Module-2, Factor Pricing and Distribution
Personal and Functional distribution
The theory of factors price is popularly known as the theory of distribution. The theory of
distribution may be functional or personal. Personal distribution means the distribution of
national income among various individuals or persons in an economy. On the other hand, in
the theory of functional distribution we study how the various factors of production are
rewarded for their services or functions performed in the production process. Thus the theory
of functional distribution discusses how rent of land, wage of labours, interest of capital, and
profit of entrepreneurs are determined.
Marginal Productivity Theory
The origin of marginal productivity theory can be traced in the works of Ricardo and West.
They applied the marginal productivity doctrine only to explain the determination of reward
of land. However, the main credit for the development of marginal productivity theory went
to the economists J.B Clark, Jevons, Wicksteed, Walras and later it was popularised by
Marshall and J.R Hicks. The neoclassical marginal productivity theory is based on the
following assumptions.
1. Perfect competition exists both in the product and factor markets.
2. There is stationary state in the economy.
3. The employers are rational and they always try to maximise profits.
4. All units of factors of production are homogeneous.
5. There is perfect mobility of factors of production between employments.
6. There is perfect substitution of factors.
7. The production is governed by the law of diminishing returns.
8. Each productive factor is perfectly divisible.
9. The techniques of production remain unchanged.
10. The theory applies in the long run.
Based on the above assumptions, the marginal productivity theory states that, in a perfectly
competitive product and factor markets, reward of a factor unit is determined by its marginal
revenue product of that factor. Marginal product of a factor, say labour is additional to the
total product by employing an additional unit of labour in the production, keeping the
quantities of all other factors remain constant. If multiply the marginal physical product of
labour by marginal revenue we get marginal revenue product of labour. According to the
marginal productivity theory, in employment decision the employer will compare the
marginal product of the last worker and the marginal wage (in a perfectly competitive labour
market marginal wage is equal to average wage) paid to him. If marginal revenue product of
labour is greater than marginal wage, i.e., (MRP > MW) the profit maximising employer
tends to employ more and more workers in the production process to increase total revenue
and hence profit. On the contrary, if marginal revenue product of labour is less than marginal
wage i.e., (MRP < MW), the profit maximising employer will reduce the employment in
order to reduce the loss. Thus it is only when marginal revenue product is equal to the
marginal wage rate the employer will neither expand nor reduce employment. This can be
explained with the help of the following figure.
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 1
, Module-2, Factor Pricing and Distribution
R1
Revenue Product and wage W2
W AW=MW
W1 R0
R2
rate
N0 MRP
o N1 N2
Units of labour
In the above figure the units of labour is measured along the horizontal axis and the marginal
revenue product and wage rate are measured along the vertical axis. Given the wage rate
‘Ow’, the average wage is equal to the marginal wage (AW=MW). MRP is the marginal
revenue product curve which is inverted U shaped represent the operation of the law of
diminishing returns. If the employer employs ON1 workers the marginal revenue product of
labour (MRPL) is R1N1 and marginal wage is W1N1. Since MRPL > marginal wage (MW), the
employer secures excess profits. In order to maximise profits he will tend to employ more
workers. If ON2 workers are employed, the MRPL is R2 N2 and marginal wage is W2N2. In a
situation in which the MRPL < MW, in order to minimise losses the employer will tend to
reduce employment. If ON0 workers are employed, the MRPL and marginal wage (MW) both
are equal to R0N0. In this situation there are neither excess profits nor loss. Thus the employer
will neither expand nor reduce the number of workers employed. Therefore according to the
marginal productivity theory the employment of the factor unit is determined, when factor
price becomes just equal to its marginal revenue product.
The marginal productivity theory is also states that in the long run the factor price tends to be
equal to both average revenue product of the factor (ARP) and marginal revenue of the
factor (MRP) of the factor, the marginal revenue products of all factors of production are
equal and the factor prices tends to be equal in all employment
Critical evaluation of marginal productivity theory
Marginal productivity theory explains the factor payments. Thus it is considered as a general
theory of distribution. However, it is based on some unrealistic assumptions. Thus the theory
is encountered the following criticisms.
1. Measurement of productivity
This theory holds that the exact measurement of factor productivity can be possible. In fact,
the measurement of factor productivity is very difficult and complex. Production of a
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 2
, Module-2, Factor Pricing and Distribution
commodity is the outcome of a combination of factors. Thus it is very difficult to measure the
productivity of one factor.
2. Unrealistic assumptions
The neoclassical marginal productivity theory rests upon the unrealistic and unsound
theoretical foundation such as existence of perfect competition, perfect mobility of factors of
production, and perfect divisibility of factors of production etc.
3. Marginal productivity and wages
According to this theory the wage rate of workers is determined by the marginal product of
labour. However, in fact the relationship in fact is the opposite. It is the wage rate that
determines the marginal productivity of labour.
4. Inapplicability under imperfect competition
Under the assumption of perfect competition in the product and factor markets, the factor
prices are equal to the value of the marginal product. However, under the conditions of
imperfect competition and monopolistic competition, factor prices are either more or less
than the value of marginal product.
5. Law of diminishing returns
The marginal productivity theory can hold if the production takes place under the law of
diminishing returns. However, organisational improvements and technical changes result a
steady increase the efficiency of factors of production.
6. Neglect of sociological and institutional factors
The factor prices, more particularly wages of workers are greatly influenced by sociological
and institutional factors like trade unions, minimum wage legislations etc. These crucial
factors have been completely overlooked in this theory.
7. Factor heterogeneity is ignored
The theory assumes that all units of a factor are homogeneous and perfect substitutes for each other.
The reality is that land, labour and entrepreneurial talents are heterogeneous in nature.
8. The theory explains the demand side of factors only
The theory does not explain how factor price are determined. It merely states how an
employer will hire a factor given its marginal productivity. This is because of the fact that the
theory makes into consideration only the demand side of the factors of production and
assumes the supply side as constant. However, a complete theory of factor price must analyse
the forces working on the demand side as well as on the supply side of factors of production.
9. Marginal productivity theory ignores the influence of selling cost
The theory ignores the influence of selling cost. The theory was based on the highly abstract
assumption of perfect competition. It is neither theoretically complete nor practically helpful.
10. The theory is applicable in the long run
The theory is set within the framework of the long run. It has limited validity for the short
run.
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 3
Personal and Functional distribution
The theory of factors price is popularly known as the theory of distribution. The theory of
distribution may be functional or personal. Personal distribution means the distribution of
national income among various individuals or persons in an economy. On the other hand, in
the theory of functional distribution we study how the various factors of production are
rewarded for their services or functions performed in the production process. Thus the theory
of functional distribution discusses how rent of land, wage of labours, interest of capital, and
profit of entrepreneurs are determined.
Marginal Productivity Theory
The origin of marginal productivity theory can be traced in the works of Ricardo and West.
They applied the marginal productivity doctrine only to explain the determination of reward
of land. However, the main credit for the development of marginal productivity theory went
to the economists J.B Clark, Jevons, Wicksteed, Walras and later it was popularised by
Marshall and J.R Hicks. The neoclassical marginal productivity theory is based on the
following assumptions.
1. Perfect competition exists both in the product and factor markets.
2. There is stationary state in the economy.
3. The employers are rational and they always try to maximise profits.
4. All units of factors of production are homogeneous.
5. There is perfect mobility of factors of production between employments.
6. There is perfect substitution of factors.
7. The production is governed by the law of diminishing returns.
8. Each productive factor is perfectly divisible.
9. The techniques of production remain unchanged.
10. The theory applies in the long run.
Based on the above assumptions, the marginal productivity theory states that, in a perfectly
competitive product and factor markets, reward of a factor unit is determined by its marginal
revenue product of that factor. Marginal product of a factor, say labour is additional to the
total product by employing an additional unit of labour in the production, keeping the
quantities of all other factors remain constant. If multiply the marginal physical product of
labour by marginal revenue we get marginal revenue product of labour. According to the
marginal productivity theory, in employment decision the employer will compare the
marginal product of the last worker and the marginal wage (in a perfectly competitive labour
market marginal wage is equal to average wage) paid to him. If marginal revenue product of
labour is greater than marginal wage, i.e., (MRP > MW) the profit maximising employer
tends to employ more and more workers in the production process to increase total revenue
and hence profit. On the contrary, if marginal revenue product of labour is less than marginal
wage i.e., (MRP < MW), the profit maximising employer will reduce the employment in
order to reduce the loss. Thus it is only when marginal revenue product is equal to the
marginal wage rate the employer will neither expand nor reduce employment. This can be
explained with the help of the following figure.
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 1
, Module-2, Factor Pricing and Distribution
R1
Revenue Product and wage W2
W AW=MW
W1 R0
R2
rate
N0 MRP
o N1 N2
Units of labour
In the above figure the units of labour is measured along the horizontal axis and the marginal
revenue product and wage rate are measured along the vertical axis. Given the wage rate
‘Ow’, the average wage is equal to the marginal wage (AW=MW). MRP is the marginal
revenue product curve which is inverted U shaped represent the operation of the law of
diminishing returns. If the employer employs ON1 workers the marginal revenue product of
labour (MRPL) is R1N1 and marginal wage is W1N1. Since MRPL > marginal wage (MW), the
employer secures excess profits. In order to maximise profits he will tend to employ more
workers. If ON2 workers are employed, the MRPL is R2 N2 and marginal wage is W2N2. In a
situation in which the MRPL < MW, in order to minimise losses the employer will tend to
reduce employment. If ON0 workers are employed, the MRPL and marginal wage (MW) both
are equal to R0N0. In this situation there are neither excess profits nor loss. Thus the employer
will neither expand nor reduce the number of workers employed. Therefore according to the
marginal productivity theory the employment of the factor unit is determined, when factor
price becomes just equal to its marginal revenue product.
The marginal productivity theory is also states that in the long run the factor price tends to be
equal to both average revenue product of the factor (ARP) and marginal revenue of the
factor (MRP) of the factor, the marginal revenue products of all factors of production are
equal and the factor prices tends to be equal in all employment
Critical evaluation of marginal productivity theory
Marginal productivity theory explains the factor payments. Thus it is considered as a general
theory of distribution. However, it is based on some unrealistic assumptions. Thus the theory
is encountered the following criticisms.
1. Measurement of productivity
This theory holds that the exact measurement of factor productivity can be possible. In fact,
the measurement of factor productivity is very difficult and complex. Production of a
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 2
, Module-2, Factor Pricing and Distribution
commodity is the outcome of a combination of factors. Thus it is very difficult to measure the
productivity of one factor.
2. Unrealistic assumptions
The neoclassical marginal productivity theory rests upon the unrealistic and unsound
theoretical foundation such as existence of perfect competition, perfect mobility of factors of
production, and perfect divisibility of factors of production etc.
3. Marginal productivity and wages
According to this theory the wage rate of workers is determined by the marginal product of
labour. However, in fact the relationship in fact is the opposite. It is the wage rate that
determines the marginal productivity of labour.
4. Inapplicability under imperfect competition
Under the assumption of perfect competition in the product and factor markets, the factor
prices are equal to the value of the marginal product. However, under the conditions of
imperfect competition and monopolistic competition, factor prices are either more or less
than the value of marginal product.
5. Law of diminishing returns
The marginal productivity theory can hold if the production takes place under the law of
diminishing returns. However, organisational improvements and technical changes result a
steady increase the efficiency of factors of production.
6. Neglect of sociological and institutional factors
The factor prices, more particularly wages of workers are greatly influenced by sociological
and institutional factors like trade unions, minimum wage legislations etc. These crucial
factors have been completely overlooked in this theory.
7. Factor heterogeneity is ignored
The theory assumes that all units of a factor are homogeneous and perfect substitutes for each other.
The reality is that land, labour and entrepreneurial talents are heterogeneous in nature.
8. The theory explains the demand side of factors only
The theory does not explain how factor price are determined. It merely states how an
employer will hire a factor given its marginal productivity. This is because of the fact that the
theory makes into consideration only the demand side of the factors of production and
assumes the supply side as constant. However, a complete theory of factor price must analyse
the forces working on the demand side as well as on the supply side of factors of production.
9. Marginal productivity theory ignores the influence of selling cost
The theory ignores the influence of selling cost. The theory was based on the highly abstract
assumption of perfect competition. It is neither theoretically complete nor practically helpful.
10. The theory is applicable in the long run
The theory is set within the framework of the long run. It has limited validity for the short
run.
Dr Ratheesh C., Dept.of Economics, FMN College, Kollam Page 3
