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SAMPLE NOTES THEORY OF DISTRIBUTION

MARGINAL REVENUE PRODUCTIVITY THEORY(MRP)

The MRP theory was first propounded by a Germany economists T.H Von Thunnen in 1826
and later on modified by economists such as J.B Clarks, Wicksteed, Ricardo,Borone ,Philip
Henry ,Marshall,and Walras who shared the same sentiments with him .The theory is based
on a perfectly competitive labour market. In other words the theory assumes that a firm
which is wishing to hire labour is operating in a perfectly competitive market. MRP theory
explains the demand for a factor of production by a single firm in terms of its productivity.
The theory applies to all factors of production but it is usually illustrated in terms of labour.
The theory emphasize that productivity can be clearly and objectively measured.

ASSUMPTIONS

For the MRP theory to determine wages, the theory is based on the following assumptions.

1. The MRP theory assumes that, firms seek to maximize profits. Thus profit
maximization is the main objective of all firms .Usually firms employ where MRP is
equal to MFC (wage rate) to maximize profits. Employees in industries which make
small profits earn less and workers in industries which are highly profitable earn
more. This is made clear where labour intensive industries pay less than capital
intensive industries because they earn less profit.

2. The theory further assumes that there are no barriers to entry and exit. Employees are free
to get in and out of the market without any fear or restriction. For example workers can go to
teaching anytime freely, without any fear.

3. The Marginal Revenue Productivity theory assumes that a firm which is wishing to hire
labour is said to be operating in a perfectly competitive market, thus firms and workers are
wage takers. Firms or workers have no market power to influence the prevailing wage rate.
Therefore firms face a perfectly elastic demand curve. This can be illustrated graphically as
shown below.
 Wage rate

W1 MFC= AFC

0 number of workers

4. The law of diminishing returns apply on marginal productivity of labour.

5. The MRP assumes that labour is homogeneous, that is all workers possess the same skills,
knowledge, education and innate abilities among others.

6. The theory also assumes that there is perfect mobility of labour. That is workers can be
switched easily from one occupation to another without loss of efficiency. For example a
worker can be switched from marketing department to auditing department without loss of
efficiency.

7. The theory assumes that, there is no trade union or government intervention on issues to do
with wage rate determination. That is, the government and trade unions are assumed to be
silent on issues to do with wage rate determination.

8. The theory assumes that, there is variable input coefficient. It assumes that factors of
production can be used in different quantities. For example a land owner can employ four or
five workers to plough a hectare of land. The same land can be ploughed by one person. If
different workers are employed different wages will be paid.

9. The MRP assumes that all employers and employees have perfect knowledge and
information about what is happening on the labour market. Employers are aware of wage
rates being paid to workers and employees are aware of the wages they are going to receive.

10. With no doubt substitutability of factors of production is another assumption of MRP

theory. The theory states that factors of production act as a substitute to each other. For
instance capital can act as a substitute of labour. If labour can be easily substituted low wages
will be paid or if labour cannot be easily substituted hence high wages will be paid.

11. The theory assumes that technology is constant. It assumes that technology used in
production is constant. If technology is constant workers who use advanced technology earn
high while those who use less advanced technology earn low wages Difference in technology
results in wage differentials.
MRP theory seeks to explain how wages are determined in an industry. The MRP is the
increase in revenue due to employing one more unit of labour. The Marginal Physical
Product (MPP) is the increase in output when one more worker is employed. The average
revenue is the price of finished product .Due to the law of diminishing marginal returns, the
MPP falls as more workers are employed to work on a given amount of fixed factor.
Therefore the following table shows the short run production and revenue.

Number Total MPP Price Total MRP (MPP X

of product AR revenue AR)
workers

1 4 4 $2 $8 $8

2 10 6 $2 $20 $12

3 17 7 $2 $34 $14

4 22 5 $2 $44 $10

5 26 4 $2 $52 $8

6 29 3 $2 $58 $6

7 31 2 $2 $62 $4

8 32 1 $2 $64 $2

When more workers are employed the MRP will eventually fall. MRP is found by
multiplying average revenue and marginal physical product. The diagram below shows the
MRP curve
MRP

MRP =MPPxP

0 number of workers

This is the firm’s demand curve.

The firms supply curve is the Average Factor Cost (AFC). In a perfectly competitive market
AFC would be equal marginal factor cost (MFC). Firms can employ an infinite number of
same workers at the same wage rate. This is shown as follows.

No of workers Wage rate(AFC) Total cost MFC

1 $100 $100 $100

2 $100 $200 $100

3 $100 $300 $100

4 $100 $400 $100

5 $100 $500 $100

6 $100 $600 $100

7 $100 $700 $100

The following diagram shows the supply curve of the firm.

MFC=AFC
As long as every additional worker adds more revenue than cost the firm will continue
employing workers. Thus the equilibrium level is where the MFC is equal to MRP. The over
simplified graphs show the analysis.

Wage

rate

w0 MFC=AFC

MRP=MPPxP

0 Q0 number of workers

The diagram above shows that the profit maximising firm will employ workers up to Q0 and
the point where MFC interacts with MRP, that’s where the equilibrium wage rate is W0
determined.

STRENGHS OF THEMRP THEORY

1. It gives importance to the productivity of labour.

2. It shows why there are differences in wage rates. Wages according to this theory vary
because of MP difference of different workers.

3. It takes into consideration the demand for labour by employers and the supply of labour
although in an indirect form.

4. This theory is not as rigid as the subsistence level theory and other classical theories.

WEAKNESSES OF THE MRP THEORY

1. The theory assumes that productivity can be clearly and objectively measured. However,
productivity of a worker is difficult to measure in some occupations that offer services.For
example , receptionist, teaching. Hence the theory is less applicable in real world situations.
2. The theory assumes that there are no barriers to entry and exit. However, the assumption is
questionable because some occupations are contract based. This will mean that workers
cannot leave jobs without notice as they can be sued for breaching contracts by their
employers. Hence theory is unrealistic.

3. The theory assumes that there is perfect mobility of labour. However, workers in real
world cannot be easily switched from one job to another without loss of efficiency

4. The theory assumes that firms seek to maximize profits, however in reality, not all firms
are keen for profit maximisation. For example public sector firms which are producing basic
commodities for the sake that if the production for those commodities is undertaken by
private firms exorbitant prices will be charged. For example water being produced by
ZINWA. Workers working in such firms earn medium wages.

5. The theory assumes that workers and employers are wage takers. However the theory
ignores that in reality there is an issue of monopsony, there are some firms who have a
greater market share thus securing more sales and has the capacity to pay higher wages as
compared to those firms with a small market share.

6. The theory assumes that there is no trade union or government intervention. However, in
reality the government and trade unions may influence wage rates by establishing wage
floors.

7. The theory assumes that there is substitutability of factors of production. However, factors
of production cannot completely substitute each other. For example architects cannot be
substituted.

8. It is a theory of wage rate determination not wages differentials since the demand curve for
labour is derived.

9. The MRP theory considers long run period and ignores the immediate period like
tomorrow.

10. The theory assumes that technology is constant. However, manufacturing firms often
change technology from time to time to keep up with effective production methods

Non economic factors

Apart from the economic theories, there are some non economic factors which explain the
causes wage differentials within and across occupations which are detailed below.

Education / Human capital investment

Predominantly, people in different occupations are paid differently depending on the
qualifications of each worker. Those with high qualifications are paid higher wages and those
with low qualifications are paid low wages to compensate individuals for longer periods of
training and education. The graph below portrays the analysis.

wages w5

w4

w3

w2

w1

0 0 level a level diploma degree masters level of education

The diagram above shows that an O level certificate holder is paid a lower wage rate W1 and
a master’s holder is paid a higher wage rate W5, hence resulting in wage differentials

Profit of the organisation

Organisation profitability determines its ability to pay its workers. An organisation earning
high profits usually pay higher wages than an organisation which earns less profit. For
example an organisation like Econet is highly profitable and thereby pays higher wages to its
workers. Thus causing wage differentials.

Experience

Solid empirical evidence reveals that longer servicing employees are normally rewarded with
higher wages compared to new employees. The former usually carry a wage differential for
their years of experience on the job. There is a positive relationship between experience
wages. This will mean that those workers who are less experienced earn less than those who
are highly experienced.

Cost of living

Cost of living is the cost of various goods and services within a country. Difference in cost of
living in different areas may lead to variations in wages. For example wage rates of
production workers in Malaysia are cheaper than in USA. Cost of living may also differ
within a country between rural and urban districts, thereby contributing to wage differentials
within the same occupation.

Hardworking

Economists argue that, there are inequalities in wages in the same occupation because some
workers are more capable or hardworking than others. This means that, they will be rewarded
with high wages. Such wage differentials can act as an incentive to work hard. In contrast
those who are not hard workers would be rewarded with less wages. Thus, existence of wage
differentials.

Discrimination in terms of gender, race nationality and sex

Discrimination although illegal plays a pivotal role in wage rate determination. Evidence
provided by different economists reveals that in most countries men earn more than woman
and in some countries whites earn more than blacks. Sometimes discrimination is endorsed
by the government. In countries like Saudi Arabia and Pakistan men are paid more than
women so as to preserve family institutions.

Natural ability/Innate abilities

Natural talents differ among individuals. A highly talented worker earns more wages than a
less talented worker. Thus existence of wage differentials

Government policy

The government can directly or indirectly influence wages in various occupations. For
example where the government seeks to increase the supply of labour in a particular
occupation, the government might raise wages in that particular occupation. In contrast if the
government want to reduce the supply of labour in a particular occupation the government
will reduce the wages and thus causing wage differentials in various occupations. If the
government wants to increase the supply of labour for doctors they will raise wages. Thus
existence of wage differentials
Effect of trade unions

Trade unions, these are independent organisations that bargain for better working conditions
for workers they represent. Ideally trade unions can ensure a certain level of wages that may
be above the equilibrium wage rate, thus securing high wages for its members. This will
mean that occupations characterised by strong trade unions earn more wages than those with
weak or no trade unions. The presence and strength of trade unions has an effect of raising
wages. This can be illustrated graphically as shown below.

wages SUPPLY

w1

DEMAND

0 Q1 Q Q2 number of labour

The diagram above shows an effective wage floor. Those trade unions which have a strong
bargaining power are able to influence the equilibrium wage rate W by establishing a legal
wage floor W1. This will mean that no worker, they represent will earn a wage which is
below W1. Thus causing wage differentials in various occupations. The assertion that low
pay in an industry is due to weak bargaining power of the trade union workers belong is
justified by the above analysis.
Risk involved

Risk is defined as the degree of uncertainty. A job which involves a higher risk should be
paid higher wages, for example a mine worker .conversely a job which involves a lower risk
should be paid a lower wage, hence resulting in wage differentials. The analysis is
represented by the over simplified graph below.

Risk curve

risk

R2

R1

0 w1 w2 wages

The diagram above shows that a highly risk job R2 is paid a higher wage W2 and a less risk
job R1 is paid a lower wage W1. Thus wage differentials exist.

Lack of perfect information

Wages differ in practice simply because of lack of information. People may not know that the
job exist and what wage rate is proper, this may be due to location resulting in wage
differentials. In real world, the market is in a situation of imperfect knowledge. For example
worker Z may not know that worker W is paid more for the same job in the same firm since
wages are kept confidential.

Labour mobility

Labour mobility can also result in wage differentials. Labour can be perfectly occupational
immobile. This occurs when people are not willing to move from one type of job to another
due to lack of skills or even information asymmetry. With full confidence those workers who
are immobile earn less wages than those who are mobile.