Marginal Factor Productivity

Marginal factor productivity is the additional output that results from employing one more unit of a factor of production, with the other factors held constant. It is a central concept in the analysis of the demand for factors and of the distribution of income.

Definition and Diminishing Returns

The marginal product of a factor is the change in output from employing one additional unit of the factor. The marginal value product is the marginal product multiplied by the price of the output, and it represents the additional revenue from employing the factor.

The marginal product of a factor typically diminishes as more of the factor is employed, holding the other factors constant. This is the law of diminishing returns, which is reflected in the shape of the production function and in the downward slope of the demand curve for the factor.

The rate of diminishing returns depends on the technology and on the quantities of the other factors. A larger quantity of the other factors raises the marginal product of the factor in question, a relationship known as complementarity.

Factor Demand

The demand for a factor is derived from the value of its marginal product. A firm employs a factor up to the point at which the marginal value product equals the price of the factor. At that point, the additional revenue from employing one more unit equals the additional cost.

The condition implies that the demand for a factor is a decreasing function of its price, since a higher price requires a higher marginal product, which is achieved with a smaller quantity of the factor. The demand for labour, for example, is a decreasing function of the wage.

The demand for a factor also depends on the prices of the other factors and on the price of the output. A rise in the price of the output raises the marginal value product and increases the demand for the factor, while a rise in the price of a substitute factor increases the demand for the factor in question.

Distribution

The marginal productivity theory holds that, in competitive markets, each factor is paid the value of its marginal product. The theory provides a framework for the analysis of the distribution of income among the factors of production.

The theory implies that the share of income that accrues to each factor depends on its marginal product and on the quantity employed. Changes in technology or in the supply of factors affect the marginal products and thereby the distribution of income.

The theory has been criticised for its assumptions and for its empirical performance. The assumptions of perfect competition and of full information are restrictive, and the observed distribution of income may reflect other factors, including the bargaining power of the parties and the institutions of the labour market.

Applications

The concept of marginal factor productivity is used in the analysis of the demand for labour, of the effects of immigration, and of the effects of technology on employment. It is used in the analysis of the effects of taxes on the demand for factors and on the distribution of the burden.

The concept is also used in the estimation of production functions, where the marginal products of the factors are derived from the estimated function. The estimates are used to assess the returns to scale and the effects of policy.

Marginal Productivity and the Demand for Labour

The marginal productivity of labour is the additional output from employing one more worker. The value of the marginal product is the marginal product multiplied by the price of the output, and it determines the demand for labour.

A profit-maximising firm employs labour up to the point at which the value of the marginal product equals the wage. The condition implies that the demand for labour is a decreasing function of the wage, and that it shifts with the price of the output and with the productivity of labour.

The demand for labour is central to the analysis of employment and of wages. The analysis of the effects of a minimum wage, of a payroll tax, and of technological change all rely on the concept of the marginal product of labour.

The Effects of Immigration

The marginal productivity framework is used to analyse the effects of immigration. An increase in the supply of labour reduces the marginal product of labour, which tends to lower wages and to raise the return to capital.

The effect on wages depends on the substitutability between immigrant and native workers and on the structure of the labour market. If immigrants and natives are substitutes, the wages of native workers may fall; if they are complements, the wages may rise.

The analysis also considers the effect of immigration on the return to capital and on the total output of the economy. The gains from immigration are distributed among the factors, and the distributional effects depend on the structure of production.

Technological Change and the Demand for Skills

Technological change affects the demand for different types of labour through its effect on marginal productivity. Technological change that complements skilled labour raises the demand for skilled workers and their wages, while change that substitutes for unskilled labour reduces the demand for unskilled workers.

The concept of skill-biased technological change has been used to explain the increase in the return to education and the rise in wage inequality in many countries. The evidence supports the view that technology has raised the demand for skilled labour relative to unskilled labour.

The analysis is complicated by the fact that technology can also create new tasks for labour, including tasks that require skills that were not previously valued. The net effect on the demand for labour depends on the balance between the displacement and the creation of tasks.

Summary

Marginal factor productivity is the additional output from employing one more unit of a factor, and it determines the demand for the factor and the distribution of income. Its analysis informs the understanding of the effects of immigration, of technology, and of policy on the labour market.

See also

• Production Economics
• Labour Economics
• Factor Price