Marginal Productivity Theory

Why is it that sometimes firms hire new workers, but the total production begins to drop? How do firms decide to hire new workers, and how do they decide their wages? This is what marginal productivity theory is all about.

Marginal Productivity Theory: Meaning

The marginal productivity theory aims to elaborate on how the input of the production functions is valued. In other words, it aims to define how much should a worker be paid according to their capacity to produce.

To better understand what the theory suggests, you have to understand what marginal productivity means. Marginal productivity is the additional output that results from an increase in input factors. It is important to note that the higher the input productivity, the higher the extra output will be.

Marginal productivity theory assumes that the markets are in perfect competition. For the theory to work, none of the parties on either demand or supply side should have enough bargaining power to influence the price paid for the extra unit of output that results from productivity.

The marginal productivity theory was developed by John Bates Clark at the end of the nineteenth century. He came up with the theory after observing and trying to explain how much firms should pay their workers.

Marginal Productivity Theory of Factor Pricing

The marginal productivity theory of factor pricing includes all factors of production, and it states that the price of factors of production will equal their marginal productivity. According to this theory, every company will pay for their factors of production according to the marginal product they bring to the company. Whether it is labour, capital, or land, the firm will pay according to their additional output.

The Marginal Productivity Theory of Labour

The marginal physical product of labour is the addition to a firm's total output brought about by employing one more worker. When a company adds one more unit of labour (in most situations, one additional employee) to its total production, the marginal product of labour (or MPL) is the increase in total production output when all other factors of production stay constant.

In other words, the MPL is the incremental production generated by a firm after hiring a new employee.

The marginal product of labour comes with an upward sloping curve during the first stages of hiring more workers and adding more input. These new workers hired by the firm keep adding extra output. However, the extra output generated per new worker hired begins to drop after a certain period. That is because the production process becomes harder to coordinate, and workers become less efficient.

Keep in mind that it assumes that capital is fixed. So if you maintain capital fixed and just keep hiring workers, at some point you won't have even enough room to fit them. Economists argue that the marginal output of labour begins to fall due to the Law of Diminishing Returns.

Figure 1. The marginal product of labour, Vaia Originals

Figure 1 shows the marginal product of labour. As the number of workers employed increases, the total output also increases. However, after a certain point, the total output begins to drop. In Figure 1, this point is where Q2 of workers produce the level of output Y2. That's because hiring too many workers makes the production process inefficient, therefore lowering the total output.

How is the marginal product of labour determined?

When a new worker is introduced to the labour force, the marginal physical product of labour quantifies the change or the additional output that the worker produces.

The marginal product of labour can be determined by calculating the following:

$MPL=\frac{Changeintotaloutput}{Changeinlabouremployed}=\frac{\Delta Y}{\Delta L}$

For the first employee hired, if you deduct the total physical output when no employees are employed from the total physical product of labour when one worker is employed, you'll get the answer.

The marginal product of labour does not continue to rise indefinitely as the number of employees grows. When the number of employees increases, the marginal product of labour decreases after a certain point, resulting in a scenario known as diminishing marginal returns. Negative marginal returns occur when the marginal product of labour becomes negative.

The marginal revenue product of labour

To calculate and find the marginal revenue product of labour (MRPL), you should use the marginal product of labour (MPL). The marginal product of labour is the extra output added when the firm hires a new worker.

Remember that the marginal revenue (MR) of a firm is the change in a firm's revenue from selling an extra unit of its goods. As MPL shows the change in output from an additional worker hired, and MR shows the difference in the firm's revenue, multiplying MPL by MR gives you the MRPL.

That is to say:

$MRPL=MPL\times MR$

Under perfect competition, a firm's MR is equal to the price. As a result:

$MRPL=MPL\times price$

Figure 2. Marginal revenue product of labour, Vaia Originals

Figure 2 shows the marginal revenue product of labour which is also equal to the firm's demand for labour.

A profit-maximising firm would hire workers up to the point where the marginal revenue product equals the wage rate because it is inefficient to pay employees more than the firm will make in revenue from their labour.

It's worth noting that the increase in productivity isn't restricted to what's directly attributed to the new employee. If the business operates with declining marginal returns, adding an extra worker diminishes the average productivity of the other workers (and impacts the marginal productivity of the additional person).

As the MRPL is a product of the marginal product of labour and the output price, any variable that affects either the MPL or the price will impact the MRPL.

Changes in technology or the number of other inputs, for example, will impact labour's marginal physical product, whereas changes in product demand or the price of complements will affect output's price. All of these would affect the MRPL.

Marginal Productivity Theory: Example

An example of the marginal productivity theory would be a local factory that produces shoes. Initially, there are no shoes produced as there were no workers in the factory. In the second week, the factory hires a worker to help with the production of shoes. The worker produces 15 pairs of shoes. The factory wants to expand production and hires an extra worker to help. With the second worker, the total output is 27 pairs of shoes. What is the marginal productivity of the second worker?

The marginal productivity of the second worker is equal to:

$\frac{Changeintotaloutput}{Changeinlabouremployed}=\frac{\Delta Y}{\Delta L}=\frac{27-15}{2-1}=12$

Limitations of Marginal Productivity Theory

One of the main limitations of marginal productivity theory is the measurement of productivity in the real world. It is hard to measure the productivity that each factor of production has on the total output produced. The reason for that is that it would require some factors of production to remain fixed while measuring the change in output resulting from one of the others. It is unrealistic to find firms that maintain their capital fixed while changing labour. Moreover, there are many factors at play that could affect the productivity of various factors of production.

The marginal productivity theory was developed under the assumption that markets are in perfect competition. That way, the value attached to a worker’s productivity is not influenced by other factors such as the power to bargain over the wage. This is unlikely to happen in the real world. Workers are not always paid according to the value of their productivity, and other factors often influence wages.