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What is the Marginal Productivity Theory?

By Osmand Vitez
Updated May 17, 2024
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Marginal productivity theory is an economic concept that postulates a firm should only add variable costs so long as they bring value to the company. For example, labor is a variable cost necessary for producing goods. Hiring too many workers when materials or equipment to produce goods are limited will increase costs while not adding value to the company. Marginal productivity theory is also a concept measuring economies of scale. This determines how much value a company will generate through increasing production output.

Economic theory relies heavily on the estimation or marginal benefits versus marginal costs. In economic terms, companies will set the price for goods and services where marginal revenue equals marginal cost. This will maximize sales to consumers. In order to achieve this profit maximization point, companies will need to calculate the variable costs that will increase when they look to increase production. These costs include materials and labor, primarily.

When marginal costs increase too much, the marginal productivity theory states that companies are better off not producing goods. This theory bases its concepts on the fact that companies that continue to produce goods at costs higher than revenue will be unable to achieve a economies of scale. Costs will continue to eat away at the company’s profits and will eventually reduce the company’s capital balances, potentially leading the company into bankruptcy. This is also known as the law of diminishing returns in marginal productivity theory. At some point, a company is unable to produce more goods to increase its economic value.

Economies of scale occur when a company can increase its production output to a point where it lowers fixed costs allocated to goods. Both fixed costs and the marginal cost increases are offset through increased production and the ability of the company to saturate the market with more products. The returns from the economies of scales may be reduced, however, if a competitor also attempts to increase output.

Marginal productivity theory can also face other factors that will reduce its impact on a company. For example, consumer income, threat of substitute goods, and limit barriers of entry can reduce the company’s market power and profit maximization. If consumers' income decreases, they are unable to purchase goods or services. Substitute goods are products a consumer will see as a cheaper product that will offer the same value as the original good. Limited or no barriers to entry means that consumer demand can result in other companies easily entering the market and producing similar goods that will earn profits.

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