Marginal Productivity Theory
This is a classical theory of factor pricing that was advocated by a German economist, T.H. Von Thunen in 1826. The theory was further developed and discussed by various economists, such as J.B. Clark, Walras, Barone, Ricardo, and Marshall.
According to this theory, under perfect competition, the price of services rendered by a factor of production is equal to its marginal productivity. Marginal product refers to the increase in the amount of output by the addition of one unit of factor of production while keeping other factors constant. The increase in the output with the addition of one unit of factor of production is known as marginal productivity.
When an organisation increases one unit of a factor of production (while keeping the other factors constant), the marginal productivity increases to a certain level of production. After reaching a certain level, the marginal productivity starts declining. This is because when an organisation keeps on increasing the amount of a particular factor of production, the marginal cost also increases. After reaching a certain point, the marginal cost exceeds marginal revenue, thus the marginal productivity declines. On the other hand, if the marginal revenue is greater than the marginal cost, the organisation opts for employing an additional unit of factor of production.
Assumptions of Marginal Productivity Theory
- Perfect competition in product market: In marginal productivity theory, it is assumed that there is perfect competition in the product market. Thus, the change in output of an organisation would not affect the market price of the product. In such a case, the marginal revenue is equal to the average revenue of the product.
- Perfect competition in factor market: This implies that organisations are required to purchase the factor of production at the prevailing market price only. In the case of perfect competition, all factors of production are mobile. In addition, the supply of factors of production is perfectly elastic.
- Homogeneity of factors: Another assumption is that all the units of a factor of production are homogeneous in nature. Therefore, the units are perfect substitutes of each other.
- Divisible factors: This implies that various factors of production can be divided in small parts.
- Full employment: Under the full employment condition, the supply of a factor of production is fixed in quantity.
- Same state of technology: This assumes that technology used in production is constant.
Limitations of Marginal Productivity Theory
- Unrealistic Assumptions: This refers to one of the major limitations of marginal productivity theory. Marginal productivity stands true under certain conditions such as homogeneity of factors of production, perfect competition, and perfect mobility of factors of production. Moreover, the theory is applicable in a static economy, while the real world economy is dynamic. A perfectly competitive market does not exist in reality. In addition, perfect mobility of factors is also not possible. Therefore, the marginal productivity theory of factor pricing is not completely applicable in the real world.
- Difficulty in Measurement: This implies that the marginal productivity of a factor of production cannot be measured accurately. This is because while determining the marginal productivity of a factor, other factors are kept constant, which is not possible in the real scenario.