The Marginal Productivity Theory explains how the price or reward of a factor of production—such as labour, capital, or land—is determined by its contribution to the production process. Central to neoclassical economics, this theory is most often used to analyze how wages are set in relation to a worker’s productivity.
1. Core Concept of Marginal Productivity
- The theory states that each factor of production is paid according to the value of its marginal product.
- Marginal Product (MP): The additional output generated by using one more unit of the factor, holding all other inputs constant.
- Marginal Revenue Product (MRP): MP multiplied by the price of the output. It represents the additional revenue from employing one more unit of the factor.
- Pricing Rule: A factor will be hired or employed up to the point where MRP = Factor Price (e.g., wage for labour).
2. Application to Labour
- Employers will hire additional workers as long as the revenue generated by each new worker exceeds or equals the wage paid.
- This explains the downward-sloping demand curve for labour—each additional worker contributes less than the previous due to the Law of Diminishing Returns.
3. Assumptions of the Theory
- Perfect competition in both product and factor markets.
- Homogeneous units of labour or capital.
- Perfect mobility and divisibility of factors.
- No government intervention or externalities.
- Full information available to all participants.
4. Limitations of the Theory
- Real-world markets are not perfectly competitive—monopolies, oligopolies, and monopsonies distort factor pricing.
- Marginal productivity is difficult to measure accurately, especially in collaborative or service-based roles.
- Ignores institutional and social factors such as minimum wage laws, unions, and discrimination.
- Assumes short-run analysis and fixed technology, which may not hold over time.
5. Importance in Economic Theory
- Provides a rational explanation for income distribution among factors of production.
- Forms the theoretical basis for the demand for labour, capital, and land in neoclassical economics.
- Encourages productivity as a means to higher earnings—workers can improve their income by increasing their marginal contribution.
Marginal Productivity Theory as a Tool for Factor Allocation
Though idealized, the marginal productivity theory remains a vital analytical tool in economics. It helps explain how markets assign value to resources based on their output contributions. While adjustments are needed to reflect real-world complexities, the core principle—that payment reflects productivity—guides labour policies, business decisions, and economic models worldwide.