What it is: The labor market is where the demand and supply of labor interact. That is an example of a factor market, which is a market for production factors transactions.
In this market, businesses demand labor services offered by households. As compensation, they pay salaries or other forms of benefits such as insurance and pension plans.
To pay for households, businesses sell products. And, households spend some proportion of their income on businesses’ products and save the rest. In economics, you can draw the flow of demand, supply, and income into a diagram, which we call a circular flow of income.
In the labor market, businesses compete to recruit quality workers. Meanwhile, workers compete for the most satisfying compensation and jobs.
What are the types of the labor market
The labor market can be a primary market or a secondary market.
- The primary market is for permanent full-time workers.
- The secondary market is for temporary or part-time workers.
The supply of labor can come from internal or external to the organization.
- Internal market is common for large or multinational companies. In this case, supply and demand take place within an organization. Companies move employees from one business unit to another.
- External markets occur in open markets, where businesses compete with each other (including competitors) for labor.
In the internal market, management has more in-depth knowledge about the labor supply quality, including related to the skills, talents, strengths, and weaknesses of their employees. Another advantage is that the company is quite free from market pressures because it is determined internally. Lastly, internal recruitment can reduce retention among existing staff.
However, external talent brings more ideas than internal staff. Also, open markets provide more alternatives for selecting prospective employees. It also offers more power in salary negotiations.
How does the labor market work
The labor market works similar to the goods market. It’s just that the roles of business and household are reversed.
In the goods market, economists use price as the primary determinant of the quantity supplied and the quantity demanded of a good. In the labor market, wages represent labor services’ price and determine the demand and supply of labor.
In the labor market, businesses and households meet to transact labor services. Firms represent the demand side, and households represent the supply side.
Supply-demand interactions determine the level of wages and employment. Higher salary encourages more labor supply. But, it reduces the demand for labor. The equilibrium wage rate is reached when the quantity of labor supplied equals the labor demanded.
Demand for labor increases as wages fall. And vice versa, demand falls as wages rise. As a result, the labor demand curve has a downward slope (negative slope).
The law of diminishing marginal return explains the negative slope of the labor demand curve. The law says, when a company employs more workers, each additional worker contributes less to output. Because additional workers contribute less to additional output, businesses are willing to increase the workforce only when wages fall.
The change in the wage rate causes the labor demanded to move along the curve. Meanwhile, changes in factors other than wages shift the curve to the right or left. Such factors include:
- Changes in production level, in the aggregate, it is measured by economic growth.
- Changes in production processes and technological advances
- Quality of human resources
- Number of companies in the market
- Government regulations such as local labor recruitment and wage policies
The law of supply also applies to the labor market. As wages rise, the labor supplied increases. Conversely, a reduction in wages reduces the labor provided. Hence, the labor supply curve is upward sloping (positive slope).
The concept of the marginal rate of substitution explains why the labor supply curve slopes upward. Economists assume that workers spend their time on two things: work and leisure. The two are interchangeable, meaning that there is less time relaxing when more time is spent working. Free time is relatively scarce, and therefore individuals are willing to work if they receive higher wages.
Changes in wages affect the labor supplied to move along the curve. Meanwhile, shifts in the labor curve are influenced by factors other than wages, such as population, immigration, worker expectations, and income levels.
Equilibrium in the labor market
As in the product market, the labor market equilibrium occurs when the quantity supplied matches the quantity demanded. At that point, the number of employed workers and the equilibrium wage are determined.
A higher wage than the equilibrium wage indicates an excess supply. Workers will compete for available jobs and inevitably receive low salaries. This, in turn, drives demand. The process continues until demand equals supply.
Conversely, when wages are below equilibrium, there is a shortage of supply. Cheaper wages keep production costs low, which encourages businesses to increase output. They then recruited more workers. Because wages are still low and there is a shortage of supply, companies agree to offer higher than current wages to attract more workers.
But, in the short term, wages may not change so quickly to equilibrate the market because of the rigidity that results from the employment contract. Also, government controls, such as minimum wages, can limit wage reductions.
Furthermore, at high wage levels, workers may be reluctant to work more. They prefer to replace work time with free time (unpaid time). Thus, instead of increasing supply, higher wage increases lead to a decrease in labor supply. Therefore, if you plotted it on a graph, it would form a backward-bending supply curve of labor.
What are the factors that affect the labor market
Apart from wage levels, many factors influence the labor market. Among the factors that influence the supply of labor are:
- Population growth, including factors such as birth and death rates. Higher population growth means greater the potential labor supply.
- Age distribution. The supply increases if the population is mostly composed of people of productive age.
- Labor mobility, including geographic mobility and occupational mobility. The first is related to the ease with which workers can move locations, which is influenced by factors such as wages, transportation networks, housing (housing), and career opportunities. The second term is related to movement from one position to another, which is influenced by factors such as education and skills.
- Net immigration is the difference between people who come to a country (immigrants) and people who leave the country (emigrants).
- Globalization increases labor mobility between countries.
- Availability of education and training centers affects the supply of qualified workers.
Meanwhile, the demand for labor depends on factors such as:
- Business profits are usually related to the conditions of the business cycle. The demand for labor decreases during an economic recession. In this period, business profits fall because aggregate demand decreases. Businesses stop hiring and choose to rationalize workers as they cut production. Conversely, the demand for labor increases during economic expansion.
- Minimum wages. Some companies offer low wages to support low operating costs. But, because the government imposes a minimum wage, they cannot do it. Hence, the minimum wage limits their demand to recruit workers.
- Wage subsidies. For example, the government provides incentives or wage subsidies for companies that employ or retain older workers. The purpose of subsidies is to compensate for the gap between wages and productivity of older workers.
- Policy on the recruitment of local labor. It affects demand because it reduces the flexibility of firms in choosing workers.
- Production processes and technological advances. Automation, for example, reduces the need for labor to operate production machines.
- Quality of human resources. Some jobs require more professional qualifications, so when the quality of local human resources does not meet the criteria, domestic labor demand is also low.
- Number of companies. More companies mean more demand for labor.
What are the labor market indicators
You can find statistics on the labor market at the central statistics agency, the World Bank, the OECD, or other agencies. You will probably come across a myriad of variables about the labor market. In the following, I will try to summarize key observed labor indicators.
- Unemployment rate is the ratio of the number of unemployed people to the total labor force. The numbers go up during a recession and fall during an economic expansion. Changes in the unemployment rate affect aggregate demand because it impacts the income and consumption of goods and services by the household sector.
- Labor force is the number of people who have jobs or are actively looking for work. Its growth can be used to measure a country’s potential GDP.
- Labor force participation rate. You can calculate this by dividing the labor force by the total working-age population. Together with the unemployment data, we can figure out how many people are actually unemployed.
- Labor productivity measures how much output a worker can produce in an hour. For aggregate figures, you can calculate this by dividing GDP by the aggregate number of hours worked. Like the growth of the labor force, increasing productivity can also increase a country’s potential GDP.
- Average weekly hours in manufacturing. These statistics often move up and down before the economy changes direction. Early in a recession, businesses are more likely to cut overtime than laying off their labor. That’s because the recruitment cost is more expensive. But, if the recession is still going on, and maybe getting worse, they have more confidence to cut their workforce.