THEORIES OF

COMPENSATION
Compensation theories mainly divided
into two parts:
• Economic theory
• Behavioral theory
• 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 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.
Economic theory consist the following
• SUBSISTENCE THEORY
• THE SURPLUS VALUE THEORY
• THE WAGES FUND THEORY
• THE MARGINAL PRODUCTIVITY THEORY
• THE BARGAINING THEORY
• DEMAND AND SUPPLY THEORY
• PURCHASING POWER THEORY
• COMPARATIVE ADVANTAGE THEORY
 SUBSISTENCE THEORY (Given by DAVID RICARDO in
1772-1823)
• it states 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)
• 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.
• 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)
• As per this theory 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
(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.
 THE MARGINAL PRODUCTIVITY
THEORY
• 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, in spite 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 BARGAINING THEORY (JOHN
DAVIDESON)
• John Davidson propounded that the wages and time period
of work were ultimately defined by the relative bargaining
power between the employers and the employees.
• 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 (MARSHALL)

• This theory assumes the whole set of factors

which govern demand for and supply of labour
affected the determination of wages.
• The employers’ demand for labour is dependent
on a number of factors such as the demand for
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.
• Wage rates are influenced by a number of factors
governing the demand for and supply of labour. 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
(PIGOUN)
• 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.
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.
 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.
 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. 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
and effective performance.
• Behavioral theories are divided into three
categories:-
1. Content theories
2. Process theories, and
3. 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
2. TWO FACTOR THEORY OF MOTIVATION
3. ERG THEORY
 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.
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:
• 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
 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.
Maslow, Hergberg and Alderfer are related to content
theories. They give useful theories but have limited
implications for policy and practice.
 CONTEMPORARY THEORIES
• EQUITY THEORY
• ATTRIBUTION THEORY
 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.
 ATTRIBUTION THEORY
• 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.
 PROCESS THEORIES
Process theories were examined by performance
of Vroom (on valence and expectancy) and
Porter and Lawer (performance-satisfaction
linkage).
EXPECTANCY THEORY: Victor Vroom developed
expectancy theory under process theory
based on the abstract of valence, expectancy
and instrumentality.
• Vroom realized that an employee's
performance is based on individual factors
such as personality, skills, knowledge,
experience and abilities. He stated that effort,
performance and motivation are linked in a
person's motivation. He uses the variables
Expectancy, Instrumentality and Valence to
account for this.
• Expectancy is the belief that increased effort will
lead to increased performance i.e. if I work
harder then this will be better. This is affected by
such things as:
1. Having the right resources available (e.g. raw
materials, time)
2. Having the right skills to do the job
3. Having the necessary support to get the job
done (e.g. supervisor support, or correct
information on the job)
• Instrumentality is the belief that if you perform
well that a valued outcome will be received. The
degree to which a first level outcome will lead to
the second level outcome. i.e. if I do a good job,
there is something in it for me. This is affected by
such things as:
1. Clear understanding of the relationship between
performance and outcomes – e.g. the rules of
the reward 'game'
2. Trust in the people who will take the decisions
on who gets what outcome
3. Transparency of the process that decides who
gets what outcome
• Valence is the importance that the individual places upon
the expected outcome. For the valence to be positive, the
person must prefer attaining the outcome to not attaining
it.
• For example, if someone is mainly motivated by money, he
or she might not value offers of additional time off.
• The three elements are important behind choosing one
element over another because they are clearly defined:
effort-performance expectancy (E>P expectancy) and
performance-outcome expectancy (P>O expectancy).
• E>P expectancy: our assessment of the probability that our
efforts will lead to the required performance level.
• P>O expectancy: our assessment of the probability that our
successful performance will lead to certain outcomes.
• Vroom's expectancy theory works
on perceptions – so even if an employer
thinks they have provided everything
appropriate for motivation, and even if this
works with most people in that organisation, it
doesn't mean that someone won't perceive
that it doesn't work for them.
Thank You