Module 06: Distribution

Marginal Productivity Theory of Distribution

Marginal Productivity theory of distribution is the general theory of factor pricing as it can be
used to determine the price of any factor of production. The theory was systematically evaluated
by J.B. Clark. According to this theory, the remuneration of a factor of production will be equal
to its marginal productivity.

Assumptions: Before presenting his theory, Clark made some simplifying assumptions
abstracting from the real world. He assumed a completely static society where population, stock
of capital, and techniques of production are constant. Following are the important assumptions of
this theory:
1) Perfect competition exists both in the output market and in the input market.
2) Every unit of input is homogeneous.
3) Inputs are perfectly mobile.
4) There exists full employment of resources.
5) Employers can measure the marginal product of an input in advance.
6) Law of variable proportions operates.
7) Firm hires input with the objective of profit maximization.

J. B. Clark’s Marginal Productivity theory of distribution states that the price of any input is
determined according to the marginal product of that input. Thus, the price of labour and the
wage rate is determined by the volume of marginal product, or to be more specific, the value of
marginal physical product (VMP). Assuming a perfectly elastic supply of labour, wage of labour
is determined in accordance with the value of marginal physical productivity of labour (VMPL).
Since the product market is characterized by perfect competition, VMPL becomes equal to
MRPL. Thus, the wage of labour tends to become equal to VMPL= MRPL. A competitive profit-
maximizing firm will go on employing labour until wage equals VMPL = MRPL, i.e., W =
VMPL = MRPL. This is the essence of the Clarkian version of the Marginal Productivity theory
of distribution.

Labour Marginal Physical Product Price of product Marginal Revenue Product Wage rate
(MPP) (MRP)

1 20 5 100 55

2 17 5 85 55

3 14 5 70 55
4 11 5 55 55

5 8 5 40 55

In the above diagram units of labour are measured on the horizontal axis and the price of labour,
i.e., wage rate or marginal product is measured on the vertical axis. Negative sloping labour
demand curves that are Marginal Revenue Product and Average Revenue Product curves (MRP
and ARP) intersect the perfectly elastic labour supply curve that is Average Fixed Cost and
Marginal Fixed Cost curves (AFC and MFC) at point ‘Q’.
Point ‘Q’ is the equilibrium point because, at the going wage rate OP, the firm employs labour
till wage rate equals MRP = ARP. In other words, the firm maximizes profit by employing ON
amount of labour at the wage rate OP. Perfect competition in the input market implies that
neither input seller nor the input buyer can influence the price of an input. At a given price, any
amount of the input may be supplied. As a result, the price of any input becomes equal to its
average cost and marginal cost, i.e., P = AC = MC. This means that the input supply curve must
be perfectly elastic.
We assume labour as the variable input. So the MRP = ARP curve is the labour demand curve.
AFC = MFC curve is the supply curve of labour. ON is the profit-maximizing level of
employment because, at the ruling wage rate OP, the firm will not be able to maximize profit if it
employs more than ON or stops employment short of ON. If the firm hires less than ON units of
labour at the wage rate OP.

Rent: Modern Theory of Rent

According to modern theory, economic rent is a surplus which is not peculiar to land alone. It
can be a part of the income of labour, capital, and entrepreneurs.

According to the modern version rent is a surplus which arises due to the difference between
actual earning and transfer earning

Transfer Earnings: The modern theory of rent is based on the concept of transfer earnings.
Transfer earning of a factor is the amount which the factor will earn in its second best use.
Transfer earning or reservation price is thus the opportunity cost of the present job and thus any
surplus of income over this transfer earning is economic rent.

Rent and Transfer Earnings: Modern economists thus base the concept of rent on the concept
of transfer earnings. According to them, transfer earnings of a factor are a part of the cost of
production and cannot be treated as a surplus. What a factor earns over and above its transfer
earning is its true rent or surplus. Thus, the difference between the present earning of a factor and
its transfer earnings is defined as economic rent. Thus, if a unit of a factor is earning more than
what it might earn if transferred to the best paid alternative use, the surplus becomes rent.

The Division of Factor Earnings: Normally, the earnings of a factor of a production contain
both the elements, transfer earning and the rent. But it is possible to imagine extreme cases
where the factor gets an income only equal to its transfer earnings and thus there is rent. Or, it
may also be imagined that the transfer earnings of a factor are zero, and hence whatever it is
getting is all rent.

Rent = Actual Earnings - Transfer Earnings

Wages
In economics, the price paid to labour for its contribution to the process of production is called
wages. Labour is an important factor of production. If there is no labour to work, all other
factors, be it land or capital, will remain idle. Thus, Karl Marx termed labour as the “creator of
all value”. However, labour alone cannot produce as most of the production is the result of joint
efforts of different factors of production. Therefore, the share of the produce paid to labour for its
production activity is called wage.

Wage Determination under Imperfect Competition:

Imperfect competition refers to market structures where sellers have some degree of control
over the price of their products. This contrasts with perfect competition where sellers have no
control over the price. In these imperfect market structures, wage determination is influenced by
a variety of factors, including:

Monopsony:

● Single buyer: A monopsony is a market where there is only one buyer of a good or
service. In this case, the buyer has significant bargaining power and can dictate wages to
workers.
● Wage setting: The monopsonist will typically set wages at a level lower than the
marginal revenue product of labor to maximize its profits. This results in lower wages for
workers compared to a competitive market.

Oligopoly:

● Few sellers: An oligopoly is a market where there are a few large firms that dominate the
industry. In this case, the firms may collude to set wages at a lower level or engage in
non-competitive practices that reduce worker bargaining power.
 ● Wage setting: Oligopoly firms may use strategies like wage cuts or work slowdowns to
reduce labor costs and increase profits.

Monopolistic Competition:

● Many sellers, differentiated products: In monopolistic competition, there are many

sellers, but each firm produces a slightly differentiated product. This gives firms some
control over pricing.
● Wage setting: While firms in monopolistic competition have some pricing power, their
ability to set wages is limited by competition from other firms. Wages tend to be higher
than in a monopsony but lower than in perfect competition.

Labor Unions:

● Collective bargaining: Labor unions negotiate wages and working conditions on behalf
of their members. In imperfect markets, unions can play a significant role in determining
wages.
● Wage setting: Unions often use collective bargaining to negotiate higher wages and
better working conditions for their members. However, their success depends on factors
like the strength of the union, the economic conditions, and the bargaining power of the
employer.

Government Regulations:

● Minimum wage laws: Governments can set minimum wages to protect workers from
exploitation. In imperfect markets, minimum wage laws can have a significant impact on
wage levels, especially for low-skilled workers.
● Other regulations: Government regulations related to labor standards, occupational
safety, and health can also influence wages indirectly by affecting the cost of labor for
firms.

In conclusion, wage determination under imperfect competition is a complex process influenced

by a variety of factors. The specific factors that influence wages will vary depending on the
market structure, the bargaining power of workers and employers, and government regulations.

Liquidity
Liquidity generally refers to how easily or quickly a security can be bought or sold in a
secondary market. Liquid investments can be sold readily and without paying a hefty fee to get
money when it is needed.

Preference Theory of Interest Profits: Dynamic, Innovation

The Preference Theory of Interest Profits, developed by Irving Fisher, argues that interest is
primarily determined by the time preference of individuals. This theory posits that people
generally prefer present consumption over future consumption, and this preference is the
fundamental driver of interest rates.

In a dynamic context, this theory suggests that interest rates can fluctuate over time due to
changes in individuals' time preferences. For instance, during periods of economic uncertainty or
rapid inflation, people may become more risk-averse and prefer present consumption, leading to
higher interest rates. Conversely, in periods of economic stability and low inflation, individuals
may be more willing to defer consumption, resulting in lower interest rates.

Innovation plays a crucial role in the Preference Theory of Interest Profits. When new
technologies or products are introduced, they can alter individuals' time preferences. For
example, if a new technology promises significant future benefits, people may be more willing to
invest in the present and forego immediate consumption, leading to lower interest rates. On the
other hand, if a new technology creates uncertainty about the future, people may become more
risk-averse and prefer present consumption, resulting in higher interest rates.

In conclusion, the Preference Theory of Interest Profits provides a valuable framework for
understanding the determinants of interest rates in a dynamic and innovative economy. By
recognizing the importance of time preference and its interplay with economic conditions and
technological advancements, we can gain valuable insights into the factors that shape interest
rates and their implications for investment, consumption, and economic growth.