Marginal Productivity Theory and Condition for Equilibrium
The Marginal Productivity Theory is based on the operation of the Law of Diminishing Returns. As we employ more and more of a factor in the production of a commodity, returns from its fall. We shall therefore employ a factor only so long as its productivity exceeds its remuneration. As soon as productivity becomes equal to the price of the factor, we discontinue employing any further units of that factor. The entrepreneur thus substitutes and combines different factors in such a way that increase in the production due to the employment of an additional unit of any factor is equal to the price that he has to pay for it. The equilibrium position where there is no inducement for the producer to affect any further change in the proportions of the different factors is as below:
MRP of Factor A / Price of Factor A = MRP of Factor B / Price of Factor B
If the marginal productivity of factor A is greater than its price while that of B is lower than its price. It is not the optimum combination of the different factors and the entrepreneur is obviously losing on factor B. He must employ most of A and less of B. As he employs less of factor B its marginal productivity will rise and as he employs more of factor A its marginal productivity will This process must continue so long as the relation between marginal productivity and price for each of the two factors becomes equal as given in the above equation.