Theory of wages

Wages

The term 'wage' has been defined as a sum of money paid under contract by an employer to a worker for services rendered. A wage payment is essentially a price paid for a particular commodity, viz., labour services. According to the classical wage theory, labour supply was considered a function of real wages. But according to Keynes, the workers acted irrationally and generally bargained for money wages and they sharply reacted against any cut in money wages. The money wage has also been called nominal wage. But money wages alone may not give us a correct idea of what a worker really earns, it is the real wage that determines the standard of living of a worker

Factors determining Real Wages:

Following are the factors that determine the real wages or the standard of living of a worker:

(a) Purchasing Power of Money: The purchasing power of money is used to compare wages at different places and at different times. It varies inversely with the price level, i.e., higher the prices, lower the purchasing power, and vice versa. A part of high wages in England and North America may be due to higher prices prevailing in those countries/regions.

(b) Subsidiary Earnings: Subsidiary earning is the income in addition to the regular money wage, an employee has in the form of money or goods. For example, free board and lodging are provided to the domestic servants or peons; professors earning additional income by marking examination papers, etc.

(c) Extra Work without Extra Payment: If an employee is required to do extra work without any compensation, his real wage is reduced by that extent.

(d) Regularity or Irregularity of Employment: Regular or more secure employment may be given money wages, but their real earning may be higher than irregular and unsecured employees receiving higher money wages.

(e) Conditions of Work: Some occupations are healthier than others, and in some the hours of work are shorter than in others. All these things are taken into account in evaluating real wages.

(f) Future Prospects: A low money income will be considered a high real wage if there are good prospects of a rise in the future.

Theories of Wages:

(a) Subsistence Theory: This theory was originated with the Physiocratic School of the French economists and was developed by Adam Smith and the later economists of the classical school. The German economist Lassalle called it the Iron Law of Wages or the Brazen Law of Wages. Karl Marx made it the basis of his theory of exploitation.

According to this theory, wages tend to settle at the level just sufficient to maintain the worker and his family at the minimum subsistence level. If wages rise above the subsistence level, the workers are encouraged to marry and to have large families. The large supply of labour brings wages down to the subsistence level. If wages fall below this level, marriages and births are discouraged and under-nourishment increases death rate. Ultimately, labour supply is decreased, until wages rise again to the subsistence level. It is supposed that the labour supply is infinitely elastic, that is, its supply would increase if the price (i.e. wage) offered rises.

Criticism: This theory is almost completely outdated and has no such practical application, especially in advanced countries. The theory was based on the Malthusian Theory of Population. It is inappropriate to say that every increase in wages must inevitably be followed by an increase in birth rate. An increase in wages may be followed by a higher standard of living.

(i) Ricardo was one of the exponents of the subsistence theory. He stressed the influence of custom and habit in determining what was necessary for the workers. But habits and customs change over time. Hence, the theory cannot hold good for a longer period of time, especially of a world characterised by fast changing habits. Ricardo, therefore, admitted that wages might rise above the subsistence level for an indefinite period in an improving society.

(ii) The second criticism against this theory is that the subsistence level is more or less uniform for all working classes with certain exceptions. The thoery, thus, does not explain differences of wages in different employment.

(iii) The third criticism is that the theory explains wages only with reference to supply; the demand side has been entirely ignored. On the demand side, the employer has to consider the amount of work which the employee gives him and not the subsistence of the worker.

(iv) The fourth criticism is that the theory explains the adjustment of wages over the lifetime of a generation and does not explain wage fluctuations from year to year.

(v) The fifth and the final criticism is that the term 'subsistence' has a very vague impression. Does it refer to the minimum requirements of a modern man or of a tribal savage?

(b) Wages Fund Theory: This theory is associated with the name of J.S. Mill. According to Wages Fund Theory wages depend upon two quantities, viz.:

(i) The wage fund or the circulating capital set aside for the purchase of labour, and

(ii) The number of labourers seeking employment.

Since, the theory takes the wage fund as fixed, wages could rise only by a reduction in the number of workers. According to this thoery, the efforts of trade unions to raise wages are futile. If they succeeded in raising wages in one trade, it can only be at the expense of another, since the wage fund is fixed and the trade unions have no control over population. According to this theory, therefore, trade unions cannot raise wages for the labour class as a whole.

Criticism: This theory has been widely criticised and stands rejected now. Even J.S. Mill himself recanted it in the second edition of his book 'Principles of Political Economy'. Mill thought that wages were paid out of circulating capital alone. Whether the source of wages is capital or the present products, has been the subject of a keen controversy in the past. The fact is that in some cases, where the process of production is short (e.g., final stages of the productive process), wages are paid out of the present production. On the other hand, when a process of production is long, the labourer obviously does not obtain wages from the product of his labour either directly or through exchange. In such cases, wages mainly come out of capital. This theory is inapplicable in highly industrialised countries, but, it is applicable in an under-developed country suffering from capital deficiency, where the wages cannot be increased unless national income is increased and capital accumulated through industrialisation.

(c) Residual Claimant Theory: The Residual Claimant Theory has been advanced by an American economist Walker. According to Walker, wages are the residue left over, after the other facts of production have been paid. Walker says that rent and interest are governed by contracts but profit is determined by definite principles. There are no similar principles as regards wages. According to this theory, after rent, interest and profit have been paid, the remainder of the total output goes to the workers as wages.

This theory admits the possibility of increase in wages through greater efficiency of employees. In this sense, it is an optimistic theory, the subsistence theory and wages fund theory were pessimistic theories. Though this theory has been rejected by most economists on several bases.

(d) Marginal Productivity Theory of Wages: This theory state that, under the condition of perfect competition, every worker of same skill and efficiency in a given category will receive a wage equal to the value of the marginal product of that type of labour. The marginal product of a labour in any industry is the amount by which the output would be increased if a unit of labour was increased, while the quantities of other factors of production remaining constant. Under perfect competition, the employer will go on employing workers until the value of the product of the last worker he employs is equal to the marginal or additional cost of employing the last worker. Further, under perfect competition, the marginal cost of labour is always equal to the wage rate, irrespective of the number of workers the employer may engage. Since every industry is subject to diminishing returns, the marginal product of labour must start declining sooner or later. Wages remaining constant, the employer stops employing more workers at that point where the value of marginal product is just equal to the wage rate:

 

It is not true, as it is assumed above, that the quantities of other factors remain constant while that of labour alone increases. To allow for this, a term 'marginal net product of labour' has been used instead of 'marginal product of labour'. The value of marginal net product of labour may be defined as being the value of the amount by which output would be increased by employing one more worker with the appropriate addition of other factors of production, less the addition to the cost of the other factors caused by increasing the quantities of other factors.

Limitations/Criticism of Marginal Productivity Theory: This theory is true only under certain assumptions such as perfect competition, perfect mobility of labour, homogenous character of all labour, constant rates of interest and rent and given prices of the product. It is a static theory. The actual world is dynamic. All assumptions are unrealistic. The following are the criticism against this theory:

(i) According to this theory, the labour is perfectly mobile so that they can be moved from one employment to another employment, which is not true in the real world.

(ii) According to this theory, there is unified wage rate across the market, which is impossible. Workers of the same skill and efficiency may not receive the same wages at two different places.

(iii) In case of monopsony, i.e., one buyer and many sellers, the employer has a grip on wages and can pull down the wages below the value of the marginal net product of labour. If the employees are collectively organised, the wage rates can be bargained. Therefore, the wages are not only determined by the number of workers employed but also by the relative bargaining strength of the labour union and the employer.

(iv) Another assumption of this theory is that there is an existence of perfect competitive market for products, which is also an unrealistic assumption. In the real world, the market for goods is characterised by imperfect competition. This also unsettles the theory.

(v) The productivity of workers is also dependent on factors such as the quality of capital and efficient management, which is outside the scope of this theory.

(vi) It should be borne in mind that the marginal net product of labour depends not merely on the supply of labour but also on the supply of all other factors of production. If other factors are plentiful and labour relatively scarce, the marginal product of labour will be high, and vice versa.

(vii) This theory takes the supply of labour for granted. Productivity is also a function of wages. Low productivity may be the cause of low wages, which may tell on the efficiency of the worker, lower his standard of living and ultimately check the supply of labour.

(e) Taussig's Theory of Wages: The American economist Taussig gives a modified version of the Marginal Productivity Theory of Wages. According to him, wages represent the marginal discounted product of labour. According to Taussig, the labourer cannot get the full amount of the marginal output. This is because production takes time and the final product of labour cannot be obtained immediately. But the labourer has to be supported in the meantime. This is done by the capitalist employer. The employer does not pay the full amount of the expected marginal product of labour. He deducts a certain percentage from the final output in order to compensate himself for the risk he takes in making an advance payment. This deduction, according to Taussig, is made at the current rate of interest.

Criticism: Two weaknesses of the theory have been recognised by Taussig himself, i.e., (i) a dim and abstract theory remote from the problem of real life. To this he replies that this weakness is common to all economic generalisations. (ii) The joint product is discounted at the current rate of interest, but according to his own analysis, the rate of interest is a result of the process of advance to the labourers. To meet this difficulty, Taussig suggests that we determine rate of interest independently of marginal productivity by the rate of time preference, and with the interest thus determined discount the marginal product of labour.

This theory is also rejected by most economists.

Modern Theory of Wages:

According to this theory, the wages are determined by the interaction of demand and supply as in the case of ordinary commodity. Thus, this theory is also referred to demand and supply theory.

Demand for Labour: According to the modern theory of wages, the demand for labour reflects partly labourer's productivity and partly the market value of the product at different levels of production. Following are the factors that determine the demand for labour:

(a) Derived Demand: The demand for labour is a derived demand. It is derived from the demand for the commodities it helps to produce. Greater the consumer demand for the product, greater the producer demand for labour required to produce that commodity. It may be observed that it is expected demand and not existing demand for the product that determines demand for labour. Hence, the expected increase in the demand for a product will increase the demand for labour.

(b) Elasticity of Demand for Labour: The elasticity of demand for labour depends on the elasticity of demand for commodity. According to this theory, the demand for labour will generally be inelastic if their wages form only a small proportion of the total wages. The demand, on the other hand, will be elastic if the demand for product is also elastic or if cheaper substitutes are available.

(c) Prices & Quantities of Co-Operating Factors: The demand for labour also depends on the prices and the quantities of the co-operating factors. If the machines are costly, the demand for labour will be increased. The greater the demand for the co-operating factors the greater will be the demand for labour, and vice versa.

(d) Technical Progress: Another factor that influences the demand for labour is technical progress. In some cases labour and machineries are used in definite proportions.

After considering all relevant factors as discussed above, the employer is governed by one fundamental factor, viz., marginal productivity.

The change in wage rate determines the direction of change in the demand for labour but the degree of this change depends on the elasticity of demand for labour. In case of elastic demand, a small change in the wage rate will lead to a considerable change in demand for labour, and vice versa. Whether the demand for labour is elastic or not will depend on (i) the technical conditions of production, and (ii) elasticity of demand for the commodity which that labour produces. Generally the short term demand for labour is less elastic than the long-term demand. That is why the employers and trade unions adopt a stiff attitude in wage negotiations.

Demand for Labour under Perfect Competition: Under perfect competition, each firm constitutes a very small portion of the entire industry that it cannot influence wages appreciably by employing more or less of labour. The supply curve of labour confronting each employer is perfectly elastic, i.e., horizontal straight line at the level of the market wage rate. The individual demand curve is determined by marginal productivity. The individual employer hires as many labourers as will equate the marginal productivity of labour with the rate of wages in the market.

 

It is the demand of the entire industry, not an individual firm, determines the wage rate. The individual firm has to accept the market rate of wages and adjust its own demand for labour accordingly.

Supply of Labour: The supply of labour depends on:

(a) The number of workers of a given type of labour which would offer themselves for employment at various wage rates, and

(b) The number of hours per day or the number of days per week they are prepared to work,

The labour may be supplied to three destinations:

(i) Supply of Labour to a Firm: To a given firm, the supply of labour is perfectly elastic because at the current wage rate, it can engage as many workers as it wants. Its own demand constitutes only a very small fraction of the total supply of labour. Hence the supply curve of labour for a firm is a vertical straight line.

(ii) Supply of Labour to an Industry: For the industry as a whole, the supply of labour is not infinitely elastic. If the industry wants more labour it has to attract it from other industries, by offering higher wage rates. The supply of labour for the industry is subject to the law of supply, viz., supply varies directly with price, which means low wage small supply and high wage large supply. Hence the supply curve of labour for an industry slopes upwards from left to the right.

(iii) Supply of Labour to an Economy: The supply of labour for the entire economy depends on economic, social and political factors or institutional factors, e.g., attitude of women towards work, working age, school and college age and possibilities of part-time employment for students, size and composition of the population and sex distribution, attitude towards marriage, size of the family, birth control, etc.

Over a short period of time, reduction in wages may not cause any reduction in the supply of labour. But if wages are driven too low, competition among employers themselves will push them up. Even over a long period, the supply of labour is not very elastic.

There is a certain minimum wage below which labour will not work at all. Once this minimum is exceeded, supply of labour will increase as the wage rate goes up. But this will happen only up to a point beyond which wage increase will lead to a reduction in the supply of labour. Again, after a point, this tendency will be reversed when the worker thinks that he can move to a higher level of living. Hence a rise in wages may lead to rise or fall in the supply of labour. It will depend on the worker's relative valuation of goods and leisure.

Thus, the supply of labour will depend on the elasticity of demand for income which will vary according to the worker's temperament and social environment. When the workers' standard of living is low, they may be able to satisfy their wants with a small income and when they have made that much, they may prefer leisure to work. That is why it happens that sometimes increase in wages leads to a contraction of the supply of labour. This is represented by a backward bending supply curve of labour as shown in the following figure:

 

For some time this particular individual is prepared to work longer hours as the wages go up (wage is represented on OY-axis). But beyond OW wage, he will reduce rather than increase his working hours.

Interaction of Demand and Supply:

 

In the above diagram, figure (a) represents the supply curve faced by an industry, and figure (b) represents the supply curve faced by an individual firm. W-AW is an extended line that cuts the MRP (marginal revenue productivity) curve of the firm at E ' in figure (b). At this level, the ARP (average revenue productivity) is MR which is greater than the wage OW in figure (b). Hence, all the firms (since this firm represents all the firms in the industry) are making supernormal profit at this wage level. This will lead to entry for new firms in the industry; the demand for labour will increase and the wage level will go up. Thus, supernormal profits will be competed away in the long run by the entry of new firms.

The new demand curve D'D' cuts the supply curve SS in figure (a) at point F. The wage level in this situation will be OW' which is higher than the original wage level OW. This is how the interaction of demand and supply determines the wage. When the wage is OW, the firm is in equilibrium at E' and when the wage rises to OW', the equilibrium is at F'. At this point, average revenue productivity (ARP) and marginal revenue productivity (MRP) are equal, and the average wage OW' is equal to both of them. It means the individual firms are earning normal profits.

It may also happen that the occurrence of supernormal profits attracts some firms from outside, which may further increase the demand for labour to D"D". The wage level will then be OW". Here the ARP is less than the wage OW", i.e., the firms are suffering from losses. The result will be that some firms will leave the industry and the wage will come down to the level of OW'.

Long Run: Under perfect competition, wages are, in the long run, equal to the marginal as well as to the average productivity of labour. If marginal productivity is greater than average, it will be worthwhile to employ more labour till marginal productivity falls to the level of average productivity. On the other hand, if marginal productivity is less than average productivity, less labour will be employed and the marginal productivity will rise to the level of average productivity. Marginal productivity and average productivity thus tend to be equalised. Since wages are equal to marginal productivity, they are also equal to average productivity in the long run. This is shown in the following diagram:

 

OR is the wage level, AP is the average productivity curve and MP is the marginal productivity curve. They intersect at P which shows that wages are equal both to the MP and AP. When AP is rising, MP > AP, and when AP is falling, MP < AP. But when AP is neither rising nor falling, MP = AP. Hence, at equilibrium point: Wage = MP = AP.

Wages Under Imperfect Competition:

Imperfect competition may result:

(a) Bilateral Monopoly: When strong employers' associations are confronted with strong labour organisations.

(b) Monopsony: When an industrial employer or a group of employers occupy a very strong monopolistic position as compared with labour.

(a) Bilateral Monopoly: The term 'bilateral monopoly' is applicable both to commodities and labour. It is applied to a situation when a monopoly of purchase is matched with the monopoly of sale, i.e., a single monopolist facing a single monopsonist. The monopolist wishes to operate on a scale where the marginal cost is equal to marginal revenue, because that will bring him the maximum monopoly profit. On the other hand, the monopsonist wishes to purchase an amount at which marginal cost is equal to marginal utility. This indicates one optimum price for the buyer and another for the seller. There is no economic principle to determine an equilibrium price.

It is not possible to indicate definitely the output and the price which will rule. The price will depend on the circumstances of each case. In some cases, it will be a compromise price which may be influenced by the bargaining power of each party. Therefore, under bilateral monopoly, the price and output are 'indeterminate'.

 

In bilateral monopoly, each side wants to get the better of the other through bargaining skill. The monopolist will like the monopsonist to behave, as if he were one of the many buyers as in perfect competition, so that he (i.e. buyer) may accept the price fixed by firm (the monopolist producer). Similarly, the monopsonist will like the monopolist to behave as if he were a perfect competition producer (i.e. one of so many) unable to influence price, so that he (the monopsonist buyer) can purchase at his own price. Now nothing can be said as to who will succeed and how far. Most probably, there will be a compromise between the two extremes.

According to the above diagram, the monopolist will be maximising his profit (MR=MC) if he sold OM' output and charged OP₁ (M'Q) price, since Q₁ is a point on the demand curve DD showing what the purchaser will be willing to pay under perfect competition. On the other hand, the monopsonist will like to buy OM at OP price, since Q₂, where DD and MC₁ intersect, is a point where buyer's marginal valuation equals marginal cost of purchase. There will be a compromise between both the parties, i.e. the employer and the employee. Hence, factor price will be somewhere between OP and OP₁, and the output between OM and OM' depending on the relative bargaining skill of the parties.

(b) Monopsony: This is the most general situation of imperfect competition, where the employer embodies in his person concentrated monopoly power of being the sole purchaser of labour, whereas labour occupies a very weak position in comparison. Monopsony also occurs when a big employer employs proportionately a very large number of a given type of labour so that he is in a position to influence the wage rate. In the following diagram, a situation is depicted where a monopsonist exploit the labour:

 

In the above diagram, the MRP is the marginal revenue productivity curve representing demand for labour. The supply curve of labour is AW (Average wage curve) which is rising to the right which shows that higher wages have to be paid to engage more labour. MW is the marginal wage curve corresponding to the AW curve. These two curves, i.e., MW curve and the MRP curve intersect at point E. It is the point where the monopsonist is in equilibrium. Here the marginal wage is equal to marginal revenue productivity of labour at the level of labour employment ON, at wage level NH (=OW).

It can be seen that this wage, i.e., NH is less than marginal revenue productivity which is NE. Thus each worker gets EH less than this marginal revenue product. This is the measure of labour exploitation under monopsony. This is called by Mrs. Robinson as 'monopsonistic exploitation'. Thus, under monopsony, wage is lower and employment is less than under perfect competition in the labour market. Under perfect competition, the equilibrium would have been at C where the supply curve AW cuts the demand curve MRP. At this point, the wage would have been higher at OW’ (=N'C) and the labour employed would have been larger at ON'.

Exploitation of Labour:

There are three types of labour exploitation:

(a) Monopsonistic Exploitation: Where the single employer has the strongest influence on the wage rate.

(b) Monopolistic Exploitation: In this condition, there is perfect competition in the labour market but there is an imperfect competition in the product market. In equilibrium, the firm will equate wage with marginal revenue product. This means that labour is paid less than the value of the marginal product which shows exploitation:

 

(c) Double Exploitation: It occurs when there is imperfect competition both in the labour market (monopsony) and in the product market (monopoly). Thus there is double exploitation of labour both monopsonistic and monopolistic and labour is exploited the most.

Remedies: Following the remedial steps or the weapons to stop labour exploitation:

(i) Government intervention, and

(ii) Trade union action.

Wage Differentials:

Wages everywhere tend to approximate to the marginal productivity of labour. But, the marginal productivity of labour is different in different employments and grades. It varies with the degree of scarcity of each kind of labour in relation to the demand for it. Following are the causes of differences in wages in different employments, professions and localities:

(a) Differences in efficiency: that is, differences in education, training, and conditions under which the work is performed.

(b) Existence of non-competing groups: These groups arise because of the difficulties in the way of mobility of labour from low-paid to high-paid empolyments. These difficulties may be due to geographical, social and economic reasons.

(c) Difficulty of learning a trade: The number of those who can master difficult trades is small. Their supply is less than demand for them, and their wages are higher.

(d) Differences in agreeableness or social esteem: Disagreeable employments must pay higher wages in order to attract labourers. If disagreeable work are performed by unskilled workers, who cannot do anything better, wages may be quite low, e.g., sweepers.

(e) Future prospects: If an occupation provides opportunities for future promotion, people will accept a lower star in it, as against another occupation offering higher initial rewards, but no chances of promotions in the future.

(f) Hazardous and dangerous occupations: generally offer higher emoluments.

(g) Regularity or irregularity of employment: also exerts a strong influence on the level of wages.

(h) Collective Bargaining: The differences in the strength and militancy of trade unions also account for differences in wages in different industries.

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