Theory of Distribution
Theory of Distribution
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.
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.
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?
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.
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.
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.
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.
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 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
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.
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.
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.
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.
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.