This principle deals with the allocation of the available resource among the alternative activities. According to this principle, an input should be allocated in such a way that the value added by the last unit is the same in all cases. This generalisation is called the equi-marginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities, which need labour services, viz., A, B, C and D. It can enhance any one of these activities by adding more labour but sacrificing in return the cost of other activities. If the value of the marginal product is higher in one activity than another, then it should be assumed that an optimum allocation has not been attained. Hence it would, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. For example, if the values of certain two activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
In this case it will be profitable to shift labour from A to activity B thereby expanding activity B and reducing activity A. The optimum will be reach when the value of the marginal product is equal in all the four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain aspects of the equi-marginal principle need clarifications, which are as follows:
- First, the values of marginal products are net of incremental costs. In activity B, we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20.
- Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will make them equivalent.
- Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity requires an alternative reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price.
- Fourthly, the equi-marginal principle may break under sociological pressures. For instance, du to inertia, activities are continued simply because they exist. Similarly, due to their empire building ambitions, managers may keep on expanding activities to fulfil their desire for power. Department, which are already over-budgeted often, use some of their excess resources to build up propaganda machines (public relations offices) to win additional support. Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.