Wage Determination


Wages are a remuneration paid to labourers for its services in production. Labour refers to all kinds of workers, skilled and unskilled, physical and mental, etc. They may receive wages, salaries, fees, commission etc.

Money wages and real wages.

Wages paid in the form of cash are known s money wages or nominal wages. The purchasing power of money wages is known as real wages. In other words what labourers can purchase with money wages is real wages.

Money wages therefore is the purchasing capacity of the workers or their claim over goods and services in the market.

“The satisfaction that a labourer gets from spending money/nominal wages is real wages”.

Real wages therefore depends on prices of goods, working hours, regularity of employment, nature of job, future profits, traditional benefits in kind etc.

Wage determination

From time to tome various theories of wages have been put forth and there is an element of truth in all of them.

I] Subsistence wage theory

It was put forth by Prof David Ricardo and other classical economists, was based on the population theory of Prof Robert Malthus. [German economist Lassale called it the “Iron law of wages”

According to this theory, wages (the market price of labour), tend to settle at a level just sufficient to maintain the workers and his family at a bare subsistence level.

If the wages rise above this subsistence wage rate there will be prosperity among workers. This prosperity however, is temporary in nature. Prosperity of the workers would increase the population and therefore the labour supply. This would depress the wages and bring them down to the level of subsistence. Wages fall to subsistence level because there is competition among workers to acquire jobs [unemployed workers would accept jobs at a lower wage rate ie subsistence wage rate as the other alternative is unemployment and starvation].

Similarly if wages fall below subsistence level, there would be starvation, misery, undernourishment and that this would decrease the supply of labour. Therefore wage rate would increase.

This takes place in the long run and therefore and therefore in the long run, according to the iron law of wages, wages must correspond to the subsistence level of workers.


1] It assumes that the supply of labour is infinitely elastic, which is wrong.

2] It is wrong to say that- increase in wages must increase the size of the family. Many people prefer high standard of living to -a larger family.

3] The theory does not explain differences in wages of workers having the same standard of living.

4] It explains adjustment of wages over a generation and does not explain fluctuations from year to year.

5] The theory is pessimistic and holds no bright prospects for labour.

6] Wage difference in different fields are not explained [trade, profession, occupation etc]

7] it does not take into account the productivity of labour which has a great influence on wages.

8] Subsistence is a vague and abstract concept.

9] The theory can only be applied in the long run.

10] According to this theory wages are supply determined. Demand for labour aspect aspect is not emphasised.

II] Wage fund theory

It was put forth by Prof J S Mill. It stated that wages depended on the capital available for the payment of workers and the size of labour force.

According to him, at any moment of time, there is a fixed proportion of capital or wage fund in a country available to employers each year, which is set aside as wages for labourers. Therefore according to him, wages at any point of time, are determined by the amount of money in that fund and total number of workers.

The economists thought that as the population changed so too would the wages of workers. If the population increased, but the amount of money available to pay as wages stayed the same, the results might be all workers would make less, or if one worker made more, another would have to make less to make up for it and workers would struggle to earn enough money to provide for basic living requirements.

In essence, wage–fund doctrine states that workers’ wages are determined by a ratio of capital to the population of available workers.

Wage rate = wage fund / number of workers

The size of the wage fund could change over time, at any given moment it was fixed. Thus, legislation to raise wages would be unsuccessful, since there was only a fixed fund to draw on.

If the number of workers remains constant and the wage fund increases, the wage rate ie it varies directly with the wage fund when number of workers is constant.

If wage fund remains constant, then it varies inversely with the number of workers ie it will rise with a decrease in the number of workers and fall with an increase in the number of workers.

According to this theory collective bargaining is useless and trade unions have no role to play in improving the workers lot.

Karl Marx, an advocate of the labour theory of value, believed that wages were held at the subsistence level by the existence of a large number of unemployed.


1] According to critics, there is nothing like fixed wage fund. It changes in national income and profits.

2] It is not true that the amount of wages paid is decided by the stock of capital accrued by past production.

3] It does not indicate how the wage fund is fixed and the source of wage fund.

4] It assumes a cordial relation between labour and capital.

5] It ignores the possibility of increased wages from increased productivity.

6] It does not explain the occupational wage differences.

7] The relation between wage rate and number of workers is a fact ie an obvious truth is pointed out by this theory.

8] The theory is indeterminate since the demand for labour and wages paid change with the prices of labour.

III]. Standard of Living and Wages:

It was realized that it was not mere subsistence but the standard of living which determined wages. Standard of living may be defined as “the amount of necessaries, comforts and luxuries to which a class of persons is accustomed and to attain and keep which they will undergo any reasonable sacrifice like working longer or postponing marriage.” Well, if one thinks of it, people with decent standards of living do seem to be earning good wages.


(i) Good wages are not paid simply because a worker has a high standard. It is rather because a higher standard means better training, better education, better food, which in their turn result in greater efficiency, and, therefore, higher wages are paid.

(ii) A person with a higher standard of living usually plans his family, and limits the number of babies. Hence, it is rather short supply than higher standard which accounts for a higher wage.

(iii) When people have a set standard they will usually exert hard to earn a wage high enough to maintain it. It is the effort rather than the standard which brings higher wage.

(iv) Standard of living is the effect of higher wages and not the cause of it.

Thus, Standard of living has an indirect influence on wages through affecting the efficiency of labour. But this is only a partial explanation of wages—that on the side of supply only. Demand side is ignored.

IV] The residual claimant theory

The residual claimant theory replaced the wage fund theory and was put forward by an American economist Prof F A Walker in 1875. According to him, wages are a residue left over after other factors of production have been paid from the national income ie land, capital and organization are paid first for their contribution to the process of production.

According to Prof Walker rent and interest are determined by independent contracts. What remains is paid to the workers as wages ie labourers are the residual claimants of the product of the industry. Therefore wages are determined only after rent interest and profits are deducted from the total produce.

According to Walker rent and interest are governed by contracts and profits are determined by certain definite principles. There are no such principles however that govern determination of wages and therefore wages are residual.

This theory is different from the wage fund theory as it admits higher wages through greater efficiency of labour.

As compared to other theories, this theory is optimistic. It shows that by increasing efficiency or by working more workers may produce more and hence their wages would increase.


1] In practice it was noticed [especially during boom period] that when rent, interest and profits increased, wages also increased [according to this theory, wages being a residue should have decreased].

2] It neglects the effect of supply of labour on wages.

3] this theory fails to explain why laws of demand and supply, that explain the remuneration of other factors of production, should not be applied to wages as well.

3] It does not explain the role of trade unions in determining or increasing wages.

4] The residual claimant not the labourer but the entrepreneur, who undertakes to pay the other factors of production before he expects to get anything.

Marginal productivity theory of wage determination

Marginal productivity theory of wage determination was put forward by neo-classical economists. It was best explained by Dr Alfred Marshall. According to Dr Alfred Marshall the price of labour was determined by its marginal productivity to the employer.

Productivity of labour is measured by two concepts

1] Marginal product [productivity]

2] Value of the marginal product

1] Marginal physical product of labour in any industry is the amount by which the output would changes if one more unit of labour was employed keeping the quantities of other factors of production constant.

According to the law of diminishing returns, if more and more unit of a factor in this case labour are employed other factors remaining constant the marginal physical product diminishes.

The employer compares the revenue from marginal product with the wage rate. Therefore the concept of marginal product is important.

2] Value of Marginal product = [Marginal physical product] X [Price per unit]

Eg if the firm employs 50 workers keeping other factors constant and if one more worker is employed, the output increases by 10 [10 units is the marginal physical product]. If Price per unit is Rs 5/-, value of marginal product is Rs 50/-[ie 10 X 5]

If one more worker is employed ie the 52nd worker and marginal physical product is 8 units [law of diminishing returns] the value of marginal product is [8 X 5] ie Rs 40/- . If market wage rate was Rs 45/-, the employer is willing to employer the 51st worker and if the market wage rate was Rs 38/-. He would be willing to employ the 52nd worker.

Therefore if employment of workers is increased at a point of time, the employer will stop further employment at a point where the value of marginal product becomes equal to the prevailing wage rate. Beyond this point, the employment of a worker will not increase.

This theory is the application of the theory of value to determine wages. It explains wage determination from the demand for labour aspect, just as there is an exchange of a commodity for its price ie exchange of utility of a commodity against the utility of money paid for it.

Wages are the price paid for labour ie exchange of labour power or its productivity for the wages, therefore a profit seeking employer compares the productivity of labour to the price paid for it.

Therefore under conditions of perfect competition, an employer will go on hiring more and more labourers till the value of the product of the last worker hired equals the additional or marginal cost of employing him.

According to this theory, under perfect competition, wage rate paid to every worker would be equal to the values of the marginal product [ie price at which the marginal product can be sold in the market].

The money value of the marginal product would be the wage rate that every worker receives. Therefore under perfect competition, the employer, the employer will continue employing more workers, until the value of the product produced by the last workers employed equal to the marginal or the additional cost of employing to him.

The employer employs labour because of its productivity.

Assumption of the marginal productivity theory

1] All units of labour are homogeneous in the market [otherwise the marginal productivity of the 52nd   worker may be greater than the 50th worker as he might be more efficient].

2] Perfect competition in the product and factor market

3] Perfect mobility of labour .

4] Full employment

3] No trade unions ie this theory assumes that the employer and the worker is the same. Therefore there is no exploitation.

Criticisms of the law

1] In reality perfect competition does not exist. The world is dynamic.

2] Labour is not homogeneous.

3] Labour is not perfectly mobile.

2] The theory ignores the supply aspect of labour.

3] Labour market may be organized or unorganized and therefore exploitation is possible.

4] Marginal productivity of labour is also affected by capital and efficiency of management, type of capital used etc.

5] Productivity also depends on the level of wages [productivity increases with arise in wages].

Modern theory of wages.

Wages ie the price of labour like any other is determined by the forces of demand and supply [A common criticism for the marginal productivity theory of wages is that it is from the demand for labour side], ie wages are determined at a point where the demand for labour is equal to the supply of labour.

Demand for labour.

Refer to chap 1

How many workers an employer will employ will depend on the marginal productivity of labour on one side and the prevailing wage rate on the other. There is an inverse relation between wage rate and demand for labour.

The demand curve for labour will therefore slope downwards from left to right.

Supply of labour

Refer to chap 1

The supply curve for labour will slope upwards from left to right upto a certain limit and then slope backwards.

Equilibrium of demand and supply of labour

a] short run equilibrium

DL = SL at point E.

b] long run equilibrium

in the long run under competitive conditions


If wages are less than the ARP the firms will earn a super normal profit. This will induce the other firms to enter the industry. The demand for labour will therefore increase and will increase the wage rate till it becomes equal to the ARP


If wages are more than the ARP the firms will incur a loss. This will induce the some firms to leave the industry. The demand for labour will therefore decrease and supply of labour will be greater then the demand for it. This will decrease the wage rate till it becomes equal to the ARP

If all people were equal in all respects wages for all would be equal.

The actual wage rate may fluctuate between the upper point set by the marginal productivity of labour and the lower point set by the cost of conventional standard of living

The comparative strength of trade union can get the actual wage rate fixed at any point between these two.

Criticisms of the theory.

Fluctuations in national income can influence the level of wages according to Lord J M Keynes.

Wages determination

Wages determination is therefore complex. Different people have put forward different theories to explain it. Though each argument has an element of truth in it, no single theory can be accepted as complete truth. The major factors influcencing wage rate are

I] Customs – In such economies occupations are pre-determined by birth in those families which are assigned certain functions in a society. Rewards for occupations were fixed by customs and traditions.

Eg  The baluta under the balutedari system in Maharashtra.

In princely states in India, certain services were paid by the king in terms of land grant.

In Indian society, priestly occupation was assigned the highest importance and therefore received adequate income. Even in modern times, the element of customs, places an importance an important part in wage determination.

Eg Wages of military personnel or farm labourers and domestic help which is paid in cash and kind or various perks in companies.

II] Charity – Quite often an element of charity is involved in payment of wages, especially when the employer – employee relation is good. In this case the employer looks after the employee and provides welfare facilities like bonus, gifts etc eg Some companies [TATAS] have been giving more than normal wages to their workers out of human consideration.

III] Laws – Labour maybe exploited by the capitalist; government has to interfere and determine the wage rate. Therefore the government in the modern state plays an important role in wage-determination in order to protect the interests of the workers and avoided their exploitation.

Eg1 In India, minimum wages act passed in 1948 [fixed by the government]

Eg2 The act for fixing bonus.

Eg3 The factory act Lays down service conditions in the factory etc.

IV] Competition – Demand and supply of labour determines wage rate [explain with reference to equilibrium price determination].


Posted in Mpm