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How Are Wages Determined by the Marginal Productivity of Labor?

Updated on June 1, 2014


The theories of wages explain how wages are determined. There are many theories of wages but not theory is free from criticism. A major difficulty in formulating a theory of wages is that while considering the remuneration for labor, we should take into account the human factor involved in labor. In other words, any realistic theory of wages should take into account even some non-economic factors, which have a great influence on the determination of wages. Marginal productivity theory of wages is an eminent concept in economics to understand the role of marginal productivity of labor in wage determination. Other most important theories of wages are the subsistence theory of wages or the iron law of wages, the standard of living theory, the wages-fund theory, and the residual claimant theory.

The Marginal Productivity Theory of Wages

The Marginal Productivity Theory of wages is nothing but an application of the marginal productivity theory of distribution (i.e., the general theory of distribution). The theory tells how wages would be determined under conditions of perfect competition. According to this theory, wages will be equal to the value of the marginal product of labor.

The demand for labor is derived demand. That is, an employer demands the services of a worker because his services are needed for the production of some goods. In other words, he demands labor because it is productive. As an employer goes on increasing the units of a factor, the returns from additional units will diminish eventually. This is because of the influence of the Law of Diminishing Returns. An employer will go on increasing more and more units of labor until the wage he pay are equal to the value of the marginal product. In other words, wages are determined by the marginal productivity of labor. The marginal productivity of labor is equal to the value of the additional product, which an employer gets when he employs an additional unit of labor, the supply of all other factors remaining constant. It is assumed that all units of labor are uniform. So the productivity of the marginal unit of labor settles the rate which is to be paid to all units of labor. This, in short, is the marginal productivity theory of wages.


  1. Every product is a joint product and its value cannot be separately attributed to either capital or labor or land. It is almost impossible to measure the specific product of each of the factors. The problem becomes more complex when we have to measure the productivity of certain categories of labor that render services (example: doctors, actors and teachers).
  2. The theory assumes perfect competition. But in the real world, imperfect competition is the general rule.
  3. Under conditions of monopoly, where there is exploitation of labor, wages will be much less than the marginal productivity of labor.
  4. It takes a long time to produce some goods. An entrepreneur pays wages for many months before his products are made and can be sold. So he cannot afford to pay them the full value of their marginal product. He pays only their discounted value because he has to deduct interest on the capital he has invested from the marginal product, until he sells his product. This, in short, is the discounted marginal productivity theory of wages. “Wages are the discounted marginal product of labor.”
  5. The theory does not carry with it any ethical justification. It may be used by the employers to show that wages are low because productivity is low. But exploitation of labor might also be a main cause of low wages.

Lastly, it does not pay much attention to influences acting on the side of supply. Nevertheless, the marginal productivity theory explains the role of productivity in the determination of wages. As Marshall puts it, “The doctrine throws into clear light the action of one of the cause that governs wages.”

The Subsistence Theory

According the subsistence theory, the sum that is paid to the worker, as wages must be just enough to cover his needs. The followers of the theory believed that in the interests of the workers, the level of wages at any time should not exceed the subsistence level. They argued that if workers were paid higher wages, that would tend to increase population. This in turn would increase the supply of labor again. Their argument seems to be that an increase in wages would eventually result in a fall in wages. So in order to prevent a fall in wages, workers should not be paid more than what is necessary to keep them at subsistence level. In addition, wages cannot be paid below the subsistence level because it would cause starvation, disease and death among workers. So there will be shortage in the supply of labor and wages will go up. In the past, economists believed that the value of a commodity is determined by the cost of production. They regarded labor as a commodity and the subsistence wages as the cost of producing labor. The subsistence theory is also known as the Iron Law of Wages.


First, the theory is based on the assumption that an increase in wages will result in an increase of population. It is not a correct view. Second, a worker is a human being. Man is different from the animal. Apart from providing the minimum needs like food, clothing and shelter, the wages of a worker should enable him to enjoy some good things of life. Third, the theory is one-sided. It looks at wages only from the side of supply and ignores the influences acting on the side of demand for labor. Fourth, it cannot explain why there are differences in wages. Lastly, it has not ethical justification.

The Standard of Living Theory

The standard of living theory is an improvement of the subsistence theory. While the subsistence theory tells that wages paid to a worker must be just sufficient to provide for his subsistence, the standard of living theory makes allowance for some comforts and a few luxuries besides the basic needs. The theory tells that wages are determined by the standard of living of workers. If standard of living is high, wages will be high. If standard of living is low, wages will be low.


It is true that there is some connection between standard of living and wages. But it is rather difficult to say which is the cause and which is the result. There theory tells that standard of living determines wages. But it may not be wrong to say that wages determine the standard of living. In fact, one of the main causes for the low standard of living of India workers is low wages. All that we can say is that both wages and standard of living are interdependent. A great difficulty with regard to the theory is that the standard of living cannot be measured correctly because it is a vague thing. Since it is always changing, it will be difficult to measure it.

The Wages Fund Theory

The Wages Fund Theory is associated with the name of J.S. Mill. According to this theory, “wages depend upon the proportion between population and capital.” The argument of the theory runs more or less in the following manner. At any time, a fixed amount of capital is allotted for payment of wages to labor. This is the wages-fund. It represents the demand for labor. Further at any time, there will be a fixed number of workers willing to work. It represents the supply of labor. Wages, at any time, are determined by the ratio between the amount of wages-fund depend upon the proportion between the number of workers and the capital that forms wages-fund. The fund remaining the same. If there is an increase in the supply of labor, wage will fall. The advocates of this theory, under the influence of Malthus, believed that a general rise in wages would increase the population, which in turn would lead to a fall in wages. Since the wages-fund is more or less a fixed amount, the theory argued that there can be rise in the wages in one industry only at the expense of wages in other industries. The conclusion of the theory is that a general rise in wages is impossible unless, the supply of labor is regulated by controlling the increase of population.


The theory has been subject to many points of criticism. First, theory assumes that a rise in wages will result in an increase in population. But there is not direct relationship between the two. Second, it does not explain inequality of wages in different occupations. Lastly, the theory believes that if wages rise, profits will fall. This is not a correct view. For, in times of good trade, both wage and profits will increase.

The Residual claimant Theory

According to this theory, wages are paid out of the residue that is left over after paying rent, interest and profits. In the words of Prof. Walker, an American economist, wages “equal the whole product minus rent, interest and profits.”


A great merit of the theory is that it takes into account productivity as a factor in determining wages. But it tells that a worker gets the residual share in the product of an industry. It is like putting the cart before the horse. Wages are in the nature of advance payment and they have to be paid first. Usually profits are taken at the end. It is the entrepreneur who gets profits at the end by taking the residual share of industry.


None of the above theories taken by itself can explain how wage are determined. Wages are governed by many causes. Each theory lays stress on one or two points but does not explain all the factors that govern wages. Any realistic theory of wages must take into account both the supply of labor and the demand for it. Demand for labor depends on its marginal productivity and supply of labor depends upon population. Where there is scarcity of labor, wages will be high. Trade unions exercise a great influence on the determination of wages. In all those industries where trade unionism is strong, wages are generally high.

© 2013 Sundaram Ponnusamy


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