6  Theories of wages

6.1 Subsistence Theory of Wages

The Subsistence Theory of Wages is an economic theory that explains how wages are determined based on the minimum subsistence level necessary for workers to survive and maintain their ability to work.

6.1.1 Key Features of the Theory:

  1. Proposed By: The theory is often associated with classical economists like David Ricardo
  2. Core Idea: Wages tend to settle at a level just sufficient to cover the basic needs of workers, such as food, clothing, and shelter.
  3. Population and Labor Supply:
    • If wages rise above the subsistence level, workers’ living conditions improve, leading to population growth. This increases the labor supply, causing wages to fall back to the subsistence level.
    • If wages fall below the subsistence level, workers’ living conditions deteriorate, reducing the labor supply and pushing wages back up.
  4. Market Dynamics: The theory suggests that wages are regulated by the interplay of labor supply and demand within the limits of subsistence needs.

6.1.2 Criticisms:

  1. Static View: The theory ignores the possibility of improving living standards through economic growth and productivity gains.
  2. Overemphasis on Biological Factors: It overlooks social, political, and institutional influences on wage determination.
  3. Inapplicability in Modern Context: The theory is less relevant in modern economies with minimum wage laws, labor unions, and welfare systems.

6.1.3 Wage Fund Theory

The Wage Fund Theory is an economic concept that explains how the total wages paid to workers are determined by the availability of a pre-existing “fund” allocated for wages.

6.1.4 Key Features of the Theory:

  1. Proposed By: Initially developed by Adam Smith and later elaborated by John Stuart Mill in classical economics.

  2. Core Idea:

    • Employers allocate a fixed amount of capital (the “wage fund”) for paying wages.
    • Wages are determined by dividing the total wage fund by the number of workers. WAGE RATE= wage fund/Number of workers

  3. Fixed Fund Assumption:

    • The wage fund is predetermined by the capital available to employers.
    • Increases in wages per worker can only occur if either the wage fund increases or the number of workers decreases.

  4. Implications:

    • Wage levels are seen as limited by the size of the wage fund, not directly by productivity or labor demand.
    • Efforts to raise wages through strikes or negotiations were thought to be ineffective because the wage fund was considered fixed in the short term.

6.1.5 Criticisms:

  1. Inflexibility of the Wage Fund:
    • Critics, including Mill himself (later in his career), argued that the size of the wage fund is not rigid but can be influenced by economic growth, investment, and productivity.
  2. Simplistic View:
    • The theory oversimplifies the dynamics of wage determination by ignoring other factors like market forces, worker productivity, and institutional arrangements.
  3. Modern Economy Incompatibility:
    • In modern economics, wages are influenced by collective bargaining, government policies, and labor market competition, making the wage fund concept largely obsolete.

6.2 Marginal Productivity Theory

The Marginal Productivity Theory of Wages is an economic concept that explains how wages are determined based on the marginal productivity of labor. It suggests that workers are paid according to the value of the additional output they produce.

6.2.1 Key Features of the Theory:

  1. Proposed By: John Bates Clark, along with contributions from other neoclassical economists.

  2. Core Idea:

    • Wages are determined by the marginal product of labor (MPL), which is the additional output generated by one more unit of labor.
    • Employers hire workers until the cost of hiring an additional worker (wage) equals the revenue generated by their marginal product.

  3. Mathematical Representation:

    • ( W = MRP ), where:
      • ( W ) = Wage rate.
      • ( MRP ) = Marginal Revenue Product = Marginal Product (MP) × Price of Output.

  4. Assumptions:

    • Perfect competition in labor and product markets.
    • Homogeneous labor force.
    • Diminishing marginal returns: As more workers are hired, the additional output contributed by each worker decreases.

6.2.2 Implications:

  • Efficiency: The theory supports the idea that wages reflect the contribution of labor to production, ensuring efficient allocation of resources.
  • Income Distribution: Differences in wages are explained by differences in workers’ productivity.
  • Hiring Decisions: Employers are incentivized to hire more workers as long as the marginal productivity of labor exceeds the wage rate.

6.2.3 Criticisms:

  1. Unrealistic Assumptions:
    • Perfect competition and homogeneous labor rarely exist in real-world markets.
    • It ignores other factors like bargaining power, labor unions, and government interventions.
  2. Diminishing Returns Limitations:
    • The assumption of diminishing marginal returns may not hold true in some industries, particularly with technological advancements.
  3. Neglect of Social Factors:
    • Wages are also influenced by social, institutional, and cultural factors that the theory does not address.

6.3 Bargaining Theory of Wages

The Bargaining Theory of Wages explains how wages are determined through negotiations between employers and workers (or their representatives, such as labor unions). It emphasizes the role of bargaining power and the negotiation process in wage determination.

6.3.1 Key Features of the Theory:

  1. Proposed By: This theory is associated with economists like John Davidson, who introduced it as an alternative to wage theories based on marginal productivity or subsistence.

  2. Core Idea:

    • Wages are the result of a bargaining process between employers and employees.
    • The bargaining power of each side determines the outcome of wage negotiations.
    • Factors influencing bargaining power include labor market conditions, union strength, employer resources, and the availability of alternative opportunities for workers.

  3. Determining Factors:

    • Employer’s Bargaining Power: Influenced by the firm’s profitability, the availability of substitutes for labor, and market competition.
    • Worker’s Bargaining Power: Affected by union organization, skill level, alternative job opportunities, and the overall economic climate.
    • The final wage reflects a balance between the two parties’ negotiating strength.

  4. Negotiation Process:

    • Both sides aim to reach a wage level where they are unwilling to concede further.
    • Employers aim to minimize costs, while workers aim to maximize wages and benefits.

6.3.2 Implications of the Theory:

  1. Flexibility: Wages are not fixed and vary based on negotiation outcomes, labor market dynamics, and institutional factors.
  2. Role of Unions: Strong unions can significantly enhance workers’ bargaining power and improve wage outcomes.
  3. Market Influence: In periods of low unemployment, workers may have more bargaining power, leading to higher wages.

6.3.3 Criticisms:

  1. Lack of Precision:
    • The theory does not provide a clear formula or mechanism to determine wages, making it less analytical than marginal productivity or other theories.
  2. Overemphasis on Power Dynamics:
    • It assumes that wages are primarily determined by negotiation, overlooking productivity, skills, and economic value contributed by workers.

7 Criteria of Wage Fixation

Criteria of Wage Fixation refers to the principles and factors considered while determining fair and appropriate wages for employees. These criteria are essential to ensure equity, efficiency, and alignment with economic and social goals. Below are the key factors influencing wage fixation:

7.0.1 1. Cost of Living:

  • Wages should reflect the cost of basic necessities like food, housing, clothing, healthcare, and education in a given region.
  • Adjustments may be made periodically to account for inflation and changes in living costs.

7.0.2 2. Fairness and Equity:

  • Wages should be equitable, ensuring equal pay for equal work and avoiding discrimination based on gender, age, or other factors.
  • Internal equity within the organization ensures that employees performing similar jobs are compensated fairly.

7.0.3 3. Market Conditions:

  • Prevailing wage rates in the industry and region influence wage fixation.
  • Demand and supply of labor: High demand and scarce supply typically result in higher wages.

7.0.4 4. Skill and Experience:

  • Higher wages are often paid to workers with specialized skills, training, or significant experience.
  • The complexity and difficulty of the job also determine pay levels.

7.0.5 5. Productivity of Workers:

  • Wages may be linked to the output or performance of workers to incentivize efficiency.
  • High-performing employees may receive higher wages through merit-based systems.

7.0.6 6. Ability to Pay:

  • The financial health and profitability of the employer play a significant role.
  • Organizations with higher profits may offer better wages and benefits.

7.0.7 7. Standard of Living:

  • Wages should enable employees to maintain a reasonable standard of living, going beyond mere subsistence to support comfort and personal growth.

7.0.8 8. Government Policies and Legislation:

  • Minimum wage laws set the floor for wages to protect workers from exploitation.
  • Regulations related to overtime, bonus payments, and wage parity also influence wage fixation.

7.0.9 9. Collective Bargaining:

  • Wage levels can be influenced by negotiations between labor unions and employers.
  • The strength of the union and the bargaining process determine the agreed-upon wages.

7.0.10 10. Economic and Social Environment:

  • The overall economic condition, including unemployment rates, inflation, and GDP growth, affects wage fixation.
  • Social goals like reducing income inequality and promoting economic justice also play a role.

7.0.11 11. Job Evaluation:

  • Organizations may use systematic job evaluation methods to assess the relative value of jobs and fix wages accordingly.