Wages: marginal productivity theory, subsistence theory, collective bargaining and wage differentials

1. The problem of distribution

The national product is produced by land, labour, capital and organisation, and is shared among them as rent, wages, interest and profit. Functional distribution asks how the price of each factor is fixed; personal distribution asks how income is divided among persons. Micro economics deals with the first: factor pricing is the application of price theory to the factors of production.

2. Marginal productivity theory

Developed by J.B. Clark, P.H. Wicksteed, L. Walras and others towards the end of the nineteenth century. Statement: under perfect competition, the price of a factor tends to be equal to the value of its marginal product. An employer goes on hiring a factor until the value of what the last unit adds to output equals the price he pays for it.

• Marginal physical product (MPP): addition to total output from one more unit of the factor.
• Value of marginal product (VMP) = MPP × price of the product.
• Marginal revenue product (MRP) = MPP × MR. Under perfect competition in the product market MR = P, so VMP = MRP.

Assumptions: perfect competition in both factor and product markets; units of the factor are homogeneous and perfectly mobile; the law of diminishing returns applies; other factors fixed; full employment; the employer seeks maximum profit; factors are substitutable.

3. Worked schedule

Product price Rs. 50 a unit; daily wage Rs. 500.

The employer hires 4 workers, where VMP = wage. Hiring the 5th would add Rs. 400 to revenue but Rs. 500 to cost. If the wage fell to Rs. 400, he would hire 5. The downward-sloping VMP curve is therefore the firm’s demand curve for labour.

In the long run, under perfect competition, the wage equals both the marginal and the average revenue product of labour (W = MRP = ARP), so the firm earns only normal profit. Described diagram: ARP and MRP are inverted-U curves with MRP cutting ARP at its peak; the horizontal wage line touches ARP at its peak.

The theory is also a general theory of distribution: each factor (land, capital, enterprise) is paid its marginal product. Under constant returns to scale, paying every factor its marginal product exactly exhausts the total product (the “adding-up” or product exhaustion problem, solved by Wicksteed using Euler’s theorem).

4. Criticism

1. Perfect competition is unrealistic; in imperfect markets the factor is paid less than its VMP (Joan Robinson’s exploitation of labour).
2. Factors are not homogeneous or perfectly mobile.
3. Marginal product cannot be isolated: output is the joint result of all factors working together, so the separate contribution of one is hard to measure.
4. Full employment is assumed, which Keynes rejected.
5. It is one-sided: it explains the demand for a factor but not its supply; wage is set by both.
6. It ignores bargaining, trade unions and minimum-wage laws.
7. It has an ethical flaw if read as saying that what a factor gets is what it deserves.

Principles of Economics covers the same theory in marginal productivity theory of distribution and wages.

5. Subsistence theory of wages

The oldest wage theory, held by the Physiocrats and the English classical economists (Adam Smith and especially David Ricardo). Statement: in the long run the wage tends to equal the minimum of subsistence needed to keep the worker and his family alive. The German socialist Ferdinand Lassalle called it the iron law of wages (eherne Lohngesetz).

The mechanism rests on Malthus’ theory of population. If wages rise above subsistence, workers marry early and have more children; the supply of labour rises and wages are pushed back to subsistence. If wages fall below subsistence, starvation, disease and later marriage reduce the labour supply and wages rise back.

Criticism:

• The Malthusian link failed: real wages in industrial countries rose far above subsistence while birth rates fell.
• It is a supply-side theory only, ignoring the demand for labour and its productivity.
• It cannot explain wage differences between occupations.
• “Subsistence” is vague; the standard of living is itself cultural and changes.
• It leaves no room for trade unions or for wages rising with productivity.

It retains some truth for unskilled labour in poor, labour-surplus economies, and it influenced Marx’s theory of surplus value.

6. Collective bargaining and wages

Collective bargaining is negotiation over wages and conditions of work between an employer and a trade union acting for the workers as a body. The bargaining theory of wages holds that the wage is fixed between an upper limit (the MRP of labour, beyond which the employer will not go) and a lower limit (the minimum the workers will accept), and where it settles depends on the relative bargaining strength of the two sides.

A union can raise wages by: (i) bargaining when the employer pays less than MRP (exploitation under monopsony), (ii) restricting the supply of labour (apprenticeship rules, closed shop), (iii) raising productivity through better working conditions, and (iv) the threat of a strike. Its power is greater where demand for the product, and so for labour, is inelastic, and where labour forms a small part of total cost.

Indian law: since 21 November 2025 the four Labour Codes are in force. The Industrial Relations Code, 2020 (replacing the Trade Unions Act, 1926 and the Industrial Disputes Act, 1947) governs trade unions, recognition of a negotiating union or council, settlements and strikes; the Code on Wages, 2019 (replacing the Minimum Wages, Payment of Wages, Payment of Bonus and Equal Remuneration Acts) provides minimum and floor wages.

7. Wage differentials

Wages differ between occupations, persons and places. Adam Smith listed five causes in the Wealth of Nations: (i) agreeableness or disagreeableness of the work, (ii) the cost and difficulty of learning it, (iii) constancy or regularity of employment, (iv) the trust reposed in the worker, and (v) the probability of success. Add:

• differences in efficiency, skill and ability;
• non-competing groups (J.E. Cairnes): social and educational barriers keep workers in separate layers between which they cannot move;
• immobility of labour between places;
• risk and danger of the job (mining, defence);
• strength of trade unions in different industries;
• discrimination by sex, caste or region, which the law forbids but which persists;
• differences in the cost of living between cities and villages;
• government policy: minimum wages and pay commissions.

How this is examined

January 2026 set “Explain the marginal productivity theory of distribution” as Q.5 (16 marks, 100-mark paper) and Q.5(a) (10 marks, 80-mark paper), with “Write a note on collective bargaining and wages” (6 marks) and “Wage differentials” (8 marks, 100-mark paper). February 2025 also set “Wage differentials” as an 8-mark note. For the long answer: statement, concepts, assumptions, the schedule, the long-run diagram described, and seven criticisms. For differentials, start with Adam Smith’s five causes and add Cairnes.