Classical economists argue that wages—the price of labor—are determined (like all prices) by supply and demand. They call this the market theory of wage determination.

1. Wage theories
Compensation Management

2. Prepared By
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Manu Melwin Joy
Assistant Professor
Ilahia School of Management Studies
Kerala, India.
Phone – 9744551114
Mail – manu_melwinjoy@yahoo.com

3. Market theories – Wage theories
Compensation Management

4. Market theories
• Classical economists
argue that wages—the
price of labor—are
determined (like all
prices) by supply and
demand. They call this
the market theory of
wage determination.

5. Market theories
• When workers sell their
labor, the price they can
charge is influenced by
several factors on the
supply side and several
factors on the demand
side.

6. Market theories
• The most basic of these
is the number of workers
available (supply) and
the number of workers
needed (demand). In
addition, wage levels are
shaped by the skill sets
workers bring and
employers need, as well
as the location of the
jobs being offered.

7. Market theories
• The interplay between all of
these factors will eventually
cause wages to settle—that
is, the number of workers,
the number of jobs, the skills
involved, and the location of
the jobs will eventually lead
workers and employers to
reach a series of wage
agreements.

8. Market theories
• If employers (demand) cannot
find enough workers to meet
their needs, they will keep
raising their wage offers until
more workers are attracted. If
workers are in abundance
(supply), wages will fall until
the surplus labor decides to go
elsewhere in search of jobs.
When supply and demand
meet, the equilibrium wage
rate is established.

9. Market theories
• If employers (demand) cannot
find enough workers to meet
their needs, they will keep
raising their wage offers until
more workers are attracted. If
workers are in abundance
(supply), wages will fall until
the surplus labor decides to go
elsewhere in search of jobs.
When supply and demand
meet, the equilibrium wage
rate is established.

10. Human Capital theories – Wage theories
Compensation Management

11. Human Capital theories
• A particular application of
marginalist analysis (a
refinement of marginal-
productivity theory)
became known as human-
capital theory. It has since
become a dominant means
of understanding how
wages are determined.

12. Human Capital theories
• It holds that earnings in
the labour market depend
upon the employees’
information and skills. The
idea that workers embody
information and skills that
contribute to the
production process goes
back at least to Adam
Smith.

13. Human Capital theories
• It builds on the recognition
that families make a major
contribution to the
acquisition of skills.
Quantitative research during
the 1950s and ’60s revealed
that aggregate growth in
output had outpaced
aggregate growth in the
standard inputs of land,
labour, and capital.

14. Human Capital theories
• Economists who explored this
phenomenon suggested that
growth in aggregate
knowledge and skills in the
workforce, especially those
conveyed in formal education,
might account for this
discrepancy.

15. Human Capital theories
• In the early 1960s the
American economist Theodore
W. Schultz coined the term
human capital to refer to this
stock of productive knowledge
and skills possessed by
workers.

16. Bargaining theories – Wage theories
Compensation Management

17. Bargaining theories
• John Davidson
propounded this theory.
Under this theory, wages
are determined by the
relative bargaining power
of workers of their union
and of employers.

18. Bargaining theories
• The bargaining theory of
wages holds that wages,
hours, and working
conditions are determined
by the relative bargaining
strength of the parties to
the agreement.

19. Bargaining theories
• Smith hinted at such a
theory when he noted that
employers had greater
bargaining strength than
employees. Employers
were in a better position to
unify their opposition to
employee demands, and
employers were also able
to withstand.

20. Bargaining theories
• Limitations on the scope of
bargaining are also
suggested by theory.
Collective bargaining can
be seen as the reduction of
two risks to which the
worker is exposed through
individual bargaining.

21. Bargaining theories
• here is first the risk that
the worker will be merely
one of a number of
applicants for a single
vacancy and that
competition between
them will force the pay
down.

22. Bargaining theories
• In the bargaining theory of
wages, there is no single
economic principle or
force governing wages.
Instead, wages and other
working conditions are
determined by workers,
employers, and unions,
who determine these
conditions by negotiation.

23. Behavioral theory – Wage theories
Compensation Management

24. Behavioral theories
• Many behavioural scientists
— notably psychologists and
sociologists- like March and
Simon, Robert Dubin, Eliot
Jacques—have presented
their views on wages and
salaries on the basis of
research studies and action
programmes conducted by
them.

25. Behavioral theories
• It has been found that wages
are determined by such factors
as . size and prestige of the
company, strength of the
union, the employer’s concern
to maintain the workers,
contribution by different kinds
of workers, etc.

26. Behavioral theories
• Wage differentials are
explained by social norms,
traditions, customers prevalent
in the organisation
psychological pressures on the
management, prestige
attached to certain jobs in
terms of social status, need to
maintain internal consistency
in wages at the higher levels,
the wages paid for similar jobs
in other firms, etc.

27. Subsistence theory – Wage Theories
Compensation Management

28. Subsistence theory
• This theory propounded by
the economists in the 18th
century was later explained
by David Ricardo.
• This theory is based on two
assumptions, namely,
– (a) The law of diminishing
return applies to industry.
– (b) There is a rapid
increase in population.

29. Subsistence theory
• The subsistence theory
laid down that ‘the
workers are paid to
enable them to subsist
and perpetuate the race
without increase or
diminution’.

30. Subsistence theory
• If the workers were paid
more than subsistence wage,
their numbers would
increase as they would
procreate more; and this
would bring down the rate
of wages.

31. Subsistence theory
• If the wages fall below the
subsistence level, the number
of workers would decrease—as
many would die of hunger,
malnutrition, disease, cold,
etc. and many would not
marry, when that happened
the wage rate would go up.

32. Subsistence theory
• The subsistence theory is criticized on
the following grounds:
– (a) The subsistence theory does not
take into consideration the demand
for labour. It considers only the
supply of labour and the cost of
production.
– (b) This theory is based on theory of
population which is itself defective.
It is wrong to say that population
will increase if the economic
condition of the labour is improved.
These days, better economic
condition is associated with lower
birth rate.

33. Subsistence theory
• The subsistence theory is criticized on
the following grounds:
– c) In developed countries, workers
are not merely contented with
fulfillment of basic needs. They also
require luxuries of life to raise their
standard of living.
– (d) This theory does not emphasis
the efficiency of the workers.
– (e) This theory fails to explain the
wage differentials in different
regions and among different
categories of workers.

34. Wage Fund theory – Wage Theories
Compensation Management

35. Wage Fund theory
• This theory was
developed by Adam
Smith and was further
expounded by J.S.Mill.

36. Wage Fund theory
• J.S. Mill said that wages
mainly depend upon
demand for and supply
of labour or the
proportion between
population and capital
available.

37. Wage Fund theory
• The amount of Wages Fund
is fixed. Wages can’t be
increased without
decreasing the number of
workers and vice versa. It is
the Wages Fund which
determines the demand for
labour.

38. Wage Fund theory
• However, the supply of
labour can’t be changed at a
given time. But if the supply
of labour increases along
with increase in population,
the average wages will go
down.

39. Wage Fund theory
• Therefore in order to
increase the average wages,
firstly, the Wages Fund
should be enlarged,
secondly, the number of
workers asking tor
employment should be
reduced.

40. Wage Fund theory
• This theory is criticized on
the following grounds:
– (a) This theory does not
explain differences in wages at
different levels and in
different regions.
– (b) It is not clear from where
the Wages Fund will come.

41. Wage Fund theory
• This theory is criticized on
the following grounds:
– (c) No emphasis has been
given to the efficiency of
workers and productive
capacity of firms.
– (d) This theory is unscientific
as Wages Fund is created first
and wages are determined
later on. But in practice, the
reverse is true.

42. Surplus Value theory – Wage Theories
Compensation Management

43. Surplus Value theory
• Karl Marx accepted Ricardo’s
labour theory of value , but
he subscribed to a
subsistence theory of wages
for a different reason than
that given by the classical
economists.

44. Surplus Value theory
• In Marx’s estimation, it was
not the pressure of
population that drove wages
to the subsistence level but
rather the existence of large
numbers of unemployed
workers.

45. Surplus Value theory
• Marx blamed
unemployment on
capitalists. He renewed
Ricardo’s belief that the
exchange value of any
product was determined by
the hours of labour
necessary to create it.

46. Surplus Value theory
• Furthermore, Marx held
that, in capitalism, labour
was merely a commodity: in
exchange for work, a
labourer would receive a
subsistence wage.

47. Surplus Value theory
• Marx speculated, however,
that the owner of capital
could force the worker to
spend more time on the job
than was necessary for
earning this subsistence
income, and the excess
product—or surplus value—
thus created would be
claimed by the owner.

48. Surplus Value theory
• This argument was
eventually disproved, and
the labour theory of value
and the subsistence theory
of wages were also found to
be invalid. Without them,
the surplus-value theory
collapsed.

49. Residual Claimant Theory– Wage Theories
Compensation Management

50. Residual Claimant Theory
• It was Francis A. Walker who
propounded this theory.
According to him, there
were four factors of
production, viz., land, labour,
capital and
entrepreneurship.

51. Residual Claimant Theory
• The residual-claimant theory
holds that, after all other
factors of production have
received compensation for
their contribution to the
process, the amount of
capital left over will go to the
remaining factor.

52. Residual Claimant Theory
• In 1875 Walker worked out a
residual theory of wages in which
the shares of the landlord, capital
owner, and entrepreneur were
determined independently and
subtracted, thus leaving the
remainder for labour in the form
of wages.

53. Residual Claimant Theory
• Wages represent the
amount of value created in
the production which
remains after payment has
been made for all these
factors of production.

54. Residual Claimant Theory
• In other words, labour is the
residual claimant. The wages
are equal to the whole
production minus rent,
interest, and profit.

55. Residual Claimant Theory
• It should be noted, however,
that any of the factors of
production may be selected
as the residual claimant—
assuming that independent
determinations may be
made for the shares of the
other factors.

56. Residual Claimant Theory
• It is doubtful, therefore,
that such a theory has
much value as an
explanation of wage
phenomena.

57. Marginal Productivity Theory– Wage Theories
Compensation Management

58. Marginal Productivity Theory
• According to this theory,
wages are based upon an
entrepreneur’s estimate
of the value that will
probably be produced by
the last or marginal
workers.

59. Marginal Productivity Theory
• In other words, it
assumes that wages
depend upon the
demand for, and supply
of, labour.

60. Marginal Productivity Theory
• Consequently, workers are
paid what they are
economically worth. The
result is that the employers
has larger share in profit as
has not to pay to the non-
marginal workers.

61. Marginal Productivity Theory
• This theory is criticized on
the following grounds:
– (a) It is wrong to assume
that more labour could be
used without increasing
the supply of production
facilities.
– (b) This theory is based
on perfect competition in
the market which is
seldom found in practice.

62. Marginal Productivity Theory
• This theory is criticized on
the following grounds:
– (c) In practice, the
employers offer wages
less than the marginal
productivity of labour. In
many cases, the labour
unions are able to bargain
for wages higher than the
marginal productivity of
labour.

63. Purchasing Power Theory– Wage Theories
Compensation Management

64. Purchasing Power Theory
• The purchasing-power
theory of wages concerns
the relation between wages
and employment and the
business cycle.

65. Purchasing Power Theory
• It is not a theory of wage
determination but rather a
theory of the influence
spending has (through
consumption and
investment) on economic
activity.

66. Purchasing Power Theory
• The theory gained
prominence during the
Great Depression of the
1930s, when it became
apparent that lowering
wages might not increase
employment as previously
had been assumed.

67. Purchasing Power Theory
• The theory is based on the
assumption that changes in
wages will have a significant
effect on consumption
because wages make up
such a large percentage of
the national income.

68. Purchasing Power Theory
• It is therefore assumed that
a decline in wages will
reduce consumption and
that this in turn will reduce
demand for goods and
services, causing the
demand for labour to fall.

69. Purchasing Power Theory
• If wages fall more rapidly
than prices, labour’s real
wages will be drastically
reduced, consumption will
fall, and unemployment will
rise—unless total spending
is maintained by increased
investment, usually in the
form of government
spending.

70. Purchasing Power Theory
• Conversely, if wages fall less
rapidly than prices, labour’s
real wages will increase, and
consumption may rise. If
investment is at least
maintained, total spending
in terms of constant dollars
will increase, thus improving
employment.

71. Purchasing Power Theory
• It should be noted that the
purchasing-power theory
involves psychological and
other subjective
considerations as well as
those that may be measured
more objectively.