Theories of Wages

Wages are the payment labour receives for its contribution to production. Before looking at how wages are determined, it is worth separating two ways of measuring a wage.

Nominal (money) wage is simply the number of rupees a worker is paid. Real wage is what that money can actually buy -- its purchasing power once the general price level is taken into account. A worker's money wage can rise year after year while the real wage actually falls, if prices are rising even faster; judging any genuine improvement in a worker's standard of living always requires looking at the real wage, not the money figure alone.

Subsistence theory of wages (the "Iron Law of Wages"). Associated first with David Ricardo and later sharpened by Ferdinand Lassalle into the phrase "Iron Law of Wages," this theory argues that in the long run competitive wages are pulled down to the bare level needed for a worker to survive and raise the next generation of workers -- no more. The logic follows Malthusian population reasoning: if wages rise above subsistence, workers live better, the population grows faster, and the resulting extra labour supply competes wages back down; if wages fall below subsistence, malnutrition and higher death rates shrink the workforce, making labour scarcer and pushing wages back up. Over time, wages keep gravitating back to this subsistence equilibrium. The theory is criticised today for its rigid, almost mechanical link between wages and population, and for ignoring trade unions, minimum-wage laws, and rising productivity, all of which have let real wages in most modern economies climb well above bare subsistence; it is studied mainly for its place in the history of wage theory.

Wage-fund theory. John Stuart Mill proposed that, at any given moment, the economy holds a fixed stock of circulating capital set aside out of past savings specifically to pay labour -- the wage fund. The average wage is then simply this fund divided by the number of workers looking for work:

On this reasoning, average wages can rise only if the fund grows faster than the workforce, or if the workforce shrinks while the fund stays put -- which implies that a general wage rise demanded by workers, without any change in the fund or the workforce, cannot succeed for labour as a whole. Mill himself later backed away from treating the fund as rigidly fixed, and the theory has been criticised for assuming a pre-set fund rather than one that expands along with the economy's growing output.

Bargaining theory of wages. John Davidson argued that, in practice, wages are not pinned down by any single mechanical formula but are settled through the relative bargaining strength of employers and workers (commonly acting through trade unions). A strong, well-organised trade union facing a less organised set of employers can push the wage rate above what a purely competitive market would set, while workers with weak or no organisation, facing powerful employers, may be forced to accept less. Actual wage rates, on this view, settle somewhere within a band bounded above by what employers can afford to pay and below by what workers are willing to accept, with the exact point fixed by each side's bargaining power. …