Generally, the prices of factors are determined by the interaction of demand and supply, which should also be applicable in determining the wages for labor.
However, the theory of demand and supply is not fully applicable while determining wages for labor.
This is because labor as a factor of production is distinct from other factors of production.
The following are the unique features of labor:
i. The demand for labor requires a different treatment in terms of demand. This is because the demand for labor is not dependent on its utility, but its productivity. However, the demand for products depends on buyer’s satisfaction in terms of utility of a product.
ii. Labor cannot be detached with laborers. Therefore, while determining wages, human factors are taken into account.
iii. The supply of labor is different from the supply of a product. The supply of a product increases with increase in its prices, whereas the supply for labor decreases with increase in wage rates.
Due to aforementioned peculiarities, economists have advocated different theories for the determination of wages.
Figure-8 shows the different classical theories of wages:
The different classical theories of wages (as shown in Figure-8) are explained in detail below;
Subsistence theory was developed by Adam Smith, who is regarded as the father of economics. According to subsistence theory, wages should be at the level where a worker can satisfy his/her own needs as well as the needs of his/her family. This level of wages is termed as subsistence level.
In case, the level of wage rises beyond the subsistence level, then the size of population would increase as the worker may get married and have children. This increase in population would increase the supply of labor. As a result, the wage level would again come down to the subsistence level.
On the other hand, if the wage level falls below the subsistence level, then the worker may not think of getting married. This would decrease the labor supply. In such a case, the wage level needs to reach back to the subsistence level so that the supply of labor can be increased.
The theory of subsistence is also criticized by economists on various grounds, which are as follows:
i. Provides a general rule for determination of wages for all countries. However, the subsistence theory is applicable in underdeveloped countries, but not for developed countries.
ii. Assumes that an increase in the wage level results in increase of population. However, an increase in the wage level may also increase.se the standard of living of individuals as well as their real wages.
iii. Focuses on the customs and habits of people for determining the wage level. However, the taste and habits of individuals is subject to change with time.
iv. Presents a general view for all types of works. However, in the real world, the level of wages differs for different types of works.
v. Takes into account only the supply of labor not the demand for labor, which is a major component in determining the wage level.
Wages Fund Theory:
Wages fund theory was advocated by J.S. Mills. According to him, “wages depend upon the demand and supply of about, or, as it are often expressed, on the proportion between population and capital. By population is here meant the number only of the laboring classes or rather of those who work for hire, and by capital, only circulating capital and not even the whole of that but the part which is expanded on the direct purchase of labor. Wages not only depend upon the relative amount of capital and population, but cannot, under the rule of competition, be affected by anything else.”
As per the wage fund theory, the wage level depends on the quantity of the wage fund and the number of people who are employed. Wage fund refers to the amount of capital that an employer keeps for paying wages to labor.
The level of wages can be determined with the help of the following formula:
Level of wages = Wage fund/Number of employees
This equation implies that wages are directly proportional to wage fund and are inversely proportional to number of employees. Therefore, wages increases when wage fund increases or number of employees decreases.
However, according to the wage fund theory, wage fund is constant. Therefore, the wage level would increase only by reducing the number of employees. According to this theory, trade unions do not have any control on the level of wages.
Wage fund theory- is also criticized by many economists on the following grounds:
i. Does not provide a clear view whether the wages are paid through capital reserved or from the revenue generated by selling products. Generally, in short term, wages are paid from the revenue generated by selling products. However, in long term, wages are paid from the capital reserved.
ii. Presents the concept of keeping a certain amount for wage fund, which is not true in the real world. This is because there is no as such fund, which is fixed for providing wages.
ii. Calculates the level of wages by dividing wage fund with number of employees, which is not an appropriate method of determining the wage level.
Residual Claimant Theory:
Residual claimant theory was given by Walker, an American economist. According to his theory, wages are the residual part of the capital left after paying to the other factors of production. Walker advocated that rent and interest factors of production are based on the contract among individuals, while profit is obtained by adopting certain principles. However, the level of wages is not determined by any such principles.
According to residual claimant theory, wages are paid from the residual amount of total output left after paying for the three factors of production, namely rent, interest, and profit. As per this theory, the level of wages would increase with an increase in the productivity of labor.
There are certain criticisms against the residual claimant theory. The theory fails to explain the role of trade unions in increasing the wages of an employee. Moreover, Walker did not explain the impact of supply of labor on wages.
Taussig’s Theory of Wages:
Taussig, an American economist, modified the marginal productivity theory. According to him, the marginal output generated by a worker is not completely provided to him in terms of wages. This is because the manufacturing of a product takes time and labor needs wages during the manufacturing process.
In such a case, the employer pays wages to labor from his/her own capital. Therefore, the employer does not provide the actual amount of marginal product to the labor. The employer deducts a certain percentage from the total output to compensate the amount that he/she pays to the labor during the production process. The amount is reduced from the total output at the prevailing rate of interest.
Therefore, wages can be calculated as follows:
Wages = Total product of labor deducted amount (to compensate)
Since most of the classical theories are faulty and not suitable for determining the wage level. Therefore, several modern economists together worked and gave a theory for determining the level of wages. This theory is known as modern theory of wages.