Marginal productivity theory contributes a significant role in factor pricing. It is a classical theory of factor pricing that was advocated by a German economist, T.H. Von Thunen in 1826.
The theory was further developed and discussed by various economists, such as J.B. Clark, Walras, Barone, Ricardo, and Marshall.
According to this theory, under perfect competition, the price of services rendered by a factor of production is equal to its marginal productivity. Marginal product refers to the increase in amount of output by the addition of one unit of factor of production while keeping the other factors constant. The increase in the output with the addition of one unit of factors of production is known as marginal productivity.
Some of the popular definitions of marginal productivity theory are as follows:
In the words of J.B. Clark, “Under static conditions, every factor including entrepreneur would get a remuneration equal to marginal product.” As per Mark Blaug, “The marginal productivity theory contends that in equilibrium each productive agent will be rewarded in accordance with its marginal productivity.”
When an organization increases one unit of a factor of production (while keeping the other factors constant), the marginal productivity increases to a certain level of production. After reaching a certain level, the marginal productivity starts declining. This is because when an organization keeps on increasing the amount of a particular factor of production, the marginal cost also increases.
After reaching a certain point, the marginal cost exceeds marginal revenue, thus the marginal productivity declines. On the other hand, if the marginal revenue is greater than marginal cost, the organization opts for employing an additional unit of factor of production.
Types of Marginal Productivity:
The theory of marginal productivity can be understood more clearly by gaining knowledge regarding the different types of marginal productivity.
The different types of marginal productivity are explained as follows:
i. Marginal Physical Productivity:
Refers to an increase in output occurred due to the increase in one unit of factor of production. According to M.J. Ulmer, “Marginal physical productivity may be defined as the addition to total production resulting from employment of one unit of a factor of production, all other things being constant.”
Let us understand the concept of marginal physical productivity with the help of an example. Suppose one labor is able to produce four quintals of wheat. If one more labor is hired, then the yield of wheat would reach to eight quintals. In such a case, the marginal physical productivity for the additional labor is four quintals of wheat (8-4=4).
The general formula for marginal physical productivity is as follows:
MPPn = TPPn -TPPn-1
Where MPPn = Marginal physical productivity for nth unit of labor
TPPn = Total physical productivity of n units of labor
TPPn-1 = Total physical productivity of n-1 units of labor
ii. Marginal Revenue Productivity:
Refers to the concept of marginal productivity with respect to change in total revenue. As per M.J. Ulmer, “Marginal revenue productivity may be defined as the addition to total revenue resulting from employment of one unit of a factor of production, all other things being constant.”
Let us understand the concept of marginal revenue productivity with the help of an example. Suppose one labor is able to produce wheat, which is worth of Rs. 50. If one more labor is hired, then the revenue generated from wheat would be Rs. 60. In such a case, the marginal revenue productivity for the second labor is Rs. 10 (60-50-10).
The formula for calculating marginal revenue productivity is as follows:
MRP = MPP * MR
Where MRP = Marginal Revenue Productivity
MR= Marginal Revenue
iii. Value of Marginal Productivity:
Refers to the value obtained by multiplying marginal physical productivity with the price of product produced. According to Ferguson, “The value of marginal product of a variable factor is equal to its marginal product multiplied by the market price of the commodity in question.”
The formula of value of marginal productivity is as follows:
VMP = MPP* AR
Where, VMP = Value of marginal productivity
MPP = Marginal physical productivity
AR = Market price of product
Let us understand the concept of value of marginal productivity with the help of an example. Suppose the market price of wheat is Rs. 10 per quintal and the marginal physical productivity for the additional labor is four quintals of wheat. In such a case, the value of marginal productivity for the additional labor would be Rs. 40 (4*10=40).
Assumptions of Marginal Productivity Theory:
The assumptions of marginal productivity theory are as follows:
i. Perfect competition in product market:
Refers to one of the main assumptions of marginal productivity theory. In marginal productivity theory, it is assumed that there is perfect competition in the product market. Thus, the change in output of an organization would not affect the market price of the product. In such a case, marginal revenue is equal to the average revenue of the product.
ii. Perfect competition in factor market:
Implies that organizations are required to purchase the factor of production at the prevailing market price only. In case of perfect competition, all the factors of production are perfectly mobile. In addition, the supply of factors of production is perfectly elastic.
iii. Homogeneity of factors:
Assumes that all the units of a factor of production are homogeneous in nature. Therefore, the units are perfect substitutes of each other.
iv. Substitutability of factors:
Assumes that various factors of production act as substitutes of each other. For example, capital act as the substitute of labor.
v. Divisible factors:
Assumes that various factors of production can be divided in small parts.
vi. Maximum profit:
Assumes that the main aim of every organization is to maximize their profit.
vii. Full employment:
Refers to one of the assumptions of marginal productivity theory. Under full employment condition, the supply of a factor of production is fixed in quantity.
viii. Variable input coefficient:
Assumes that an organization can use the factors of production in different quantities. In other words, the quantity of a factor can be changed, while keeping the other factors constant. For example, a land owner can employ two to three workers to plough a one hectare land.
ix. Same state of technology:
Assumes that the technology used in production is constant.
Limitations of Marginal Productivity Theory:
Marginal productivity theory contributes a significant role in factor pricing.
In spite of its major contribution in factor pricing, the theory suffers from certain limitations, which are as follows:
i. Unrealistic assumptions:
Refer to one of the major limitations of marginal productivity theory. Marginal productivity theory stands true only under certain conditions, such as homogeneity of factors of production, perfect competition, and perfect mobility of factors of production.
Moreover, the theory is applicable in a static economy, while the real world economy is dynamic. A perfectly competitive market does not exist in reality. In addition, perfect mobility of factors is also not possible. Therefore, the marginal productivity theory of factor pricing is not applicable in the real world.
ii. Difficulty in measurement:
Implies that the marginal productivity of a factor of production cannot be measured accurately. This is because while determining the marginal productivity of a factor, other factors are kept constant, which is not possible in the real scenario. For example, if the number of labor is increasing, then the other factors of production, such as tools, machinery, and raw material, needs to be increased for increasing the output.