When producing goods and services, businesses require labor and capital as inputs to their production process. The demand for labor is an economics principle derived from the demand for a firm's output. That is, if demand for a firm's output increases, the firm will demand more labor, thus hiring more staff. And if demand for the firm's output of goods and services decreases, in turn, it will require less labor and its demand for labor will fall, and less staff will be retained.
Labor market factors drive the supply and demand for labor. Those seeking employment will supply their labor in exchange for wages. Businesses demanding labor from workers will pay for their time and skills.
Demand for labor is a concept that describes the amount of demand for labor that an economy or firm is willing to employ at a given point in time. This demand may not necessarily be in long-run equilibrium. It is determined by the real wage firms are willing to pay for this labor and the number of workers willing to supply labor at that wage.
A profit-maximizing entity will command additional units of labor according to the marginal decision rule: If the extra output that is produced by hiring one more unit of labor adds more to total revenue than it adds to the total cost, the firm will increase profit by increasing its use of labor. It will continue to hire more and more labor up to the point that the extra revenue generated by the additional labor no longer exceeds the extra cost of the labor. This relationship is also called the marginal product of labor (MPL) in the economics community.
According to the law of diminishing marginal returns, by definition, in most sectors, eventually the MPL will decrease. Based on this law: as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline.
Another consideration is the marginal revenue product of labor (MRPL), which is the change in revenue that results from employing an additional unit of labor, holding all other inputs constant. This can be used to determine the optimal number of workers to employ at a given market wage rate. According to economic theory, profit-maximizing firms will hire workers up to the point where the marginal revenue product is equal to the wage rate because it is not efficient for a firm to pay its workers more than it will earn in revenues from their labor.
- Changes in the marginal productivity of labor, such as technological advances brought on by computers
- Changes in the prices of other factors of production, including shifts in the relative prices of labor and capital stock
- Changes in the price of an entity’s output, usually from an entity charging more for their product or service
The labor market, also known as the job market, refers to the supply of and demand for labor, in which employees provide the supply and employers provide the demand. It is a major component of any economy and is intricately linked to markets for capital, goods, and services.
- The labor market refers to the supply of and demand for labor, in which employees provide the supply and employers provide the demand.
- The labor market should be viewed at both the macroeconomic and microeconomic levels.
- Unemployment rates and labor productivity rates are two important macroeconomic gauges.
- Individual wages and the number of hours worked are two important microeconomic gauges.
- In the United States, the Bureau of Labor Statistics compiles detailed reports on national and local labor markets.
At the macroeconomic level, supply and demand are influenced by domestic and international market dynamics, as well as factors such as immigration, the age of the population, and education levels. Relevant measures include unemployment, productivity, participation rates, total income, and gross domestic product (GDP).
At the microeconomic level, individual firms interact with employees, hiring them, firing them, and raising or cutting wages and hours. The relationship between supply and demand influences the number of hours employees work and the compensation they receive in wages, salary, and benefits.
The macroeconomic view of the labor market can be difficult to capture, but a few data points can give investors, economists, and policymakers an idea of its health. The first is unemployment. During times of economic stress, the demand for labor lags behind supply, driving unemployment up. High rates of unemployment exacerbate economic stagnation, contribute to social upheaval, and deprive large numbers of people of the opportunity to lead fulfilling lives.
In the U.S. unemployment was around 4% to 5% before the Great Recession, when large numbers of businesses failed, many people lost their homes, and demand for goods and services—and the labor to produce them—plummeted. Unemployment reached 10% in 2009 but declined more or less steadily to 3.5% in February 2020. However, more than 6 million people filed unemployment claims in a single week in April 2020; that number dropped to a little more than 1 million people in the week ending Aug. 1, 2020, according to the U.S. Department of Labor.
Labor productivity is another important gauge of the labor market and broader economic health, measuring the output produced per hour of labor. Productivity has risen in many economies, the U.S. included, due to advancements in technology and other improvements in efficiency.
In the U.S., growth in output per hour has not translated into similar growth in income per hour. Workers have been creating more goods and services per unit of time, but they have not been earning much more in compensation. An analysis of U.S. Bureau of Labor Statistics data by the Economic Policy Institute showed that while net productivity rose 61.8% from 1979 to 2020, wages only grew 17.5% (after adjusting for inflation).
The fact that productivity growth has outstripped wage growth means that the supply of labor has outpaced the demand for it.
According to the macroeconomic theory, the fact that wage growth lags productivity growth indicates that the supply of labor has outpaced demand. When that happens, there is downward pressure on wages, as workers compete for a scarce number of jobs and employers have their pick of the labor force.
Conversely, if demand outpaces supply, there is upward pressure on wages, as workers have more bargaining power and are more likely to be able to switch to a higher paying job, while employers must compete for scarce labor.
Image by Julie Bang © Investopedia 2019Some factors can influence labor supply and demand. For example, an increase in immigration to a country can grow the labor supply and potentially depress wages, particularly for unskilled jobs. An aging population can deplete the supply of labor and potentially drive up wages.
These factors don’t always have such straightforward consequences, though. A country with an aging population will see demand for many goods and services decline, while demand for healthcare increases. Not every worker who loses their job can simply move into healthcare work, particularly if the jobs in demand are highly skilled and specialized, such as doctors and nurses. For this reason, demand can exceed supply in certain sectors, even if supply exceeds demand in the labor market as a whole.
Factors influencing supply and demand don’t work in isolation, either. If it weren’t for immigration, the U.S. would be a much older—and probably less dynamic—society, so while an influx of unskilled workers might have exerted downward pressure on wages, it likely offset declines in demand.
Other factors influencing contemporary labor markets, and the U.S. labor market, in particular, include the threat of automation as computer programs gain the ability to do more complex tasks; the effects of globalization as enhanced communication and better transport links allow work to be moved across borders; the price, quality, and availability of education; and a whole array of policies such as the minimum wage.
The microeconomic theory analyzes labor supply and demand at the level of the individual firm and worker. Supply—or the hours an employee is willing to work—initially increases as wages increase. No workers will work voluntarily for nothing (unpaid interns are, in theory, working to gain experience and increase their desirability to other employers), and more people are willing to work for $20 an hour than $7 an hour.
Gains in supply may accelerate as wages increase, as the opportunity cost of not working additional hours grows. However, supply may then decrease at a certain wage level: The difference between $1,000 an hour and $1,050 is hardly noticeable, and the highly paid worker who’s presented with the option of working an extra hour or spending their money on leisure activities may well opt for the latter.
Image by Julie Bang © Investopedia 2019Demand at the microeconomic level depends on two factors: marginal cost of production and marginal revenue product. If the marginal cost of hiring an additional employee, or having existing employees work more hours, exceeds the marginal revenue product, it will cut into earnings, and the firm would theoretically reject that option. If the opposite is true, it makes rational sense to take on more labor.
Neoclassical microeconomic theories of labor supply and demand have received criticism on some fronts. Most contentious is the assumption of “rational” choice—maximizing money while minimizing work—which to critics is not only cynical but not always supported by the evidence. Homo sapiens, unlike Homo economicus, may have all sorts of motivations for making specific choices. The existence of some professions in the arts and nonprofit sector undermines the notion of maximizing utility. Defenders of neoclassical theory counter that their predictions may have little bearing on a given individual but are useful when taking large numbers of workers in aggregate.
The effects of a minimum wage on the labor market and the wider economy are controversial. Classical economics and many economists suggest that a minimum wage, like other price controls, can reduce the availability of low-wage jobs. On the other hand, some economists say that a minimum wage can increase consumer spending, thereby raising overall productivity and leading to a net gain in employment.
The effects of immigration are difficult to measure precisely, due to the size and complexity of the modern economy. The classical model of economics predicts that high levels of immigration may cause wages to fall due to an increased supply of labor. However, some studies suggest a more complicated picture. Some studies suggest that immigration can also have a positive effect on aggregate demand, depending on the skillset of the new arrivals. Because new workers are also consumers, the research found that immigration can increase the demand for labor as well as the supply.
The Bureau of Labor Statistics compiles a monthly employment report, based on a survey of around 60,000 representative households in the United States. Data from the survey are used to estimate the employment figures for the entire country. The unemployment rate is based on the percentage of people who are not employed but actively looking for a job, as a percentage of the total labor force. Those who have no job and are no longer looking are not included in the unemployment rate.
The labor market is an economic term for the availability and price employment. Like other markets, the price for labor is largely determined by supply and demand, although the labor market is also heavily regulated in many countries.