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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 applicable for some of the definite occupations or line of work, 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.


Compensation theories mainly divided into two parts:

Economic theory

Behavioral theory

Economic theory consist the following and described as under:


David Ricardo, in his famous book ‘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 of labour would increase as they would reproduce more; and this would bring low the rate of compensation. If the rate of compensation decreased below the subsistence level, the number of workers would reduced – as many would die because of lack of food or hunger, increased inability due to scarcity of nutrition, abnormal health conditions, cold, etc. and many of them could not marry because they fell that they could not able to accept the responsibility . This will result in decreased labour supply, which will lastly be same like as 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”.

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This theory owes its development to Karl Marx. According to this theory, the labour was an article of trade, 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. Labour supply always cared for the excess of the demand for it 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. Product price was set or fixed by the total time needed for generating the output by the labour. The price of any product was determined by the labour time needed for producing it. According to Marx, the labour did not receive complete remuneration for the time he spent on their work place or job. 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.

THE WAGES FUND THEORY (Given by ADAM SMITH in 1723-1790)

This theory was propounded by Adam Smith. His basic assumption was that wages are paid out of money 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 increased for getting the labour work; 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, because of increase or decrease in the size of labour getting job opportunity.

The wages fund theory based on the productivity of labour and profitability of any organization it shows that increased in the savings increased in the wages, it may change after the fixed tenure. Increase in remuneration could help to increase the efficiency of labour, it would presumably augment the employers ‘ demand for that 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 propounded by Phillips Henry Wicksteed (England) and John Bates Clark (USA). According to this theory, compensation are based upon an entrepreneur’s calculation of the rate that will probably be acquire by the marginal worker. The marginal productivity theory pretended that there was a certain quantity of worker received the job and the remuneration value at which this worker 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 pretended 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 time period of work were ultimately defineds by the relative bargaining power between the employers and the employees.

According to this theory, there is a top limit and a lower limit of compensation and the actual wage rates in between these limits are set or calculated by the bargaining power of the employers and the employees. 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 the workers at the necessary remuneration below which they will not be ready 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.

Supply of manpower can be stated in a number of senses. First, it refers to the number of workers getting job and the workers with no alternative for survival, join the labour market for getting the job for wages. Secondly, it may be the number of hours or given time period for which each worker is ready for doing job. 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.


In the 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 labour. The same workers and their families consume a major part of the products of the industry.

Hence, if the earning of the labour is high they will have more consuming power, which would help to higher the aggregate demand for goods and also a high level of output. On the other hand, if the wage rates were low, their purchasing power would be less, which would bring about a decrease 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.


Behavior 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. Remuneration of every worker has a behavioral objective and seeks to fulfill the survival need (physiological or psychological) to fulfill the goals. Luthans argues that `motivation is a process that starts with a physiological or psychological deficiency or need that activates behavior or a drive that is aimed at a goal.

Compensation policy are targeted at rewarding manpower for their skill, talent, performance, effort, responsibility and working conditions and increase their morale for efficient performance.

Behavioral theories are divided into three categories:-

Content theories

Process theories, and

Contemporary theories


The content theories explain what inspires manpower at their jobs. Maslow, Hergberg and Alderfer gives their significant contribution to content theories. These are as follows:-


Abraham Maslow proposed the first theory called the hierarchy of needs theory. He proposed five needs of any people in needs hierarchy physiological or basic need (food, shelter, clothing), safety need (emotional and physical safety – health insurance, pension), social need (affection and belongingness to society), Self-esteem need (power, achievement, status, etc.), and self- actualization (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.

2.TWO FACTOR THEORY OF MOTIVATION: Herzberg extended work of Maslow and developed a specific content theory of work motivation. Factors of this motivational theory divided into two categories:

Intrinsic cand Extrinsic. Interinsic factors are the motivators (satisfiers) for the workforce and, Exterinsic factorsar the hygiene factors (dissatisfiers). Intrinsic remuneration are motivators or satisfiers work for satisfy workers related to job content. It includes success, identification, responsibility, work enrichment, and works enlargement. Extrinsic remuneration are hygiene factors and helps to reduce the dissatisfaction on the job. It includes company rules regulation and administration, supervision, co-ordination, salary structure, interpersonal relations, working environment

3.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 connected needs and 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 social environment, one set of needs may precede over others.

The job of Maslow, Hergberg and Alderfer are related to content theories. They give useful theories but have limited implications for policy and practice.


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

EXPECTANCY THEORY: Victor Vroom developed expectancy theory under process theory based on the abstract of valence, expectancy and instrumentality.

Valence states to an individual’s orientation for a individual result. For instance, most old employees perceives value benefits against fewer, if any, younger employee in today’s knowledge industry, single (unmarried) workers with fewer family responsibility have less or no need for benefits like children’s education, health benefits, leave travel allowance etc. than older, married employees with one or more children.

Instrumentality refers that a people would be inspired to give better performance in anticipation of promotion.

Expectancy states that the degree of chances accor to a particular activity or process or effort will lead to particular first-level results on the other hand, Instrumentality states to the degree of chances that relates first-level results and desired second-level results. In simple words, Motivation is a -function of valence and expectancy.

According to Vroom’s concept it can be interpreted that: manpower gives to the organization what it needs from people, higher performance and in exchange they expect promotion.


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, developed by equity theory, and give their views that primary input on job performance and satisfaction on the basis of equity that people fells in their working conditions. Inequity comes in existence when a manpower feels that the ratio of his or her results to inputs and the ratio of a relevant other’s results to inputs are imbalanced.

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Equity can be stated in two elements. One is internal and other is external. Internal equity states that the imbalance in the remuneration between the several skills or talent and responsibility level among the various manpower. Internal equity is determined through job evaluation.

External equity states that when remuneration levels for same skills levels in one organization compare with other workers in any different organization in same industry and geographical region. External equity is determined usually through compensation surveys or interview and compensation satisfaction surveys. Companies, which pay remuneration at lower rate than the market rates, would be in problem to attract, retain and inspire manpower to perform with full efficiency.

Our manpower doesn’t perceive happiness when they get lower remuneration than what they deserve. When an employee gets remuneration at higher rates than what he/she considers is fair. Now the question is that to check out what they are receiving, what they deserve and what is fair for our manpower to maintain balance or equity in compensation system.


This theory is contributed by Fritz Heider, Lewin and Festinger. They assume that people are rational and logical in their behavior and that both inter and outer forces get composed additively to conclude behaviour. People will behave differently if they realize that their results are controlled or supervised more internally than externally. This theory has great efficiency for understanding organizational behaviour and contributes 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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