Read this article to learn about the Marginal Productivity Theory of Distribution!
For a long time, economists explained the determination of factor prices with the help of a theory called the Marginal Productivity Theory.
Statement of the Theory:
The entrepreneur buys the services of the various factors of production. He is the agent through whom the various factors get their rewards in the form of rent, wages, interest, etc. The entrepreneur works for profit. He can only pay a price for a factor which he finds just worth-while.
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Obviously, he cannot afford to pay more than its marginal productivity. Since there is open competition, no factor-owner will accept less than the marginal productivity of the factor supplied by him. That is how marginal productivity (not total productivity) determines the remuneration or the price of a factor of production.
The entrepreneur, in employing the various factors of production, acts according to the principle of substitution. He substitutes one factor for another till the marginal productivities of all the factors divided by their respective prices are equalized. This will be the most economical combination which yields him the maximum profits. What is marginal productivity?
By the marginal productivity of a factor of product in we mean the addition made to total output by the employment of the marginal unit, i.e., the unit which the employer thinks just worthwhile employing. At the margin of employment, the payment made to the factor concerned is just equal to the value of the addition made to the total output on account of the employment of the additional unit of a factor.
If, for instance, the prevailing wage is less than the marginal productivity, then more labour will be employed. Competition among employers will raise the wage to the level of marginal productivity. If, on the other hand, the marginal productivity is less than the wage, the employers are losing and they will reduce their demand for labour. As a result, the wage rate will come down to the level of marginal productivity.
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In this way, by competition, wage tends to equal the marginal productivity. This applies also to the other factors of production and their rewards. Also, factors of production tend to move from those uses in which their marginal productivity is low to those in which it is high.
In this way, a given supply of a factor of production is distributed in such a way that its marginal productivity is equal in all the uses. That is why, we can say that the price of a factor of production is determined by its marginal productivity and this marginal productivity is the same in all its uses.
Thus, in a position of competitive equilibrium:
(i) The marginal productivity of a factor of production is the same in all employments;
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(ii) The marginal productivity of a factor of production is measured by the price of the factor of production; and
(iii) Marginal productivities of various factors are proportional to their respective prices.
Over the whole field of employment, therefore, each factor of production tends to be paid in proportion to its marginal productivity. Thus, the distribution of National Dividend or the total aggregate output of an economy is not a scramble as the strikes or lock-outs make it appear to be. It is governed by a definite economic principle, viz., and marginal productivity.
It should be noted that for an individual employer working under perfect competition, the prices that he has to pay for the factors of production are already determined. Since his demand for the factors of production is only an insignificant proportion of the total demand, his employing more or less of the factors does not appreciably affect their prices.
What he does is to push the use of each of the factors he employs to such a point as to make its marginal productivity equal to its price as already determined by the market forces. But the price’ of a factor of production is determined by the marginal productivity not of any particular employer but of employers in the aggregate.