Lesson 5: Labor Markets

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The focus of this lesson is on the choices made by buyers and sellers of labor services, and the factors and constraints that affect these choices.


At the end of this lesson students will be able to:

  • Use supply and demand to illustrate how wages are determined.
  • Explain how productivity influences wages.
  • Provide examples of how technology can be a compliment or substitute for labor.
  • Determine the good or service from which the demand for labor is derived.
  • Predict how various policies or regulations will impact labor markets.

Economic Concepts

Derived demand Productivity
Labor supply Technology
Total labor income / Individual income Investment
Excess demand / Excess supply Unemployment

National Content Standards Addressed

Standard 4: Incentives Matter

People respond predictably to positive and negative incentives.

  • Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.
  • Small and large firms, labor unions, and educational and other not-for-profit organizations have different goals and face different rules and constraints. These goals, rules, and constraints influence the benefits and costs of those who work with or for those organizations and, therefore, their behavior.

Standard 13: Income and Productivity

Income for most people is determined by the market value of the productive resources they sell. What workers earn depends, primarily, on the market value of what they produce and how productive they are.

  • People can earn income by exchanging their human resources (physical or mental work) for wages or salaries.
  • Employers are willing to pay wages and salaries to workers because they expect to sell the goods and services those workers produce at prices high enough to cover the wages and salaries and all other costs of production.
  • A wage or salary is the price of labor; it usually is determined by the supply of and demand for labor.
  • More productive workers are likely to be of greater value to employers and earn higher wages than less productive workers.
  • In a labor market, in the absence of other changes, if wage or salary payments increase, workers will increase the quantity of labor they supply and firms will decrease the quantity of labor they demand.
  • Changes in the prices of productive resources affect the incomes of the owners of those productive resources and the combination of those resources used by firms.
  • Changes in demand for specific goods and services often affect the incomes of the workers who make those goods and services.

Standard 15: Investment

Investment in factories, machinery, new technology, and in the health, education, and training of people can raise future standards of living.

  • Workers can improve their productivity by improving their human capital.
  • Workers can improve their productivity by using physical capital such as tools and machinery.
  • Productivity is measured by dividing output (goods and services) by the number of inputs used to produce the output. A change in productivity is a change in output relative to input.
  • Increases in productivity result from advances in technology and other sources.
  • Investments in physical and human capital can increase productivity, but such investments entail opportunity costs and economic risks.
  • Investing in new physical or human capital involves a trade-off of lower current consumption in anticipation of greater future production and consumption.
  • The rate of productivity increase in an economy is strongly affected by the incentives that reward successful innovation and investments (in research and development, and in physical and human capital).

Standard 19: Unemployment

Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices.

  • Unemployment exists when people who are actively looking for work do not have jobs.
  • The labor force consists of people aged 16 and over who are employed or actively seeking work.
  • The unemployment rate is the percentage of the labor force that is willing and able to work, does not currently have a job, and is actively looking for work.
  • Full employment means that the only unemployed people in the economy are those who are changing jobs.

Key Ideas

Download full lesson guide for procedures and teaching tips.

1. Review:

  • Institutional differences help to explain differences in countries’ wealth and standards of living.
  • The interaction of supply and demand in markets generates the prices that allocate goods, services, and resources (including labor).

2.The demand for labor is derived demand.

  • There is no demand for labor apart from the demand for the goods and services labor can produce.
    • Employers are the demanders in labor markets.
    • Workers are the suppliers in labor markets.
  • Wages (the “price” of labor generated by the interaction of employers’ demand and workers’ supply in labor markets) are a production cost in the markets for the goods or services labor is hired to produce.
    • The quantity supplied of these goods and services is determined by marginal production costs.
    • The availability of substitutes for labor affects wages and employment.
  • When demand for an output good or service decreases, total labor income in the affected industry will decrease.
    • As demand for the good decreases, demand for labor must also decrease. Possible results include:
      • Workers are laid off;
      • Workers’ hours are cut;
      • Workers’ wages are reduced.
      • The magnitude of the impact on individuals’ income depends on the alternatives available to workers in other employment.
    • An increase in demand for an output good that generates a positive impact on industry revenue also increases total labor income, the latter by increasing the demand for labor.

3. Market changes may produce different effects on total labor income and individual income.

  • Total labor income equals the payments to all workers, whereas individual income is the payment to an individual worker.
    • Differences in individuals’ income result from the choices of buyers and sellers of labor services in labor markets.
  • In the labor market, wages and benefits combined are used to pay workers for their labor services.
  • Note that the term “wage” or the “wage rate” represents compensation per unit of time, which is not the same as income. Income for hourly workers equals the wage rate times the hours worked. The term “salary” represents a total payment per period, regardless of the number of hours worked in the period.
  • An increase in derived demand for labor will increase the wages and benefits paid in the market, at least in the short run, as employers compete to hire new workers. Total income of all workers will increase and income for individual workers will increase.
  • In the long run, the increased wage and benefits paid are expected to attract new workers to the market. This will cause wages and benefits to decrease toward (but not beyond) their levels before the increase in demand.
  • Wages and benefits may change slowly (“sticky” wages) in some local markets in response to changes in the demand and supply for labor.
    • This is largely due to two distinctive features of labor in many jobs:
      • Individuals may have firm-specific human capital – skills they have acquired on the job which are valuable to their current employers but worth little to other firms.
      • Workers often have subtle characteristics that make them singularly well-suited (or poorly-suited) to particular jobs. Employers face high fixed costs in hiring new workers because they must learn about worker-specific characteristics to make successful hiring decisions.
      • Together, these two features give many employers and their workers incentives to tie themselves together in relatively long term, usually implicit, labor agreements, in which there may be substantial variation in hours worked per year in response to demand fluctuations, without corresponding short term changes in hourly wages and benefits.

4. Workers’ wages and benefits are affected by the value of what they produce and by each worker’s individual productivity.

  • As the value of what is produced increases (e.g., shoe makers versus diamond cutters), worker’s compensation is expected to increase, ceteris paribus.
  • Labor productivity is measured by output per worker per day or per year.
    • Other resources affect labor productivity. More capital (buildings, machines, tools and technology) increases laborers’ output per time period.
      • A nation’s infrastructure – capital that facilitates transportation and communication, for example – is a significant factor in labor productivity and economic growth.
    • Within an industry, more productive workers generally earn higher wages than less productive workers.
    • Technology is a key determinant of the productivity of the worker in most types of jobs. Workers trained to use advanced machinery, computers, robots, etc. are more productive to employers and earn higher wages.
  • Derived demand and productivity also explain the extremely high income of Superstars
    • Some labor markets have a “tournament” nature: the high demand is only for those with the very best abilities (or highest productivity).
      • In sports, for example, those at the very top earn substantially more than those with very similar, but not quite “tournament winning,” abilities.
      • The top sales person in a company may be awarded a higher percentage commission as the winner of the sales “tournament.”
  • In other industries, technology may create huge increases in productivity that leverage the time input of the Superstar.

5. Institutions affect labor markets.

  • Labor unions generate market power by controlling the supply of labor available to employers; unions do this for the purpose of raising wages and increasing non-wage compensation (benefits) to workers.
      • In the U.S. there has been significant decline in labor union membership in the private sector, but not in the public sector.
      • In 2018, union members accounted for 10.5 percent of employed wage and salary workers. In 1983, the first year for which comparable union data are available, the union membership rate was 20.1 percent.
      • Although union members are more likely to be employed in the private than public sector, in 2018, 33.9% of public sector employees were union members, compared to 6.4% of private sector employees. Workers in the public sector had a union membership rate more than five times that of private sector employees. In 2018, 7.2 million employees in the public sector belonged to a union, compared with 7.6 million workers in the private sector.
      • There are several factors affecting unionization rates between public and private sectors, including improved wages and working conditions in the private sector and the lack of a “residual claimant” in the public sector.
  • Laws and government regulations also impact the income of various segments of the labor force by affecting the supply of or demand for labor.
    • Minimum wage legislation has greatest impact on entry-level, first time, and unskilled workers.
    • U.S. Immigration laws limit chiefly the supply of lower-skilled workers.
    • OSHA safety regulations comprise a complex burden that varies by industry.
    • Federal and state child labor laws restrict hours worked by minors and thus the supply of unskilled labor.

6. Unemployment occurs for a variety of reasons, some detrimental to workers’ incomes and some beneficial.

  • Many types of resources are “unemployed” at one time or another without there necessarily being anything “wrong” with the market.
    • Unemployment is a natural (and necessary) part of the process of reallocation of resources in changing markets.
    • Workers currently unemployed are often searching for the “best” match for their labor services. Such search provides information about how valuable their skills are to the marketplace.
  • The government defines the level of unemployment as the portion of the labor force not presently employed but actively seeking work.

Ideas To Take Away From This Lesson

  • Labor markets are affected by the demand for the goods and services that labor helps to produce.
  • Individual productivity affects wages and technology affects individual productivity.
  • Institutional features of labor markets affect the supply of labor, cost of hiring and the price of goods produced.

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