Wage fund theory

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Aug 20, 2021

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Adam Smith took over from the physiocrats the idea that wages are advanced to workers in anticipation of the sale of their output. Wages could not be increased unless the capital destined to pay them was increased. Capital, in turn, was determined by savings. The classical school developed its theory of wages around these ideas. In the short-run, there was a given number of workers and a given amount of savings to pay their wages. The two together determined the average wage. In the long-run, the supply of labour was related to the minimum of subsistence needed to sustain the labour force. (This subsistence level was not simply physiological; it was related to a standard of living accepted by custom.) If the wage rate rose above this, the population increased; if it fell below, it contracted. In the long run, the leve! of the demand for labour was determined by the size of the wages tund, and this, in turn, by the level of savings. This meant that, as J. S. MILL put it, ‘the demand for commodities is not the demand for labour’. If you increased consumption you reduced savings and therefore the wage fund. Productivity did not influence real wages, what mattered was the level of profits, for savings depended on profits. The argument assumed that savings flowed into fixed capital and variable (wage) capital in equal proportions so that what Marx called the organic composition of capital remained constant. Ricardo worried about this point in his analysis of the effect of machinery on employment. lnvestment bypassed the wages fund and the demand for labour was reduced. W. T. Thornton criticized the wages-fund doctrine on the grounds that wages were determined by supply and demand in the market. J. S. Mill accepted some of Thornton’s points and admitted that the wages-fund idea might be more appropriate in the context of a discontinuous production process (akin to seed-time to harvest) rather than a continuous flow of output, which was the true state of affairs. There was some popular confusion at the time, because it was thought the economists meant there existed a definite fund available for wages so that there was no hope of workers obtaining higher average earnings.

Reference: The Penguin Dictionary of Economics, 3rd edt.