FACTOR PRICING – MARGINAL PRODUCTIVITY THEORY
(Home Academy – Exam Oriented Notes)
🔹 1. Definition of Factor Pricing
Factor pricing refers to the determination of prices of factors of production:
Land → Rent
Labour → Wages
Capital → Interest
Entrepreneur → Profit
👉 It explains how much each factor is paid in the production process.
🔹 2. Marginal Productivity Theory (MPT)
📌 Definition
The Marginal Productivity Theory states:
“The price of a factor is equal to the value of its marginal product.”
In simple words:
A factor (like labour) is paid according to its contribution to total output.🔹 3. Key Concept: Marginal Product (MP)
Marginal Product (MP) = Addition to total output by employing one more unit of factor📌 Formula:
MP = TP_n - TP_{n-1}
🔹 4. Core Principle
👉 A firm will hire a factor until:
Wage (or price of factor)= Value of Marginal Product (VMP)
🔹 5. Assumptions of Marginal Productivity Theory
For exams, these are very important:
Perfect Competition in product and factor markets
Homogeneous factors (all labour units are identical)
Full employment of resources
Perfect mobility of factors
Law of diminishing returns applies
Rational producer (profit maximization)
No government intervention
Constant technology
🔹 6. Explanation with Example
Suppose:
Price of product = ₹10
Worker produces 5 extra units👉 Then:
MP = 5
VMP = 5 × 10 = ₹50✔ The firm will pay ₹50 wage to that worker.
If wage > ₹50 → firm will not hire
If wage < ₹50 → firm will hire more workers
🔹 8. Important Features
Based on demand for factors
Derived demand (depends on demand for final goods)Applies to all factors: labour, land, capital
Explains wage determination in classical economics
🔹 9. Criticism of Theory
Unrealistic assumptions (perfect competition rarely exists)
Difficult to measure marginal product in real life
Ignores trade unions and bargaining power
Does not apply in monopoly markets
Over-simplified theory
🔹 10. Important Points for Exams 🔥
Payment = VMP (Value of Marginal Product)
Based on Law of Diminishing ReturnsAlso called Demand Theory of Distribution
Factor demand is derived demand
Equilibrium condition:
VMP = Factor Price
📘 MCQs (Practice for Exams)
Q1. Marginal Productivity Theory explains:
A. Price of goods
B. Price of factors
C. Inflation
D. Demand
✅ Answer: B
Q2. Value of Marginal Product (VMP) is:
A. MP ÷ Price
B. MP × Price
C. TP × Price
D. MP + Price
✅ Answer: B
Q3. Under MPT, wage is equal to:
A. Average product
B. Total product
C. Marginal product
D. Value of marginal product
✅ Answer: D
Q4. Which law is the base of MPT?
A. Law of Demand
B. Law of Supply
C. Law of Diminishing Returns
D. Law of Utility
✅ Answer: C
Q5. Factor demand is:
A. Direct demand
B. Derived demand
C. Joint demand
D. Composite demand
✅ Answer: B
📘 Previous Year Questions (PYQs)
🔹 PYQ 1 (UGC NET)
“Marginal Productivity Theory is also known as:”
A. Demand theory of distribution
B. Supply theory
C. Utility theory
D. Cost theory
✅ Answer: A
🔹 PYQ 2 (SSC)
“A firm hires labour up to the point where:”
A. MP = AP
B. VMP = Wage
C. TP is maximum
D. AP is maximum
✅ Answer: B
🔹 PYQ 3 (UPSC)
“Which of the following determines factor pricing?”
A. Utility
B. Marginal Productivity
C. Cost
D. Demand only
✅ Answer: B
🔚 Conclusion
The Marginal Productivity Theory is a fundamental concept in factor pricing, explaining that:
👉 Each factor is rewarded according to its contribution to production.