Distribution is an important division of economics. The theory of distribution deals with the distribution of the national income of the country among the various factors of production. The total volume of goods and services produced in a given country during a given time, say a year, may be roughly called its national income. National income is the product of the cooperation of the factors of production namely land, capital, organization, and labor. Since the factors of production are scarce, we are required to pay a price for them. Rent is the reward for land; wages are the reward for labor; interest is the price we pay for capital and profits are the reward for organization. In other words, we study in distribution how the national income is shared among the various factors of production. It should be borne in mind that the theory of distribution doesn’t deal here with the problem of personal distribution, I.e., how the income of each person is determined. It deals with functional distribution, I.e., how the income of each factor is determined. In the past, economists regarded the problem of production of wealth as the most important business of economies. Now the problem of distribution occupies a prominent place in economic discussions.
The Marginal Productivity Theory is the general theory of distribution. The theory explains how the prices of the various factors of production would be determined in conditions of perfect competition and full employment.
The price of any factor will be equal to the value of its marginal product according to the Marginal Productivity Theory. We know that a consumer will demand a commodity up to the time at which its marginal utility is proportionate to the price he pays for it, for example. Similarly, a house will go on employing more and more units of a factor until the price of the factor is equal to the value of the marginal product. In other words, each factor is rewarded according to its marginal productivity. The marginal productivity is equal to the value of the extra product. These an employer gets when he employs an additional unit of that factor, the offer of all other factors remaining constant.
In theory at least, all units of a factor are uniform and are interchangeable. So the productivity of the marginal unit of a factor determines the rate that is to be given to all units of the factor. The employer adopts what is called the principle of substitution and combines land, labor and capital so that the cost of production is minimal. Then the reward for each element is determined by its marginal productivity. The Marginal Productivity theory of distribution has been used to account for the determination of rent, wages, profits, and interest. That is why, it is known as the general theory of distribution.
All units of a factor are homogeneous. It means that one unit is equal to the other unit in all respects.
One factor of production can be substituted for another. In other words, all factors are interchangeable.
The theory is built on the Law of Diminishing Returns as applicable to a business organization. In consumption, the Law of Diminishing Utility tells us that marginal utility diminishes for every rise in the stock of a good. Similarly, the Law of Diminishing Marginal Returns tells that if you go on employing more and more units of a factor, say labor, its marginal productivity will diminish. So an employer, when once he comes to know that the sum of a certain factor is resulting in diminishing returns, he’ll substitute it by some other factor. Thereby, he’ll try to help reduce the cost of production.
The ‘tax handle’ theory offers a sweeping historical explanation of tax structure change. It argues that low-income economies are obliged to collect revenue from easy-to-administer taxes (or tax handles), but that this administrative constraint lessens as countries develop and become able to choose ‘better’ taxes as determined by the normative objectives discussed above. Measures of tax handles typically include per trade taxes, capita income, and the number of people living in urban areas (Liebaman, 2003).
The optimal tax theory, the reigning normative approach to taxation combines the set of available taxes to the government, information on a nation’s economic structure, and aims of tax policy to make recommendations on tax mix, structure and incidence (see Slemrod, 1990; Burgess and Stern, 1993). Optimal taxes are those that raise a desired amount of revenue with the lowest marginal efficient cost, with few distortions and that support the desired amount of wealth. While optimal tax theory tackles the trade off of different taxes, it doesn’t explain the architecture of government revenues.
The Marginal productivity Theory has been criticized on many grounds. The following are some of the questions or criticism.
Every product is a common product and its value cannot be separately attributed to either capital, or labor or land. It is near impossible to assess the specific product of each and every one of the factors. The problem becomes more complex once we have to measure the ‘productivity’ of certain types of labor that render services (Example: doctors, teachers and actors). If, for instance, some labor is involved in the production of some commodity, then there is a certain scope for quantitative measurement. But with regard to the people who render services, the problem of determination of their reward becomes rather a difficult one.
The theory takes into account that the factors operating on the edge of demand and ignores the influences acting on the part of supply. It tells that a factor is demanded, as it is productive and it’s paid pursuant to its marginal productivity. But this cannot be the case always. There are many cases where a factor of production has to be paid much more than its normal price because of the scarcity of the factor with respect to the demand for it.
The theory assumes perfect competition and full employment. But in the real world, ‘imperfect competition is the rule”. There is no perfect competition.
Lastly, the theory doesn’t carry with it any ethical justification. If the theory is accepted, it means that factors get the value of what they produce. Suppose wages are low in a firm. The employer may say wages are low because productivity is low. But the real cause of low wages might be the operation of labor by the employer. Hence the theory shouldn’t be applied to substantiate the present system of distribution.