November 3, 2012

MU0015 [Compensation Benefits] Set1 Q2

Q.2 Explain the economic theories of wages?

Ans:

Economic Theories of Wages : Many things influence the compensation decisions made in organisations and one of them is economics.
Economists view compensation as a labour market determinant. Economic theories specify the economic factors that determine employee compensation, the manner in which they do so, and the importance of each.

Subsistence theory
Subsistence theory, also known as the “Iron Law of Wages” was proposed by David Ricardo. According to this theory, employees should be paid towards their labour in producing goods so as to enable them to survive, thereby neither increasing nor diminishing the human race. In other words, wages cannot fall below subsistence level because without subsistence, labourers will be unable to work. On the contrary, if the compensation increases beyond the subsistence level, then the number of employees would also increase, because the employees will be in a better position to support larger families. This would then cause the compensation to fall due to the increased supply of labour than demand. When the compensation falls below the subsistence level, employees would die of hunger, malnutrition and diseases. Hence, the number of employees available for employment will come down, which, in turn, would push up the demand for labour. This increase in demand will push up the compensation beyond subsistence level.

Differences in the statement of the subsistence theory of wages continued to arise, even from those who have been regarded as its reliable advocates. Malthus, basing his theory of wages on his theory of population, followed the supply and demand theory, advocating the restraint of marriages as a means of decreasing the supply of employees and thus raising the standard of wages. Malthus stated it as "that amount of those necessaries and conveniences, without which they would not consent to keep up their numbers."

Wages fund theory
This theory was proposed by Smith. This theory assumes that every organisation has a fixed fund of capital to pay wages. The inventory of goods or capital is termed as the wages fund, and its source is the savings of the industrialists.

Given the size of the labour force and the wages fund, the wage rate is determined as:
Wage rate= wages fund/labour force.

Surplus value theory
This theory was proposed by Karl Marx (1818-1883). According to this theory, an employee was an article of commerce, which could be purchased on payment of the ‘subsistence price’[2]. The price of any product and the time needed for producing it was determined by an employee. An employee was not paid in proportion to the time spent on work, but was paid much less, and the surplus was utilised for paying other expenses.

Residual claimant theory
The residual-claimant theory states that, after all other factors of production have received compensation for their contribution to the process, the amount of money left over will go to the remaining factors like wages. Smith suggested this theory for wages, since he assumed that rent would be deducted first and profits next. Walker worked on a residual theory of wages and suggested that the shares of the landlord, capital owner, and industrialist were determined independently and subtracted, thus leaving the remainder for an employee in the form of wages. However, it should be noted that any of the factors of production may be selected as the residual claimant assuming that independent determinations may be made for the shares of the other factors.

Marginal productivity theory
According to marginal productivity theory, the rate of wages paid to the employees tends to be equal to the marginal net product of employees employed at the margin. This theory assumes that all units of the factors are homogeneous. The factors used can be continuously varied. This theory is based on the law of falling marginal returns. The theory shows that when the employment increases, the wages decreases. It is difficult to calculate the marginal productivity of a factor in most of the areas. It also assumes that the supply of factors is fixed. This theory is applicable only under perfect competition.

Bargaining theory of wages
Bargaining theory of wages was developed by Davidson. According to this theory, wages are determined by the relative bargaining power of workers, the trade unions and employers. When a trade union is involved, basic wages, benefits, job differentials and employee differences tend to be determined by the relative strength of the organisation and the trade union.

A neoclassic competitive theory
The neoclassic economic theory argues that it will be good if employees can choose their own wage benefits among various alternatives. Further, if employees are sufficiently compensated, then the economic welfare of society as a whole is increased. The basic idea for this argument is that employees can decide what is best for them. However, in matters of employee benefits, wages or compensation, there are several rules which define the range of choices.

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