Demand-Supply Theory of Wage

The demand-supply theory of wage is also known as the modern theory of wage. According to this theory, wages are determined by the forces of demand and supply of labour. When there is a perfect competition in labour market, wage rate is determined by the equilibrium between the demand for and supply of labour.

Fig a: Wage Determination in Industry and Wage Determination in Firm

The wage determination in the industry is depicted in the fig. a. The producer will employ more units of labour at lower wage rates. Demand for labour is governed by the marginal revenue product of labour (MRP). Hence, the demand curve for labour slopes downward from left to right. However, there is a positive relationship between wage rate and supply of labour, i.e., higher the wage rate, more will be the supply of labour and vice-versa. At the point E, where demand for labour equals supply of labour, the wage rate (OWO) gets determined. Thus, in equilibrium, OLo units of labour will be employed at the wage rate of OWo. In the long run, wage rate under perfect competition=MRP=ARP. Since marginal revenue product (MRP) and average revenue product (ARP) are equal only at the former’s highest point, the equilibrium employment of labour by the firms in the long run will be corresponding to the highest point of the marginal productivity curve as shown in the figure b. In this, the firm has to accept the market wage OWo settled by the industry. Therefore, in this long run equilibrium situation, wage rate, OW=MRP=ARP.