CHAPTER - II

COMPENSATION : ECONOMIC THEORIES

2.1. Macro Theories

2.1.1 Classical Wage Theories

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2.1.2 Wage Control Theories

2.2 Micro Theories

2.3 Micro-Micro Theories
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2.1.3 Justification Theories
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 CHAPTER- II

COMPENSATION : ECONOMIC THEORIES

The theoretical framework of compensation management has traversed an evolutionary

trajectory with its underpinnings dating back to the pre-Christian era of Plato and Aristotle. The

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economic theories that have developed overtime can be broadly classified as:

Macro Theories
Micro Theories
Micro-Micro Theories
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The macro theories attempt to provide an explanation of the level of compensation of
workers from a broader perspective of the economy as a whole. The classical theories in this
group do not consider individual knowledge and skill differences. With the revival in the
Renaissance and the emergence of the Industrial revolution supply and demand forces came to
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be recognised. The Marxian philosophy and Keynesian prescriptions are also included in this
group. The perspective of the micro theories is a given industry or a firm. Wage structures are
analysed in the context of a bargain or exchange between the employer and the employee. The
human element was not given due importance in both the micro and the macro theories. Micro-
micro theories give due consideration to models of behavioural economics. These theories under
score the importance of management practices on the attainment of the higher order needs of the
individuals and organisational productivity.

The combined impact of these theories can be analysed in terms of the 'funnel' model.
Coming down the model through the funnel are the theories that see to have a stronger influence
on wage levels. The influence of a theory is more pronounced as it becomes closer to
'compensation'.
 Figure 2.1

Model of Economic Theories

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Source: The original idea and components of this model of economic theories was developed by
John. W. Crim, Crim's original model has been modified by the contributions made by
Bruce E. Kaufman, Robert Figler and Richard I, Henderson.
2.1. Macro Theories

These theories being 'macro' in nature focus on the economic influences of the society
that determine the level of compensation of workers. The macro theories of compensation are of
the earliest vintage and the initial theories, though applicable in their times have little or no
applicability in modern times.

2.1.1 Classical Wage Theories

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The Social Wage Theories which are classified as the classical Wage Theories do not
consider the talents and skills of the workers or the quality and volume of production. The

their need or right.

Subsistence Theory of Wages

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purpose of these theories is to justify what the society ought to pay to its members depending on
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The origin and cardinal aspects of this theory predate the Christian era. The rudimentary
notions of this theory were further refined and elaborated by David Rickardo in 1817. The
influence of the earlier works of Thomas Num and Thomas. R. Malthus are evident in this
theory. Rickardo's proposition deals with population rather than labour. It is suggested the
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provision of food, clothing and shelter to each member of the society should be such that they
continue to exist. The implication is that if the workers' remuneration is more than their
subsistence level they world procreate more resulting in increased population and increased
labour force. The pressure exerted because of the forces of supply and demand world result in
the lowering of wages.

Just Price Theory

This theory was developed by philosophers of Rome and Greece in the pre-Christian
eras. They attempted to explain and elaborate the economic relationship among social groups.
The basic tenets of this theory were proposed by Plato and Aristotle and suggested that each
person is ordained to be placed in the same status and to enjoy those comforts as that of their
parents. The obligation of the society is to offer these individuals the level of compensation to
maintain the same status and position into which they were born. The rule of birthright is
defended by this theory and establishes a two-tier society, with an elitist upper class and a lower
class surviving at the subsistence level. No mention is made about the small group between
these two tiers which provided the knowledge and skills to make society functions and enjoyed a
lifestyle much better than at the subsistence level.

This two-tiered structure of the society was defended by the Biblical teachings. It has been
proposed in the old Testament, a form of philosophical equality by stressing that the have-nots
or the lower class will have the first priority in heaven vis-a-vis the upper class. The concern for

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equality and the provision of a subsistence wage has been described in the New Testament
where every worker is paid a penny regardless of the working-conditions, hours worked and
output delivered.

Just Wage Theory

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This theory is the evolved version of the Just Price Theory and established itself during the
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feudal period of the Middle Ages in Europe. Artisans, artists and traders got more job
opportunities because of expansion of commercial activities and the construction of churches
and government buildings. The artisans and artists, like their earlier counterparts in ancient
Rome, Greece and Egypt felt that they should receive better wages than the unskilled workers
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who provided physical work that required very less of intellectual effort. This was a deviation
from the Just Price Theory which advocated the same level of remuneration to all workers to
maintain them just at the subsistence level.

The Church strongly supported this theory with the philosophical under- pinnings provided
by St. Thomas Aquinal. He proposed the concept of a common father and brotherhood of man. It
was suggested that the price of any article should be adequate to cover the cost of production
which is based on the standards of living of the producers of that article. Aquinas supported the
view that the society should give each individual adequate compensation to maintain exactly the
position in life into which the individual was born. Entrepreneurial profit and differences in
productive efficiency between workers was not given any consideration. The Just Wage Theory
gained acceptance in the Middle Ages and the Renaissance. In spite of this acceptance artists
and artisans were able to demand and receive wages exceeding the subsistence wage for their
efforts. This was because of the shortage of skilled workers due to the expansion of building
activities. Formal recognition was accorded to supply and demand forces in the market and in
compensation practices, if not in economic theories.

A key feature of the Renaissance was the invention of the printing press. This provided
an opportunity to people who were infested in advancing their knowledge in a variety of
professional fields like teaching, medicine and engineering. An avenue was created to escape
from preordained subsistence to a more comfortable and secure middle-class lifestyle. Affluence
and influence of the middle-class increased even questioning the the authority of the King. In

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Netherlands, the merchant class became powerful enough to enable their country to become
independent of the Spanish empire. During the eighteenth century the middle class grew both in

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proportion and prosperity. This helped ushering in the Industrial Revolution resulting in a
movement of workers from farms to factories spawning a new set of compensation theories.

Wage Fund Theory

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This theory was proposed by John Stuart Mill stating that wages of workers are paid by
an employer from a fund accumulated by the operations of the preceding years. The employer
who exercised some control over this fund divided it evenly among the workers. This is contrary
to conventional practice where wages are usually paid from current operations rather than past
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operations. In spite of this shortcoming, this theory has some validity if the application is
extended to government and public services where the wage fund is pre-determined and
budgeted in advance.

Residual Claimant Theory

The conceptual framework constructed by David Rickardo in his „Theory of Political

Economy' was further refined into the Residual Claimant Theory by Francis A. Walker. This
theory can be conceived as a version of the Wage Fund Theory as it proposed that the wage fund
is not derived from previous years' operation but from the residue of total revenues. This residue
is obtained after deducting expenses of business operations such as interest, profits, rent and
taxes. A logical but somewhat strange conclusion of this theory would be that if the expenses
were in excess of the total revenue, labour being the 'residual claimant' would have no
entitlement to wages.
Marxian Theory

Karl Marx postulated that the sole source of economic value is labour and hence the first
claim on revenue should be that of the labour. This assertion can be viewed as the inversion f the
Residual claimant Theory. Marx held a pessimistic view of the working conditions of the
workers in the emerging industrial era. He held that the workers would be having no
opportunities to improve their economic condition. Marx advanced further, Rickardo's Iron Law
of Wages through his theory. He stated that only subsistence levels of income would be received

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by the workers in spite of the fact that the profits generated were because of their labour.

The bourgeoisie, who were the influential and affluent section of the society were the

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main villains. Marx, strongly felt that the bourgeoise occupying the middle-class rung of the
society along with the upper-class would relentlessly exploit the lower class and would stall
their mobility from a life of stark poverty and bare subsistence. Despair over this lack of upward
mobility prompted Marx to write the communist Manifesto, urging the proletariat or the working
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class to revolt and overthrow the upper classes. The would result in the formation of a classless
society where the proletariat would have the ownership of the means of production offering than
an avenue for upward mobility.
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The further generation of economic theories was not obstacled by the pessimistic view
held by Marx with respect to the lack of economic opportunities for the workers. The notion of a
market-based economy and its influence on wages started gaining importance. Economic
theories, in the nineteenth century began to deviate away from wage theories based don
subsistence towards the forces of supply and demand of labour in the marketplace.

2.1.2. Wage Control Theories

The Wage Control Theories suggest a varying degree of state intervention to exercise
some control over the wage levels. It is postulated that between the two two extremes of pure
democracy and pure dictatorship, space can be found for constructive state intervention. This
intervention permits, and even demands some degree of indirect control of wage levels.
Full Employment Wage Theory

John Maynard Keynes held the view that for a thriving middle class economy there
should be full employment. This theory states that the level of national income determines the
level of employment. National income comprises of the total consumptions and the private and
public investment. In a situation where the level of income falls below the level which calls for
full employment, it is the responsibility of the government to manipulate any or all three
variables to to bring the economy to the full employment level. The government is an agency,

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potent enough, to design monetary and fiscal policies as well as exercise direct controls over the
private enterprise for maintaining full employment and hence the desired wage level.

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Labour supply is treated as fixed in the Full Employment Wage Theory. The labour
force, in reality, is constantly growing and can vary within rather wide limits. This short-term
variation is because a proportion of the population can exercise their option to be a part of the
labour force or not. This option can be exercised by a second wage earner in the family or by
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older people.

Neo-Keynesian Distribution Theory

This theory is a refinement and extension of the full employment Wage Theory. It
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attempts to explain how the level of full employment can be achieved and maintained without
affecting the stability of prices and the general living standards. This theory encompasses both
the short and the long term. The general level of wages in the short run can be determined to a
large extent by entrepreneurial decisions. Within limits, the money wage rates are determined by
the bargaining strengths of the capitalist and the employees. This is distinct feature of this theory
as the earlier theories held that the wage level is determined entirely by economic forces. The
change in labour supply over time is also given recognition.

Consumption Theory

Henry Ford, on of the greatest industrialists of the United States developed the
Consumption Theory which is also referred to as the Purchasing Power Theory. In 1913, Ford
instituted the $ 5-a-day wage for workers in his automobile plant which was almost twice what
the competitors were paying at that time. The rationale behind this decision was rather simple.
Higher paid workers could buy more products which would enrich their lifestyles. This in turn,
would provide more business and profits for capitalists and stockholders. Ford's actions has also
been termed as the 'New Wage Theory' indicating that higher wages, by encouraging
consumption call for increased scale of productions thereby lowering commodity prices. This
theory involves a macro approach to the general price level in the entire economy though the
instrument of control is private enterprise and not the government.

2.1.3 Justification Theories

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In these theories the level of an individual workers compensation is explained or

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justified. The justification offered is on the basis of the investment a worker makes on himself,
interdisciplinary considerations and the forces of supply and demand.

Investment Theory
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H.M. Gitelman has proposed a wage theory centered or the input side of the employment
exchange. It is acknowledged that the scope of a labour market varies with respect to 'workers
investment' for a specific industry. The investment that is made by an individual on himself or
herself as a human resource is indicative of specific value. It is assumed by the organisation that
investment in human capital and individual productivity are related. The individual worker‟s
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investment' consists of education, training and experience that a worker has acquired. Wage
setting practices utilise the investment concept through the job evaluation system in which a job
is priced on the basis of skills and education required to perform the job. It is hypothesized that
the rate of return on the worker's investment determines the worker's compensation. This theory
conceptually combines broad economic influences on compensation with the specific means
whereby workers can control the level of their compensation.

Institutional Wage Theory

This theory attempts to establish an emperical or quantative basis aligned to a system to

derive the level of compensation. The approach to compensation is interdisciplinary and
considers factors like variability of wage relationships, impact of collective bargaining and
latitude of decision makers. It indicates that the wage level depends on a variety of options
exercised by the decision makers and these options can be assigned weights to emphasize the
significance and importance of the options exercised. Consideration is given to various types of
wage structures, such as, interpersonal, inter-firm, inter-industry, inter-area and inter-
occupational. It suggest that compensation must be analysed from a dynamic perspective based
on general equilibrium rather than on a ceteris-paribus basis assuming the all other factors
affecting compensation are held constant and only one factor is varied.

Supply and Demand Theory

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Logically robust and the least refuted, this theory, postulates that if there are few jobs
and the supply of workers is high, wages will fall, conversely, if there are lots of jobs and a

demand and supply is equated.

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shortage of workers, wages will rise. In the long run wages will be leveled at a point where

At the central core of labour economics is wage determination because, over time the
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changes in the structure and level of wages determine the efficient allocation of labour and the
maintenance of demand and supply of labour in the marketplace. The starting point of the
theoretical construct in this context is the theory of perfect competition which makes some key
assumptions:
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Employers driven by profits seek to maximize utility or satisfaction.

Both employers and workers have perfect information about job opportunities and wages
in the market.

The skills and performance potentials of all workers are identical, and the jobs offered in
the market are identical in terms of working conditions and non-wage attributes.

In the labour market, there are infinite employers on the demand side and infinite number
of workers on the supply side. These large numbers of workers and employers result in
negligible influence of either in the marketplace.
 There are no institutional barriers preventing the mobility of workers from one job to
another. The supply demand model, in labour economics considering these assumptions
take the form as illustrated below.

The forces of demand and supply determine the rate of pay for a particular type of labour
in a specific labour market. This model predicts that wages in the long run will be determined by
the equalisation of the demand and supply forces. The wages so determined will the equilibrium
wage. If the prevailing wage rate is higher than the equilibrium wage there will be excess supply

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of labour and the resulting competition will push down the wage to the equilibrium wage. If the
prevailing wage is lower than the equilibrium wage the excess demand for labour and the

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competiton for workers will raise the wage to the equilibrium wage.

In spite of the assumptions of perfect competition being restrictive and unrealistic this
model is important as it highlights the role of market forces in the process of wage
determination. The imperfections in the real world cause the wage rate to deviate from the
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theoretical ideal of perfect competition. The market forces in the real world do not determine a
unique wage rate for each type of job but establish a range with an upper limit and a lower limit.
The employer has some discretion within this range The employers or the firm cannot pay more
than the upper limit as the profits will be drastically reduced. Paying wage below the lower limit
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will not attract workers at all. An area of indeterminacy is established between the lower limit
and the upper limit within which the firm can formulate its own wage policy. As firms have
some discretion over the wage rate they pay, it is possible to find a distribution of firms in the
labour market. These firms in terms of wage payment can be high wage firms, and low ways
firms and the remainder somewhere in middle. This placements are called contours. The
determinants of a firm in being a particular contour are the profitability of the firm and its ability
to pay. These are additional determinants, the primacy being the level established by supply and
demand.

2.2 Micro Theories

The micro theories of compensation attempt to analyse the wage structure within a given
industry and also within affirm from the perspective of an exchange between the employer and
the employee or from a bargaining view point.
Marginal Productivity Theory

The basis for this theory was first proposed by Johrann Thuren a German economist in
1876. Further developments are attributed to Philip Henry Wicksteed in England and John Bates
Clarke in America. This theory basically proposes that the wage paid to an employee should be
equal to the extra value of productivity that the employee adds to total production. Clark
assumed a completely static society free from the influence of economic growth or changes. He
assumed constant capital, constant population and unchanging techniques of production. Besides

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the assumption of static economy he also assumed perfect competition in the labour market and
perfect mobility on part of both labour and capital. With these assumptions, it was attempted to

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find the natural values of wages and other productive factors towards which all actual values in
the real dynamic world tent at any moment of time. Besides assuming that the total stock of
capital remains constant the form of capital can be varied. This implies that the physical
instruments of production can be adapted to varying quantities and abilities of available labour.
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The wage paid to an employee should be equal to the extra value of productivity that the
employee adds to the total production. The revenue obtained by the employer from the worker's
productivity determines the value of the worker's production. The last worker hired is called the
marginal employee and his contribution in production is called as the marginal product. Wage
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paid to this last marginal employee determines the wages of all other workers doing a similar
job.

Every rational employer or entrepreneur will try to utilize his capital stock so as to
maximise his profits. Towards this objective he will hire workers that can be profitably put to
work with the given amount of capital. Marginal productivity of labour for an individual firm or
industry declines as more workers are added to the fixed stock of capital. The employer will
keep on hiring more workers as long as the addition made to the total product by a marginal
worker is greater than the wage rate he has to pay for it, Equilibrium position would be reached
by the employer when the wage rate is just equal to the marginal product, employment of more
workers beyond this point will result in losses.

Since perfect competition is assumed to be prevailing in the labour market, an individual

firm or industry will have no control over the wage rate, Marginal productivity theory has been a
pillar in the traditional theory of distribution and even today it continues to be so, though in a
less restrictive form, an important factor in modern analysis of factor pricing. It represents the
first formal theory based on the principle that the payment to a worker should be according to
the quantity of work produced.

Productive Efficiency Theory

This theory is a refinement and extension of the Marginal Productivity Theory in terms
of the provision of opportunities to workers to increase their wages by increasing their

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productive efficiency. A basis is created for a range of motivational tools such as individual and
group incentives. In the recent wage theories, this theory has prominence because of its realistic
application.

Bargaining Theory of Wages

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The origin of this theory is found in the writings of Adam Smith. John Davidson in the
late nineteenth century is credited for its explicit and detailed description. The theory states that
wages tend to settle between and upper and lower limit depending upon the bargaining strength
of the parties in the employment exchange. The upper limit is determined by the physical
productivity of labour, degree of product market competition both domestic and foreign and the
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ability of the management to substitute capital for labour. The lower limit is determined by the
subsistence level, government regulation and workers' knowledge of what other employers are
paying. Implicit is the assumption that there is no single fixed rate for a particular kindof work
but a range of rates between these two limits. The bargaining power coefficient is determined by
the position in the business cycle, size and quality of labour in the labour market, political and
social attitudes and the strategies of the involved parties. In a booming economy labour
shortages occur, firms earn higher profits and thus the power coefficient swings towards the
worker and the wage will move towards the upper limit. Conversely there will be a movement
towards the lower limit if the economy is experiencing recessionary times. This theory is also
indicative of the fact that the the work performed by a worker is an exchange of economic value
which balances the original commitment of the employer who is making the bargain.
 The Bargaining Theory is quite a practical and valid explanation for the level of a given
employee's compensation. If employees choose to utilize a union for bargaining with the
employer, this theory becomes the Collective Bargaining Theory. Even when bargaining is
conducted through a union, the basis of the theory remains unchanged.

2.3 Micro-Micro Theories

Micro- micro theorists emphasize that output of an organization can be influenced

significantly by the general and compensation management practices. These theories incorporate

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behavioural assumptions and became prominent in the later half of the twentieth century when

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Behaviourial Economic Theories started developing

X-Efficiency Theory

This model was developed by H. Leibenstein and acknowledges the influence of internal
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management practices on organizational productivity. He postulated that if perfect competition
prevails in the market, firms could produce additional levels of output without any change in
technology or scale of operations. He stated that equality between the actual output level and the
competitive optimal level of a firm is a rare occurrence. X-inefficiency is the measure of this
difference and is due to the internal operation of the firm rather than the allocative efficiency of
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the market. The assumption of optimising behaviour in the Wage Control and Justification
Theories was an exception and not the general rule. Leibenstein further stressed that the internal
structure of rewards, work-effort, incentives and the management system have profound impact
on the productivity of the firm.

Sub-optimisation Theory

The work and findings of Herbert Simon support the Leibenstein's view of non-optional
behaviour Extensive research conducted by Simon clearly demonstrates that managers sub-
optimize and do not make optimal decisions. The Sub-optimization Theory asserts that managers
work under constraints of bounded rationality and they satisfice. The occurrence of bounded
rationality is because managers very rarely have the entire knowledge, information and facts to
select the optimal action in a specific situation. Besides this there can be actual or perceived
limits on available resources inducing the managers to satisfice. Both Simon and Leibenstein
support the view that there is a direct link between economic behaviour and individual decisions
along with the situation related constraints.

Another set of economic theories and models incorporating elements of behaviourial

economic focus on the nature of the firm and are referred to as organizational economics
Theories these theories include the Agency and the Transaction Cost Theory.

Agency Theory

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Centering on the relationship between owners and employees, this theory states that the

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goals and interests of the owner called the principal and the employees called the agents are not
the same. Profit maximization is the dominant objective of the principal while the agents have
their own personal goals which may hold profit maximisation as a subsidiary objective or none
at all. In spite of conflicting objectives there are several reasons why principals use agents.
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Lack of time or inclination on part of the principal to function as the agent is a major
reason. It may also be due to the large size of the organization or the diverse interests of the
principal. This makes it essential to use agents for organizing the middle management and
operational employees. At times the principal requires specialised knowledge and creative input
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of agents. The agent could be a good source of experience, educations and innovative ideas that
would benefit the principal in terms of enhanced profitability. thus, agents are needed in spite of
divergences between the goals of the principal and the agent. Profits can be maximised only
when it is somehow devised to satisfy the interests of both the parties. The ways to bring about
this kind of dual satisfaction is called the principal-agent problem.

The theory suggests two types of incentives which motivate agents towards achievement
of the orgnaisational goals. The external labour market provides the first type of incentives.
Information about a worker‟s previous performance depends upon the efficiency of the labour
market. If it is efficient then there is adequate information which determines the worker's ability
to seek and secure future employment. An employment record consisting of termination or
demotions adversely impacts an agent's prospects of future employment whereas one that of
promotion and commendation enhance the agent's employment potential. The second incentive
is the type of compensation. It is suggested that a compensation system should be developed that
ensures an alignment of the principal‟s goals to those of the agents. Being under the principal's
control, compensation is a stronger incentive as compared to the labour market. The
compensation components are base salary, annual bonus, stock options and other long terms
incentive plans.

The principal-agent problem has been primarily concerned with the alignment of the
principal's goals and objectives with the top management of the organization called the principal

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agents. The need to align the interests of all the employees called the secondary agents has also
been considered by theorists. It has been proposed that top managers should be actively involved

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in designating the compensation structure for the rest of the employees. There are explicit and
implicit contracts which make possible the exchange of labour services for compensation. This
imposes transaction costs on the principal and therefore, compensation should be based on
policies and procedures which are fair from all possible perspectives. The theory lays specific
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stress that the fairness of rules for determining compensation motivates employee actions
towards the output desired by the owners or the principals.

Transaction Cost Theory

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The primary influences of this theory are attributed to Frank Knight and Ronald Coose.
Oliver Williamson is credited for its development. The primary focus is on the nature of
exchange of goods and services among parties. Unlike, the earlier economic theories,
uncertainty and complexity is assumed in the process of exchange. Besides uncertainty,
asymmetrical distributions of information, and the potential opportunism of the parties in
exchange. The costs incurred in negotiating, monitoring and enforcing measures for making an
exchange possible between the two parties comprise the transaction costs. When these costs
became unreasonably large a requirement arises to remove them from the market and attempt to
produce them internally. An internal structure that elaborates and describes incentive and
monitoring systems can internalise these costs.

The Micro-Micro framework of the economic theories of compensation does not displace
the earlier theories. The earlier theories have their own uniqueness, significance and importance.
Micro-Micro theories help in comprehending the variability in organizational strategies and
structures and also the various compensation practices that are prevalent in the real world.

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