Labour Demand, Supply & Equilibrium
Labour economics seeks to understand the functioning of labour markets and how they impact supply, demand and wages. Essentially, if demand for a specific labour category is high and supply is low, then the expectation is that wages will increase to attract more workers into the sector. Labour economics is important given the result it has on wages, income and unemployment, with many governments around the world seeking full employment as it would raise incomes and reduce welfare dependence.
However, this basic argument assumes that the labour market operates perfectly. However, inefficiencies lead to an imperfect market shaped by:
Compensating Differentials. A worker may be given lower wages because they receive compensation in the form of other (hard-to-observe) job/roles characteristics e.g. lower effort requirements and better working conditions.
Labour Market Imperfections. Two workers that are essentially the same may be paid differently because of job/role variations which shape both productivity and reward mechanisms. For example, a larger business may be able to offer better pay and benefits than a smaller company for exactly the same effort.
Direct Discrimination. Employers may pay lower wages to some workers due to institutional preferences e.g. around ethnicity, gender and nationality.
Elasticity of demand must also be considered. If a business is in a highly competitive sector with elastic product pricing (i.e. any price increase has the potential to significantly reduce demand) then they will be unable to offset higher wage demands by raising the prices charged for their outputs. Globalisation also shapes this dynamic, with many business now able to take forward overseas sourcing and manufacture to maintain or increase outputs whilst still minimising wage costs.
Substitution between the cost of labour and the cost of capital i.e. replacing workers with machinery can also shape the market. If wage costs increase significantly, then businesses will look to other solutions (such as increased automation) to reduce this overhead. National economic and social policies designed to protect the wage interests of workers can also (unintentionally) increase this pressure e.g. the UK National Minimum Wage legislation.
In examining such factors, the labour market can be considered in both microeconomic and macroeconomic terms. Macroeconomics refers to the overall economy and so consider interrelations between labour markets, trade and money markets. The government can intervene in the economy to change the macroeconomic situation such as through wage legislation, education policies to increase workforce skills or economic approaches (such as international trade agreements and taxation) to stimulate and increase aggregate demand. Microeconomics focuses on individual businesses and workers in order to examine their role in the labour force.
Human capital can be considered as a set of skills that can be used to increase worker productivity. It can be seen as a stock of knowledge and know-how, mental and physical abilities and/or the capacity to adapt and learn. However, this is a challenging concept given the nature of change being experienced within national economies as workers seen as highly skilled and ‘rare’ assets in the past (e.g. miners) seek to address real and perceived barriers in an effort to gain employment in new/emerging business areas.
National education policies seek to provide a future workforce that is equipped to meet such demands, but these approaches favour new entrants to the labour market rather than established workers whose current skills may no longer be in demand. Establishing the cost-benefit return of education investment in older workers is more challenging, particularly when social support costs and associated factors (e.g. status and community impact of unemployment) are considered.
The wages offered by a business will generally depend upon the supply/demand fundamentals of the market. However, with the globalisation and automation issues already noted, there are now choices available to businesses which may depress or limit wage rates. In some sectors, the perceived ‘pay-back’ of the worker rather than productivity is seen as the key wage determinant e.g. workers in hospitality and service areas being paid lower rates per hour than those in the financial sector. This neo-classical view suggests that a worker will earn a wage equal to their marginal product of labour, but this assumes the operation of a perfect market. In reality, this may not be the case, with some businesses making abnormal profits from workers and paying at rates which are below the marginal product of labour. It can also be argued that some manufacturing roles should receive a lower wage if the process concerned could be undertaken by machinery, particularly if this could be a more cost-effective option.
Generally, there is a wage incentive for many workers - work harder and earn more and some legislative policy interventions seek to shape this decision space e.g. the UK National Minimum Wage seeking to increase workforce participation by making state benefits less attractive. However, such incentivisation will only work as long as workers are content to substitute their available leisure time for labour. Once income levels reach a certain level (so that their core requirements are satisfied) then workers are more likely to protect their remaining leisure time. Essentially, at this point the marginal utility of leisure time exceeds that of work/labour time.
Cyclical unemployment is created by a general downturn in the economy which causes aggregate demand to fall, reducing labour requirements and therefore increasing unemployment rates. This can also be described as ‘Demand Deficient Unemployment’, as there is insufficient aggregate demand for full employment to be achieved in the economy.
In the UK, the main driver of aggregate demand has been consumer spending, with commentators suggesting that future growth needs to be driven by investment, trade and increased exports. Continued globalisation has allowed some countries to increase national employment through international demand for their products and services rather than rely on domestic requirements.
Structural employment is caused when certain national industries decline, reflecting long-term changes in the market (e.g. due to technology changes and/or alternative/cheaper overseas supply). The long-term impact of this will be dependent on a range of factors such as other sector/regional opportunities, training availability and impact as well as workforce flexibility. Structural unemployment can be driven by regional concerns (the lack of any viable alternatives to the industry lost) and seasonal variations (such as agricultural workers and those in the tourism industry).
Classical unemployment reflects the traditional supply/ demand model, stating that unemployment will occur when the wage demands are too high. Frictional unemployment reflects the hiatus that occurs when a worker is ‘between’ jobs (e.g. made redundant but with the skills to be re-hired elsewhere). Because of this liquidity in the labour market, it can be argued that an unemployment rate of between 3-4% is a closer reflection of full employment. The impact of voluntary unemployment on the market must also be considered given the factors that may lead people to exclude themselves from the workforce. Social concerns - such as attitudes to the employment of women and discriminatory attitudes (e.g. surrounding the perceived abilities and adaptability of older workers) are key issues in this area.
The production frontier considers the possible production of goods in an economy. Essentially, given current inputs, the economy can produce up to a certain level but for workers to achieve above inflation pay increases productivity also needs to increase. Doing so increases corporate revenues, creating the margins needed to potentially increase wages. If productivity slows, the economy contracts, aggregate demand decreases and there is downward pressure on wages. If productivity increases, not only is there an increase in corporate margins the associated wage increases may also stimulate consumer demand (people can buy more!) which can sustain the pull for the higher productivity levels being achieved.
It can therefore be argued that productivity growth is vital for long-term sustainable growth and that this is achieved through two key inputs - labour and capital. For a country to increase the size of their economy, they need to either increase the size of the labour force, or invest in the market to expand productivity. However, this is relatively simplistic given some of the social factors already outlined and the impact of emerging factors such as automation.
Labour mobility refers to worker movement around an economy or even internationally. Geographical mobility refers to location, whereas occupational mobility refers to the worker’s ability to change job types. Geographic mobility can increase the supply of labour (e.g. moving from rural to urban environments to support manufacturing) and can deliver both specialisation and comparative advantage. For example, in China, the move of cheap (previously agricultural) labour into large cities allowed specialisation in large volume, lower quality goods for export at prices which were difficult for competitors to mirror.
A mobile labour force can also mitigate the impact of regional/sector unemployment as people move to exploit other opportunities. Productivity can also increase when geographic, more specialised labour clusters develop allowing shared innovation and associated skills development. Examples include ‘Silicon Valley’ in the United States and the UK financial sector in London. International labour movement can be either facilitated or restricted by treaties and collective economic agreements as well as national policies such as work visa requirements.
Occupational mobility, whilst essential to the transformation of any economy, does require national policy support through interventions such as training and education opportunities for older workers. It can also be restricted if the sector(s) concerned are too heavily regulated which can inhibit the free flow of labour. However, in many roles such regulation and associated licensing and training requirements are deemed essential (e.g. medical professionals). In these areas, higher wages can be commanded due to both high demand and restricted supply.
Employee representational groups such as Trade Unions play an important role in areas such as collective bargaining and associated pay issues. However, there has been a large decline in union membership over the last few decades which in turn has eroded the collective bargaining power of such entities. Unions might seek to exercise their collective bargaining power with employers to achieve a wage premium compared to the rates available to non-union members. Their focus also includes skills development, the protection of workers’ rights and supporting both occupational and geographic labour mobility. Unions retain the power to restrict the supply of labour, although within the UK this is now highly regulated and controlled through legislation.
This Chapter has sought to outline the key economic arguments in relation to the operation of labour markets. Ultimately supply and demand will determine wage rates, but as has been shown this dynamic is complicated by a number of factors. The importance of productivity and the elements shaping aggregate demand have wider implications of the economy, especially as growth in consumer spending may be needed to increase job opportunities, sustain growth and create the margins needed for wage increases.
The nature of human capital also affects the wage structures that are likely to materialise and the importance of education, skills and skills transfer must not be underestimated. As workers acquire more skills/ capital the demand for their services increase as they are seen to be able to support a business in its aspiration to improve/increase productivity. However, the wages offered must be high enough to generate positive utility - in essence, it has to be worth the worker’s time and attractive enough for them to sacrifice alternative opportunities such as increased leisure time.
This Chapter also discussed the challenges surrounding unemployment and the social and economic issues that shape unemployment rates. The structural challenges that may be present in a national economy (such as limited labour mobility and limited skills re-training opportunities) can exacerbate the economic impact of unemployment, further undermining economic growth aspirations/expectations. It is also necessary to maintain an international view of labour economics given the drivers behind globalisation and the increased labour competition that results.
Sloane, P., Latreille, P., O’Leary, N. (2013). Modern Labour Economics, London, Routledge.
Sloman, J., Norris, K., Garrett, D. (2013). Principles of Economics, London, Pearson Higher Education.