Labor Market: Supply, Demand, and the Forces that Shape It

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.

Types of Labor Market

The labor market can be a primary market or a secondary market.

• Primary market: Focuses on permanent, full-time positions offering greater employment continuity.
• Secondary market: Provides workers for temporary, part-time, or project-based roles with less employment security.

The supply of labor can come from internal or external to the organization.

• Internal labor market: Large or multinational companies often utilize an internal labor market. This system fulfills staffing needs by shifting existing employees to different business units within the organization. Internal recruitment allows companies to leverage their existing knowledge of employee skills and strengths. Additionally, it can boost employee retention.
• External labor market: External labor markets are the traditional open marketplaces where companies compete with each other to attract qualified workers. External recruitment offers a wider pool of talent and fresh perspectives. It also allows companies to respond to specific skill requirements not readily available within the organization.

Understanding labor supply and demand

The labor market works similarly to the goods market. 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 the price of labor services 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 salaries encourage more labor supply but reduce the demand for labor. The equilibrium wage rate is reached when the quantity of labor supplied equals the labor demanded.

Labor demand

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, that 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

Labor supply

The law of supply also applies to the labor market. As wages rise, the labor supply increases. Conversely, a reduction in wages reduces the labor provided. Hence, the labor supply curve is upward-sloping (positive slope).

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 less time is spent 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, which 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 plot it on a graph, it would form a backward-bending supply curve of labor.

Factors affecting labor supply

On the worker side of the labor market equation lies labor supply, which reflects the number of people willing and able to work at a given wage. This willingness is influenced by a variety of factors that go beyond just needing a paycheck. Let’s delve into the key forces that shape how many people choose to enter the workforce, how many hours they’re willing to work, and what kinds of jobs they might pursue.

Demographic shifts:

• Population growth: A rising birth rate and declining death rate lead to a larger population, creating a potential pool of new workers as these individuals reach working age.
• Age structure: A population with a high proportion of individuals in their prime working years (typically 25-64) signifies a stronger potential labor supply. Conversely, an aging population with a declining birth rate can lead to a shrinking workforce over time.

Worker mobility:

• Geographic mobility: The ease with which workers can relocate to areas with better job opportunities plays a significant role. Factors like transportation infrastructure, affordable housing, and competitive wages all influence geographic mobility. When these factors make relocation easier, it expands the labor supply in growing regions.
• Occupational mobility: Educational opportunities and accessible skill development programs allow workers to transition between careers. This adaptability helps fill gaps in the labor market as job demands evolve.

Immigration and globalization:

• Net immigration: A country with a positive net migration (more immigrants than emigrants) experiences a direct boost to its labor force. Immigration can introduce new skills and perspectives, enriching the overall talent pool.
• Globalization: As international borders become more porous, skilled workers can more easily move between countries. This global labor mobility can benefit regions facing labor shortages by connecting them with a wider talent pool.

Investment in human capital:

• Education and training: A robust network of educational institutions and training programs equips the workforce with relevant skills and qualifications. This not only increases the overall labor supply but also elevates the skillset of available workers, making them more employable and productive. Additionally, it fosters labor flexibility by enabling workers to adapt to changing industry demands and technological advancements. By providing opportunities to acquire new skills, workers can transition between jobs more seamlessly and contribute to a more dynamic and adaptable workforce.

Factors Affecting Labor Demand

Companies aren’t simply passive recipients of labor; they actively seek workers based on their needs and the economic climate. This driving force is called labor demand, which reflects the number of workers businesses are willing to hire at a given wage. But what exactly determines a company’s hiring appetite? We’ll explore the key factors that influence how many workers businesses need, the skills they seek, and how much they’re willing to pay.

Economic conditions:  Economic expansions lead to increased consumer spending, boosting business profits. This incentivizes companies to expand production and hire more workers to meet this rising demand. Conversely, during recessions, businesses experience declining profits and may resort to layoffs or hiring freezes to control costs.

Labor costs:

• Minimum wage: Government-mandated minimum wages can influence a company’s hiring decisions. If the minimum wage is set too high relative to worker productivity, businesses may be less willing to hire, especially for entry-level positions.
• Wage subsidies: Government programs that incentivize companies to hire specific demographics, like older workers, can help offset potential productivity concerns and encourage businesses to expand their workforce.

Local recruitment policies: Policies that mandate companies prioritize local workers over foreign talent can limit a company’s ability to find workers with the specific skills or experience needed.

Technological advancements: As technology advances, automation can replace some human labor, particularly in repetitive tasks. This can lead to decreased demand for workers in certain sectors while creating new opportunities in areas like technology development and maintenance.

Human resource quality: Companies need workers with the right skills and qualifications to perform specific jobs effectively. If the available workforce lacks the necessary skills, businesses may be less likely to expand or invest in training programs to bridge the skill gap.

Number of businesses: A growing number of companies entering a market creates a higher overall demand for labor. As these businesses compete and expand, they need to hire workers to fill various positions.

Labor market indicators

Statistics on the labor market can be found at the Central Statistics Agency, the World Bank, the OECD, or other agencies. You will probably encounter 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. It goes up during a recession and falls during an economic expansion. Changes in the unemployment rate affect aggregate demand because they impact 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 lay 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.

Labor market reform

Labor market reform is a broad term encompassing initiatives designed to optimize the way workers and employers connect within an economy. These reforms can target various aspects of employment with the ultimate aim of achieving a balance between economic growth and worker well-being.

Here are some key areas that labor market reforms might address:

• Flexibility: This could involve streamlining hiring and firing processes to allow businesses to adapt to changing market conditions. Additionally, promoting worker skill development through training programs or apprenticeships can enhance adaptability and make the workforce more responsive to technological advancements.
• Worker protections: Reforms in this area might involve updating regulations on minimum wage, unemployment benefits, or safety standards to ensure fair compensation, adequate support during job transitions, and a safe work environment.
• Labor participation: Another focus can be encouraging more people to enter or re-enter the workforce. This could involve initiatives such as affordable childcare support, targeted skills training for specific demographics (e.g., returning mothers or older workers), or policies that address discrimination faced by certain groups.
• Matching skills with demand: Labor market reforms might also aim to bridge the gap between the skills employers seek and the skills workers possess. This could involve improved career counseling in schools, better aligning vocational training programs with industry needs, or creating more efficient platforms for connecting job seekers with relevant opportunities.

Labor market reforms can strive to create a more dynamic and efficient system by addressing these areas. This can benefit both workers through increased job opportunities and improved working conditions and businesses by fostering a skilled and adaptable workforce that can drive productivity gain and innovation.

However, it’s important to acknowledge that labor market reforms are often complex and can have far-reaching consequences. Striking the right balance between flexibility and worker protection, for instance, requires careful consideration.