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Home Wages How are Wages Determined/Theories of Wages Determination


How are Wages Determined/Theories of Wages Determination:


There are various theories of wages which lave been put forward by different economists from time to time but none of them is free from criticism. The most important theories of wages determination are:

(1) Subsistence Theory of Wages.

(2) Wage Fund Theory.

(3) Residual Claimant Theory.

(4) Marginal Productivity Theory.

(5) Modern Theory of Supply and Demand.


Let us now explain these theories one by one.

(1) Subsistence Theory of Wages/Iron or Brazen Law of Wages:

The subsistence theory of wages
owes its origin to Physiocratic School of France. The theory is also named as Iron or Brazen Law of Wages. According to this theory:


"The wage in the long run tends to be equal to the minimum level of subsistence. By 'minimum level of subsistence is meant the amount which is just sufficient to meet the bare necessities of life of the worker and his family".


It is argued that if wages exceed the subsistence level, the labor will marry earlier and will produce more children. This will result in the increase in number of workers than what is required by employers. So the money wages will fall to the level of subsistence. If wages remain below the subsistence level, the labor will not be able to maintain their families. Due to starvation and malnutrition, etc. the death toll will increase. The-supply of labor will fall short of demand and the wages would go up to the subsistence level.

Criticism on Subsistence Theory of Wages:

This theory has beep criticized on the following grounds:

(i) It is incorrect to say that when the money income of a person increases above the subsistence level, he marries early and the birth rate increases. On the other hand, the fact is that when the income increases, it is generally followed by a higher standard of living and the workers do not produce more children.

(ii) The theory fails to explain the wage differences in different employments. According to the theory, the wage rate tends to be equal to the subsistence level of all the workers. So then, how is it that wages differ from occupation to occupation and from person to person The theory has nothing to say in defense of this criticism.

(iii) The third criticism levied on the subsistence wages is that it entirety ignore the demand side of the labor and emphasizes only the supply side for the determination of the wages.

(iv) The theory does not take into account the influence of trade unions in the determination of wage rate though it is one of the every important factor to be taken into consideration.

(2) Wage Fund Theory:

theory of wage fund first introduced in Economics by Adam Smith and later on it was developed by J.S. Mill. The theory briefly explains that:


"Wages depend upon the proportion between population and capital, or rather between the number of laboring classes who work for hire and the aggregate of what may be called the wage fund which consists of that part of circulating capital which is expanded in the direct hire of labor".


In short, we can say, wage fund is that amount of' floating capital which is set apart by employers for paying wages to the labor. The average wage rate is determined by dividing the wage fund by the total number of workers employed.


Formula for Wage Fund Theory:


Wage Rate =         Wage Fund        

                                                                              Total Number of Workers

If it is desired that the average rate should increase, it can be achieved in two ways. Firstly, by increasing the floating capital and secondly by reducing the number of workers.

Criticism on Wage Fund Theory:

The theory has been subjected to a great deal of criticism by Longe, Thornton and Jevon on the following grounds:

(i) There is no special fund which is particularly meant for the payment of wages to the workers. The wages are paid out of the national dividend which is a flow and not fixed like that of fund.

(ii) The theory is inadequate to explain the wage differences in different occupations.

(iii) The theory gives undue importance to the supply side. It makes wrong assumption that the demand for labor remains constant.

(iv) The theory assumes that labor is homogeneous but in fact it is heterogeneous.

(v) The level of wages do not necessarily depend upon remuneratory capital. In newly developed countries, the capital available is generally less than the established countries but there the wages are relatively higher because of the greater productivity of each worker.

(3) Residual Claimant Theory:

Residual claimant theory is associated with the name of American economist Walker. According to Walker:


"Wages equal to Whole product minus rent interest and profit".


Jevon has stated the theory of residual claimant in the following words:


"The wages of a working man are ultimately coincident with what he produces, after the deduction of rent, taxes and the interest on capital".

In short, the theory states that labor receives what remains after payment of rent, interest, profit and taxes out of the national dividend.

Criticism on Residual Claimant Theory:

The theory has been criticized by
Longe and Thornton on the following points:

(i) The theory ignores the influence of supply side in the determination of wages.

(ii) If fails to explain as to how the trade unions raise the wages of the workers.

(iii) It is also point out that the residual claimant is the entrepreneur and not the labor. The labor gets his share during the process of production of a commodity.

(4) Marginal Productivity Theory of Wages Under Perfect Competition:

Some of the modern economics explain the determination of wages by means of marginal productivity analysis. According to this theory:


"Wages in perfect competition tend to be equal to the marginal net product of a labor. By marginal net product of a labor is meant net addition or net subtraction made to the value of the total produce of a firm when one unit is added or withdrawn from it".


When an entrepreneur employs a unit of labor, how much he pays to him as wages depend upon the addition which he makes to the total revenue of the firm. If the addition made to the total revenue by a labor is $5000, the rate of wages wilt be equal to $5000. The entrepreneur will not pay him more than the return which he contributes to the total production.

The aim of the firm, as we already know, is to maximize profits. If the net product of a labor is higher than the amount paid to him. the entrepreneur will go on employing more units of labor. As he engages more and more units of labor, the net produce on the successive units begins to diminish. It is not because the successive units of labor are in any way inferior to the previous units but because of the operation of law of diminishing returns. When the net product of the labor becomes equal to the rate of wages paid to him, the employer discontinues the employment of further unit of labor, The last unit which he thinks just worth while to engage is called the
marginal  unit. The net addition made to the total revenue of a firm by the marginal labor is called the marginal net product. The rate of wages paid to the labor tends to be equal to the marginal net product of the labor employed '<' the margin.

As we have assumed that all units of labor are of the same grade, the remuneration which is paid to the marginal labor will be given to all the units of labor employed earlier. If any worker demands more than the marginal net product of the labor, he will not be engaged by the employer.

Professor Taussing has reproduced the marginal productivity theory of wages
in a slightly refined form. According to him:


"Wages tend to be equal not to the marginal net product but the discounted marginal net product of the labor employed at the margin".


When goods are produced, he says, they are not sold at the same time. There is a time lag between the production and the sale of the commodities. The labor receives their remuneration during the course of production. If the prices of goods fail, the entrepreneur will have to undergo losses as he has paid the wage to the labor keeping in view the prices of the goods prevailing at that time. As the entrepreneur has borne the risk, so he should pay little less that the actual marginal net product of the labor keeping in view the risk of fluctuation of price. Secondly, the entrepreneur has to pay interest on the capital invested. So a deduction at the current rate of interest is to be made from the final output of the labor. Thus, we find that wages according to Taussing tend to be equal not to the marginal net-product but discounted marginal net product of a labor employed at the marginal.

Criticism on Marginal Productivity Theory of Wages:

The theory of marginal net product of wages has been criticized on the following grounds:

(i) The theory assumes that there is perfect competition, among the entrepreneurs and the wage earners while in the real world there is no such perfect competition.

(ii) The theory assumes that all units of labor engaged are perfectly homogeneous but the fact is otherwise.

(iii) The theory also assumes perfect mobility amongst the labor but the assumption does not held good in the real life.

(iv) The theory emphasizes on the demand side of the problem and makes a wrong assumption that the supply of labor remains constant.

It is dear now that marginal net product theory of wages is true only under certain assumed conditions. In. spite of the flaws which have been discussed above, it offers a bit satisfactory explanation of the wages.


(5) Modern Theory of Wages:


Wages Determination Under Perfect Competition:

We have studied various theories which explain the determination of wages but they all stand discredited as they do not offer satisfactory explanation of wages. The modern economist are of the opinion that just as the price of a commodity is determined by the interaction of the forces of demand and supply, the rate of wages can also be determined in the same way with the help of usual demand and supply analysis. Let us now discuss in brief as to what we mean by demand for and supply of labor.

(A) Demand for Labor:

There are various factors which influence the demand for labor. These factors in brief are as under:-

(i) Demand for labor is a derived demand. The demand for labor is not a direct demand. It is derived from the demand for the commodities and services it helps lo produce. If the demand for a product is high in the market, the demand for labor producing that particular type of product will also be high. In case, the demand for a commodity is small, the demand for that labor will also be low.

(ii) Elasticity of demand for the product. If the demand for a particular product is inelastic, the demand for the type of labor that produces this product will also be inelastic. The demand for labor will be elastic, if cheaper substitutes of the product are available in the market or the demand for the commodity it produces is elastic.

(iii) Proportion of labor cost to total cost. If the wages of workers account for only a small proportion to total cost of a product, then the demand for labor will tend to be inelastic. In a capital intensive industry, for instance, a slight increase in the workers wages with have little effect on the unit cost of product; So, the rise in wages will not reduce the demand for labor.

(iv) Availability of substitutes for labor. If the substitutes of labor producing a particular product are easily available in the market, the demand for labor will then be elastic.

After considering the various factors which influence (he demand for labor, we now take up the demand price of labor.

Demand Price of Labor:

Marginal Revenue Productivity (MRP). An employer hires labor in order to make profit. He, while employing a worker, compares the cost of hiring a worker to the contribution he is expected to make to the total revenue of the firm. So long as the addition made by the labor to the revenue is greater than the cost of employing him, the entrepreneur will engage that labor. In other words, we can say that so long as the marginal revenue product of labor is higher than the cost of employing him, the employer employs that worker. The entrepreneur will continue hiring the worker up to the point at which the cost of employing a worker is just equal to the marginal revenue product of the labor.

The marginal revenue productivity of labor due to the operation of law of diminishing returns decreases, as more workers are put to work. The wage rate also decreases with the fall in the MRP of labor. Thus the demand curve for labor is downward, sloping (The demand curve for labor is the MRP curve of the firm as each worker earns what his labor is worth). If we add up the demand curves for labor of all the individual firms (the MRP curves) we get the demand curve of the industry, it is the demand of the industry which determines wage rate for labor. The individual firm in a competitive market has to accept wage rate set in the market.

Diagram for Demand Price of Labor :

The demand for labor of an individual firm in a competitive market is explained with the help of diagrams.20.1(a) and 20.1(b).


In a competitive labor market, a firm employs 100 workers at a wage rate of $10 each per hour and 250 workers at the wage rate of $2 per hour, see fig 20.1(a). The demand curve of the industry for labor is down sloping. In fig 20.1(b) the demand curve of the industry for labor is derived from the total summation of the demand: curves of the individual firms. The total demand of all the firms in the market is 2000 workers at the wage rate of $10 per hour.

(B) Supply of Labor:

Supply of labor is the number of hours of work which the labor force offers in the factor market. The supply of labor for the entire economy is influenced by various factors such as wage rate, size of population, age composition, availability of education and training, the length of training period, provision of opportunities for women to work, the social security programmes etc., etc.

The supply of labor for the industry as a whole is less elastic in the short-run. The supply of labor here depends on the availability of workers in the locality and from the nearby areas and the willingness of the labor to work overtime. In the long-run, the supply of labor for the industry is more elastic. The labor can be attracted by offering higher wages, providing training facilities, making working conditions pleasant etc, So the supply of labor for the industry is of the normal shape rising upward from left to the right.


Diagram for Supply of Labor:

In the figure (20.2), supply curve of labor to an industry shows an upward slope.



At OW  wage rate, ON workers are ready to work. At OW1 wage, the supply of labor increases to ON1.

Wage Determination:

So far we have discussed the forces operating behind the demand for and supply of labor in the market. As regards the price or the wage of particular grade of labor, it is determined by the interaction of the forces of. demand for and supply of labor in the competitive market. The determination of wage, rate is explained with the help of diagrams.


Diagram of Wage Determination:

In fig. 20.3(a) DD/ is the demand curve of labor say carpenters to the industry.



It is found by summation of the demands of carpenters of all the firms. Similarly SS represents the supply curve of carpenters to the industry. The market demand curve DD/ intersects the market supply curve SS at point N. The equilibrium wage rate is NL or $20 and the number of workers hired at the equilibrium wage rate ($20) is 200 thousand.


Fig. 20.3{b) shows that a firm in a competitive market takes the market wage rate of carpenters as given. So the supply curve which it faces is a horizontal one. A firm will continue hiring labor so long the MRP is higher than the wage rate. When the MRP and the wage rate are equal, it will stop employing further labor. The firm at the wage rate of $20 per hour employs 40 workers. We, thus, conclude that in a competitive market, the wages are set in the market much like other prices.


Relevant Articles:


Definition of Wages
Various System of Wages Payments
Payments of Wages on the Basis of Form/Kinds of Wages
Why Wages of Women Lower Than Men
How are Wages Determined/Theories of Wages Determination
Nominal and Real Cost of Labor
Minimum Wage

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance

History of Money

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