Marginal productivity theory of income distribution and how it works

What determines the prices of factors of production? It may, however, be pointed out that in recent years its popularity has somewhat declined due to bitter criticisms levelled against it. The essence of this theory is that price of a factor of production depends upon its marginal productivity. It also seems to be very fair and just that price of a factor of production should get its reward according to the contribution it makes to the total output, i.

Marginal productivity theory of income distribution and how it works

Marginal Productivity Theory of Distribution: 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. 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. The main assumptions of the theory are as under: 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. 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. 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.

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. 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. 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.

The theory takes for granted that various factors of production are perfectly adaptable as between different occupations.

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Knowledge about Marginal Productivity: 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.

Law of Variable Proportions: The law of variable proportions is applicable in the economy. It is assumed that the quantity of factors of production can be varied i. Then the remuneration of a factor becomes equal to its marginal productivity. The Law of Diminishing Marginal Returns: It means that as units of a factor of production are increased the marginal productivity goes on diminishing.

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. 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.

Marginal productivity theory of income distribution and how it works

Moreover, marginal revenue productivity of a factor constitutes its demand curve. A firm will employ that number of labourers at which their marginal revenue productivity is equal to the prevailing wage rate.1.

How factors of production—resources like land, labor, and both physical and human capital—are traded in factor markets, determining the factor distribution of income. 2. How the demand for factors leads to the marginal productivity theory of income distribution.

3. An understanding of the sources of wage disparities and the role of discrimination. 4. Capital in neoclassical theory.

The fact that the theory does not match reality does not stop marginal productivity theory and diminishing returns being reproduced in the textbooks because it is useful ideologically as an “explanation” of income distribution. The Marginal Productivity Theory of Income Distribution a.

Marginal Productivity and Wage Inequality i.A large part of the observed inequality in wages can be explained by considerations that are consistent with the marginal productivity theory of income distribution.

The fact that the theory does not match reality does not stop marginal productivity theory and diminishing returns being reproduced in the textbooks because it is useful ideologically as an “explanation” of .

And so the theory of income distribution passed into the domain of microeconomics. Textbooks taught neoclassical marginal productivity theory, loosely rooted in two-factor.

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Concluding remark – different meanings of “diminishing returns” Marginal product may he the increase ill output secured h.
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Marginal productivity theory: Marginal productivity theory, to its buyer’s income than what it costs. This marginal yield of a productive input came to be called the value of its marginal product, and the resulting theory of distribution states that every type of input will be paid the value of its marginal product.

(See distribution theory.).

The marginal productivity theory of Distribution explained