Theory (Neo-Classical Version):
productively theory is an attempt to explain the
determination of the rewards of various
factors of production in a competitive market. The marginal
productivity theory of resource demand was the work of many
writers, it was widely discussed by many economists like J.B.
Clark, Walras, Barone, Ricardo, Marshall. It was improved,
amended and modified later on. The final version of the theory
as stated by Neo Classical economists is given below.
Definition and Meaning:
productively theory of a factor is meant the value of
the marginal physical product of the factor. It is worked out by
multiplying the price of the output per unit by units of output.
VMP = MP x P
Value of Marginal Product (VMP) =
Marginal Physical Product x Price
productivity theory contends that in a competitive market, the
price or reward of each factor of production tends to be equal
to its marginal productivity.
The demand for
various factors of production is a derived demand. The resources
do not usually directly satisfy consumer wants. They are
demanded because these help in producing goods and service's. An
entrepreneur while hiring a factor of production calculates the
contribution which it makes to total production and the amount
which has to be paid to it in a competitive market. An
individual firm cannot influence the price of the factor of
production. It has to take the ruling price in the market as
given. The firm can employ as many number of factors units as it
wishes at the ruling price of the factor.
It has been observed
that as a firm hires increasing amounts of a variable factor to
a combination of fixed amounts of other factors, the marginal
productivity increases up to a certain stage of production and
then it begins to decline. The buyers of a factor of production
while deciding whether one more unit of factor should be
employed or not, compares the net addition which it makes to
total revenue and the cost which has to be incurred on engaging
it. If the marginal revenue product of a factor is greater than
its marginal cost, the entrepreneur will employ that unit
because it earns more than what he has to spend on employing the
As he employs more and more units of factor of
production, the marginal revenue productivity increases up to a
certain limit and then it begins to decrease. On the other hand,
marginal cost decreases as production is expanded. After a
certain point, when business becomes difficult to manage,
marginal cost begins to increase. When both marginal revenue
productivity of a factor and its marginal cost are equal, (MRP =
MC) the entrepreneur stops giving further employment to a factor
The last variable
unit which an employer just thinks it worthwhile employing is
called the marginal unit and the addition made to the total
production by the employment of the marginal unit is called
marginal productivity or marginal revenue productivity. The
entrepreneur will pay the remuneration to each factor of
production according to its marginal revenue productivity.
Schedule and Example:
productivity theory is explained with the help of a schedule:
Demand for a Factory or Resource (Daily):
Units of Resource (Labor)
Total Product Meters
Marginal Productivity MP
Product Price ($)
Marginal Revenue (Product)
For Employing a Factor of Production:
An entrepreneur is to
maximize profits. While hiring any resource, he compares the
marginal revenue product of a factor with the additional cost he
has to pay. So long as the marginal revenue product is greater
than the marginal cost of the factor, he will continue hiring
it. When the MRP of the factor is equal to its MC, he will stop
engaging more labor. The firm at this point will be in
equilibrium and maximizing profit. In the table above, the
entrepreneur adds more to its total revenue than to total cost
up to the fifth unit. When he hires the sixth labor, the MRP =
MC. The firm here is in equilibrium and maximizing profits, In
case, the 7th worker is hired, the MRP is then < MC. The firm
suffers loss and is not reaping the optimum profit.
Least-Cost Combination of Resources:
There are a number of
resources which are required for the production of a commodity.
The entrepreneur can maximize his profit only if the least cost
combination can be arrived at by equalizing the ratios between
the marginal products and the prices of the different factors of
production. If the ratios differ, then it is in the interest of
the employer to make necessary adjustment by employing more of
one factor and less of other till be ratio between the marginal
productivity and price of each factor becomes equal. The least
cost combination will be achieved, when:
MRP of Factor A = MRP of Factor
B = MRP of Factor C = MRP of Factor N
Price of Factor A Price
of Factor B Price of Factor C Price of
In the long run,
under conditions of
perfect competition, the price of each factor of production
is already determined in the market. An individual entrepreneur
cannot affect the market price of various factors of production
by his own individual action as his demand for a factor or
factors forms only a small part of the total demand. He is a
price taker. So, what he does is that he goes on employing each
factor of production up to a point which makes marginal revenue
productivity of the factor equals to its price.
In the figure 18.1,
the supply of labor is perfectly elastic. The wage (W) is equal
to average wage (AW) and marginal wage, (MW) = W = AW = MW. At
point E, the MRP of labor is equal to marginal wage (MW). The
producer is-in equilibrium at point E. He will employ ON units
of labor because when ON units of labor are employed, the
marginal revenue productivity of labor MRPL = Wage. To the left
of E the MRP of labor is higher than wage (MRP > W), the
producer will increase the units of labor. To the right of the
MRPL < wage, so the firm will curtail the units of labor. It is
only at point E, the firm is in equilibrium where MRPL = Wage.
The theory of
marginal productivity is based on the following assumptions:
identical: It assumes that all the units of a factor are
exactly alike and so can be substituted to any extent.
(ii) Factors can
be substituted: It is assumed that the various factors of
production, which help in the production of particular commodity
can also be substituted for one another. We can use more of
labor or less of land or more of labor and less of capital.
mobility of factors: It is assumed that the various factors
of production can be moved from one use to another.
of law of diminishing return: The theory rests en the
assumption that the law of diminishing returns applies also to
the organization of a business.
competition: It is based on the assumption that the reward
of each factor of production is determined under conditions, of
perfect competition and full employment.
productivity theory has been subjected to scathing criticism on
the following grounds.
(i) Theory based
on unrealistic assumptions: The theory is based on a very
wrong assumption, that all the units of a factor of production
are homogeneous. The fact is that neither all land, nor all
labor, nor all capital, nor all organizations are alike. We know
it very well that labor varies in efficiency; capital in form,
land in fertility and entrepreneur in ability.
(ii) Factors are
not perfect substitutes: It is also wrong to assume that the
factors of production are close substitutes for one another.
Labor is not a perfect substitute for capital, and vice versa.
So is also the case with land in relation to other factors of
(iii) Law of
proportionate return: The theory rests on a very wrong
assumption that the law of diminishing returns applies to a
business. Is this not a fact that when there is proportionate
increase in the factors of production, "the law of diminishing
return is held in, abeyance in all businesses.
(iv) Wage cuts
does not determine demand: According to this theory, if
employment is to be increased, the wages should be lowered. J.M.
Keynes vehemently disagrees with this view and says that this
may be true in case of an individual firm or industry but it is
wrong when it is applied to aggregate or effective demand.
(v) Difficulty In
the measurement of MP: The other criticism levied on the
marginal productivity theory by Tausslng, Davenport and Ardiance
is that production is the outcome of joint efforts of different
factors and so it is not possible to separate the contribution
of each factor individually.
(vi) Effect of
withdrawal of a factor: Hobson criticizes this theory on the
ground that if a factor of production which works in
co-operation with other factors is withdrawn, it will
disorganize the whole business and it may result in the decrease
of production which may be greater than the addition made by the
(vii) Factor units
cannot be raised: Another criticism levied by Hobson on the
marginal productivity theory is that there are many cases in
which the variations in the use of factors is not possible. The
proportion in which factors of production are to be employed is
already determined by the technical conditions prevailing in a
business. For instance, there are many machines for the working
of which only one labor is required. If we engages two laborers,
it will not be of much use. A variation in proportions in such
cases are not possible, therefore, the marginal productivity of
such a factor cannot be ascertained.
(viii) One sided:
The marginal productivity theory is also criticized on the
ground that it assumes the supply of a factor or factors as
fixed while in reality the remuneration paid to a factor does
influence its supply. As the theory approaches the problem only
from the side of demand and neglects the effect of supply,
therefore, it cannot be accepted as true.
theory: Marginal productivity theory neglects the problem of
technical change altogether. It is therefore, static theory.
From all that we have
said above, It can be concluded that the Theory is true only
under the assumption of perfect competition and state of full
employment Fraser has commented on the theory of distribution as
"No economist would
claim that theory is as yet complete, even as a purely academic
structure of framework. It has the defects of its quantities
being simple and self-consistent; it is abstract and impersonal
it is quantity of sins both of omission and commission; its
postulates are unduly rigid and narrow".
In the words of
productivity theory is not a theory that at explains
wages, rent or interest; on the contrary it simply explains how
factors of production are hired by the firms, once their prices