Topic 3 - Marginal Productivity Theory of Demand and Factor Shares

Factor Shares (FS)

the share in the total income of an input (rK/PQ or wL/PQ)

Marginal Productivity Theory (MPT)

factor prices are reflective of MVPs

• MVP = P x MP

• under prof max: P x MP = w

• FS= wL(or rK)/PQ = P x MP x L/PxQ = MP x L (or K)/Q

factor shares depend only on:

marginal products and input-output ratio, it does not depend on factor prices

factor shares are determined by

the respective output elasticities of the factors

In what cases will FS=1 hold?

Perfectly competitive market (P=MR) and Constant returns to scale

When is FS not equal to 1?

When the firm is experiencing increasing returns to scale (change in TR > change in TC → FS < 1) or decreasing returns to scale (change in TR < change in TC → FS > 1) . Thus, the factor shares of labor and capital combined is less than or greater than the total income. The respective factor prices may not be reflective of the marginal value products of each input, i.e. MVP is not equal to w or r