Read this article to learn about: 1. The Subsistence Theory of Wages 2. The Standard of Living Theory of Wages 3. The Wage Fund Theory of Wages 4. Residual Claimant Theory of Wages 5. Modern Theory of Wages 6. Marginal Productivity Theory of Wages
Some of these theories are discussed below:
1. The Subsistence Theory of Wages:
The theory was first propounded by Adam Smith and later on it was developed by classical economists. The theory is also known as Iron Law of Wages. According to this theory wages tends towards the minimum subsistence level in the long run. Minimum subsistence level is the amount which is necessary to maintain the minimum level of living for a family. Production cost of labour is assumed equal to subsistence expenses. Subsistence means those minimum needs of workers and their family which can keep them alive.
If the wages are above the subsistence level workers are induced to have more marriages, more children and the supply of labour will increase thereby the wages will be reduced to subsistence level. Contrary to it when wages are less than subsistence level there will be starvation, increase in infant mortality rate and thereby the supply of labour will be reduced and the wage would increase to subsistence level. Thus, in the long run the actual wage rate will be equivalent to subsistence level.
The theory has been criticised on the following grounds:
(1) The theory is one sided. It emphasises on the supply of labour but does not explain the demand for labour.
(2) The theory does not take into consideration the productivity of labour while determining the wages rate. Higher the productivity of labour higher will be the wage rate and lower the productivity lower will be the wage rate.
(3) Subsistence level cannot be easily measured because it depends upon the number of members of the family, nature and wants of the labour.
(4) The theory has explained that there is a direct relationship between wage rate and population growth. But we know with the increase in wage rate the standard of living of workers will improve and they will believe in “small family is the happiest family”.
(5) The theory emphasizes on the exploitation of workers. The wage rate should not be more than that subsistence level workers. But in actual practice we see that the wage rate should be based on the productivity of labour.
Thus, the theory is outdated theory of wages. It has historical importance only.
2. The Standard of Living Theory of Wages:
This theory is an improvement over the subsistence theory of wages. According to this theory the wage rate should be determined on the basis of standard of living of workers. The wages change according to change in the standard of living of workers. The wage rate should be determined on the basis of the minimum needs of workers including the necessaries, comforts and luxuries of life to whom workers have accustomed. The wage rate should be suffice to maintain a given standard of living of a worker to which he is accustomed.
If the wage rate is higher than the standard of living of workers there will be more marriages, more children and the supply of labour will increase and thereby the wage rate will be brought down to the standard of living. Contrary to it, if the wage rate is less than the standard of living there will be less marriages, less children and the supply of labour will be reduced thereby the wage rate will increase to the standard of living of workers.
The theory is based on the assumption that the standard of living will maintain the efficiency of workers high and high wage rate is desirable from the point of view of high productivity of workers. If the workers have attained a high standard of living they will try to maintain it and more work and less leisure is preferred. The higher standard of living of workers will motivate them to save something and their bargaining power with the employers will increase.
The standard of living theory of wages has been criticised on the following grounds:
(1) The theory is one sided as it emphasises on the supply of labour and does not explain the demand for labour. The wage rate not only depends upon the supply of labour but it is also determined by the demand for labour.
(2) The theory explains that wage depends on the standard of living. But the critiques of the theory say that the wage rate determines the standard of living of workers. Generally, high wage rate keeps the standard of living high.
(3) The theory explains that the standard of living remains constant and the wage rate should also remain constant. But in actual practice there is frequent change in wage rate while the standard of living does not change frequently.
3. The Wage Fund Theory of Wages:
The theory was developed and propounded by Professor J.S. Mill. According to this theory wage rate is determined by the ratio of wage fund and the population. The population means the number of workers employed. An entrepreneur keeps a part of his capital for the payment to worker which is called wage fund and this fund is fixed.
Wage fund being fixed the wage rate depends upon the number of workers. More the workers low will be the wage rate and less the number of workers high will be the wage rate. Thus, there is inverse relationship between the wage rate and number of workers.
The wage rate can be calculated with the help of the following formula:
According to this theory, wage rate can be increased in two ways—firstly, by increasing the wage fund and secondly, by reducing the number of workers. The wage fund is based on the savings of an entrepreneur and generally it is fixed during a given period. Thus the wage rate can be increased by reducing the number of workers. The theory points out that the wage rate cannot be raised through the trade unions in an organisation.
The wage fund theory has been criticised as given below:
(1) Wage Fund is an Imaginary Concept:
The theory assumes that there is a fixed wage fund created by an entrepreneur. But in actual practice such fund is not realistic and it is an imaginary concept.
(2) Efficiency of Workers Ignored:
The theory assumes that the wage fund is fixed and wage rate can be increased only by reducing the number of workers. But in actual practice we see that by increasing the efficiency of workers we can raise their wages. The differential wage rate is an example of this factor which has not been taken into consideration by the theory.
(3) The Demand for Labour is a Derived Demand:
The theory assumes that the demand for labour depends upon the wage fund. But in actual practice we see that the demand for labour depends upon the demand for various goods and services which are produced by the labour.
(4) Increase in Wages do not Affect the Profit:
The theory explains that with the increase in wages the profit will decrease. But when productivity and production increase wages and profit will also increase. Hence, increase in wages will not affect profit of the capitalists.
(5) Wage Differentials are not Explained:
The wage fund theory does not explain the causes of wage differentials in different parts of the country and different industries.
(6) Trade Unions Ignored:
The theory has not taken into consideration the pulls and pressures of trade unions in influencing and determining the wage rates. Trade unions play an important role in wage determination.
4. Residual Claimant Theory of Wages:
The theory was propounded by an American economist F.A. Walker. According to Professor Walker the total production of an industry is distributed among land, labour, capital and entrepreneur in the form of rent, wages, interest and profit. When the rent, interest and profit are distributed among landlord, capitalist and entrepreneur, the remaining share goes to labour which is residual claimant.
According to this theory, rent, interest and profits are determined on the basis of some principles of remuneration but there is no theory as such for the determination of wages. Thus, after the payment of rent, interest and profit from output whatever the residual share is wages.
Wage can be calculated on the basis of the following formula:
Wage rate = Total output – (Rent + Interest + Profit)
According to this theory higher the productivity high will be share of labour in output. The theory also explains the causes of wage differentials on account of productivity differentials in different organisations. Wage rates are high where the productivity is high and it is low where the productivity is low.
The theory has been criticised on the following grounds:
(1) One Sided Theory:
The theory takes into consideration the demand for labour while the supply of labour has been ignored. Wage can be determined by demand and for supply of labour as is the case of commodity pricing.
(2) Residual Claimant is Entrepreneur:
The theory explains that the residual claimant of total production is labour but in actual practice we see that the entrepreneur is the last factor of production who gets the share out of the total production in the form of profit or loss. Hence, the residual claimant is entrepreneur and not labours.
(3) No Need of Separate Theory of Wages:
When rent, interest and profit are determined by the marginal productivity theory then the wages can also be determined by the same theory and there is no need of separate theory of wage determination.
(4) Role of Trade Unions Ignored:
The theory has also ignored the role of trade unions in the determination of wages. In practice trade unions play an important role in wage determination in different industries.
5. Modern Theory of Wages:
Wage is the payment made for the services of labour. Modern theory of wages has been propounded to determine the wage. It takes into consideration the demand for labour and supply of labour for the determination of wages. It is also called demand and supply theory of wages. Wage determination is a specific form of general theory of value.
Wage Determination under Perfect Competition:
We assume that there is perfect competition in the factor market and commodity market. The demand and labour and supply of labour are studied separately with the rate and the combined effect of both the sides (demand and supply) with wage rate determination is studied and the wages are determined accordingly.
Demand for Labour:
The demand for labour is a derived demand. The demand for labour is determined by the demand for various goods and services in the economy.
When consumers demand for a particular commodity producer will also produce more of that commodity and demand for labour will increase. Contrary to it, the demand for the commodity decreases the demand for labour will also decrease.
The demand for labour is also affected by the prices of other factors of production. If other factors are cheaper the labour will be substituted by these factors and demand for labour will decrease. Contrary to it, the demand for labour will increase if other factors are costlier.
The demand for labour is also affected by the technological factors in an economy. The technological progress has reduced the demand for labour because labour saving devices are used in the production of various goods and services. Thus, the relationship between demand for labour and wage rate can be seen from Diagram 2.
Wage rate and demand for labour are shown on OY-axis and OX-axis respectively. DD is the demand curve for labour which is declining. Higher the wage rate lower will be the demand for labour and lower the wage rate higher will be the demand for labour.
Supply of Labour:
The supply of labour means the number of workers who are ready to work on prevailing wage rate. Man-days and hours of work are the variables on which the supply of labour depends.
The supply of labour is affected by social, economic and political factors in an economy. The size of population, age group and sex- ratio determine the supply of labour. The supply of labour is also affected by the hours of work and leisure preferences of workers on a given wage rate during a given period. In the beginning there may be a direct relation between wage rate and the supply of labour.
Higher is the wage rate higher will be the supply and lower is the wage rate lower will be the supply of labour. But after a point there will be backward bending of supply of labour because when workers have satisfied their wants, not only necessaries but also comforts, then they will prefer to have more of leisure and less of work.
The relation between wage rate and supply of labour can be studied with the help of the following diagram:
There is direct relationship between the wage rate and the supply of labour. After a point there is backward bending of supply curve because workers prefer leisure and work less.
The point of equilibrium of an industry will be at point where the total demand for labour is equal to its total supply.
It is explained with the help of the following diagram:
Wage rate is shown on OY-axis and demand for labour (DD) and supply of labour (SS) on the OX-axis. The wage rate is OW where the demand for labour is equal to its supply and the industry attains its equilibrium at point E. At wage rate OW1 the supply of labour is greater than its demand (PT) and the wage rate is pushed down to OW and when the wage rate is OW2 the demand for labour is greater than its supply (P1T1) and the wage rate is pushed to OW level.
Thus, during short run the wage rate may fluctuate due to imbalances between demand for labour and supply of labour but there will be stable wage rate OW in the long run where the total demand for labour is equal to its total supply.
6. Marginal Productivity Theory of Wages:
Marginal productivity theory of distribution is the general theory of factor price determination. When the same theory is applied for the wage determination then the theory is called marginal productivity theory of wages.
According to this theory under perfect competition each worker gets wage rate equal to its marginal productivity (W=MP). Marginal productivity of labour is an addition to the total productivity when an additional unit of labour is employed. It is also called marginal physical productivity (MPP).
When the MPP is multiplied by the price of a commodity we will get the volume of marginal product (VMP). Under perfect competition the marginal revenue productivity (MRP) and value of marginal productivity (VMP) are one and the same or are equal (MRP=VMP).
Labour is demanded because of its productivity. Higher the productivity of labour higher will be its demand and higher will be wage rate and lower the productivity lower will be the demand for labour and its wage rate. The wage rate is determined by the total demand for labour and supply of labour by the industry under perfect competition and individual firm adjusts its production and number of workers to be employed. The supply curve for labour will be perfectly horizontal to OX-axis.
The average wages and marginal wages will be equal (AW=MW). The point of equilibrium of an individual firm will be at point where the MRP is equal to MW (MRP=MW). When the MRP is greater than MW the firm is earning profit (MRP>MW), when MRP is lesser than MW (MRP<MW) the firm is incurring losses and normal profit when MRP is equal to MW (MRP=MW). But in the long run there will always be normal profit to an individual firm.
Assumptions of the Theory:
The MP theory of wages is based on the following assumptions:
(1) All the units of labour are homogeneous.
(2) The ratio of factors can be changed.
(3) Perfect competition in factor market (labour) and commodity market.
(4) Perfect knowledge of market conditions.
(5) Perfect mobility of labour.
(6) Long run determination of wage rate.
(7) Operation of the law of diminishing returns.
(8) Marginal productivity is measurable.
(9) Full employment.
(10) Maximisation of profit is the objective of each individual firm.
Under perfect competition the industry will determine the wage rate and individual firms will accept the wage rate as given under:
The above diagram shows the equilibrium of industry and firm. The point of equilibrium in industry at E shows that the DD and SS of labour intersects. The demand for and supply of labour are equal to OL and the wage rate is determined which is OW. At OW wage the firm employs OL labour and the firm’s average wage is equal to its marginal wages (AW=MW).
The point of equilibrium of firm is at E point where marginal revenue productivity is equal to marginal wages (MRP=MW) and marginal revenue productivity passes through the maximum point of average revenue productivity. The firm is earning normal profit and its average wage is equal to average revenue productivity, marginal revenue productivity is equal to marginal wages (AW=ARP=MW=MRP).
When the industry determines its wage at OW2 the D2D2 intersects supply curve (SS) at E2 and the demand and supply of labour are OL2. At OW2 wage rate firm is incurring losses because its average wage is greater than average revenue productivity and firm attains its equilibrium at E2 point. Here the MW is greater than MRP (MW>MRP).
When the wage is OW1 the demand and supply of labour will be OL1 where SS is intersected by D1D1 at E1. The firm attains equilibrium at E1 point where the MW is lesser than MRP and the firm is earning profit.
Thus, during short period under perfect competition there may be some firms earning profit (MW<MRP), incurring losses (MW>MRP) and earning normal profit (MW=MRP). But in the long run firms will earn normal profit (AW=MRP=MW=MRP) only because of free entry and exit of firms in industry.
Criticism of the Theory:
The marginal productivity theory of wages has been criticised on the same grounds as was done the marginal productivity theory of distribution as given under:
(1) Output is the result of collective efforts of different factors of production. Marginal productivity of labour cannot be easily calculated as the productivity is shared by other factors of production.
(2) All the units of labour are not identical or homogeneous because the efficiency differs from one unit of labour to another. There are three categories of labour—skilled, semi-skilled and unskilled.
(3) Perfect competition is an unrealistic and imaginary assumption. In practice we find imperfect competition.
(4) Assumption of full employment is also unrealistic because even developed countries have 5-10 per cent of unemployment. Hence, there is less than full employment situation.
(5) Perfect knowledge of market conditions and perfect mobility of labour are also unrealistic assumptions. Mobility of labour is also affected by non-economic factors. There is laziness and ignorance on the part of buyers and sellers in factor market and commodity market.
(6) One sided theory as it explains the demand for labour and ignores the supply of labour which is equally important in determination of wage rate.
(7) The theory is determining wage rate during long period. It fails to determine wages during short period. In the long run we all are dead and there is no economic problem.
(8) The theory does not explain the causes of wage differentials prevailing in various parts of the country as well as the different industries.