Question

Explain why marginal productivity theory cannot be used to explain profit and how this controversy was resolve, and how Marshall resolved the controversy over whether cost of production or utility determines price? ( 50 marks)

reference exercise for tutorial

Answer 1

Solution:

Marginal Productivity Theory oldest and most significant theory of factor pricing which was initially tabled by German economist, T.H. Von Thunen in 1826. this theory was further value added by various economists, such as J.B. Clark, Walras, Barone, Ricardo, and Marshall.

Marginal Productivity Theory suggest that the price of services rendered by a factor of production is equal to its marginal productivity under perfect competition. The increase in the output with the addition of one unit of factors of production is known as marginal productivity. The increase in amount of output by the addition of one unit of factor of production while keeping the other factors constant is refers as Marginal product.

But now a day there is lot of criticism that marginal productivity theory cannot be used to explain profit by many economists. This is because this theory can be said true only if certain assumptions are imposed. These assumptions are non-realistic in nature and now where practically possible in economic atmosphere.

We will discuss in detail below how marginal productivity theory cannot be used to explain profit:

• Homogeneity of factors: In this theory it is assumed that all units of a factor are homogeneous which is not true. For example if all labour working in organisation cannot have same efficiency or the different capital equipment used in organisation will not be same.
• Perfect competition in product market: This theory assumes that there is perfect competition in the product market. Thus, the change in output of an organization would not affect the market price of the product. But this is not practical as the production will change product market will also get affected by this.
• Perfect competition in factor market: This theory assumes that market price of factor of production will be constant which not realistic.
• It assumes that various factors of production are substitute of other one. For example labour can be substituted by capital factor. This is also un-realistic.
• It is also assumed that the amount of a particular factor that is used can be continuously varied, so that it is possible to apply a little more or a little less of the same factor. But there are many cases in which factor of production cannot be pushed beyond a point.

We may conclude it that marginal productivity theory is not a theory that explains wages, rents, interest, profit, production; on the contrary, it simply explains how factors of production are hired by the firm, once their prices are known. For instance, it tells us how many things are produced by orgenization at a given profit level. It does not tell how that profitability itself is determined.

Since 17th century there was a belief among economist that price is determined by its factors of production that went into making it i.e. land, Labour, capital. Some pre-classic thoughts also advocate that price of any goods or service is determined by its use and factors of production depends upon price of product.

In neo-classical era economist William Jevons and Carl Menger separately formulated marginal utility theory and calculated that cost of production determines supply, supply determines final degree of utility, final degree of utility determines price.

This controversy over whether cost of production or utility determines price is resolved somehow by Alfred Marshall. He acknowledged that the study of any economic concept, like price, is obstructed by interrelations of the economy and varying time effects. Marshall used a partial equilibrium framework to analyze the theory of price in which most variables are kept constant.

Marshall divide his study in 4 time frame:

• Very short span of time in which production cannot be change and supply is fixed. In this case price is governed by demand only.
• Short period in which supply can be changed little but not much because plant size cannot be changed. This study shows price having effect of both demand and supply.
• In long run in which plant size can be changed and supply can be varied. In this study it was observed that price is major dependent of supply.
• Last a very longer span of time in which technology, population, preference of population all have changed.

Marshall resolved the controversy over whether cost of production or utility determines price by his theories as determination of price has multiple dimensions in different time framework and his attempt to find one single cause of price were doomed to failure.