The Labor Market

This chapter uses the supply and demand model (discussed in Chapter 2) to study labor markets. Labor markets are similar to product markets (markets for things like food, clothing, crime prevention) discussed previously. However, in labor markets it is the services of labor (people) that are sold. In labor markets, individuals are sellers and firms are buyers. A firm must buy (hire) labor from households to produce output — in the labor market the two groups have switched roles!

Since price is always measured on the vertical axis, the price of labor (the WAGE) is on the vertical axis in a labor market graph. The quantity of labor (which can be measured in hours, days, number of workers, etc.) is on the horizontal axis. The supply and demand for labor conform to the laws of supply and demand discussed in earlier chapters. More labor is demanded at lower wages and less is demanded at higher wages (the Law of Demand). More labor is supplied at higher wages (people want to work more if the wage is high) and less is supplied at lower wages (the Law of Supply). Therefore, the supply and demand curves for labor look just like the supply and demand curves in a product market — just like they have looked in all supply and demand graphs to this point.

The equilibrium wage and quantity of labor are determined the same way equilibrium price and quantity were determined in the markets you have studied before. An example of a labor market in equilibrium is shown below.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/007340280x/520416/Ch3_img1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (11.0K)</a>

The details of the explanations behind the demand curve for labor are different from those for the demand curve for a product. The demand for labor is a DERIVED demand. That means that firms don't hire labor to "consume" it, the way individuals buy goods to consume them. Firms hire labor for the output it produces. The demand for labor is DERIVED from what labor can produce — labor is not demanded just to have around and enjoy! In addition, firms produce output to SELL, not just to stack in a warehouse! Firms want to sell output to earn the highest possible profit. Therefore, the demand for labor is also derived from the value of the output it produces. The more output labor can produce and the higher the value of that output, the higher the firm's demand for labor will be.

Because the demand for labor is derived from the value of the output it can produce, two important concepts are used to determine the demand for labor: marginal product (MP) and marginal revenue (MR). These values are both MARGINAL, so they look at the additional value of an additional unit (marginal always refers to 1 more unit or the additional unit). MP is the additional output produced by an additional unit of labor. That is, it represents how much extra will be produced if an extra unit of labor is hired (one more worker or one more hour of work — depending on how the horizontal axis is labeled). This value is very important to firms because it helps to measure the benefit of hiring another unit of labor. MR is the additional revenue received as a result of selling an additional unit of output. It represents the value of an additional unit of output. Thus, the MR tells a firm how much the additional output produced by an additional unit of labor will sell for. Multiplying the MP and the MR gives the additional revenue for the firm from hiring an additional unit of labor. For example, if hiring an additional worker at a car wash results in 5 additional car washes per day and each car wash sells for $20, then the MP of an additional worker is 5 and the MR of an additional car wash is $20. The additional revenue for the firm from hiring the additional worker is $100 ($20 x 5). The additional revenue from hiring an additional worker is called the MRP (marginal revenue product). It is equal to MP × MR.

Firms will decide how many units of labor to hire based on the MRP. In the example above, the maximum a firm would be willing to pay the additional worker is $100. The firm won't pay $101 per day to hire a worker that will only bring in $100 in additional revenues. As more and more labor is hired, each worker adds less and less additional output. That is, MP declines as more workers are hired. This is known as the Law of Diminishing Returns. If the MP of each additional worker declines as more workers are hired, the maximum that firms are willing to pay to hire additional workers must also be falling. This explains why the demand curve for labor slopes downward. It explains the law of demand as it applies in the labor market.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/007340280x/520416/Ch3_img2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (12.0K)</a>

When the quantity of labor is low, MP and therefore MRP are high and firms are willing and able to pay higher wages. At high quantities of labor, MP is lower (due to the Law of Diminishing Returns) and therefore MRP and the wage firms are willing and able to pay is lower.

The supply of labor slopes upward because workers are willing and able to work more when they are paid higher wages and are less willing and able to work when the wage is low. This is the law of Supply as applied to labor markets.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/007340280x/520416/Ch3_img3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (11.0K)</a>

At a high wage, the quantity of labor supplied is high. At a low wage, the quantity of labor supplied is low. This can be explained by the substitution effect (discussed in the text). The substitution effect causes workers to work more as the wage increases. This is because the worker's opportunity cost goes up as the wage goes up. When workers take time off, they give up the wage (i.e. the opportunity cost of leisure is the wage). When the cost of time off increases, workers take less time off — it is TOO expensive not to work at a high wage. There is also an income effect at work when the wage increases. The income effect causes people to work less as the wage goes up, because they can earn the same amount working fewer hours when the wage is higher. While the income effect may dominate for an individual — causing her to work less as the wage increases — evidence indicates the substitution effect dominates in the market, yielding the positively sloped market supply curve for labor. The labor supply curve looks just like the supply curve studied in the product market.

The labor market graph is very similar to the product market graph. Each market uses supply and demand to determine the equilibrium price and quantity. However, because the labor market considers the supply and demand for labor (a DERIVED demand) and because people can make their own decisions about how much to work (goods and services don't make decisions), studying the labor market is also different in many ways than studying the product market.