Marginal Productivity Theory

MARGINAL PRODUCTIVITY THEORY:

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:
Marginal Product: This is the change in total product resulting from an incremental change in the quantity of the variable factor input used.

Marginal Physical Product: This is another term for marginal product which serves to emphasize that production is measured in physical units rather than monetary units.

Marginal Revenue: This is the change in total revenue resulting from an incremental change in the quantity of the output produced.

Marginal Revenue Product: This is the change in total revenue resulting from an incremental change in the quantity of the variable factor input used.
Marginal revenue product is marginal product stated in monetary units rather than physical units. Rather than stating productivity of an input in terms of the physical quantity of production, marginal revenue product states productivity in terms of the revenue generated.
Suppose, for example, that Edgar Millbottom contributes 5 tacos per hour of production when hired by Waldo's TexMex Taco World. Edgar's marginal (physical) product is thus 5 tacos per hour. However, because each taco sells for $2 each (marginal revenue), Edgar contributes $10 per hour of revenue to Waldo's TexMex Taco World.

Waldo, the owner of Taco World, is more interested in the amount of revenue Edgar generates when it comes to making out a paycheck, than just the number of tacos produced.

This connection between marginal product, marginal revenue, and marginal revenue product is summarized in by the following equation:

marginal revenue product = marginal product x marginal revenue A Derived Demand

Marginal productivity theory reveals that the demand for a factor input is not based so much on the factor itself, but on the contribution the input makes to the firm's revenue and profit. The demand for an input is thus a derived demand.
In particular, an input is highly valued if it produces an output that is highly valued. Alternatively, an input is not highly valued if it produces an output that is not highly valued.

For example, Harold "Hair Doo" Dueterman thrills millions of fans from April to September as a superstar baseball player for the Shady Valley Primadonnas. His efforts contribute to the production of a highly valued entertainment product. Although he works only six months each year and usually only a few hours a day, he is paid millions of dollars for his productive services.

In contrast, George Grumpinkston, an economics professor at the Ambling Institute of Technology, works longer and harder for twelve full months of the year. However, the educational service that he provides is not has highly valued. As such, his annual income is measured in thousands of dollars, rather than millions.

Factor Market Structures

The structure of a factor market depends on the number of competitors on the demand side, which determines the market control of each firm. This gives rise to four alternative market structures.
Perfect Competition: This contains a large number of relatively small buyers, each with no market control.

Monopsonistic Competition: This contains a large number of relatively small buyers, each with a small degree of market control.

Oligopsony: This contains a small number of relatively large buyers, each with extensive market control.

Monopsony: This contains a single buyer with complete control of the demand-side of the market.
If a factor market is perfectly competitive such that the buyers have no market control, then inputs are paid a price exactly equal to the value of their contribution to the firm, that is, marginal revenue product. However, if the buyers have any market control, then the inputs are paid a price less than the value of their contribution to the firm.