6.1.

1 Marginal productivity theory

The marginal productivity theory of distribution, as developed by J. B. Clark, at the end of the 19th century,
provides a general explanation of how the price (of the earnings) of a factor of production is determined.
In other words, it suggests some broad principles regarding the distribution of the income among the four
factors of production.
According to this theory, the price (or the earnings) of a factor tends to equal the value of its marginal product.
Thus, rent is equal to the value of the marginal product (VMP) of land; wages are equal to the VMP of labor
and so on. The neo-classical economists have applied the same principle of profit maximization (MR = MC)
to determine the factor price. Just as an entrepreneur maximizes his total profits by equating MR and MC, he
also maximizes profits by equating the marginal product of each factor with its marginal cost.
Assumptions of the Theory
The marginal productivity theory of distribution is based on the following seven assumptions:
1. Perfect competition in both product and factor markets:
Firstly, the theory assumes the perfect competition in both product and factor markets. It means that both the
price of the product and the price of the factor (say, labor) remains unchanged.
2. Operation of the law of diminishing returns:
Secondly, the theory assumes that the marginal product of a factor would diminish as additional units of the
factor are employed while keeping other factors constant.
3. Homogeneity and divisibility of the factor:
Thirdly, all the units of a factor are assumed to be divisible and homogeneous. It means that a factor can be
divided into small units and each unit of it will be of the same kind and of the same quality.
4. Operation of the law of substitution:
Fourthly, the theory assumes the possibility of the substitution of different factors. It means that the factors
like labor, capital and others can be freely and easily substituted for one another. For example, land can be
substituted by labor and labor by capital.
5. Profit maximization:
Fifthly, the employer is assumed to employ the different factors in such a way and in such a proportion that
he gets the maximum profits. This can be achieved by employing each factor up to that level at which the
price of each is equal to the value of its marginal product.
6. Full employment of factors:
Sixthly, the theory assumes full employment for factors. Otherwise, each factor cannot be paid in accordance
with its marginal product. If some units of a particular factor remain unemployed, they would be then willing
to accept the employment at a price less than the value of their marginal product.
7. Exhaustion of the total product:
Finally, the theory assumes that the payment to each factor according to its marginal productivity completely
exhausts the total product, leaving neither a surplus nor a deficit at the end.

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Explanation
The theory is also based on key certain concepts.
1. Marginal Physical Product (MPPL):
The first is marginal physical product of a factor. The marginal physical product (MPP) of a factor, say, of
labor, is the increase in the total product of the firm as additional workers are employed by it.
MPPL = ΔQ / ΔL
2. Value of Marginal Product VMPL:
The second concept is value of marginal product. If we multiply the MPPL of a factor by the price of the
product, we would get the value of the marginal product (VMPL) of that factor.
VMPL = MPPL × P
3. Marginal Revenue Product (MRP):
The third concept is marginal revenue product (MRP). Under perfect competition, the VMP of the factor is
equal to its marginal revenue product (MRP), which is the addition to the total revenue when more and more
units of a factor are added to the fixed amount of other factors, or MRP = MPPL x MR under perfect
competition. It is simply MPPL multiplied by constant price, as P = MR. [VMP of a factor = MPP of the factor
x price of the product per unit, and MRP of a factor=MPP of the factor x MR under perfect competition. So,
under perfect competition VMP of a factor = MRP of that factor.]
MRP = MPPL × MR
In perfect competition MR = P. So,
MRP = MPPL × P
For perfect competition VMPL = MRPL
The Essence of the Theory:
The theory states that the firm employs each factor up to that number where its price is equal to its VMPL.
Thus, wages tend to be equal to the VMPL of labor; interest is equal to VMP of capital and so on. By equating
VMP of each factor with its cost a profit- seeking firm maximizes its total profits. Let us illustrate the theory
with reference to the determination of the price of labor, i.e., wages.
Let us suppose that the price of the product is P = Rs. 10 (constant under perfect competition) and the wages
per unit of labor are W = Rs. 300 (constant). As the number of factors other than labor remain unchanged,
wages represent the marginal cost (MC).
Calculation of MPP, VMP and MRP of a Variable Factor (Labor)
Total
Labor Wage Rate
Land Capital Product MPPL = ΔQ / ΔL VMPL or MRP = MPPL × P
(L) (W)
(Q)
1 unit 1 unit 1 unit 50 units 50 units Rs. 500 Rs. 300
1 unit 1 unit 2 units 90 units 40 units Rs. 400 Rs. 300
1 unit 1 unit 3 units 120 units 30 units Rs. 300 Rs. 300
1 unit 1 unit 4 units 140 units 20 units Rs. 200 Rs. 300
1 unit 1 unit 5 units 150 units 10 units Rs. 100 Rs. 300

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Table shows that at 1 or 2 laborers, the VMP or MRP of labor is greater than wages; so, the firm can earn
more profits by employing an additional labor. But at 4 or 5 laborers, the VMP or MRP of labor is less than
wages, so it would reduce the number of laborers. But when it employs 3 laborers, the wage rate (Rs. 300)
becomes equal to the VMP or MRP of labor (also Rs. 300). Here the firm gets the maximum profits because
its marginal revenue (VMP or MRP, Rs. 300) is equal to its marginal cost of labor (or marginal wage Rs. 300).
MRP = MC (Optimal or maximum profits)
Thus, under the assumption of perfect competition a firm employs a factor up to that number at which the
price of the factor is just equal to the value of the marginal product (=MRP of the factor). In the same way it
can be shown that rent is equal to the VMP of land, interest is equal to the VMP of capital, and so forth.
The theory may now be illustrated diagrammatically. See Figure below. In this diagram, units of labor along
OX axis and Marginal Revenue Product and wage rate are measured along OY axis. According to the table a,
b, c, d and e points have been, shown. By joining these points, we get MRP curve. This curve falls from left
to right showing that marginal revenue product is decreasing with an increase of units of labour. Here wage
rate remains unchanged. WW curve intersects MRP curve at point "c" which is the equilibrium point of the
firm. Here firm will employ three units of labour because here MRP of labour is equal to wage rate (MC),
which is Rs.300.

Criticisms of the Theory:

The marginal productivity theory of distribution has been subjected to a number of criticisms:
1. In determination of marginal product:
Firstly, main product is a joint product, produced by all the factors jointly. Hence the marginal product of any
particular factor (say, land or labor) cannot be separately determined. As William Petty pointed out as early
in 1662: Labor is the father and active principle of wealth, as lands are the mother.
2. Unrealistic:
It is also shown that the employment of one additional unit of a factor may cause an improvement in the whole
of organization in which case the MPP of the variable factors may increase. In such circumstances, if the factor
is paid in accordance with the VMP, the total product will get exhausted before the distribution is completed.
This is absurd. We cannot think of such a situation in reality.

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3. Market imperfection:
The theory assumes the existence of perfect competition, which is rarely found in the real world. But E.
Chamberlin has shown that the theory can also be applied in the case of monopoly and imperfect competition,
where the marginal price of a factor would be equal to its MRP (not to its VMP).
4. Full employment:
Again, the assumption of full employment is also unrealistic. Full employment is also a myth, not a reflection
of reality.
5. Difficulties of factor substitution:
W. W. Leontief, the Nobel economist, denies the possibility of free substitution of the factors always owing
to the technical conditions of production. In some products process, one factor cannot be substituted by
another. Moreover, organization or entrepreneurship is a specific factor which cannot be substituted by any
other factor.
6. Emphasis on the demand side only:
The theory is one-sided as it ignores the supply side of a factor; it has emphasized only the demand side i.e.,
the employer’s side, hi the opinion of Samuelson, the marginal productivity theory is simply a theory of one
aspect of the demand for productive services by the firm.
7. Inhuman theory:
Finally, the theory is often described as ‘inhuman’ as it treats human and non-human factors in the same way
for the determination of factor prices.

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6.1.2 Ricardian theory of rent
David Ricardo, a classical economist developed a theory in 1817 to explain the origin and nature of economic
rent. Rent is the payment made to landlord for the use of land. Ricardo was of the view that rent is paid for
the fertility of land. Ricardo stated “Rent is the portion of the produce of the earth which is paid to landlord
for the use of the original and indestructible powers of the soil.
Assumptions of the Theory
1. It is assumed that condition of perfect competition prevail in the product and factor market.
2. Rent of land arises due to the differences in the fertility of the soil.
3. Law of diminishing marginal returns. As the different plots of land differ in fertility, the produce from
the inferior plots of land diminishes though the total cost of production in each plot of land is the same.
4. Rent accrues only to land i.e., none of the other factors of production earn rent. However later on
Modern economists disagreed on it.
5. There is tendency to move from most fertile land to the less fertile one.
6. Land on which no rent is earned is known as marginal land.
7. Total cost spent on each piece of land is same.
According to Ricardo rent arises as the difference between production of Marginal land (On which zero rent
accrues) and superior land. As there is general tendency to move from most fertile land (Attracts highest rent)
to the less fertile land, a point comes where no rent accrues to what is called a Marginal land. So, in this way
Ricardo classified land into various grades according to their fertility. The most fertile land will attract highest
rent and Marginal land will attract no rent indicating the land to be the infertile one.
Explanation
Suppose, there are 6 grades of land I, II, III, IV, V, VI. The classification is on the basis of fertility. A is most
fertile. The fertility of soil is known by its production. Most fertile soil will have more production and
consequently more value of output. So, the column of value of output is indicator of fertility of the soil. As
mentioned in assumption total cost remains same. Say here total cost = 1000.
Calculation of Rent Earned
Grades of Amount Spent Value of Rent = Value of output – Amount Spent
Land (Cost) Rs. Output (Rs.)
I 1000 5000 5000 – 1000 = 4000
II 1000 4000 4000 – 1000 = 3000
III 1000 3000 3000 – 1000 = 2000
IV 1000 2000 2000 – 1000 = 1000
V 1000 1000 1000 – 1000 = 0000
VI 1000 NIL --

As can be seen that Grade I is the most superior land producing maximum output of 5000 on which Rent
earned is 4000. Similarly Grade II land earns 3000 and so on. This shows direct relation between the value
of output and rent earned thereof keeping the amount spent on land same on every piece of land. On Grade
V land Amount spend = Value of output i.e. Total rent is 0. This is Marginal land. Grade VI land will never
be cultivated as the Value of Output is NIL.
Highest Rent = On Grade I land i.e. Most superior piece of land
Marginal land = Grade V land where Amount spend and Value of Output is Equal i.e., ZERO RENT

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Land left uncultivated = Grade VI land as the value of output is nil and Amount spent is 1000 so it is
irrational to cultivate it.

Most Fertile land = I Grade land

Grade VI = Infertile
Grade V Land = MARGINAL LAND = Rent = 0
Grade VI land will not be cultivated
Criticisms of the Theory:
Ricardian theory of rent has been criticized on the following grounds:
1) Lack of perfect competition:
It is assumed that perfect competition exists but in practical life the conditions of perfect competition are-not
fulfilled.
2) No historical proof:
There is no historical proof that people first cultivated the most fertile land and then less fertile land. People
cultivated that land first which was easily accessible and nearer to wells, rivers and water storage.
3) No prior knowledge of fertility:
It is not right to assume that people have prior knowledge of fertility so they cultivate the most fertile land
first; actually, the fertility of land is known after cultivation.
4) Law of Diminishing Return:
It is assumed that only law of diminishing return applied which is wrong. By using modern methods of
production and Improved inputs, produce increases instead of diminishes.
5) Rent is not only due to fertility:
It is assumed that rent is only paid due to fertility of land which is not true, because fertility of land is not
always same. Actually, scarcity of land is also counted for determination of rent.
6) Multiple uses of land:
The land has multiple uses when it is used for construction, then the concept of fertility of land is useless.
7) Rent is included in price:
According to Ricardian theory of rent, Rent is separate from price while rent is included in price as wages of
labor interest on capital and profits of entrepreneurs etc.

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Liquidity Preference Theory of Interest Rate Determination
The determinants of the equilibrium interest rate in the classical model are the ‘real’ factors of the supply of
saving and the demand for investment. On the other hand, in the Keynesian analysis, determinants of the
interest rate are the ‘monetary’ factors alone.
Keynes’ analysis concentrates on the demand for and supply of money as the determinants of interest rate.
According to Keynes, the rate of interest is purely “a monetary phenomenon.” Interest is the price paid for
borrowed funds. People like to keep cash with them rather than investing cash in assets. Thus, there is a
preference for liquid cash.
People, out of their income, intend to save a part. How much of their resources will be held in the form of
cash and how much will be spent depend upon what Keynes calls liquidity preference, Cash being the most
liquid asset, people prefer cash. And interest is the reward for parting with liquidity. However, the rate of
interest in the Keynesian theory is determined by the demand for money and supply of money.
Demand for Money
Demand for money is not to be confused with the demand for a commodity that people ‘consume’. But since
money is not consumed, the demand for money is a demand to hold an asset.
The desire for liquidity or demand for money arises because of three motives:
(a) Transaction motive
(b) Precautionary motive
(c) Speculative motive

(a) Transaction Demand for Money

Money is needed for day-to-day transactions. As there is a gap between the receipt of income and spending,
money is demanded. Incomes are earned usually at the end of each month or fortnight or week but
individuals spend their incomes to meet day-to-day transactions.
Since payments or spending are made throughout a period and receipts or incomes are received after a
period of time, an individual needs ‘active balance’ in the form of cash to finance his transactions. This is
known as transaction demand for money or need- based money—which directly depends on the level of
income of an individual and businesses.
People with higher incomes keep more liquid money at hand to meet their need-based transactions. In other
words, transaction demand for money is an increasing function of money income.
Symbolically,
Tdm = f (Y)
Where,Tdm stands for transaction demand for money and Y stands for money income.
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(b) Precautionary Demand for Money
Future is uncertain. That is why people hold cash balances to meet unforeseen contingencies, like sickness,
death, accidents, danger of unemployment, etc. The amount of money held under this motive,
called ‘Idle balance’, also depends on the level of money income of an individual.
People with higher incomes can afford to keep more liquid money to meet such emergencies. This means that
this kind of demand for money is also an increasing function of money income. The relationship between
precautionary demand for money (Pdm) and the volume of income is normally a direct one.
Thus,
Pdm = f (Y)
(c) Speculative Demand for Money
This sort of demand for money is really Keynes’ contribution. The speculative motive refers to the desire to
hold one’s assets in liquid form to take advantages of market movements regarding the uncertainty and
expectation of future changes in the rate of interest.
The cash held under this motive is used to make speculative gains by dealing in bonds and securities whose
prices and rate of interest fluctuate inversely. If bond prices are expected to rise (or the rate of interest is
expected to fall) people will now buy bonds and sell when their prices rise to have a capital gain. In such a
situation, bond is more attractive than cash.
Contrarily, if bond prices are expected to fall (or the rate of interest is expected to rise) in future, people will
now sell bonds to avoid capital loss. In such a situation, cash is more attractive than bond. Thus, at a low rate
of interest, liquidity preference is high and, at a high rate of interest, securities are attractive. Now it is clear
that the speculative demand for money (Sdm) varies inversely with the rate of interest. Thus,
Sdm = f (r)
Where, Y is the rate of interest.
Total Demand for Money:
The total demand for money (DM) is the sum of all three types of demand for money. That is, Dm = Tdm +
Pdm + Sdm. The demand for money has a negative slope because of the inverse relationship between the
speculative demand for money and the rate of interest.
However, the negative sloping liquidity preference curve becomes perfectly elastic at a low rate of interest.
According to Keynes, there is a floor interest rate below which the rate of interest cannot fall. This minimum
rate of interest indicates absolute liquidity preference of the people.

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This is what Keynes called ‘liquidity trap’. In Figure above, Dm is the liquidity preference curve. At
minimum rate of interest, r-min, the curve is perfectly elastic. However, there is a ceiling of interest rate, say
r-r-max, above which it cannot rise. Thus, interest rate fluctuates between r-max and r-min.
Money Supply
The supply of money in a particular period depends upon the policy of the central bank of a country. Money
supply curve, SM, has been drawn perfectly inelastic as it is institutionally given by State Bank of Pakistan.
Determination of Interest Rate
According to Keynes, the rate of interest is determined by the demand for money and the supply of money.
OM is the total amount of money supplied by the central bank. At point E, demand for money becomes equal
to the supply of money. Thus, the equilibrium interest rate is determined at or. Now, suppose that the rate of
interest is greater than or.
In such a situation, supply of money will exceed the demand for money. People will purchase more securities.
Consequently, its price will rise and interest rate will fall until demand for money becomes equal to the supply
of money.
On the other hand, if the rate of interest becomes less than or, demand for money will exceed supply of money,
people will sell their securities. Price of securities will tumble and rate of interest will rise until we reach point
E.
Limitations
Even Keynes’ liquidity preference theory is not free from criticisms:
Firstly, like the classical and neo-classical theories, Keynes’ theory is an indeterminate one. Keynes charged
the classical theory on the ground that it assumed the level of employment fixed.
Same criticism applies to the Keynesian theory since it assumes a given level of income. Keynes’ theory
suggests that Dm and SM determine the rate of interest. Without knowing the level of income we cannot know
the transaction demand for money as well as the speculative demand for money. Obviously, as income
changes, liquidity preference schedule changes—leading to a change in the interest rate.
Therefore, one cannot, determine the rate of interest until the level of income is known and the level of income
cannot be determined until the rate of interest is known. Hence indeterminacy. Hicks and Hansen solved this
problem in their IS-LM analysis by determining simultaneously the rate of interest and the level of income.
It is indeed true also that the neo-classical authors or the pro-pounders of the loanable funds theory earlier
made attempt to integrate both the real factors and the monetary factors in the interest rate determination but
not with great successes. Such defects had been greatly removed by the neo-Keynesian economists—J.R.
Hicks and A.H. Hansen.
Secondly, Keynes committed an error in rejecting real factors as the determinants of interest rate
determination.
Thirdly, Keynes’ theory gives a choice between holding risky bonds and riskless cash. An individual holds
either bond or cash and never both. In the real world, it is the uncertainty or risk that induces an individual to
hold both. This gap in Keynes’ theory has been filled up by James Tobin. In fact, today people make a choice
between a variety of assets.

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Conclusion
Despite these criticisms, Keynes’ liquidity preference theory tells a lot on income, output and employment of
a country. His basic purpose was to demonstrate that a capitalist economy can never reach full employment
due to the existence of liquidity trap.
Though the liquidity trap has been overemphasized by Keynes yet he demolished the classical conclusion the
goal of full employment. Further, his theory has an important policy implication. A central bank is incapable
of reviving a capitalistic economy during depression because of liquidity trap. In other words, monetary policy
is useless during depressionary phase of an economy.

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