Toward the end of the 19th century, marginal-productivity analysis was applied not only to labour but to other factors of production as well. It was not a new idea as an explanation of wage phenomena, for Smith had observed that a relationship existed between wage rates and the productivity of labour, and the German economist Johann Heinrich von Thünen had worked out a marginal-productivity type of analysis for wages in 1826. Economists in the Austrian school made important contributions to the marginal idea after 1870, and, building on these grounds, a number of economists in the 1890s—including Philip Henry Wicksteed in England and John Bates Clark in the United States—developed the idea into the marginal-productivity theory of distribution. It is likely that the disturbing conclusions drawn by Marx from classical economic theory inspired this development. In the early 1930s refinements to the marginal-productivity analysis, particularly in the area of monopolistic competition, were made by Joan Robinson in England and Edward H. Chamberlin in the United States.

As applied to wages, the marginal-productivity theory holds that employers will tend to hire workers of a particular type until the contribution that the last (marginal) worker makes to the total value of the product is equal to the extra cost incurred by the hiring of one more worker. The wage rate is established in the market through the demand for, and supply of, the type of labour needed for the job. Competitive market forces assure the workers that they will receive a wage equal to the marginal product. Under the law of diminishing marginal productivity, the contribution of each additional worker is less than that of his predecessor, but workers of a particular type are assumed to be alike—in other words, all employees are deemed interchangeable—and any one could be considered the marginal worker. Because of this, all workers receive the same wage, and, therefore, by hiring to the margin, the employer maximizes his profits. As long as each additional worker contributes more to total value than he costs in wages, it pays the employer to continue hiring. Beyond the margin, additional workers would cost more than their contribution and would subtract from attainable profits.

Although the marginal-productivity theory was once the prevailing theory of wages, it has since been attacked by many and discarded by some. The chief criticism of the theory is that it rests on unrealistic assumptions, such as the existence of homogeneous groups of workers whose knowledge of the labour market is so complete that they will always move to the best job opportunities. Workers are not, in fact, homogeneous, nor are they interchangeable. Usually they have little knowledge of the labour market, and, because of domestic ties, seniority, and other considerations, they do not often move quickly from one job to another. The assumption that employers are able to measure productivity accurately and compete freely in the labour market is also far-fetched. Even the assumption that all employers attempt to maximize profits may be doubted. The profit motive does not affect charitable institutions or government agencies. And finally, for the theory to operate properly, these ideal conditions must be met: labour and capital must be fully employed so that increased productivity can be secured only at increased cost; capital and labour must be easily substitutable for each other; and the situation must be completely competitive. Obviously, none of these assumptions fits the real world.

Monopolistic or near-monopolistic conditions, for example, are common in modern economies, particularly where there are only a few large producers (such as in the automotive industry). In many cases wages are determined at the bargaining table, where producers negotiate with representatives of organized labour. Under such circumstances, the marginal-productivity analysis cannot determine wages precisely; it can show only the positions that the union (as a monopolist of labour supply) and the employer (as a monopsonistic, or single, purchaser of labour services) will strive to reach, depending upon their current policies.

Some critics feel that the unrealistic nature of its assumptions makes marginal-productivity theory completely untenable. At best, the theory seems useful only as a contribution to understanding long-term trends in wages.

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John Maynard Keynes, detail of a watercolour by Gwen Raverat, c. 1908; in the National Portrait Gallery, London.

Courtesy of the National Portrait Gallery, London

The purchasing-power theory of wages concerns the relation between wages and employment and the business cycle. It is not a theory of wage determination but rather a theory of the influence spending has (through consumption and investment) on economic activity. The theory gained prominence during the Great Depression of the 1930s, when it became apparent that lowering wages might not increase employment as previously had been assumed. In General Theory of Employment, Interest, and Money (1936), English economist John Maynard Keynes argued that (1) depressional unemployment could not be explained by frictions in the labour market that interrupted the economy’s movement toward full-employment equilibrium and (2) the assumption that “all other things remained equal” presented a special case that had no real application to the existing situation. Keynes related changes in employment to changes in consumption and investment, and he pointed out that economic equilibrium could exist with less than full employment.

The theory is based on the assumption that changes in wages will have a significant effect on consumption because wages make up such a large percentage of the national income. It is therefore assumed that a decline in wages will reduce consumption and that this in turn will reduce demand for goods and services, causing the demand for labour to fall.

The actual outcomes would depend upon several considerations, particularly those that involve prices (or other cost-of-living considerations). If wages fall more rapidly than prices, labour’s real wages will be drastically reduced, consumption will fall, and unemployment will rise—unless total spending is maintained by increased investment, usually in the form of government spending. Then again, entrepreneurs may look upon the lower wage costs (as they relate to prices) as an encouraging sign toward greater profits, in which case they may increase their investments and employ more people at the lower rates, thus maintaining or even increasing total spending and employment. If employers look upon the falling wages and prices as an indication of further declines, however, they may contract their investments or do no more than maintain them. In this case, total spending and employment will decline.

Conversely, if wages fall less rapidly than prices, labour’s real wages will increase, and consumption may rise. If investment is at least maintained, total spending in terms of constant dollars will increase, thus improving employment. If entrepreneurs look upon the shrinking profit margin as a danger signal, however, they may reduce their investments, and, if the result is a reduction in total spending, employment will fall. If wages and prices fall the same amount, there should be no change in consumption and investment, and, in that case, employment will remain unchanged.

It should be noted that the purchasing-power theory involves psychological and other subjective considerations as well as those that may be measured more objectively. Whether it can be used effectively to predict or control the business cycle depends upon political as well as economic factors, because government expenditures are a part of total spending, taxes may affect private spending, etc. The applicability of the theory is to the whole economy rather than to the individual firm.