Marginal Productivity Theory of Distribution

The General Theory of Factor Pricing

The marginal productivity theory of distribution, associated with neoclassical economists such as J.B. Clark, Alfred Marshall, and Philip Wicksteed, is the general theory explaining how each factor of production is priced and rewarded under conditions of perfect competition. It applies the same basic logic to land, labour, capital, and entrepreneurship alike: a firm hires any factor up to the point where the extra revenue that factor brings in just equals the price the firm must pay for it.

Marginal Physical Product and Marginal Revenue Product

As a firm employs successive units of a variable factor (say, labour) while holding other factors fixed, the marginal physical product (MPP) of that factor is the addition to total physical output from employing one more unit. Because of the law of diminishing returns, MPP eventually falls as more units of the factor are added.

To convert this physical addition into a money figure, MPP is multiplied by marginal revenue (MR) — the addition to total revenue from selling one more unit of output:

Under perfect competition, the firm is a price-taker, so marginal revenue equals price ($MR = P$), and MRP becomes identical to the value of the marginal product (VMP):

The Employment Rule

A profit-maximising firm keeps hiring additional units of a factor as long as the factor's MRP exceeds its price (wage rate, rent, or interest rate), and stops hiring at the point where:

At this point the factor is being paid exactly the value of what it contributes at the margin — no more, no less. This single principle explains the pricing of every factor of production, and it underlies the more specific theories of rent, wages, interest, and profit developed later in this chapter.

Assumptions and Criticisms …