The wage fund theory combining capital and wages was first propounded by Adam Smith and J S Mill gave the final shape for the theory. According to the theory, the part of the capital is used to support the working population and this capital or fund set part is the deciding factor for the rates related to wages.
The wage fund theory has been explained in detail in "Principles of Political Economy" authored by J S Mill. According to the theory, "Wages depend upon the demand and supply of labor, as it is often expressed, on the proportion to population and capital. By population means, the number of the laboring class or rather of those who work for hire and by capital, circulating capital and not even the whole of that, but the part which is expended on the direct purchase of the labor"
According to this theory, at any given time, a certain wage fund is available; i.e. a determinate amount of capital destined for the payment of labor. There is similarly a determinate number of laborers who must work, whatever be the wages. If the laborers want to get more, there is no alternative except to reduce their number so that each might get a larger share of the wage fund which is fixed.
Out of their annual produce, the producers set apart a wage fund after appropriating the amounts due on rent, interest and profit. This fund becomes the working capital in the next period and wages are paid out of this fund. Hence, it has come to be called as the wage fund. The wages of labor are determined strictly on the basis of the formula:
The wages rate = wage fund/number of laborers
The wage fund thus is constituted by the demand for labor and the working population and the supply of labor.
Criticism of the theory:
This theory does not explain the principle behind creating wage fund; however, it depends on the arbitrary will of the producer and it gives a high degree of arbitration and makes it illogical.
Even though it is admitted that the payment of wages is available from the working capital of the country, there is no justification as to why it should be made available from the wage fund created by producers during the previous period.
The theory ignores the efficiency of labor and the consequent difference in wages in the practical life. In case the labor is more productive, it is entitled to a higher wage;
The theory has completely ignored the way in which the wage fund is distributed and it has also ignored the influence of trade unions in bargaining.