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What are the economical and behavioral issues involved in compensation?

Wages are determined by both the supply and demand of particular type of labour. The factors which
influence wages are supply, price, skill, experience, ability, reputation. The wages theories have important
policy implications and applicable for some of the definite occupations or line of work, none of these is
adequate as a general theory having universal applicability. The economic theories of wages fail to
provide a complete explanation of the problem of wage determination. Studies conducted by behavioral
scientists to some extent fill the gaps in the earlier theories, which have highlighted the importance of
psychological and sociological factors on wages.

Compensation theories mainly divided into two parts:

• Economic theory
• Behavioral theory

SUBSISTENCE THEORY (Given by DAVID RICARDO in 1772-1823)

David Ricardo, in his famous book 'Principles of Political Economy and Taxation' propounded the
subsistence theory of wages: Ricardo states that the price of labour depends upon subsistence of
labour. The theory was based on the assumption that if the workers were paid more than
subsistence wage, their numbers of labour would increase as they would reproduce more; and this
would bring low the rate of compensation. If the rate of compensation decreased below the
subsistence level, the number of workers would reduced - as many would die because of lack of
food or hunger, increased inability due to scarcity of nutrition, abnormal health conditions, cold,
etc. and many of them could not marry because they fell that they could not able to accept the
responsibility . This will result in decreased labour supply, which will lastly be same like as the
demand for it. Ricardo viewed that the market price of labour could not vary from the subsistence
level for a long time. For this reason, the subsistence wage theory was also known as the" Iron
Law of Wages".

THE SURPLUS VALUE THEORY (Given by KARL MARX in 1818-1883)

This theory owes its development to Karl Marx. According to this theory, the labour was an article
of trade, which could be purchased on payment of 'subsistence price.' Marx in many ways is closer
to Ricardo in his approach to the question of value for labour power. He accepted Ricardo's view
that the market price of labour power could not for long depart from the value of the subsistence
which is required for the maintenance of that labour power. He, however, viewed that it was not
the tendency of population, which brought wages to the subsistence level, but it was the tendency
in the capitalist system to chronic unemployment and the existence of industrial reserve army,
which drove wages to the subsistence level. Labour supply always cared for the excess of the
demand for it of capitalist wage system. The capitalist was in a position to force the worker to
spend more time of his job than what was necessary to earn his subsistence wage. Product price
was set or fixed by the total time needed for generating the output by the labour. The price of any
product was determined by the labour time needed for producing it. According to Marx, the labour
did not receive complete remuneration for the time he spent on their work place or job. Marx,
however, held the view that the introduction of trade union bargaining and similar interferences
could stop the tendency of wages falling to their minimum level and even reverse it.

THE WAGES FUND THEORY (Given by ADAM SMITH in 1723-1790)

This theory was propounded by Adam Smith. His basic assumption was that wages are paid out of
money which lay surplus with wealthy persons - as a result of savings. It was the size of the fund,
which determined the demand for labour and the wages paid to them. According to wages fund
theory, wages are determined by:

(a) the wage fund or part of working capital which has been increased for getting the labour work;
and (b) the number of workers seeking employment. The wage fund was assumed to be fixed and
it does not change. Any change in wage rate, because of increase or decrease in the size of labour
getting job opportunity.

The wages fund theory based on the productivity of labour and profitability of any organization it
shows that increased in the savings increased in the wages, it may change after the fixed tenure.
Increase in remuneration could help to increase the efficiency of labour, it would presumably
augment the employers ' demand for that labour. Hence, a rise in wage level not only influences
the supply conditions of labour but also causes a shift in the demand for labour. This is quite
opposite to the assumption made by the theory that the demand for labour is fixed.

THE MARGINAL PRODUCTIVITY THEORY (Given by J.B.CLARCK)


This theory was propounded by Phillips Henry Wicksteed (England) and John Bates Clark (USA).
According to this theory, compensation are based upon an entrepreneur's calculation of the rate
that will probably be acquire by the marginal worker. The marginal productivity theory pretended
that there was a certain quantity of worker received the job and the remuneration value at which
this worker could secure employment in a competitive labour market was equal to the addition to
total production that resulted from employing the marginal unit of that labour force. It was also
pretended that production is carried out under the conditions of diminishing returns to labour. The
principle of diminishing marginal productivity postulates that the contribution of each additional
unit of labour would be less than that of the unit previously hired. Therefore, inspite of the fact
that the productivity of the individual labourer may be higher than that of the marginal labourer,
he will not be paid more than what the marginal labourer will get.

In the short run wage rate can be both higher and lower than the marginal revenue productivity of
labourers, but in the long run it gets equalised with the marginal revenue productivity of labourers.
If the prevailing wage rate is lower than marginal productivity, it will be profitable for the
employers and the resulting competition among employers to employ more workers will tend to
raise the wages. On the contrary, if the prevailing wage rate is higher than the marginal
productivity, the employment of marginal workers will yield him losses and he would stop
employing them. This will result in competition among workers for jobs, which would lower the
wages. Thus in the long run the equilibrium wage rate will become equal to the marginal revenue
productivity of labour.

The marginal productivity theory is considered superior to the earlier theories on wages.

THE BARGAINING THEORY (Given by JOHN DAVIDESON)

John Davidson propounded this theory. He argued that the wages and time period of work were
ultimately defineds by the relative bargaining power between the employers and the employees.

According to this theory, there is a top limit and a lower limit of compensation and the actual wage
rates in between these limits are set or calculated by the bargaining power of the employers and
the employees. The upper limit could be the highest wages that the employers would be willing to
pay beyond which they will incur losses resulting from high labour costs. The lower limit could
be either the minimum wages prescribed under the statute or the strength of the workers at the
necessary remuneration below which they will not be ready for work.

DEMAND AND SUPPLY THEORY (Given by MARSHALL)

This theory is given by Marshall. He assumed the whole set of factors which govern demand for
and supply of labour affected the determination of wages. It is therefore necessary to understand
the various factors, which influence the demand for and supply of labour. The employers' demand
for labour is dependent on a number of factors such as the demand for his/her product, availability
of other factors of production (the most important being the supply of capital), the level of
technological progress, etc. The demand price of labour is determined by the marginal productivity
of individual worker.

Supply of manpower can be stated in a number of senses. First, it refers to the number of workers
getting job and the workers with no alternative for survival, join the labour market for getting the
job for wages. Secondly, it may be the number of hours or given time period for which each worker
is ready for doing job. Finally, the supply of labour varies with the intensity of work. The supply
of labour tends to increase if the workers work harder than before.

Thus, Wage rates are influenced by a number of factors governing the demand for and supply of
labour. The marginal productivity of labour, determines its demand price. It is the standard of
living of workers that plays an important role in the determination of supply price of labour. The
actual wage rate is determined at that level where the demand for and supply of labour are equal.

In real world, however, labour markets are generally non-competitive. The wage levels expected
to result from the free interaction of demand and supply are often modified by the resistance from
workers to accept wages below the subsistence level; trade union action, government intervention
in wage fixation, and immobility of workers.

PURCHASING POWER THEORY (Given by PIGOUN)

In the book "General Theory of Employment, Interest and Money" explained the concept of
purchasing power. According to him, wage is not only the cost of production to the employer but
also an income for the labour. The same workers and their families consume a major part of the
products of the industry.

Hence, if the earning of the labour is high they will have more consuming power, which would
help to higher the aggregate demand for goods and also a high level of output. On the other hand,
if the wage rates were low, their purchasing power would be less, which would bring about a
decrease in the aggregate demand. This will have an adverse effect on the levels of employment
and output. According to Keynes, unemployment and depression will further add to the problem.
Therefore, a cut in wage national income falls; it would have an adverse effect on employment
rate.

According to the Keynesian Theory, fill employment is a function of national income; the higher
the level of national income the greater the volume of employment and both income and
employment are determined by effective demand. Hence, if the national income falls, it would
have an adverse effect on employment.

COMPARATIVE ADVANTAGE THEORY

Economists specializing in international trade argued about countries, industries and companies
competing on the basis of comparative advantage of cheap labour Employers are known to move
to areas where labour is cheap, be it within a country or across countries. Subject to internal and
external constraints, labour also tends to show a tendency to move to areas, which pay higher value
for their skills and effort. In recent years, however, there is pressure on countries and companies
competing on the basis of cheap labour to ensure compliance with minimum core labour standards
concerning minimum age, freedom of association, right to collective bargaining forced labour and
non-discrimination.

LIMITATIONS OF ECONOMIC THEORIES

1. According to Subsistence theory, the assumption that the supply of labour is perfectly elastic at
the subsistence wage level is incorrect. The theory does not consider wage differentials, which are
bound to exist across regions.
2. The subsistence theory ignores the importance of the role of the demand for labour and the role
of trade unions in wage determination.

3. Economic theories either assume that wages and prices are either fully fixed or fully flexible.
The reality lies somewhere in between.

4. Most wage theories are based on the assumption of full employment. In most developing
countries this is not really the case.

5. Labour is not as mobile as capital and products are. Therefore wage rates could be influenced
by the changes in the demand for and supply of factors other than labour too.

6. Wages and benefits reflect industry characteristics and personal characteristics (including skill
differentials) as well as societal preferences and prejudices.

8. Interference by government and trade unions could minimize the influence of the market forces
of demand and supply of labour.

9. Technology and productivity are major determinants. Low wages may not mean low wage costs.
Similarly high wage rates may not mean high unit labour costs.

10. With the growing pressure for linking labour standards with international trade, increasingly it
will become difficult (for countries, industries and companies) to compete on the basis of
comparative advantage of cheap labour.

BEHAVIOURAL THEORIES AND RELEVANT ISSUES

Behavior means naturally reaction or movement to the environment and yourself. Motivation is
the process of attempting to influence others to do your work will through the possibility of gain
or reward. Remuneration of every worker has a behavioral objective and seeks to fulfill the survival
need (physiological or psychological) to fulfill the goals. Luthans argues that `motivation is a
process that starts with a physiological or psychological deficiency or need that activates behavior
or a drive that is aimed at a goal.
Compensation policy are targeted at rewarding manpower for their skill, talent, performance,
effort, responsibility and working conditions and increase their morale for efficient performance.

Behavioral theories are divided into three categories:-

✓ Content theories
✓ Process theories, and
✓ Contemporary theories

CONTENT THEORIES

The content theories explain what inspires manpower at their jobs. Maslow, Hergberg and Alderfer
gives their significant contribution to content theories. These are as follows:-

1.HIERARCHY OF NEEDS:

Abraham Maslow proposed the first theory called the hierarchy of needs theory. He proposed five
needs of any people in needs hierarchy physiological or basic need (food, shelter, clothing), safety
need (emotional and physical safety - health insurance, pension), social need (affection and
belongingness to society), Self-esteem need (power, achievement, status, etc.), and self-
actualization (personal growth, realization of potential). Maslow believed that within every
individual, there exists a hierarchy of five needs and each level of need must be satisfied before an
individual pursues the next higher level of need. As an individual progresses trough the various
levels of needs, the proceeding needs loose their motivational value.

2.TWO FACTOR THEORY OF MOTIVATION: Herzberg extended work of Maslow and


developed a specific content theory of work motivation. Factors of this motivational theory divided
into two categories:

Intrinsic cand Extrinsic. Interinsic factors are the motivators (satisfiers) for the workforce and,
Exterinsic factorsar the hygiene factors (dissatisfiers). Intrinsic remuneration are motivators or
satisfiers work for satisfy workers related to job content. It includes success, identification,
responsibility, work enrichment, and works enlargement. Extrinsic remuneration are hygiene
factors and helps to reduce the dissatisfaction on the job. It includes company rules regulation and
administration, supervision, co-ordination, salary structure, interpersonal relations, working
environment

3.ERG THEORY: Clayton Alderfer identified 3 groups of core needs; they are- Existence,
Relatedness and Growth.

(a) The existence needs are concerned with survival.

(b) The connected needs and the importance of interpersonal and social relationship.

(c) The growth needs are concerned with individual's intrinsic desire for personal development.
Based on a person's background and social environment, one set of needs may precede over others.

The job of Maslow, Hergberg and Alderfer are related to content theories. They give useful
theories but have limited implications for policy and practice.

PROCESS THEORIES

Process theories were examined by performance of Vroom (on valence and expectancy) and Porter
and Lawer (performance-satisfaction linkage). They look at the related procedingss that go into
motivation or effort, particularly the way they relate to one another.

EXPECTANCY THEORY: Victor Vroom developed expectancy theory under process theory
based on the abstract of valence, expectancy and instrumentality.

Valence states to an individual's orientation for a individual result. For instance, most old
employees perceives value benefits against fewer, if any, younger employee in today's knowledge
industry, single (unmarried) workers with fewer family responsibility have less or no need for
benefits like children's education, health benefits, leave travel allowance etc. than older, married
employees with one or more children.

Instrumentality refers that a people would be inspired to give better performance in anticipation of
promotion.
Expectancy states that the degree of chances accor to a particular activity or process or effort will
lead to particular first-level results on the other hand, Instrumentality states to the degree of
chances that relates first-level results and desired second-level results. In simple words, Motivation
is a -function of valence and expectancy.

According to Vroom's concept it can be interpreted that: manpower gives to the organization what
it needs from people, higher performance and in exchange they expect promotion.

CONTEMPORARY THEORIES

The contemporary theories describe the modern concept of how people motivates at work. These
include Equity and Attribution theories. These are explained as follows:-

1. EQUITY THEORY

J. Stacy Adams, developed by equity theory, and give their views that primary input on job
performance and satisfaction on the basis of equity that people fells in their working conditions.
Inequity comes in existence when a manpower feels that the ratio of his or her results to inputs and
the ratio of a relevant other's results to inputs are imbalanced.

Equity can be stated in two elements. One is internal and other is external. Internal equity states
that the imbalance in the remuneration between the several skills or talent and responsibility level
among the various manpower. Internal equity is determined through job evaluation.

External equity states that when remuneration levels for same skills levels in one organization
compare with other workers in any different organization in same industry and geographical
region. External equity is determined usually through compensation surveys or interview and
compensation satisfaction surveys. Companies, which pay remuneration at lower rate than the
market rates, would be in problem to attract, retain and inspire manpower to perform with full
efficiency.

Our manpower doesn't perceive happiness when they get lower remuneration than what they
deserve. When an employee gets remuneration at higher rates than what he/she considers is fair.
Now the question is that to check out what they are receiving, what they deserve and what is fair
for our manpower to maintain balance or equity in compensation system.

2.ATTRIBUTION THEORY:

This theory is contributed by Fritz Heider, Lewin and Festinger. They assume that people are
rational and logical in their behavior and that both inter and outer forces get composed additively
to conclude behaviour. People will behave differently if they realize that their results are controlled
or supervised more internally than externally. This theory has great efficiency for understanding
organizational behaviour and contributes deep insights on goal setting, leadership behaviour and
diagnosing causal factors of employee performance.

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