Select Wage Theories And Economic Issues Economics Essay

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5/12/16 Economics Reference this

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Wages are determined by both the supply and demand of particular type of labour. The factors which influence wages are supply, price, skill, experience, ability, reputation. The wages theories have important policy implications and some relevance for certain occupations or in certain regions, none of these is adequate as a general theory having universal applicability. The economic theories of wages fail to provide a complete explanation of the problem of wage determination. Studies conducted by behavioral scientists to some extent fill the gaps in the earlier theories, which have highlighted the importance of psychological and sociological factors on wages. The key issues developed by economic and behavioral theorists are briefly reviewed in this chapter.



David Ricardo in his famous book on `Principles of Political Economy and Taxation’ propounded the subsistence theory of wages: Ricardo states that the price of labour depends upon subsistence of labour. The theory was based on the assumption that 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. 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. This will result in decreased labour supply, which will ultimately be equal to the demand for it. Ricardo viewed that the market price of labour could not vary from the subsistence level for a long time. For this reason, the subsistence wage theory was also known as the” Iron Law of Wages”.

The subsistence theory of wages is generally attributed to David Ricardo, and plays a large role in Marxist economics. Most modern economists dismiss the theory, arguing instead that wages in a market economy are determined by marginal productivity.


This theory owes its development to Karl Marx. According to this theory, the labour was an article of commerce, which could be purchased on payment of ‘subsistence price.’ Marx in many ways is closer to Ricardo in his approach to the question of value for labour power. He accepted Ricardo’s view that the market price of labour power could not for long depart from the value of the subsistence which is required for the maintenance of that labour power. He, however, viewed that it was not the tendency of population, which brought wages to the subsistence level, but it was the tendency in the capitalist system to chronic unemployment and the existence of industrial reserve army, which drove wages to the subsistence level. The supply of labour always tended to be kept in excess of the demand for it by a special feature of capitalist wage system. The capitalist was in a position to force the worker to spend more time of his job than what was necessary to earn his subsistence wage. The price of any product was determined by the labour time needed for producing it.

According to Marx, the worker did not get full compensation for the time he spent on the job. The rate of surplus value, which is the ratio of surplus labour to necessary labour, is also called the `rate of exploitation’ under the capitalist form of production. Marx, however, held the view that the introduction of trade union bargaining and similar interferences could stop the tendency of wages falling to their minimum level and even reverse it.


This theory was developed by Adam Smith. His basic assumption was that wages are paid out of a predetermined fund of wealth which lay surplus with wealthy persons – as a result of savings. It was the size of the fund, which determined the demand for labour and the wages paid to them. According to wages fund theory, wages are determined by: (a) the wage fund or part of working capital which has been expended for obtaining the services of labour; and (b) the number of workers seeking employment. The wage fund was assumed to be fixed and it does not change. Any change in wage rate, therefore, would be due to change in the number of workers seeking employment.

The wages fund theory maintained that the wage rate might increase over time due to an increase in wage fund resulting from higher savings or a decrease in the size of workforce. It showed that the level of wages determined the productivity of labour. If a rise in wages could augment the efficiency of labour, it would presumably augment the employers ‘ demand for that labour as well, stimulating them to set out more funds in the purchase of labour. Hence, a rise in wage level not only influences the supply conditions of labour but also causes a shift in the demand for labour. This is quite opposite to the assumption made by the theory that the demand for labour is fixed.


This theory was developed by Phillips Henry Wicksteed (England) and John Bates Clark (USA). 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 worker. The marginal productivity theory assumed that there was a certain quantity of labour seeking employment and the wage rate at which this labour could secure employment in a competitive labour market was equal to the addition to total production that resulted from employing the marginal unit of that labour force. It was also assumed that production is carried out under the conditions of diminishing returns to labour. The principle of diminishing marginal productivity postulates that the contribution of each additional unit of labour would be less than that of the unit previously hired. Therefore, inspite of the fact that the productivity of the individual labourer may be higher than that of the marginal labourer, he will not be paid more than what the marginal labourer will get.

In the short run wage rate can be both higher and lower than the marginal revenue productivity of labourers, but in the long run it gets equalised with the marginal revenue productivity of labourers. If the prevailing wage rate is lower than marginal productivity, it will be profitable for the employers and the resulting competition among employers to employ more workers will tend to raise the wages. On the contrary, if the prevailing wage rate is higher than the marginal productivity, the employment of marginal workers will yield him losses and he would stop employing them. This will result in competition among workers for jobs, which would lower the wages. Thus in the long run the equilibrium wage rate will become equal to the marginal revenue productivity of labour.

The marginal productivity theory is considered superior to the earlier theories on wages.


John Davidson propounded this theory. He argued that the wages and hours of work were ultimately determined by the relative bargaining strength of the employers and the workers.

According to this theory, there is an upper limit and a lower limit of wage rates and the actual rates between these limits are determined by the bargaining power of the employers and the workers. The upper limit could be the highest wages that the employers would be willing to pay beyond which they will incur losses resulting from high labour costs. The lower limit could be either the minimum wages prescribed under the statute or the strength of resistance of the workers at the subsistence wages below which they will not be available for work.


This theory is given by Marshall. He assumed the whole set of factors which govern demand for and supply of labour affected the determination of wages. It is therefore necessary to understand the various factors, which influence the demand for and supply of labour. The employers’ demand for labour is dependent on a number of factors such as the demand for his/her product, availability of other factors of production (the most important being the supply of capital), the level of technological progress, etc. The demand price of labour is determined by the marginal productivity of individual worker.

The term supply of labour can be expressed in a number of senses. First, it refers to the number of workers seeking employment. These are the workers with no alternative livelihood join the labour market seeking employment for wages. Secondly, it may be the number of hours for which each worker is available for work. The supply of labour in this sense is being increased by an increase in the number of working hours. Finally, the supply of labour varies with the intensity of work. The supply of labour tends to increase if the workers work harder than before.

Thus, Wage rates are influenced by a number of factors governing the demand for and supply of labour. The marginal productivity of labour, determines its demand price. It is the standard of living of workers that plays an important role in the determination of supply price of labour. The actual wage rate is determined at that level where the demand for and supply of labour are equal.

In real world, however, labour markets are generally non-competitive. The wage levels expected to result from the free interaction of demand and supply are often modified by the resistance from workers to accept wages below the subsistence level; trade union action, government intervention in wage fixation, and immobility of workers.


Lord Keynes in his book “General Theory of Employment, Interest and Money” explained the concept of purchasing power. According to him, wage is not only the cost of production to the employer but also an income for the wage earners who constitute a majority in the total working population. The same workers and their families consume a major part of the products of the industry.

Hence, if the wage rates are high they will have more purchasing power, which would increase the aggregate demand for goods and also a high level of output. Conversely, if the wage rates were low, their purchasing power would be less, which would bring about a fall in the aggregate demand. This will have an adverse effect on the levels of employment and output. According to Keynes, unemployment and depression will further add to the problem. Therefore, a cut in wage national income falls; it would have an adverse effect on employment rate.

According to the Keynesian Theory, fill employment is a function of national income; the higher the level of national income the greater the volume of employment and both income and employment are determined by effective demand. Hence, if the national income falls, it would have an adverse effect on employment.


Economists specializing in international trade argued about countries, industries and companies competing on the basis of comparative advantage of cheap labour Employers are known to move to areas where labour is cheap, be it within a country or across countries. Subject to internal and external constraints, labour also tends to show a tendency to move to areas, which pay higher value for their skills and effort. In recent years, however, there is pressure on countries and companies competing on the basis of cheap labour to ensure compliance with minimum core labour standards concerning minimum age, freedom of association, right to collective bargaining forced labour and non-discrimination.


1. According to Subsistence theory, the assumption that the supply of labour is perfectly elastic at the subsistence wage level is incorrect. The theory does not consider wage differentials, which are bound to exist across regions.

2. The subsistence theory ignores the importance of the role of the demand for labour and the role of trade unions in wage determination.

3. Economic theories either assume that wages and prices are either fully fixed or fully flexible. The reality lies somewhere in between.

4. Most wage theories are based on the assumption of full employment. In most developing countries this is not really the case.

5. Labour is not as mobile as capital and products are. Therefore wage rates could be influenced by the changes in the demand for and supply of factors other than labour too.

6. Wages and benefits reflect industry characteristics and personal characteristics (including skill differentials) as well as societal preferences and prejudices.

8. Interference by government and trade unions could minimize the influence of the market forces of demand and supply of labour.

9. Technology and productivity are major determinants. Low wages may not mean low wage costs. Similarly high wage rates may not mean high unit labour costs.

10. With the growing pressure for linking labour standards with international trade, increasingly it will become difficult (for countries, industries and companies) to compete on the basis of comparative advantage of cheap labour.


Behaviour means naturally reaction or movement to the environment and yourself. Motivation is the process of attempting to influence others to do your work will through the possibility of gain or reward. Every reward or element or compensation/remuneration has a behavioural objective and seek to fulfill a need (physiological or psychological) and achieve a goal. Luthans argues that `motivation is a process that starts with a physiological or psychological deficiency or need that activates behaviour or a drive that is aimed at a goal.

Reward systems are aimed at compensating people for their skill, effort, responsibility and working conditions and motivating them for higher performance.

Behavioural science theories are classified into three categories:-

Content theories

Process theories, and

Contemporary theories


The content theories explain what motivates people at work. Maslow, Hergberg and Alderfer contributed significantly to content theories. These are very briefly explained as follows:-


Abraham Maslow proposed the first theory called the hierarchy of needs theory. He proposed a hierarchy of five needs physiological (food, shelter, clothing which wages can buy), safety (emotional and physical safety – health insurance, pension), and love (affection and affiliation – belongingness, social), esteem (power, achievement, status, etc.), and self- actualisation (personal growth, realization of potential). Maslow believed that within every individual, there exists a hierarchy of five needs and each level of need must be satisfied before an individual pursues the next higher level of need. As an individual progresses trough the various levels of needs, the proceeding needs loose their motivational value.

TWO FACTOR THEORY OF MOTIVATION: Herzberg extended work of Maslow and developed a specific content theory of work motivation. Two-factor theory of motivation by Friedrich Hergberg classifies rewards into two categories: intrinsic and extrinsic. These are also called as motivators (satisfiers) and hygiene factors (dissatisfiers). Intrinsic rewards are motivators and satisfiers related to job content. They include achievement, recognition, work itself, responsibility, job enrichment, and job enlargement. Extrinsic rewards are hygiene factors and job dissatisfiers. These include company policies and administration, supervision, salary, interpersonal relations, working conditions.

ERG THEORY: Clayton Alderfer identified 3 groups of core needs; they are- Existence, Relatedness and Growth.

(a) The existence needs are concerned with survival.

(b) The relatedness needs stress the importance of interpersonal and social relationship.

(c) The growth needs are concerned with individual’s intrinsic desire for personal development.

Based on a person’s background and cultural environment, one set of needs may precede over others.

The works of Maslow, Hergberg and Alderfer are referred to as content theories. They are useful, but have limited implications for policy and practice.


Process theories were examined by work of Vroom (on valence and expectancy) and Porter and Lawer (performance-satisfaction linkage). They look at the cognitive antecedents that go into motivation or effort, particularly the way they relate to one another.

EXPECTANCY THEORY: Victor Vroom proposed expectancy theory based on the concepts of valence, expectancy and instrumentality. Valence refers to an individual’s preference for a particular outcome. For instance, most older workers might value retrial benefits against fewer, if any, younger workers in today’s knowledge industry, Younger, single (unmarried) workers with fewer family obligations have less or no need for benefits like children’s education, health benefits, leave travel concession, etc. than older, married people with one or more children. Instrumentality could mean that an individual would be motivated to give superior performance (first-level outcome) in anticipation (expectation) of promotion (second-level outcome).

Expectancies are mental and cognitive. Expectancy is the degree of probability that a particular action or effort will lead to particular first-level outcomes whereas Instrumentality refers to the degree of probability that relates first-level outcomes and desired second-level outcomes. Although the concept of expectancy seems to be the same as that of instrumentality, expectancy relates efforts to first-level outcomes while instrumentality relates first-level outcomes and second-level outcomes. In simple words, Motivation is a -function of valence and expectancy.

According to Vroom’s concept it can be interpreted that: Individual gives company what it values, superior performance and expects, in return, promotion. He provides insights into the conceptual determinants of motivation. Though he doesn’t offer specific suggestions on what motivates, and his theory as based on the assumption that people are rational and logically calculating, real life situations may not be so idealistic.


The contemporary theories describe the modern concept of how people motivates at work. These include Equity and Attribution theories. These are explained as follows:-


J. Stacy Adams, proposed equity theory, and argues that a major input into job performance and satisfaction is the degree of equity (or inequity) that people perceive in their work situation. Inequity occurs when a person perceives that the ratio of his or her outcomes to inputs and the ratio of a relevant other’s outcomes to inputs are unequal.

Equity can be internal or external. Internal equity refers to the pay differential between and among the various skills and levels of responsibility. Internal equity is established through job evaluation. External equity refers to concerns how wage/pay levels for similar skill levels in one firm compare with those in other firms in similar or same industry and location/region. External equity is assessed usually through pay surveys and pay satisfaction surveys. Companies, which pay significantly less than the market rates, would find it difficult to attract, retain and motive people to perform better.

People feel unhappy not only when they receive less than what they consider they deserve, but also when they receive more than what they consider they deserve. When an employee receives more than what he/she considers is fair, they begin to wonder whether others too are receiving more than what they deserve. Now the question arise is to compare what they are getting, whether others are receiving much more than what they deserve.


This theory is contributed by Fritz Heider, Lewin and Festinger. They assume that people are rational and logical in their behaviour and that both internal and external forces combine additively to determine behaviour. People will behave differently if the realize that their outcomes are controlled more internally than externally. This theory has great potential for understanding organisational behaviour and provides deep insights on goal setting, leadership behaviour and diagnosing causal factors of employee performance.


1. Explain the importance of the theory of wages.

2. What are the different types of theory of wages? Explain in detail.

3. Are wages determined only on the basis of the demand and supply of labour?

4. Explain the significance of behavioural theories in Wages determination?

5. What are the limitations that arise while wages determination in economic theories?

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