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The marginal productivity theory of distribution explains how the national income distributed amongst various factors of production, it also explains how the price or the share of each factor of production is determined. This theory is known as the theory of factor pricing.

The sum and substance of this theory is that the price of a factor of production depends upon its marginal productivity means, a particular factor of production gets its reward according to the marginal contribution it makes to total output.

• The reward or the price which a particular factor or production gets income for that factor but its cost to the employer using that factor. For eg- factors of production get income is in form of rent, wages, interest, etc. but from employer's point of view these are expenses or costs which he has to incur in order to secure the services of these factors.
• The other important point to note is that productivity of a factor of two types that is - [1] Physical productivity and [2] Revenue productivity. 

Physical productivity refers to the amount of a commodity in terms of physical units which a factor unit helps to produce. When physical productivity is represented in terms of money through the system of prices, it is considered as revenue productivity.

For example- Suppose if a labourer produces three metres of cloth and if the price of cloth is Rs. 50 per metre, then the physical productivity of labour is three meters of cloth while its revenue productivity is Rs. 150. It is considered as revenue productivity.

The marginal productivity theory of distribution indicates the reward which each factor of production gets tends to be equal to its marginal productivity. It based on assumption that the marginal productivity of a factor diminishes as more and more units of that factor are used. This assumption seems not true in initial stages, but later, noted that a point will come when the marginal productivity of a factor will begin to decline. This follows the law of variable proportions which states that if the quantity of one factor of production is increased, the quantity of other factors remain constant, the marginal productivity of the variable factor, after certain stage, will progressively diminish.

On the basis of the law of diminishing marginal productivity, it proved that the remuneration of a factor of production tends to be equal to its marginal productivity. If the marginal productivity of a factor is greater than the reward paid to it, it clearly indicates profits for the employer to use more and more units of that factor. But when employer uses more and more units of that factor, he notice that marginal productivity of that factor, after certain stage, it starts to diminish progressively till a point is reached when the marginal productivity of that factor becomes equal to its price. He stops at this point due to any further use of that factor unit will mean a lower marginal productivity than the price to be paid for it.

Suppose, if on the other side, marginal productivity of a factor is less than its price, the employer would use less units of that factor and more of another factor whose marginal productivity is high. The employer would substitute high cost factors by low cost factors. The process of substitution will go on till the marginal productivity of all factors becomes equal.

If the marginal productivity of labour ÷ the price paid to it that (i.e. wages) is less than the marginal productivity of capital ÷ its price (i.e. interest), the employer would substitute more units of capital for labour. It clearly indicates that as more and more units of capital are used, its marginal productivity will fall after a certain stage, while the marginal productivity of labour will rise as less of its units are used. It continues till the marginal productivity of each factor used ÷ the price paid to it become equal.

Thus, under equilibrium stage:

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