Marginal Productivity Theory of Distribution

The marginal productivity theory of distribution is the general neoclassical explanation, associated with economists such as J.B. Clark, Alfred Marshall, and Philip Wicksteed, of how the price of every factor of production -- land, labour, capital, or entrepreneurship alike -- is determined under conditions of competition. It uses a single logic for all four factors: a firm keeps hiring additional units of a factor only so long as doing so adds more to revenue than it costs.

Marginal physical product (MPP) is the addition to total output that comes from employing one more unit of a variable factor, while every other factor is held unchanged. Because of the law of diminishing returns, MPP eventually declines as more and more units of the variable factor are added. To turn this physical addition into a rupee figure, it is multiplied by marginal revenue (MR) -- the addition to total revenue earned from selling the extra output -- giving the marginal revenue product:

Where the firm sells its product in a perfectly competitive market, it is a price-taker, so marginal revenue is simply the market price ($MR = P$), and MRP collapses to the value of the marginal product (VMP):

The employment rule. A firm aiming to maximise profit compares each additional unit of a factor's MRP with the price it must pay for that unit (the wage rate for labour, rent for land, the interest rate for capital). As long as MRP is greater than the factor's price, hiring one more unit is worthwhile, since it adds more to revenue than it costs. The firm stops exactly where:

At this point of equilibrium employment, every factor is being paid precisely what its last unit contributes to output -- no more and no less. This one rule, applied identically to land, labour, capital, and entrepreneurship, is the analytical skeleton on which the separate theories of rent, wages, interest, and profit are built later in this chapter. …