Theory of Marginal Productivity

By Gaurav Dawar
Introduction
• A theory developed at the end of the 19th century, argued
that a business firm would be willing to pay a productive
agent only what he adds to the firm’s well-being or utility;
that it is clearly unprofitable to buy.

• Marginal productivity  demand for a factor of production

• Hire inputs up to the point where the marginal revenue

product = price of the input (MRP = P)
Statement of the Theory
• “The distribution of income of society is controlled by a
natural law, if it worked without friction, would give to every
agent of production the amount of wealth which that agent
creates.” -J.B. Clark
• The entrepreneur buys the services of the various factors of
production i.e. rent, wages, interest, etc.
• The entrepreneur works for profit. He can only pay a price for
a factor which he finds just worth-while.
• 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.
• The determination of factor prices with the help of a theory
called the Marginal Productivity Theory.
• Marginal productivity  demand for a factor of production
• Hire inputs up to the point where the marginal revenue
product = price of the input (MRP = P)
• 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.
 Assumptions of Theory
• Perfect Competition
• Homogeneous Factors
• Rational Behavior
• Perfect Substitutability
• Perfect Mobility
• Interchangeability
• Perfect Adaptability
• Knowledge about Marginal Productivity
• Full Employment
• Law of Variable Proportions
• The Amount of Factors of Production should be Capable of being Varied
• The Law of Diminishing Marginal Returns
• Long-Run Analysis
Explanation (MRP from the point of view of
industry)
• 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.
• for industry, it is a theory of factor pricing
• for a firm it is a factor demand theory
• 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.

• A firm will employ that number of labourers at which their

marginal revenue productivity is equal to the prevailing wage
rate.
 MRP from the point of view of Firm
• Under perfect competition, Every firm acts as a price taker.
• No employer would like to pay more than what others are
paying.
• A firm will employ that number of a factor at which its price is
equal to the value of marginal productivity.
• It is due to this reason that it is also called Theory of Factor
Demand
Factor Pricing under Imperfect
Competition
 Inputs and Their Derived Demand Curves

• The demand curve for an input is the downward-

sloping portion of its marginal revenue product
curve.
• The demand for an input is called a derived demand
because it is derived from the underlying demand for
the final product.
MRP Schedule for Naomi’s Natural Farm

$26
24
22 A
20
MRP per Bag of Corn per Week

18
16 D B
14
12
10 C
8
6
4
2
0
–2
–4
–6
–8
–10
–12
–14
–16
0 1 2 3 4 5 6 7 8 9 10 11 12

Bags of Corn per Week

 MARGINAL PRODUCTIVITY THEORY

• The market price for a factor of production is determined by the supply and
demand for that factor.
• Demand for a factor of production is derived from the demand for the things it
helps produce.
• Demand by a firm for a factor of production is the marginal productivity
schedule of the factor.
• Cost-minimizing firms will hire factors of production until the cost of hiring an
additional unit of the factor,  the marginal factor cost equals Value of Marginal
Product or Marginal Revenue Product.

• Marginal Factor Cost = Marginal Revenue Product

MARGINAL PRODUCTIVITY THEORY OF WAGES

• All laborers are homogenous in character.

• The theory is based on the law of diminishing marginal
returns.
• It assumes that different factors can substitute each other
• It assumes the existence of perfect competition
• According to this theory, wage is equal to the value of
marginal product.
• If the marginal product is more than the wages, then it will be
profitable to engage more number of laborers.
• Due to law of diminishing marginal return, the marginal value
product will decline, if labor is engaged beyond a limit.
• If wages are higher than the marginal value product, then it
will be unprofitable to engage more laborers and their
engagement will be reduced until wages are equal to the
marginal value product.
How MRP is calculated