Chapter 2 Theory of Wages and Wages Structure

Theories of Wages:

1. Subsistence Theory
2. Wage Fund Theory
3. Marginal Productivity Theory
4. The Residual Claimant Theory
5. Employment Theory
6. Exploitation Theory
7. Labour Theory of Value
8. Competitive Theory
9. Low-wage Labour Market Theory
10.Purchasing Power Theory
11.Micro-economic Wage Theory
12.Multi-disciplinary Theories

1. Subsistence Theory

This theory states that in the long run, wages would tend towards that sum
which is necessary to maintain a worker and his family.

While Adam Smith and David Ricardo argued that it is the growth of
population which brings down wages to the level of minimum subsistence, Karl
Marx argued that subsistence wages emerge because of the phenomenon of
unemployment and the reserve army of labour.

Malthus held that wages were bound to remain at the subsistence level because
any increase in wages would bring about an increase in population.
2. Wage Fund Theory:

This theory stated that at any given moment, wages are determined by the
relative magnitude of the work force and the whole or a certain part of the
capital of the country.

The wages are paid from a fixed wage fund.

According to John Stuart Mill, wage was a variable dependent on the relation
between the laboring population and the aggregate funds set aside by the
capitalists to pay them.

3. Marginal Productivity Theory:

This theory focused on demand for labour.

Marginal productivity theory explains not only the general level of wages but
the entire wage structure of a highly competitive economy in terms of
interaction of supply and demand.

As a demand theory of wages, the marginal productivity theory fails to make

full allowance for the particular nature of supply curves for labour.

4. The Residual Claimant Theory:

Francis A. Walker has propounded this theory of wages as a part of residual

surplus which is left after other factor charges have been met.

This theory was designed to emphasize the interest of the working class in
continual process and accumulation.
 It does not explain how trade unions are able to increase the wages.

This theory does not consider the aspect of labour market and the role of labour
in productivity.

5. Bargaining Theory:

This theory was propounded by John Davidson.

According to him, wages are determined by the relative bargaining power

between workers or trade unions and employers and basic wages, fringe
benefits, job differentials and individual differences tend to be determined by
the relative strength of the organization and the trade union.

Bargaining has received considerable attention in view of the fact that wages
are now being determined by collective groups of workers organized into trade
unions and employers organized into employers association.

Collective bargaining may be seen as the process through which labour supply
and demand are equated in the labour market.

Walton and McKersie identified four bargaining sub-processes:

Intra-organization bargaining
Distributive bargaining
Integrative bargaining
Attitudinal bargaining

6. Employment Theory:

There are essentially two schools of thought which propounded the inter-
relationship between wages and employment.
 According to Pigou, unemployment would disappear if the workers were to
accept a voluntary cut in wages.

John Maynard Keynes, in his theory of employment, advocated wage rigidity in

place of wage flexibility.

Voluntary of employment would not doubt increase, if the cut in money wages
is applied to a single industry.

7. Exploitation Theory:

Adam Smith suggested the basis of an exploitation theory as the original state
of things in which the whole produce of labour belonged to the laborers and
when there were neither landlords nor masters to share with them.

Starting with Ricardos notion that labour creates all value, Marx contended
that profit, interest, and rent are unwarranted deductions from the product that
labour alone creates.

8. Labor Theory of Value:

According to Marx, the simplest concept which related to mans activity of

producing his means of livelihood was human labour.

He considered labour as an article of commerce which could be purchased on

payment of subsistence price.

The price of any product was determined by the labour time needed for
producing it.

His theory is also known as surplus value theory of wages.

9. Competitive Theory:

The competitive theorists assume that neither employers nor employees

combine together to influence demand or supply conditions and that markets are
perfect.

Unfortunately these do not hold well in the case of a monopolistic world

market.

The forces of demand and supply may be affected by government intervention

in the regulation of wages, the application of awards, and the statutory
extension of the provision of collective agreement to employers and workers
who were not parties to them.

10. Low-wage Labor Market Theory:

There are several conceptual approaches which can be adopted for analyzing the
behavior of low-income labour market:

Queue Theory:
It asserts that workers are ranked according to the relationship between their
potential productivity and their wage rates.

Dual Labour market theory:

This theory argues that labour market is divided into primary and secondary
markets.
11. Purchasing Power Theory:

According this theory, wage increases are desirable because they raise labour
income and thereby stimulate consumption.

Purchasing power and consumption are usually increasing just prior to

recession; workers account for only part of total consumers spending; the
assumption that general overproduction can be overcome by higher wages; are
some of the basic limitations of this theory.

12. Micro-economic Wage Theory:

According to Jean Marchal, such a theory must have three essential requirements:
The usual concept of wages must be replaced by a wider concept.

General behavior of employers and workers affect the general price level only if
there is sufficient compatibility between the structures of the groups and of
production.

Integration of the theory of wages into a theory of national income distribution.

13. Multi-disciplinary Theories:

A number of multi-disciplinary theories have emerged to encompass the

increasing range of variables which empirical work provides.

Lester has studied labour market behavior to explain wage differentials by

contemplating what he calls competitive, anti-competitive, and impeditive
factors.
 Dunlop sought to identify job clusters by which he meant a stable group of jobs
within a company linked together by technology, administrative organization,
and social custom.

Determining Base Salary:

Definition:
Base salary is a fixed amount of money paid to an employee by an employer in
return for work performed. Base salary does not include benefits, bonuses or any
other potential compensation from an employer. Base salary is paid, most
frequently, in a bi-weekly paycheck to an exempt or professional employee. In
most years, an employee's base salary is paid in 26 even paychecks over the course
of the year.

An employee who is paid a base salary is expected to complete a whole job in

return for the base salary. This is different from a non-exempt employee who is
paid an hourly rate or by the piece produced. This employee is generally eligible to
collect overtime.

The salaried employee or employee who is paid by base salary does not track hours
worked and is not paid for overtime. (Some public sector, often union represented,
employees expect to account for hours and collect compensatory time off. This is
not the norm in the private sector.)

Because of Fair Labor Standards Act (FLSA) rules about overtime payment,
employers are required to closely track the hours and partial hours worked by non-
exempt or hourly employees.

Base salary is determined by market pay rates for people doing similar work in
similar industries in the same region. Base salary is also determined by the pay
rates and base salary ranges established by an individual employer. Base salary is
also affected by the number of people available to perform the specific job in the
employer's employment locale.
Many companies participate in base salary market surveys to create a trustworthy
resource for base salary research. More and more base salary research is occurring
online using base salary calculators.

Concepts of Pay Equities:

Definition Pay Equity:

It may be defined as the degree to which the actual pay of an employee matches
what he or she thinks to deserve. High pay equity means high employee
satisfaction with his or her job, low pay equity increases the potential for
absenteeism, grievances, strikes, and turnover. Also called pay satisfaction.

Internal Equity:
It may be defined as the employees' perception of their responsibilities, rewards,
and work conditions as compared with those of other employees in similar
positions in the same organization.

In other words, workers access their current work situation by evaluating how
much they are paid by for their services relative to the effort and skill required
to perform those duties. It is also the analysis of the value of an employee to the
organization as well as the analysis by the employee of the difference between
the pay structures between organizations.

The reason why the application of internal equity is so important to

organizations is because it is the law in most cases, and where this is not the
case, it helps prevent a possible degradation of industrial relations between an
organization and employees or organized labor. Apart from any mandatory laws
and rules, it is also part of good human resource practice for concerned
organizations to apply the principles of internal equity in their pay structure.
This is a necessary process that helps to appease, encourage and facilitate
greater productivity among employees due to their satisfaction with the pay
they receive.
Internal equity studies analyze the nature of a particular position including:
1. Skill
2. Effort
3. Responsibility
4. Working Conditions

External Equity:

It may be defined as the employees' perception of the conditions and rewards

of their employment, compared with those of the employees of other firms.

External equity represents the perception of employees of a companys pay

structure and compensation system. In a market society, companies most
often need to pay the market rate in order to hire competent employees.
Paying below the market rate results in negative external equity as
individuals do not see value in working for the business.

Compensation rates above the market rate will attract more potential
employees, but there is no guarantee these individuals are better than those
paid at the market rate. Companies can gauge their perceived external equity
through a review of internal and external human resource factors.

A company may find it difficult to determine its true external equity point.
The biggest problem here is that employees and other individuals, such as
potential employees may hold a different opinion on the companys
external equity.

For example, a company may believe it is competitive in its compensation

plans based on current market guidelines. Employees, however, may not
believe the amount of work for the specific compensation is actually
worthwhile. Overcoming this divide is among the biggest issues a company
must deal with in order to rectify this perceived inequality.
 Individual Equity:

Individual pay equity may be defined as the compensation given to an

employee based on the value that the individual employee brings to the
corporation.

Your pay or salary is based on your value as an employee, which translates

into how your input as an employee contributes to the profit or earning
capacity of the company.

Components of Wages and Salary:

An average employee in the organized sector is entitled to several benefits-both

financial as well as non-financial. To be specific, typical remuneration of an
employee comprises:

Incentives:
Also called payments by results, incentives are paid in addition to wages and
salaries. Incentives depend upon productivity, sales, profit or cost reduction efforts.
There are:
i) Individual incentive schemes and
ii) Group incentive programmes.

Individual incentives are applicable to specific employee performance. Where a,

given task demands group effort for completion, incentives are paid to the group as
a whole. The amount is later divided among group members on an equitable basis.

e.g. premium, bonus, job security, recognition, quick promotion, etc.

Fringe Benefits:
These include such motley (mixed) crowd of employee benefits as provident fund,
gratuity, medical care, hospitalization, accident relief, health and group insurance,
canteen, uniform, recreation and the like.
Perquisites (Perks):
These are allowed to executive and include company car, club membership, paid
holidays, furnished house, stock option scheme and the like. Perquisites are offered
to retain competent executives.

Non-monetary Benefits:
These include challenging job, responsibilities, recognition of merit, growth
prospects, competent supervision, comfortable working conditions, job sharing and
flexi time.

Job Evaluation:

Definition:
A job evaluation is a systematic way of determining the value/worth of a job in
relation to other jobs in an organization. It tries to make a systematic comparison
between jobs to assess their relative worth for the purpose of establishing a rational
pay structure.

Features:
The purpose of job evaluation is to produce a defensive ranking of jobs on which a
rational and acceptable pay structure can be built. The important features of job
evaluation are as follows:
It tries to assess jobs, not people.
The standards of job evaluation are relative, not absolute.
The basic information on which job evaluations are made is obtained from
job analysis.
Job evaluations are carried out by groups, not by individuals.
Some degree of subjectivity is always present in job evaluation.
Job evaluation does not fix pay scales, but merely provides a basis for
evaluating a rational wage structure.
Purpose:
Balance two (02) goals: Job evaluation aims at balancing two goals i.e.,
internal equity and external competitiveness. Internal equity - paying
different jobs differently, based on what the job entails. And, external
competitiveness: - Paying satisfactory performers what the market is paying.
Focus on job content: It basically focuses on what each individual is doing
their part of the jobs efficiently and effectively.
Ranks all jobs: It seeks to rank all the jobs in a hierarchy with in a hierarchy.
This helps to create job structure as well as payment structure for the
organization.

Benefits:
The following are the benefits:
It tries to link pay with the requirements of the job.
It offers a systematic procedure for determining the relative worth of jobs.
Jobs are ranked on the basis of rational criteria such as skill, education,
experience, responsibilities, hazards, etc., and are priced accordingly.
An equitable wage structure is a natural outcome of job evaluation. An
unbiased job evaluation tends to eliminate salary inequities by placing jobs
having similar requirements in the same salary range.
Employees as well as unions participate as members of job evaluation
committee while determining rate grades for different jobs. This helps in
solving wage related grievances quickly.
Job evaluation, when conducted properly and with care, helps in the
evaluation of new jobs.
It points out possibilities of more appropriate use of the plant's labour force
by indicating jobs that need more or less skilled workers than those who are
manning these jobs currently.

Limitations:
The following are the limitations:
Job evaluation is not exactly scientific.
The most of the techniques is difficult to understand, even for the
supervisors.
 The factors taken by the programme are not exhaustive.
There may be wide fluctuations in compensable factors in view of changes
in technology, values and aspirations of employers, etc.
Employees, trade union leaders, management and the programme operators
may assign different weight to different factors, thus creating grounds for
dispute.

Survey in market pay and compensation practices:

Paying people fairly is good for business. Underpay, and employees will
eventually look for a better offer. Overpay, and the payroll budget and profitability
will suffer. That's why companies use market data to research the value of their
jobs. But what is "market data" anyway?

To determine the prevailing rate for a job, companies can "benchmark" jobs
against compensation surveys that are detailed and specific to the companies'
industries and regions. A good compensation survey uses standard, proven
methods of data gathering and statistical analysis to determine how much
companies pay for a specific job in a specific industry.

A number of types of organizations conduct salary surveys, including

compensation information businesses, compensation consulting firms, industry
associations, educational institutions, and state and federal governments.

Surveys are conducted on a semiannual, annual, or biennial basis. Surveys

normally fall into one of two categories: Custom and standard. Custom surveys are
ones that attempt to answer very specific questions from a narrow selection of peer
companies (e.g., what is the prevailing pay rate for salespeople in the
pharmaceuticals business in the Northwest?).

These custom surveys tend to be available to, and used by, the participants only.
Standard surveys, on the other hand, are often published each year and attempt to
cover the same range of companies and jobs.
The process of collecting data and producing a salary survey takes careful planning
and execution that requires economic investment, people resources, and time.
Some companies conduct surveys in-house using their own staff and compensation
experts.

However, most companies contract a third party to collect the data and do the
number- crunching. The third-party approach provides a level of independence that
most participants want. Some salary surveys are co-sponsored to attract more
participants and to add credibility to the numbers. An experienced data provider in
survey methods and statistical analysis is expected to put out high-quality, reliable,
accurate data.

Consumer Price Index:

A consumer price index (CPI) measures changes in the price level of a market
basket of consumer goods and services purchased by households. The CPI in the
United States is defined by the Bureau of Labor Statistics as "a measure of the
average change over time in the prices paid by urban consumers for a market
basket of consumer goods and services."

The CPI is a statistical estimate constructed using the prices of a sample of

representative items whose prices are collected periodically. Sub-indexes and sub-
sub-indexes are computed for different categories and sub-categories of goods and
services, being combined to produce the overall index with weights reflecting their
shares in the total of the consumer expenditures covered by the index. It is one of
several price indices calculated by most national statistical agencies.

The annual percentage change in a CPI is used as a measure of inflation. A CPI can
be used to index (i.e., adjust for the effect of inflation) the real value of wages,
salaries, pensions, for regulating prices and for deflating monetary magnitudes to
show changes in real values. In most countries, the CPI is, along with the
population census and the USA National Income and Product Accounts, one of the
most closely watched national economic statistics.
The CPI can be calculated as-

The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread
in 2010) is divided by the initial year (the price of bread in 1970), then multiplied
by one hundred.

Dearness Allowance:

The Dearness Allowance (DA) is a cost of living adjustment allowance paid to

Government employees and pensioners in India.

As of June 2012, the Dearness Allowance is calculated as a percentage of an Indian

citizen's basic salary to mitigate the impact of inflation on people belonging to the
low income group.

Indian citizens may receive a basic salary or pension that is then supplemented by
housing or a dearness allowance, or both. The guidelines that govern the DA vary
according to where one lives (for example, whether rural or urban).

The Dearness Allowance was introduced following the First World War, and was
then known as the "Dear Food Allowance". The "Old Textile Allowance" was also
introduced in 1947, though this was revised and reintroduced in 1953 as the
"Revised Textile Allowance".

The system used for paying DA is diverse. The term "DA" includes any payment
made to protect an employee against inflation and rising prices; dearness
allowance, variable dearness allowance (VDA), interim relief and dearness pay are
all included in the "DA" category. The payment of the Dearness Allowance is not
restricted to specific occupations.
Calculation of Dearness Allowance (DA):

How to calculate Dearness Allowance from the year 2006, twice a year using this
average index?

Say, if you want to calculate Dearness Allowance with effect from Jan-06, get the
average of monthly All India Consumer Price Index (IW) with the base year
2001=100 for the preceding 12 months and apply the same in the following
formula:

Dearness Allowance = (Avg. of AICPI for the past 12 months

115.76)*100/115.76

Month All India Index % of increase

Jan-12 198 66.15

Feb-12 199 67.16

Mar-12 201 68.31

Apr-12 205 69.68

May-12 206 71.04

Jun-12 208 72.41

Jul-12 212 73.78

Aug-12 214 75.22

Sep-12 215 76.51

Oct-12 217 77.88

Nov-12 218 79.25

Dec-12 219 80.83

Jan-13 221 82.49

Feb-13 223 84.22

Mar-13 224 85.87

Apr-13 226 87.38

May-13 228 88.96

Jun-13 231 90.62

Compensation and Tax Planning:

Tax planning encompasses many different aspects, including the timing of both
income and purchases and other expenditures, selection of investments and types
of retirement plans, as well as filing status and common deductions.
This can ultimately be counterproductive, as virtually all courses of financial
action will have some tax consequences, and they should not be avoided solely on
this basis.

The goal of tax planning is to arrange your financial affairs so as to minimize your
taxes. There are some basic ways to reduce your taxes like you can reduce your
income, increase your deductions, etc. and each basic method might have several
variations.

Reducing Income:
Adjusted Gross Income (AGI) is a key element in determining your taxes. Lots of
other things depend on your AGI (or modifications to your AGI)-- such as your tax
rate and various tax credits. AGI even impacts your financial life outside of taxes:
banks, mortgage lenders, and college financial aid programs all routinely ask for
your adjusted gross income. This is a key measure of your finances.

AGI is your income from all sources minus any adjustments to your income. The
higher your total income, the higher your adjusted gross income. The less money
you make, the less tax you will pay.

Increase Tax Deductions:

Taxable income is another key element in your overall tax situation. Taxable
income is what's left over after you have reduced your AGI by your deductions and
exemptions. Almost everyone can take a standard deduction, and some people are
able to itemize their deductions.

Itemized deductions include expenses for health care, state and local taxes,
personal property taxes (such as car registration fees), mortgage interest, and gifts
to charity, job-related expenses, tax preparation fees, and investment-related
expenses.
Dearness Allowance:
Employees are employed with a particular wage or salary rate. In due course of
time due to price increase, the real income of employees goes down. It means with
the same level of wages employees are unable to buy goods and services, which
they were able to buy before increase in prices. Dearness Allowance is paid to
employees by way of compensating them for the loss of real income caused to
them by increase in the cost of living due to increase in prices.

Systems of Payments of Dearness Allowance:

The system of payment of Dearness Allowance is mainly classified into two

categories. They are:

(i) Not linked to consumer price index numbers and

(ii) Linked to consumer price index numbers.

Not linked to consumer price index numbers:

(A) Flat Rate: Flat Rate system of payment is a method under which a fixed
amount is paid to all employees irrespective of their categories and wage scales.
The practice of paying Dearness Allowance at a fixed rate is regardless of any
change in the consumer price index.

(B) Graduated Scale: Workers belonging to higher income groups objected to the
award of the same amount of Dearness Allowance to all employees irrespective of
their wages or salaries. , With this background the graduated scale system came
into existence.

According to this method, Dearness Allowance is paid on a graduated scale

according to various wage scales. On the basis of different wage scale the workers
are divided into groups. Dearness allowance increases with each scale of salary
increase but after a limit, there is no increase in the amount of Dearness allowance,
whatever high the wage rate is.
A minimum amount of dearness allowance is also set for the workers in each scale,
below which the dearness allowance is not allowed to fall.

This method is considered to be equitable and hence it is quite popular.

Linked to consumer price index numbers:

Under this system the dearness allowance is linked with the consumer price index
number.

(A) Flat rate: In this method dearness allowance rate per point or scale is fixed
and this varies only with variations in points of consumer price index numbers.

(B)As a percentage of Pay: In this method the dearness allowance is fixed. It is

calculated as the percentage of pay per slab of the consumer price index numbers.
The dearness allowance is expressed as a fixed percentage of pay and equated to a
scale of points of the consumer price index.

The system of dearness allowance being linked with consumer price index is in
vogue today.

The payment of Dearness Allowance for central government employees is based

on the recommendation of the Pay Commissions.
In the banking sector Dearness Allowance is paid as per the Desai Award. Under
this dearness allowance is paid at a rate of 3 percent for every 4 points rise over
100 in the quarterly average of the consumer price index of the working class.

In various other industries and commercial houses, payment of dearness allowance

is paid in common according to the scales.

In many companies a 100 percent neutralization system has been introduced

against the rise in prices. This implies that the employees are under complete
protection against the rising prices. On the other hand some organizations have
provided a ceiling on the payment of dearness allowances, in terms of maximum
amount of dearness allowance payable to a person.