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The marginal productivity theory of wages emerged from a debate over the wage-fund doctrine. This doctrine held that wages were paid from a fixed fund laid aside to pay workers. Despite the patent unrealism of such a theory, it had a number of supporters. A fierce controversy between the supporters and the critics of the doctrine ensued in 1870-90. Following this controversy, J.B. Clark and others proposed the marginal productivity theory of wages as an alternative.
The marginal productivity theory of wages is a highly aggregative, demand side theory of wages that takes the firm as the starting point. In essence, it holds that in a competitive economy, the marginal productivity of labour determines the demand for labour, and the demand for labour determines its price. To bring out the logic of this theory, let us make the following assumptions.
Assumptions:
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1. The product and input markets are perfectly competitive.
2. The analysis is in the short run, where only labour may be varied.
3. The supply of labour is fixed at some historically given level.
4. Ceteris Paribus: All other things, such as tastes, incomes and technology remain constant. Firm’s demand for labour
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Under these assumptions, the firm’s equilibrium is defined by conditions [1] and [2] –
Pfi = pl and pfll< 0
which gives the demand for labour x, and its characteristics as –
pl = price of services of labour or wage rate,
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p = product price,
fl-1(pl/p) is the demand function of labour and it depends upon the marginal productivity of labour fl,
When labour alone is variable, its demand depends only on the wage rate and product price. And the form of dependence is determined by the marginal productivity of labour (fl). In this sense, the marginal productivity of labour determines the firm’s demand for labour at any wage rate and product price.
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Firm’s Demand Curve for Labour:
Assuming the product price to be given, the firm’s demand curve for labour is the same as the falling portion of its value of marginal product curve, VMPl. This is shown in Fig. 14.3. This curve shows the demand for labour at any wage rate, say p0l. It can be seen that at p0l, x0l, both the conditions for equilibrium [1] and [2] are satisfied. This is why only the falling portion of the VMPl is taken. The rising portion of VMPl does not satisfy condition [2].
Market Demand Curve for Labour:
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On the basis of the firm’s demand curve for labour, the market demand curve for labour is constructed. The naive version of the theory aggregates the firms’ demand curves in the industry and across industries over the economy as a whole. In contrast, the sophisticated version takes the firm’s demand curve only as an analogy for the aggregate demand curve. This version is essentially macroeconomic, because it derives from broad aggregates rather than individual behaviour.
Pricing of Labour:
The market demand curve for labour is set against the fixed supply (S1) of labour to determine its price, as is shown in Fig. 14.4. Since the supply (S1) of labour is fixed, the demand for labour alone determines the price of the services of labour. Thus, we see that if the demand for labour falls from D1 to D2, the wage rate, too, falls from 12 p1l to p2l.
Since the demand curve for labour is derived from the marginal productivity of labour (given the product price), we may say that the marginal productivity of labour determines the price of the services of labour.
Criticisms:
The above proposition is fraught with difficulties:
1. Usually, supply conditions also play a role. This is because the supply of labour is not fixed but is responsive to the wage rate. If we allow the supply curve of labour to become elastic, as is the case with S2 in Fig. 14.4, we see that the fall in the wage rate is arrested at p0l when the demand curve falls. This is a higher wage rate than when the supply was fixed. Thus, supply of labour, when and to the extent it is sensitive to the wage rate, also determines the wage rate. The determination of the wage rate is not exclusively the work of demand side forces representing the marginal productivity of labour.
2. Even on the demand side, marginal productivity of labour does not occupy a solus position. The demand for the product also affects the demand for labour. Figure 14.5 explains how this may happen.
Suppose the wage rate decreases from p1l to p2l (1). Every firm demands more labour (2:L1→ L2) in the hope of producing and selling more than before, at product price p1. This action by all the firms shifts the product supply curve to the right (3), with Q2 now being offered at the price p1. Since the demand for the product is not infinitely elastic at p1, the increase in supply precipitates a fall in the product price (4).
The fall in the product price reduces the value of the marginal product of labour, shifting the VMP, curve down (5). As a result, the net increase in the demand for labour after the product price adjustment is only from L1 to L3 (6).
The above argument shows that unless the product demand is infinitely elastic at the going product price, it also determines the demand for labour.
3. The demand for labour in different industries are not independent of each other. It is vertically linked because many industries use as inputs, the output of others. It is also horizontally linked because the outputs of several industries are treated as substitutes or complementaries by buyers. Due to this interdependence of industry demand curves, the ‘one plus one equals two’ type of summation underlying the market demand curve for labour can be quite misleading.
4. Finally, and fundamentally, labour is not the sole variable input, even in the short run. In the short run, materials and fuel can be varied along with labour. In general, this means that the demand curve for labour cannot be derived from the marginal productivity of labour alone. Thus, if materials are also variable along with labour, the equilibrium conditions read –
Since fl and fm are both functions of labour as well as materials, the two equations [2] and [3] have to be solved simultaneously to derive the demand for labour (and materials). Thus the demand for labour does not depend on its marginal productivity alone.
It is possible to explain this graphically as in Fig. 14.6. Here we assume that labour and materials are ‘gross’ complementaries, so that more materials will be purchased when labour is cheaper. Now, suppose the price of the services of labour declines (1). By VMPl, the demand for labour expands to L2 (2). But when labour is cheaper, more materials are used. In general, the use of more materials will displace the VMPl, say upwards (i.e. fml > 0).
Since the VMP, shifts with a change in the price of labour services (3), it cannot be used as a demand curve to determine the price of labour services or the wage rate. Thus the derivation of the demand curve of labour solely from the marginal productivity of labour is no longer warranted when other inputs can also be varied.
Monopolistic Exploitation:
Although the marginal productivity of labour does not ‘determine’ the wage rate, its value is nevertheless equal to the wage rate in perfect competition. Equality of VMP, with the wage rate is one of the conditions for equilibrium in perfect competition when labour is variable.
Some writers consider the just of the marginal product as the ‘right’ compensation for labour. Going by this norm, Pigou defines exploitation of labour as a situation where wage is less than the marginal physical product of labour valued at its selling price.
That is to say, labour is exploited when the wage is less than VMPl.
In perfect competition, output is stretched to the point where VMPl equals the wage rate. In contrast, a monopoly restricts its output to a level where the marginal revenue product of labour equals the wage rate. Since marginal revenue is less than the product price, the marginal revenue product is less than VMPl. Hence the wage rate which equals MRPl under monopoly is less than VMPl. This has been called the monopolistic exploitation of labour.
‘Exploitation’ of labour, here, is only another way of describing a restriction of employment. It does not imply the ‘expropriation’ of surplus, as the Marxian usage suggests. In fact, the monopolist may make no surplus at all, even when he ‘exploits’ labour. This happens when the product demand curve is tangential to the average cost curve of the monopolist. In such an event, price equals average cost so that no abnormal profit is made. However, at the equilibrium output, the wage rate equals MRPl which is less than VMPl. This is a case of ‘exploitation’ without profit!
Since monopolistic exploitation only refers to a restriction of employment and output, Samuelson suggests that it is exploitation of labour and other transferable resources and society in general, and not just of labour. Society as a whole is exploited under monopoly, he says, because its choice between goods and leisure, and goods in general is distorted under monopoly.
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