity. Higher the productivity of a factor, greater will be its price. Marginal product or otherwise called marginal physical product (MPP) refers to addition to the total physical product by employing one more unit of a factor.
When MPP is multiplied by price it is called value of marginal product (VMP). Marginal revenue product (MRP) is the addition made to total revenue by employing an additional unit of a factor. Average revenue product (ARP) is the average revenue per unit of a factor of production.
Explanation of the Theory:
Marginal productivity theory explains the following facts,
(a) Reward of each factor is equal to its marginal productivity:
Under perfect competition a firm employs various units of a factor up to that point where the price paid to the factor is equal to. Its marginal productivity. Every producer compares the price with its productivity. The price paid to a factor is income to it while it is cost to the producer. The point of equilibrium reaches at that point where MPP=price. If the producer employs less units of factors the productivity will be more and the cost will be less. Thus in such a case the producer will increase his profit by employing more units of factors and reaches the equilibrium point. On the other hand if the number of factor employed is more than the equilibrium level, the cost will be more than the productivity. The producer will lower the units of factors so long he reaches equilibrium. Thus his profit is maximized at the point of equilibrium
(MRP=MW). In other words a producer will employ the factors only up to the point where the cost of an additional factor unit equals its marginal revenue.
(b) Reward for each factor is same in every use.
Marginal productivity theory assumes that productivity of a factor is equal in all its uses. If the factor cost in two different uses is not uniform i.e. of the factor cost in one use is greater than other use, factors will move to that use where the factor cost is high.
This price will continue so long as the productivity of a factor becomes equal in all its uses. Besides this the marginal productivity of, all factors is the same in a particular use and thus they are the perfect substitutes of each other. The producer goes on substituting dearer factors by the cheaper factors so long as the marginal productivity of the factor becomes proportional to their prices. This condition for achieving equilibrium is stated as follows.
When a producer employees more and more of a factor unit, the marginal physical productivity of additional factor will start diminishing. That is why Marginal Productivity Curve diminishes after a particular point of employment of a factor. Since the objective of a firm is to maximize profit, he will always compare the cost of employing (MR) an additional laborer with the contribution (MP) made by that additional laborer.
He will go on employing additional factor so long as Marginal factor cost is equal to Marginal Productivity. The moment the productivity of an additional factor equals the marginal factor cost, he will stop employing additional factors and thereby his profit is maximized. The equilibrium situation is explained by the following diagram.
As there is perfect competition in factor market, AFC and MFC are the same. At point Q, AFC (MFC) is equal to MRP. The number of laborers employed is ON. At point Q the producer attains equilibrium. At point Q, MFC=MRP. If the producer employees ON1 of factors, the MRP is P1N1, but factor cost is Q" Nr as Q1N1, < P1N1, the producer will increase additional factors. It he employees ON2 laborers, MRP is P2N2 and MFC is Q2N2. As Q2N2 > P2N2 he will incur loss. He will reduce the number of laborers. Thus it is concluded that a producer will get maximum profits in production only if the different factors are so employed by him that their prices equal their marginal productivity.
Assumptions of the theory,
1. Prevalence of perfect competition in factor as well as product market.
2. All factors are identical.
3. Factors are perfect substitute for each other.
4. Factors are perfectly mobile.
5. Perfect divisibility of factors.
6. The theory operates in the long-run.
7. The theory is based on full employment.
(1) Unrealistic assumptions:
The theory is founded on certain unrealistic assumptions like prevalence of perfect competition and they are perfectly mobile. In reality there assumptions are not found.
(2) Difficulty in the measurement of MRP:
It is difficult to measure marginal revenue productivity of a factor. Marginal revenue productivity is the addition made to total revenue by employing an additional unit of a factor. But actually it is difficult to get it. In a large-scale industry if the work of a laborer is decreased, it will have no fall in total production.
(3) Factors are not perfectly identical:
In reality, different units of a factor are not identical. They are heterogeneous and hence can not be substituted by one another. Land and capital can not be substituted for each other. Labor as a factor cannot be equal in health and efficiency. They are not equally productive.
(4) Reward determines productivity:
The reward of a factor is determined by the factor's marginal productivity. Hence MRP is the cause and reward is the effect. When a laborer is given higher wages, his living standard will develop and his health and efficiency will increase. Hence reward is the cause and not the wage.