Various theories have been put forward from time to time to explain how wages are determined.

We briefly refer below to some old theories and discuss in detail the Marginal Productivity Theory and the Modern Theory of Wages.

Old Theories of Wages:

1. Subsistence Theory:

For long it was believed that wages, in the long run, would tend to equal just enough of food, clothing and shelter to maintain existence. This is known as the Iron Law of Wages or the Subsistence Theory of Wages. This theory was for the first time propounded by David Ricardo He believed that if wages were more than what is required for mere subsistence, it would be temporary.

Prosperity of the workers would soon increase the population, and hence the labour supply. This would depress wages and bring them down to the level of subsistence. Similarly, wages below the subsistence level would starve certain workers; others won’t marry. This will reduce the supply of workers, and raise wages. Thus, according to the Subsistence Theory of Wages, wages must, in the long run-, correspond to the subsistence level of workers.



The subsistence theory can be criticised on the following grounds:

(i) It assumes that the supply of labour is infinitely elastic, which is wrong.

(ii) 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.


(iii) The theory does not explain differences in wages of workers having the same standard of living.

(iv) It explains adjustment of wages over a generation and does not explain fluctuations from year to year.

(v) The theory is pessimistic and holds no bright prospects for labour.

2. 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.

3. Wages Fund Theory:

The Wages Fund Theory was developed by J. S. Mill. He maintained that a certain fixed proportion of the capital of a country was set apart for payment as wages of labourers. This proportion, he called the Wages Fund. Thus, according to him, wages at any moment were determined by the amount of money in the wages fund and the total number of workers in the country. If the fund remained constant and the supply of labour increased, wages would fall, and vice versa. It is implied that if wages are forced up, capital will leave the country.


(i) The theory does not explain how the wages fund arises and why it remains fixed,


(ii) It has been proved to be historically false,

(iii) It is no theory, but only a truism and says what is self-evident,

(iv) The interests of labour and capital do not always, conflict as the theory implies. During industrial prosperity both wages and profits rise,

(v) Capital is not so sensitive as it is assumed,


(vi) It does not explain differences in wages in different occupations,

(vii) Actually, wages do not correspond to the total amount of capital available.

In some countries, wages are high even though capital is scarce, e.g., in new countries.

4. Residual Claimant Theory:

The residual claimant theory replaced the wages fund theory. According to this theory, the worker is the residual claimant of the product of industry. He gets out of the product what remains after land, capital and organisation have been paid their rewards. Thus, wages are determined after rent, interest and profits have been deducted from the total product.



(i) In actual practice, it is found that at times of business boom when rent, interest and profits rise, wages also increase at the same time

(ii) It is not the worker who is the residua! Claimant, but the entrepreneur,

(iii) It does not explain how trade unions are able to raise wages,

(iv) It ignores the influence of supply or labour.