A theory used to analyze the profit-maximizing quantity of inputs (that is, the services of factor of productions) purchased by a firm in the production of output. Marginal-productivity theory indicates that the demand for a factor of production is based on the marginal product of the factor. In particular, a firm is generally willing to pay a higher price for an input that is more productive and contributes more to output. The demand for an input is thus best termed a derived demand. Marginal productivity theory is a cornerstone in the analysis of factor markets and the input side of short-run production. It provides insight into the demand for factors of production based on the notion that a profit-maximizing firm hires inputs based on a comparison between the productivity of the input and the cost of the input. The Law of Diminishing Marginal Returns
The central principle underlying marginal-productivity theory is the law of diminishing marginal returns. This law states that as additional units of a variable input are added to a fixed input, eventually the marginal product of the variable input decreases. This principle is an essential component of short-run production analysis, which offers insight into the positively-sloped marginal cost curve and the law of supply.
The law of diminishing marginal returns also plays a key role in the demand for an input. It works like this: As more of an input is employed, marginal productivity declines. Because each unit is less productive and generates less revenue, the firm is inclined to pay less to use the input. As such, an inverse relation exists between the price of the input and the quantity of the input demanded, which traces out a negatively-sloped factor demand curve.
Three (or Four) Marginals
The focus of marginal productivity theory and the law of diminishing marginal returns is on marginal product. There are, however, three related "marginals" that need to be noted:...