Marginal productivity theory of income distribution

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In economics, the marginal productivity theory of income distribution refers to the idea that every factor of production that is sold in a factor market is paid its equilibrium value of the marginal product, or the additional value generated by employing the last unit of that factor in the factor market as a whole. In a perfectly competitive market for labor, for example, wherein the wage rate is exogenously determined, a firm will hire workers up until the point at which the value of the marginal product of the final worker employed is equal to the wage rate. Note that all workers employed are paid the value of the marginal product of the final worker, not their own.

Marginal productivity theory under imperfect competition

In a perfectly competitive market, the marginal revenue product of a factor of production is equal to its marginal physical product (the additional quantity produced by employing that factor) times its price. Because firms under perfect competition are price takers, price will stay constant and MRP will be determined solely by changes in MPP.

Under imperfect competition, however, MRP will diminish more rapidly, as firms will have to lower prices in order to sell a greater quantity of goods or services. Whereas perfectly competitive firms face a horizontal demand curve, oligopolies face a kinked demand curve, and monopolies a downward-sloping one.

Exceptions to marginal productivity theory

There are various exceptions to marginal productivity theory, particularly in the case of labor markets. Compensating differentials, efficiency wages, and employer discrimination all represent examples of situations in which this theory alone is not sufficient to account for the manner in which workers are paid.