Wages are the remuneration that is provided by the employer to the employees for the service they provide to him. Wages are usually fixed and paid at consistent intervals of time. There are different theories proposed by economists in fixing wages. These theories are of high essence because of the economic conditions and standard of living of the workers considered while proposing these theories.
Table of Contents
The Wage Theories
On a broad classification, there are 6 major wage theories:
- The Subsistence Theory of Wages
- The Standard of Living Theory
- Wage Fund Theory
- Residual Claimant Theory
- Marginal Productivity Theory
- Discounted Marginal Productivity Theory
Subsistence Theory of Wages
The Subsistence Theory of Wages [1] was formulated by Lassale, a German economist. He was a physiocrat and believed that wages would be equal to the amount just sufficient for subsistence. The subsistence level refers to the cost of production of labour. So as per this theory, wages should be fixed according to the cost of production of labour.
Lassale has mentioned the possibility of 2 circumstances and thereby emphasised the need of fixing wages at the subsistence level. Firstly, when the actual wage is more than the subsistence level, the population will increase, which will increase the labour force thereby leading to a decrease in wage per head. Secondly, when the actual wage is less than subsistence level, the population will decrease, which will decrease the labour force leading to an increase in wage per head. Either of these situations would shift the balance of the market which would be detrimental in the future.
Therefore, this leads to a fixed wage rate in the market and hence this wage theory is also known as Iron Law of Wages or Brazen Law of Wages.
There are 2 assumptions associated with the Theory of Subsistence:
- Food production is subject to the law of diminishing returns, i.e., there is a limit to expansion of food production.
- Population increases at an increasing rate.
However, there were some critical spaces which were left open by this theory. Here are the major criticisms of the Subsistence Theory of Wages:
- This theory only views wages from a supply perspective and gives no recognition to demand side wages.
- This theory ignores different wages by stressing on equal wages for all with its support to supply side wages.
- The assumption of fixed wages at the subsistence level ignores the role of different unions in fighting for wage increment.
- This theory states that a rise in wage above subsistence level will increase the population whereas in practice it is the purchasing power which increases with rise in wage.
The Standard of Living Theory
This theory [2] was proposed in continuance to the criticisms of the Subsistence Theory. British Economist, John Hicks proposed this theory as a remedial addition to the Subsistence Theory. As per him, wages are determined by the standard of living of the workers. Standard of living is an economic principle which refers to the bare necessities of life such as health, food, education etc., in giving an individual a meaningful life. All nations strive to maintain a high standard of living of its citizens as it shows the progress of the nation.
Emphasizing on standard of living, this theory gave importance to the efficiency and productivity of the workers and it also gave a fair chance to workers to improve their standard of living when there is an increase in wage.
Even though this theory conceptualised wage in a more holistic manner, there were several criticisms regarding this theory:
- Firstly, there is no fixed standard of living and hence it cannot be used as a factor in determining real wages in the market.
- Moreover, the vice versa of the theory is true in general practice. Wage affects standard of living more than standard of living affecting wages.
- As per the theory, if there is a change in standard of living, the wages must change accordingly, but there have been numerous instances where even though wages have not changed, the standard of living was at a rise due to government policies.
Wage Fund Theory
The Wage Fund Theory [3] was developed by J.S.Mill. He formulated this theory on the dependence between the wage fund and the number of workers employed. The wage fund is basically an account set-up by the employers out of their capital earnings.
As quoted by J.S.Mill, “wages depend upon the demand and supply of labour or as it is often expressed as proportion between population and capital. By ‘population’ here meant the number only of the laboring classes or rather of those who work for hire and by capital, only circulating capital”. J.S.Mill implies both the demand and supply aspect of the labour-wage mechanism, which is directly related to the capital earnings of the employer.
Therefore, the Wage Rate = Wage Fund / Number of Labourers
Even though this theory gave a numerical representation of ascertaining wages by considering a real capital approach, economists highly criticised this approach. Here are some of the major criticism faced by the Wage Fund Theory:
- Even though a numerical representation of wage rate has been provided, no inference has been made as to the source of the wage fund and estimating it.
- This theory neglects the concept of minimum wages as it purports to estimating a wage fund and thereby paying wages out of it. In reality, wages must be first determined and the wage fund should be fixed depending on the allocation made for paying wages.
- This theory assumes that wages can increase only at the expense of profit. This is not correct. The operation of the law of increasing returns will lead to a great increase in total output which may be sufficient to raise both wages and profits.
- It does not explain the difference in wage rates which are directly affected by the efficiency of the workers and their power of bargaining by forming various unions.
- This theory assumes that wages are paid out of the circulating capital, but wages can be paid out of the current production capital as well when the overall production process is short. When the production process is long, the wages can be paid out of the capital assets of the production house.
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Residual Claimant Theory
This theory[4] was propounded by American Economist Francis Walker. As per Walker, wage is dependent on the interest, rent and profits, which together constitute the factors of production. Both interest and rent are contractual payments according to this theory. From the total product, firstly the contractual payments will be deducted. After the rent and interest is deducted, the owner will deduct his profits. The leftover amount would be distributed as wages. So, wages are the residuary of contractual and personal payments of the owner.
But there are certain drawbacks of this residual claimant theory. These are the major drawbacks:
- The Theory has not given any significance to supply side labour and has focused on the residuary labour ratio.
- The Residual Claimant is the producer/owner and not the labourer. This works in favour of the claimant and the whole essence of proposing a wage theory would be ineffective.
- This theory assumes that interest, rent and profits are shared in an equal proportion amongst capitalists, landlords and entrepreneurs, which is a wrong assumption because the proportion varies significantly as to the nature of work.
Marginal Productivity Theory
The Marginal Productivity Theory [5] was formulated by John Clark and Philip Wicksteed in the 19th century. Under this theory, the wage for labour should be equal to the marginal product under a perfect competition. Marginal Product (MP) is the addition to Total product by an increase of 1 unit of factor of production (here labour). This theory is posted as an extension to the Marginal Productivity Theory of Distribution.
When there is an increase in labour, there would be an increase in factor cost for that labour. This increase in cost is known as Marginal Factor Cost (MFC). Under a perfectly competitive market, the producer will keep on employing labourers till the situation where the MP = MFC. The employment of one additional worker would increase the cost as well as the output.
The employer will keep on employing labourers when the MP > MFC. Once MPP = MFC, the employer will stop employing labour force as the market reaches an optimum level and if any addition happens after this stage, then it will lead to a diminishing return.
This theory has certain fundamental assumptions:
- Firstly, the conditions are similar to a perfectly competitive market, where there are a large number of buyers and a large number of sellers selling homogeneous products.
- All the units of labour are identical and homogeneous in nature.
- All buyers and sellers have perfect knowledge about the market conditions.
- There is free entry and free exit prevailing in the market.
- The Law of Diminishing Returns operates freely in the line of production. This means that once the producers exceed the optimum limit of employing workers, they will start experiencing negative returns.
- All factors of production are substitutes for each other and can be perfectly mobilized in the market. This means that a worker can easily move from one firm to another firm in the market without affecting the market conditions.
Alfred Marshall strongly rejected this theory by analysing the various assumptions that were taken into consideration and also stated that demand and supply must be given equal importance while estimating wages and went on to state that this theory could be a part of framing wage estimates but would not exhaustively comprise wage estimation. Various other economists have also found this theory to be unsatisfactory and have raised various criticisms:
- This theory has omitted supply side economics in toto and focused only on demand aspects.
- The theory is unjust in the nature that it considers Marginal Productivity in determining wages, whereas wages must be determined by the Average Productivity of the worker.
- The assumption that factors of production are perfect substitutes are mobilized in the market is a fallacy because individual talents and skills differ and mobilization is perfect only in theory.
- The assumption of perfect competition is deterred by imperfect competition prevailing in the practical world.
- Factors of production are indivisible and therefore Marginal Productivity cannot be calculated.
Discounted Marginal Productivity Theory
Due to a variety of criticisms of the Marginal Productivity Theory, Taussig gave a modified version and proposed the Discounted Marginal Productivity Theory[6]. He introduced the concept of discounted marginal productivity and stated that wages would therefore depend on the discounted marginal productivity and not the marginal productivity.
The production process has many stages and hence marginal productivity cannot be effectively calculated for a short interval of time. But the labourers cannot wait for the entire production process to get over to be paid their wages. At the same time, the employer does not have the funds to pay the workers at a rate equal to the marginal product. In order to arrive at a break even stage between the employer and the employees, a discount rate is determined which is basically a percentage deducted at the current interest rate from the expected final output. Therefore, this discounted rate determines the wage of the workers.
This theory was also coupled with certain criticisms:
- The estimation of discount rate is ambiguous and tedious. It is very difficult to estimate what would be the discount rate fit for an appropriate wage rate.
- It does not take into account other factors affecting wage and revolves only around the productivity and discount factor.
- This theory does not explain wage gaps and change in wage rates.
Conclusion
Apart from these 6 theories, there are many wage theories formulated by different economists who view wage fixation using different aspects. What is essential to note is that whatever maybe the theorem there will be certain merits, at the same time there will be fallacies and criticism against such theory. The last decider of the wage becomes the Government, which plays a vital role in distribution of wage and fixing minimum wage rates which all employers must follow.
REFERENCES
[1] The Top 6 Theories of Wages (With Exceptions), available at: https://www.economicsdiscussion.net/theories-of-wages/top-6-theories-of-wages-with-criticisms/21067 (last visited on December 09, 2020).
[2] Supra note 1.
[3] Supra note 1.
[4] Top 7 Theories of Wages – Explained!, available at: https://www.yourarticlelibrary.com/employee-management/wages/top-7-theories-of-wages-explained/35346 (last visited on December 09, 2020).
[5] Supra note 1.
[6] Supra note 1.
BY NAGANATHAN RAMASWAMY IYER | SASTRA DEEMED TO BE UNIVERSITY