Four factors of production, i.e. land, labor, capital and organization are engaged to have a certain level of output. They charge prices for their services. Landlord gets rent, labor class receives wages, capitalist gets interest and organization receives profit. These are rewards of factors of production.

The summation of these rewards of factors of production in an economy during a year represents national income. The distribution of rewards of factors of production is termed as distribution of national income or factors pricing.

The ultimate objective of a firm is the maximization of profit. Symbolically, = R – P

It shows that profit is determined by two components, i.e. revenue and cost, obviously cost is one of the major pillars of profit theory. The payment of the rewards of factors of production constitutes costs. Hence determination of rewards / prices of factors of production plays a vital role in a firm’s behavior. Now we shall discuss different theories for determination of optimum prices of factors of production. First of all, we discuss marginal productivity theory.

It is considered general theory of distribution of income or factor pricing in the sense that it is applicable to all factors of production. It is also called classical theory of pricing of factors of production.

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Generally marginal productivity theory is associated with the name of J.B. Clark. Anyhow, Wood, Walras and Marshall are considered the major contributors. Input pricing and input employment are considered the key-issues for a firm to achieve equilibrium. Marginal productivity theory provides the basic principles by following which a firm can determine optimum prices and employment level of inputs.

Nature of analysis:

Marginal productivity theory can be discussed under two cases:
(i) Partial analysis (ii) General analysis

ASSUMPTIONS - Both the cases are based on the following assumptions.

1. Perfect competition

There exists perfect competition in goods market and factors market.

2. Homogeneity

All the units of a factor are homogeneous in skill, efficiency, experience etc.

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3. Mobility

Factors are mobile and they can move from one place to another place, from one job to another job for better rewards within economy.

4. Substitutability

Factors are perfect substitute of each other.

5. Law of diminishing returns

Law of diminishing operates i.e. marginal product decreases with the consecutive application of variable factor of production over fixed factor of production.

6. Divisibility

The various units of factors are divisible.

7. Full employment

There is full employment of factors and resources.

8. Measurability

Marginal productivity of an individual factor is measurable.

9. Profit maximization

The prime objective of a firm is profit maximization.

10. Perfectly elastic

Supply of variable factor of production is perfectly elastic, i.e required units of variable (what so ever) are available at the prevailing price.

11. Long run analysis

It is long run theory and any fixed factor can be converted into variable factor.

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12. General theory

It is applicable to all factors of production.

13. No change in technology

Technology remains the same.

14. No state intervention

State does not intervene in fixing the price of output and inputs (like implementation of price control, law of minimum wages etc.)

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