The Marginal Productivity Theory of Wages is one of the most important theories of wage determination in economics. It was developed by economists like J.B. Clark and Marshall. According to this theory, wages are determined by the marginal productivity of labour, i.e., the additional output produced by employing one more unit of labour.
Marginal productivity of labour refers to the additional output produced by employing one more unit of labour while keeping other factors constant. In monetary terms, it is known as the value of marginal product (VMP).
According to this theory, an employer hires labour up to the point where the marginal productivity of labour equals the wage rate. This is because hiring an additional worker is profitable only if the revenue generated by that worker is equal to or greater than the wage paid.
When more workers are employed, the marginal productivity of labour starts declining due to the law of diminishing returns. Initially, productivity may increase, but after a certain point, it begins to fall.
The demand for labour depends on its marginal productivity. Therefore, the wage rate is determined by the demand and supply of labour, where demand is based on marginal productivity.
In equilibrium, wage rate equals the value of marginal product (W = VMP). If wages are higher than marginal productivity, employers will reduce employment. If wages are lower, more workers will be hired, pushing wages up.
Wage is determined where Demand (VMP) equals Supply of Labour
The Marginal Productivity Theory provides a logical explanation of wage determination based on productivity. However, due to unrealistic assumptions and practical limitations, it is considered incomplete. Modern theories combine this with other factors for better explanation.