Theory of Distribution

Meaning of Distribution:
By “distribution” in the present context, we do not mean the distributive activities
of traders and middlemen.

“The economics of distribution,” says Chapman, “accounts for the sharing of the
wealth produced by a community among the agents, or the owners of the agents,
which have been active in its production.”

The theory of distribution is concerned with the evaluation of the services of the
factors of production, a study of the conditions of demand for and supply of the
units of these factors and the influences bringing about changes in their market
price. In this sense, the theory of distribution is mostly an extension of the theory
of value.

In the theory of distribution, however, we determine the prices not of the factors
of production but of their services. For instance, in the factor market, it is not
hectares of land which are being bought or sold, but the services of land.
Similarly, neither labour nor capital goods are being evaluated, but the services of
labour or of capital. Thus, rent is not the price of land but the price of service or
use of land; wages, the price of the service of labour; interest, the price of the use
of capital, and profit, the reward of entrepreneur’s services.

Functional vs. Personal Distribution:

It may be pointed out that the distribution discussed here is functional and not
personal. It is distribution not among individuals but among agents of production.
The same person may represent in his person all the four agents, e.g., a peasant-
proprietor.

He is the entrepreneur, the laborer, the capitalist (for he has some capital of his
own), the landlord all rolled in one. Here we do not discuss how much he earns as
an individual out the reward that he gets separately for supplying each factor of
production. Thus, we study distribution in the form of rent, wages, interest and
profits and not among the different individuals in the nation.

It may also be understood that the prices of the factors of production are really the
prices paid for them by the firms producing that commodity. From the point of
view of the firms they are the costs of production. In other words, what is cost to a
firm is income to the factors of production.
Wages, rent, interest, profit are the functional incomes respectively of laborer,
owner of land, owner of capital and the entrepreneur. The reward that each factor
gets is the price paid for his service by the entrepreneur. Thus, from one angle it is
income and from the other it is cost.

National Dividend:
By the term ‘national dividend’ is meant that part of the annual national income
of the country which is distributed among the various agents of production.
Marshall defines national dividend thus: “The labour and capital of the country,
acting on its natural resources, produce annually a certain net aggregate of
commodities, material and immaterial, including services of all kinds. This is the
national income or the national dividend.”

The word ‘net’ in this definition is important. It means that the entire national
income of the year cannot be distributed among the agents which have
contributed to its production. A part of it has to be kept back for the purpose of
maintaining productive activity in the community. This may be called the
replacement fund. For example, in the case of agricultural income, something
must be kept for seed, maintenance of bullocks, etc. What remains is the national
dividend.

The production of national wealth is compared to the pouring of water in a

reservoir by four big pipes representing the four agents of production. Out of this
reservoir, four small channels flow out in the form of rent, wages, interest and
profit, the total of which constitutes the national dividend.

Thus, national dividend is at once the aggregate net product of, and the sole
source of payment for, all the agents of production. The national income is not
first produced, and then distributed. Production and distribution go on side by
side. Hence it is said that the National Dividend is not a fund but a flow.

Concepts of Productivity:
The term “product” or “productivity” is frequently used in economic theory for
discussing product pricing or factor pricing. But it is very necessary to have a
clear idea about the various concepts of productivity and differentiate between
them.

Productivity means the quantity of the output turned out by the use of a factor or
factors of production. For instance, how much wheat can be produced on 3
hectares of land under certain conditions or how much earth-digging can be done
by 5 laborers? But how do we measure the product? Do we measure it in physical
terms or in terms of value? Also, do we take the average product or the marginal
product, i.e., the addition made to the total product by the employment of the
marginal factor?

The answers to these questions give rise to different concepts of productivity

or product which we may distinguish as under:
(a) Marginal Physical Product:
In this case, we measure the quantity of the product in physical terms. For
instance, we may express it in terms of quintals of wheat or the number of chairs
produced. But we are not concerned here with the total quantity of wheat or the
average yield. We are concerned here with the marginal product which means an
addition made to the total output of the commodity by the addition of one unit of
a factor of production.

Suppose 2 hectares of land yield 30 quintals of wheat and 3 hectares, 40 quintals.

The use of the third hectare has added 10 quintals. This is the marginal physical
product. The total product has been increased by 10 quintals by the employment
of the third or the marginal hectare. That is why it is called marginal product. But
it is the physical product and not product in terms of value, which we explain
below.

(b) Marginal Value Product:

We have explained above what we mean by marginal product and we repeat that
it is an addition to the total product by the addition of one more unit of a factor of
production, say one hectare or one worker, or a unit of Rs. 1,000 in capital. When
this marginal product is expressed not in physical terms but in terms of its value
in the market, it is called Marginal Value Product.

This marginal value product means the value of additional product obtained by
the employment of another unit of a factor of production. We can get value
product by multiplying the physical product (i.e., the quantity of the commodity)
by its price in the market.

(c) Marginal Revenue Product:

The marginal revenue at any level of firm’s output is the net revenue earned by
selling another (additional) unit of the product. Algebraically, it is the addition to
total revenue earned by selling n units of product instead of n — 1 unit when n is
any given number.

The word net in the definition given above is important. If the price of a product
falls when more of it is offered for sale, then that would involve a loss on the
previous units which were sold at a higher price before, but will now be sold at a
reduced price along with the additional unit. This loss must be deducted from the
revenue earned by the additional unit.

The marginal revenue can be found by taking out the difference between the
total revenue before and after selling the additional unit as under:
Total revenue of 7 units sold @ Rs. 16 = Rs. 112.

Total revenue of 8 units sold @ Rs. 15 = Rs. 120.

Hence, marginal revenue = Rs. 120—Rs. 112 = Rs. 8.

It will be seen that revenue means the sale proceeds and is found by multiplying
the quantity sold by price.

Under perfect competition, marginal revenue (MR) is equal to price; hence there
is no difference between the value of marginal product and the marginal revenue
product; they are the same. But under imperfect competition marginal revenue
(MR) is less than price, because the monopolist is able to maintain a higher price.
In this case, there is a difference between these two concepts.

Marginal Productivity Theory of Distribution: Definitions, Assumptions,

Explanation!
The oldest and most significant theory of factor pricing is the marginal
productivity theory. It is also known as Micro Theory of Factor Pricing.

It was propounded by the German economist T.H. Von Thunen. But later on
many economists like Karl Mcnger, Walras, Wickstcad, Edgeworth and Clark etc.
contributed for the development of this theory.

According to this theory, remuneration of cache factor of production tends to be

equal to its marginal productivity.

Marginal productivity is the addition that the use of one extra unit of the factor
makes to the total production. So long as the marginal cost of a factor is less than
the marginal productivity, the entrepreneur will go on employing more and more
units of the factors. He will stop giving further employment as soon as the
marginal productivity of the factor is equal to the marginal cost of the factors.
Definitions:
“The distribution of income of society is controlled by a natural law, if it worked
without friction, would give to every agent of production the amount of wealth
which that agent creates.” -J.B. Clark

“The marginal productivity theory contends that in equilibrium each productive

agent will be rewarded in accordance with its marginal productivity.” -Mark
Blaug

“The marginal productivity theory of income distribution states that in the long
run under perfect competition, factors of production would tend to receive a real
rate of return which was exactly equal to their marginal productivity.” -
Liebhafasky

Assumptions of the Theory:

The main assumptions of the theory are as under:
1. Perfect Competition:
The marginal productivity theory rests upon the fundamental assumption of
perfect competition. This is because it cannot take into account unequal
bargaining power between the buyers and the sellers.

2. Homogeneous Factors:
This theory assumes that units of a factor of production are homogeneous. This
implies that different units of factor of production have the same efficiency. Thus,
the productivity of all workers offering the particular type of labour is the same.

3. Rational Behaviour:
The theory assumes that every producer desires to reap maximum profits. This is
because the organizer is a rational person and he so combines the different factors
of production in such a way that marginal productivity from a unit of money is the
same in the case of every factor of production.

4. Perfect Substitutability:
The theory is also based upon the assumption of perfect substitution not only
between the different units of the same factor but also between the different units
of various factors of production.

5. Perfect Mobility:
The theory assumes that both labour and capital are perfectly mobile between
industries and localities. In the absence of this assumption the factor rewards
could never tend to be equal as between different regions or employments.
6. Interchangeability:
It implies that all units of a factor are equally efficient and interchangeable. This
is because different units of a factor of production are homogeneous, since they
are of the same efficiency, they can be employed inter-changeable, and e.g.,
whether we employ the fourth man or the fifth man, his productivity shall be the
same.

7. Perfect Adaptability:
The theory takes for granted that various factors of production are perfectly
adaptable as between different occupations.

8. Knowledge about Marginal Productivity:

Both producers and owners of factors of production have means of knowing the
value of factor’s marginal product.

9. Full Employment:
It is assumed that various factors of production are fully employed with the
exception of those who seek a wage above the value of their marginal product.

10. Law of Variable Proportions:

The law of variable proportions is applicable in the economy.

11. The Amount of Factors of Production should be Capable of being Varied:

It is assumed that the quantity of factors of production can be varied i.e. their
units can either be increased or decreased. Then the remuneration of a factor
becomes equal to its marginal productivity.

12. The Law of Diminishing Marginal Returns:

It means that as units of a factor of production are increased the marginal
productivity goes on diminishing.

13. Long-Run Analysis:

Marginal productivity theory of distribution seeks to explain determination of a
factor’s remuneration only in the long period.

Explanation of the Theory:

The marginal productivity theory states that under perfect competition, price of
each factor of production will be equal to its marginal productivity. The price of
the factor is determined by the industry. The firm will employ that number of a
given factor at which price is equal to its marginal productivity. Thus, for
industry, it is a theory of factor pricing while for a firm it is a factor demand
theory.

Analysis of Marginal Productivity Theory from the Point of View of

an Industry:
Under the conditions of perfect competition, price of each factor of production is
determined by the equality of demand and supply. As the theory assumes that
there exists full employment in the economy, therefore, supply of the factor is
assumed to be constant. So, factor price is determined by its demand which itself
is determined by the marginal productivity. Thus, under such conditions, it
becomes essential to throw light on the demand curve or marginal productivity
curve of an industry.

As the industry consists of a group of many firms, accordingly, its demand curve
can be drawn with the demand curves of all the firms in the industry. Moreover,
marginal revenue productivity of a factor constitutes its demand curve. It is only
due to this reason that a firm’s demand or labour depends on its marginal revenue
productivity. A firm will employ that number of labourers at which their marginal
revenue productivity is equal to the prevailing wage rate.

Fig. 2 shows that at wage rate OP1, the demand for labour is ON1 and marginal
revenue productivity curve is MRP1. If wage rate falls to OP, firms will increase
production by demanding more labour. In such a situation the price of the
commodity will fall and marginal revenue productivity curve will also shift to
MRP2.
At OP wages, the demand for labour will increase to ON. DD1 is the firm’s
demand curve for labour. The summation of demand of all the firms shows
demand curve of an industry. Since the number of firms is not constant under
perfectly competitive market, it is not possible to estimate the summation of
demand curves of all firms. However, one thing is certain that is the demand
curve of industry also slopes downward from left to right. The point where
demand for and supply of a factor are equal will determine the factor price for the
industry. This theory assumes the supply of a factor to be fixed.

Thus factor price is determined by the demand for factor i.e. factor price will be
equal to the marginal revenue productivity. It has been shown by Fig. 3. In the
Fig. 3, number of labour has been taken on OX axis whereas wages and MRP
have been taken on OY axis. DD1 is the industry’s demand curve for labour. This
is also the Marginal Revenue Productivity curve.
Factor Price (OW) = Marginal Revenue Productivity MRP.

Thus under perfect competition, factor price is determined by the industry and
firm demands units of a factor at this price.

Analysis of Marginal Productivity Theory from the Point of View of

Firm:
Under perfect competition, number of firms is very large. No single firm can
influence the market price of a factor of production. Every firm acts as a price
taker and not a price maker. Therefore, it has to accept the prevailing price. No
employer would like to pay more than what others are paying. In other words, a
firm will employ that number of a factor at which its price is equal to the value of
marginal productivity. Therefore, from the point of view of a firm, the theory
indicates how many units of a factor it should demand.

It is due to this reason that it is also called Theory of Factor Demand. Other things
remaining the same, as more and more laborers are employed by a firm, its
marginal physical productivity goes or- diminishing. As price under perfect
competition remains constant, so when marginal physical productivity of labour
goes on diminishing, marginal revenue productivity will also go on diminishing.
Therefore, in order to get the equilibrium position, a firm will employ laborers up
to a point where their respective marginal revenue productivity is equal to their
wage rate.

Table 2 indicates that wage rate of labour is Rs. 55 per laborers. Price of the
product produced by the laborer is Rs. 5 per unit. Now, when a firm employs one
laborer, his marginal physical productivity is 20 units. By multiplying the MPP
with price of the product we get marginal revenue productivity. Here, it is Rs. 100
for the first labour. The marginal revenue productivity of second laborer is Rs. 85
and of third laborer it is Rs. 70.

The marginal revenue productivity of fourth laborer is Rs. 55 which is equal to

wage rate. The firm will earn maximum profits if it employs up to the fourth
laborer. If the firm employs fifth laborer, it will have to suffer losses of Rs. 15.
Therefore, to get maximum profits, a firm will employ a factor up to a point
where MRP is equal to price.
In Fig. 4 number of laborers has been measured on OX-axis and wage rate on Y-
axis. MRP is marginal revenue productivity curve and WW is the wage rate
prevailing in the market. Since, under perfect competition wage rate will remain
constant that is why WW wage line is parallel to OX-axis.

MRP curve is sloping down-ward. It cuts WW at point E which is the equilibrium

wage rate of Rs. 55. At point E, firm will demand only four laborers. Thus, from
the above, we can conclude that a factor is demanded up to the limit where its
marginal productivity is equal to prevailing price.

Under perfect competition, in long period in the equilibrium position, not only the
marginal wages of a firm are equal to marginal revenue productivity, even the
average wages of the firm are equal to average net revenue productivity as has
been shown in Fig. 5. The fig. 5 shows that at point ‘E’ marginal wages of labour
are equal to marginal revenue productivity and the firm employs OM number of
workers. At this point, even the average net revenue productivity is equal to
average wages. Thus firm earns only normal profit. If wage line shifts from NN to
N[N] then the demand for labour increases from OM to OM1.
Determination of Factor Pricing under Imperfect Competition:
Marginal productivity theory applies to the condition of perfect competition. But
in real life we face imperfect competition. Therefore, economists like Robinson,
Chamberlin have analyzed factor pricing under imperfect competition. There are
various firms under imperfect competition. But here we shall analyze only
Monopsony. Under Monopsony, there is perfect competition in product market.
Consequently MRP is equal to VMP. There is imperfect competition in factor
market.

It indicates that there is only one buyer of the factors. Therefore, Monopsony
refers to a situation of market where only a single firm provides employment to
the factors. If the firm demands more factors, factor price will go up and vice-
versa. However, the determination of factor price under Monopsony can be
explained with the help of Fig. 6.

In Fig. 6 number of laborers has been shown on X-axis and wages on Y-axis. MW
is marginal wage curve and ARP is the average wage curve. MRP is the marginal
revenue productivity curve and AW is the average revenue productivity curve.

In the fig. 6 a Monopsony will employ that number of laborers at which their
marginal wage is equal to MRP. In the fig. 6 firm is in equilibrium at point E.
Here, firm will employ ON laborers and they will be paid wages equal to NF. In
this way, ON laborers will get less wages than their MRP i.e. EN. Monopsony
firm will have EF profit per laborer which arises due to exploitation of laborers.
Total profit SFWW’ is due to exploitation of labour.