Wage Theories and Reality 4.

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HISTORICAL THEORIES Just Price Theory Although most historical theories of wages are economic, the oldest is essentially sociological. The just-price theory, adhered to in the Middle Ages, involved setting wages in accordance with the established status distribution. Wages were systematically regulated to keep each class in its customary, and hence "right," place in society. Higher-status persons got higher wages. This emphasis on tying of wages to status, and the preservation of customary relationships, although developed in pre-industrial times, has a modern ring. These ideas are still common today. Employees and organizations are concerned with using correct comparisons to assign "proper" relationships and maintain some hierarchical order of wages in the organization. An example would be organizations' pay policies that call for supervisors to be paid more than subordinates.

Classical Wage Theory During the Industrial Revolution, market forces became dominant and laissez-faire principles were invoked to free market forces from custom and regulation. Adam Smith set the stage for what is now called classical wage theory by providing a plausible explanation of the relation between the price of goods and the amount of labor required to secure them. Although he did not develop a wage theory, he made a number of observations pertinent to wages. His labor theory of value, which concluded that the full value of any commodity is the amount of labor it will buy, may be considered a theory of labor demand. But his observations on wage differentials speak to today's wage issues. He suggested that people choose the employment that yields the greatest net advantage. He proposed that there are five characteristics used to differentiate jobs and thus net advantage: (1) hardship, (2) difficulty of learning the job, (3) stability of employment, (4) responsibility of the job, and (5) chance for success or failure in the work. He also identified two quite different standards for comparing things of value: use value and market value. Use value refers to the value anticipated from use of the item. It varies among individuals and over time. Market value refers to the price something will bring. In a free market where demand and supply are equal, use value will equal market value.

Subsistence Theory It was Thomas R. Malthus's theory of population that provided the raw material for the first economic wage theory. Population, according to the theory, is limited by the means of subsistence: it increases geometrically whereas the means of subsistence increases arithmetically. David Ricardo translated Malthus's theory into the subsistence theory of wages. According to this theory, wages in the long run tend to equal the cost of reproducing labor, the subsistence of the laborer. This theory, often called the iron law of wages, indicated that little could be done to improve the lot of the wage earner because increasing wages leads only to increasing the number of workers beyond the means of subsistence.
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The subsistence theory was an explanation of the general level of wages in terms of labor supply. Any increase in the wage rate above the subsistence level would induce an increase in the birth rate and therefore in the supply of labor. The expanded labor supply would force the wage rate back to the subsistence level. Any decrease in the wage rate below the subsistence level would result in starvation and a reduction in the labor supply. Although the market price of labor might temporarily climb above or fall below the natural price, the two would converge in the long run. In the industrial world, the theory erred in two ways: (1) improvements in technology have greatly increased the ease and methods by which subsistence can be attained, and (2) cultural forces have limited birth rates. Although Ricardo recognized the potential effects of the second factor, he believed that labor supply rather than labor demand would determine the general wage level in the long run. Although the iron law of wages seems to have been repealed in the industrial world, it appears to still be in effect in many other parts of the world. Population growth holds back economic development in many developing countries. Famine is still part of the world scene. High unemployment in most of the industrial world and the effects of the Baby Boom on the American labor force suggest further that Ricardo had a point.

Wages-Fund Theory The short-term version of classical wage theory was the wages-fund theory. As described by John Stuart Mill, this theory explained the short-term variations in the general wage level in terms of (1) the number of available workers and (2) the size of the wages fund. The wages fund was thought to come from resources accumulated by employers from previous years and allocated by them to buy labor currently. Employers were thought to have a fixed stock of "circulating capital" for the payment of wages. Dividing the labor force (assumed to be the population) into the wages fund determined the wage. The theory erred in assuming that a fixed fund for the payment of wages exists and that it accounts for labor demand. Most workers are paid out of current production. Employers balance labor costs against other costs in determining labor demand. Both employers and workers, however, often talk as if such funds exist and as if they determine the amount of labor services needed. They may also accept the implication of the theory that any gain to one group is a loss to others.

Residual Claimant Theory Francis A. Walker's residual claimant theory may be thought of as an American version of the wages-fund theory. Here, the workers' demand for wages represents the residual claimant on output after rent, interest, and profit have been independently determined and deducted. Assigning wages rather than profits as the residual seems curious, but it does suggest that distribution of income is a matter of decision. It also permitted Walker to suggest that if labor increased its productivity without the use of more capital or land, its residual would increase the germ of a productivity theory.
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Marxian Wage Theory The economic and social climate that produced classical wage theory perhaps inevitably produced Marxian wage theory. Marx accepted the subsistence and the wages-fund theories. He interpreted Smith's and Ricardo's labor subsistence theory of value as meaning that labor is the sole source of economic value. His explanation of the wage-setting process was that the entrepreneur collects the value created by labor but pays labor only the cost of subsistence. The difference is surplus value, roughly equivalent to profit. The existence of surplus value means exploitation of labor. Competition among capitalists, Marx argued, results in the accumulation of labor saving capital (jellied labor). This substitution of capital for labor results in technological unemployment and a reserve army of unemployed. Because labor is the only source of value, substituting capital for labor results in a falling rate of profits. The only solution for capitalists is to spend relatively more on capital and relatively less on labor. In this way, surplus value can be maintained by further exploitation of labor. This exploitation of labor in turn results in a class conflict which would, according to Marx, result in the demise of capitalism. Although Marx's assumptions and predictions were faulty, his arguments are still voiced in parts of the underdeveloped world and by radical economists in the United States. Capital produces value, but it can be defined as embodied labor. Land also produces value. In the industrial world, labor's absolute and relative shares of the fruits of production have continually increased and real wages have risen. Although many of Marx's objectives have been realized without revolution, his argument that income distribution depends on social decisions as well as economic forces remains valid.

Human Capital Theory The quality of labor supplies is explained by human capital theory. Experience, schooling, and on-the-job training are all forms of investment in human capital, as are expenditures designed to improve worker health. The costs of migration to labor markets offering better employment opportunities are also investments. Human capital theory analyzes the effects of additional experience, education, and on-the-job training on the quality of the labor force. It also analyzes employee and employer decisions on investment in human capital. Private investment in schooling is analyzed by comparing the age-earnings profiles of individuals having differing amounts of schooling. The cost of continued education to the individual includes the cost of foregone earnings as well as direct costs. To be worthwhile, an investment in additional education must yield lifetime earnings in excess of these costs. The analysis usually includes discounting additional earnings at some rate of interest to yield the present value of that investment. Such analyses show that the more schooling, the higher the average wage within that age group. Also continued-education returns are greater at completion points than in intermediate years. They also show, not surprisingly, that these investments made later in life yield a lower return. Furthermore, a high rate of return could attract many more college entrants and eventually eliminate the return.

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Marginal-productivity theory The generally accepted theory of labor demand is an application of the marginalproductivity theory of the demand for any factor of production. Because the demand for labor is derived from the demand for a product or service, it is almost always employed in combination with other productive factors. A demand schedule for labor is the relationship between a price (wage) and the quantity of labor needed. Demand alone does not determine the wage except where the supply schedule is perfectly vertical (inelastic), a very unusual situation. Demand has no effect on the wage where the supply curve is perfectly flat (elastic), but it does determine employment. In all other cases, wages and employment are jointly determined by supply and demand.

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