Europa Science & Commerce Academy

Q. No. 18: Answer:

Explain marginal productivity theory of distribution. Also discuss it limitations.

Economics Notes

INTRODUCTION: Marginal productivity theory is also called Classical Theory of Income Distribution. MP theory explains that the prices or rewards of any factor of production depend upon its marginal product. In other words we can say that: Distribution according to contribution. In every factor market two basic forces are interacting. Firms motive is to get maximum profits. Facto owners motive is to get maximum Statement of the Theory: The price of a factor of production in equilibrium is equal to marginal revenue product. OR The distribution of income among the factors of production is determined by marginal revenue product of different factors of production. Explanation: Land, Labour, Capital and Organization are four factors of production. Rewards of these factors are rent, wages, interest and profit respectively. Prices of these factors are determined in market. According to modern economists prices of factors are determined by the forces of demand and supply. But classical economists were of the view that the prices are determine where M R P = M F C Marginal Productivity: Marginal productivity means the net change in total production due to change in units of labour. Marginal Revenue Product: MRP = Marginal Revenue Product MRP = MP x P Marginal Factor Cost: MFC = Marginal Factor Cost The addition in total cost when an additional unit of labour is employed is called MFC. SCHEDULE: Units of V. F MRP = MP x MFC MP P (Labour) P (Wages) 1 16 10 16x10=160 100 2 14 10 14x10=140 100 MRP > MFC 3 12 10 12x10=120 100 4 10 10 10x10=100 100 MRP = MFC 5 8 10 8x10=80 100 6 6 10 6x10=60 100 MRP < MFC 7 4 10 4x10=40 100

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In the above schedule wages (MFC) and prices are fixed. From 1 st to 3rd unit of variable factor Marginal Revenue Product is greater then Marginal Factor cost. When 4th unit of labour is applied on fixed factors of production MRP & MFC are
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Economics Notes

equal. Entrepreneur will not apply 5th and more units of labour because MRP is less than MFC. It can be explained with the help of diagram. DIAGRAM:
(y-axis)

160 140 120 MRP 100 Wages 80 60 40 20 0

MRP>MFC

B A EMRP=MFC C D

Wage (M F C)

MRP<MFC

2 (x-axis)

Units of Variable Factors (Labour)

Explanation: In the above diagram units of labour is measure along x-axis MRP and wages are taken on y-axis. MRP curve is downward sloping due to the application of law of diminishing return. Point E is the equilibrium point where MRP = MFC. At this point firm maximizes its profits by employing 4 units of labour. If firm employs less workers like 3, it will decrease its profits which is shown by area ABE. If firms hire more workers like 5 again, its profits will decrease 4 by CDE. So it concludes that firms gaining maximum profit by employing 4 units of variable factors of production. ASSUMPTIONS: Theory of marginal productivity holds under the following assumptions. 1) Perfect Competition: MP theory holds when there is perfect competition in factor and product markets. 2) Homogeneous Units: It is assumed that all units of factor are homogeneous. 3) One Variable Factor: MP theory is based on the assumption that the reward of only one factor is considered because other factors are constant. 4) Perfect Mobility: It is further assume that factors are substitutes for one another. 5) Law of Diminishing Return: This theory is based on the application of law of diminishing return. 6) Perfect mobility: There is perfect mobility of factor between places and employments.

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7) Full Employment: It is further assume that there is perfect competition in factor market. CRITICISM: The theory has been criticized on the following grounds. 1)

Economics Notes

Lack of Perfect Competition: This theory assume that the reward of each factor is determined under the condition of perfect competition and full employment actually it is not possible. 2) Lack of Homogeneity: The units of factor of production are not homogeneous. For example, workers are different in efficiency. 3) Factors are not perfect substitutes: The factors of production are not perfect substitutes all the time. For example, land cannot be substituted with labour. 4) Lack of Mobility: It is observed that the factors a like labors are not perfectly mobile. Sometimes they do not move from one place to another place, from one area to another, area and from one industry to another industry. 5) Law of Diminishing Return: In this theory law of increasing return has been ignored. In industrial sector we have seen a very little application of law of diminishing return. 6) Lack of Full Employment: Classical economists believed existence of full employment of productive resources. While in an economy either there is a situation of unemployment and under employment. 7) Supply of Factors: In this theory supply of factors is assumed to be constant. Actually, reward is determined demand and supply. So the theory considered the demand side while ignores supply side. 8) Interdependence: Each factor of production works in cooperation with other factors. If one of these is withdrawn it will effect the whole activity and may cause of loss. 9) All Factors are not divisible: It is assumed that all factors are divisible into smaller quantities but it does not hold. For example units of organization are not divisible. 10) Difficulty in Measurement: It is very difficult to measure the marginal product and its value especially in agriculture sector. Because, efficiencies of land and labour depends upon weather conditions as well as themselves.

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