Q.Explain the marginal productivity theory of distribution. How is the price of a factor of production determined under this theory?

The marginal productivity theory is the general neoclassical explanation of how every factor of production — land, labour, capital, or entrepreneurship — gets priced under competitive conditions.

MRP is calculated as marginal physical product (MPP) multiplied by marginal revenue (MR): $MRP = MPP \times MR$. Under perfect competition, MR equals price, so MRP equals the value of the marginal product. The firm keeps hiring the factor as long as its MRP exceeds its price, stopping exactly where the two are equal.

The marginal productivity theory of distribution, developed by neoclassical economists such as J.B. Clark, Alfred Marshall, and Philip Wicksteed, provides a single, general explanation for how every factor of production — land, labour, capital, and entrepreneurship — is priced under conditions of perfect competition.

As a firm employs successive units of a variable factor, holding other factors constant, the marginal physical product (MPP) is the addition to total output from the last unit employed. Because of the law of diminishing returns, MPP falls as more units of the factor are added. To express this contribution in money terms, MPP is multiplied by marginal revenue (MR) — the addition to total revenue from selling one more unit of output — giving the marginal revenue product:

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

A profit-maximising firm compares the MRP of a factor with its price (wage rate for labour, rent for land, interest rate for capital). As long as MRP exceeds the factor's price, hiring one more unit adds more to revenue than it costs, so the firm keeps hiring. The firm stops hiring exactly at the point where:

At this equilibrium point, every factor is paid a price exactly equal to the value it contributes at the margin.

The theory rests on assumptions of perfect competition, homogeneous factor units, and full employment, and has been criticised for explaining only the demand side of factor pricing and for assuming conditions not always found in practice. Nonetheless, it remains the foundational principle from which the more specific theories of rent, wages, interest, and profit are derived.