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Equilibrium in Labor Markets

Author: Sophia

what's covered

In this lesson, you will learn how wages in a competitive labor market are determined, and how changes in the supply or demand affect the wage equilibrium in the labor market. Specifically, this lesson will cover:

1. Wage Determination and Equilibrium
2. Partial Changes in Supply or Demand
3. Simultaneous Changes in Supply and Demand

before you start

As you have learned, markets have demand and supply curves. The intersection of these two curves in a graph determines the equilibrium price and quantity for the market. At the market equilibrium price, we say that the market clears, because there is neither surplus nor shortage of the item. If a factor other than the price of the item changes, then either the supply curve or the demand curve shifts, and a new equilibrium occurs. At this new equilibrium, the market clears, unless the government is an actor in the market and imposing a restriction.

1. Wage Determination and Equilibrium

You have learned that in a perfectly competitive market, equilibrium prices are determined by demand and supply. Neither buyers nor sellers can influence the market outcome for price and quantity. Buyers and sellers of labor lack market power in perfectly competitive labor markets, because they represent a very small fraction of the market. Both buyers and sellers of labor accept the market-determined price of labor ( bold italic W subscript bold E ) and quantity of labor ( bold italic Q subscript bold E ).

In equilibrium, the quantity of labor supplied and the quantity of labor demanded are equal at wage equilibrium. At wage equilibrium, employers find the number of workers they are seeking, and all individuals seeking employment find jobs. The graph below illustrates the case of wage determination in a perfectly competitive labor market.

A line graph on an x-y coordinate plane. The x-axis is labeled ‘Quantity of Labor’ with a point marked QE, and the y-axis is labeled ‘Price of Labor, Wage per hour’ with a point marked WE. A line labeled ‘Supply’, representing the supply curve, slopes upward from the y-axis below the point WE. Another line labeled ‘Demand’, representing the demand curve, slopes downward to the right from a point above WE, intersecting the supply curve. A vertical dashed line from the point QE and a horizontal dashed line from the point WE extend to meet the intersection point of the demand and supply curves. — The Labor Market in Equilibrium

big idea

At wage equilibrium, employers find the number of workers they are seeking, and all individuals seeking employment find jobs.

When the price of labor is not at equilibrium, economic forces work to return the market to equilibrium. Suppose the graph below represents the labor market for tutors in the local community. If the wage rate for tutors in the local community was above the market equilibrium ( bold italic W subscript bold E ), it would attract more individuals to tutoring work than employers would want to hire at equilibrium quantity ( bold italic Q subscript bold E ).

A line graph on an x-y coordinate plane. The x-axis is labeled ‘Quantity of Labor’, with a point marked QE. The y-axis is labeled ‘Price of Labor, Wage per hour’, with points marked Wbelow, WE, Wabove, such that Wbelow is positioned below WE and WE is positioned below Wabove. A line labeled ‘Supply’, representing the supply curve, starts from a point below WE on the y-axis and slopes upward. Another line labeled ‘Demand’, representing the demand curve, slopes downward to the right from a point above WE on the y-axis and intersects the supply curve at a point. A vertical dashed line from the point QE and a horizontal dashed line from the point WE extend to meet the intersection point of the demand and supply curves. Two horizontal lines extend from Wbelow and Wabove to the right, intersect the supply and demand curves, and are labeled ‘Excess Demand’ and ‘Excess Supply’, respectively. — The Labor Market in Disequilibrium

At an above-equilibrium wage rate, excess supply, or a surplus of workers occurs. In a situation of excess supply in the labor market, with many applicants for every job opening, employers will have an incentive to offer lower wages. The wage rate for tutors will move back down toward equilibrium, and the market will clear once again.

Alternatively, if the wage rate is below the equilibrium ( bold italic W subscript bold E ), then a situation of excess demand, or a shortage of workers arises. In this case, employers encouraged by the below-equilibrium wage rate want to hire more tutors than are available at bold italic Q subscript bold E . Some individuals will desire to work at this below-equilibrium wage rate. Notice that bold italic W subscript bold b bold e bold l bold o bold w end subscript intersects the supply curve at its lower end.

In response to a shortage of tutors, some employers will begin to offer higher pay to attract tutors. Other employers will have to match the higher pay to keep their own employees. A change in the price of labor (wage per hour) will result in a change in the quantity supplied of labor. A higher wage will encourage more individuals to enter the market for tutors. Similarly, a lower wage will cause individuals to leave the market for tutors. As quantity adjusts to the price change, the market will move toward equilibrium, and once again clear. When surplus and shortage situations occur in a labor market, it is the free movement of the price that causes the market to adjust back toward equilibrium.

terms to know

Market Power

The ability of a firm to influence market price.

Excess Supply

The difference between the quantity supplied over the quantity demanded at any above-equilibrium price, which is sometimes referred to as a market surplus.

Excess Demand

The difference between the quantity demanded over the quantity supplied at a below-equilibrium price, which is sometimes referred to as a market shortage.

2. Partial Changes in Supply or Demand

If wages are determined by the interaction of supply and demand, then changes in supply and demand should cause wages to change. Changes to labor supply or labor demand are a result of changes in non-wage factors, assuming the price of labor (wage per hour) is held constant (ceteris paribus).

You have learned how a change in one non-wage factor shifts the labor supply and demand curve. Now, let’s turn our attention to the graphical analysis of wage determination. We will examine the cases of partial change when only one curve shifts, and then the case of simultaneous changes when both curves shift in the labor market.

Now let’s explore four scenarios of partial changes in supply or demand (ceteris paribus).

2a. Scenario 1 - An Increase in Supply

Suppose that an individual could attend a two-year college paying for books, but not tuition or room and board. More individuals would obtain a two-year degree, increasing human capital. Lowering the cost of acquiring the requisite human capital would result in a higher supply of workers with degrees. The Bureau of Labor Statistics reports that workers with an associate’s degree had median weekly earnings of $938 in 2020, compared with $781 for workers with a high school diploma. If more individuals with degrees are seeking employment, what will the effect be on wages in this market?

A supply and demand graph on a coordinate plane with the x-axis labeled ‘Quantity of Labor’; two points QE1 and QE2 are marked on the x-axis, such that QE2 is greater than QE1. The y-axis is labeled ‘Price of Labor, Wage per hour’ with points WE1 and WE2 marked on it, such that WE1 is at a higher point. A downward-sloping line labeled ‘Demand’ starts from the upper portion of the y-axis, representing a demand curve. There are two upward-sloping parallel lines representing supply curves—the left one is labeled ‘Supply’, and the right one is labeled ‘S2’; both intersect the demand curve at the points labeled ‘1’ and ‘2’, respectively. Two vertical dashed lines rise from the points QE1 and QE2 to meet the intersection points 1 and 2, respectively. Two horizontal dashed lines from the points WE1 and WE2 extend to meet the intersection points 1 and 2, respectively. A horizontal arrow is placed between the supply curves, pointing rightward. — Supply Shift in the Labor Market

Assuming all else is the same (ceteris paribus), an increase in supply causes a rightward shift of the supply curve along the demand curve. At the new equilibrium (2) wage falls from bold italic W subscript bold E bold 1 end subscript to , and the quantity of labor rises from bold italic Q subscript bold E bold 1 end subscript to . Wage is now lower with more workers in the market.

2b. Scenario 2 - A Decrease in Supply

According to the Bureau of Labor Statistics, bank teller is among one of the fastest declining occupations in the U.S. In 2020, the median salary of a bank teller was about $32,000. As new technology integrates into the banking industry, the employment opportunities for tellers has declined. Between 2020 and 2030, employment is projected to fall by 73%. Fortunately the individual skills learned as bank teller easily transfer to customer service representative. How will this transition of alternative job type affect wage in the market for bank tellers?

Assuming all else is the same (ceteris paribus), a decrease in supply causes a leftward shift of the supply curve up along the demand curve. At the new equilibrium (2) wage rises from bold italic W subscript bold E bold 1 end subscript to , and the quantity of labor falls from bold italic Q subscript bold E bold 1 end subscript to . Wage is now higher with fewer workers in the market.

2c. Scenario 3 - An Increase in Demand

Suppose that firms invest more in the physical capital used by assembly-line workers in the auto industry. Such an investment increases worker productivity, and this reduces the cost of production. As marginal productivity of labor rises, firms will hire more workers. How does this affect the market wage for assembly-line workers?

Assuming all else is the same (ceteris paribus), an increase in demand causes a rightward shift of the demand curve up along the supply curve. At the new equilibrium (2) wage rises from bold italic W subscript bold E bold 1 end subscript to , and the quantity of labor rises from bold italic Q subscript bold E bold 1 end subscript to . Wage and the quantity of workers are both higher.

2d. Scenario 4 - A Decrease in Demand

Suppose that concern over air quality causes the government to impose strict new laws on the grade of coal that can be mined. What is the likely impact on the market for coal miners as the number of coal mining operations shrink?

Assuming all else is the same (ceteris paribus), a decrease in demand causes a leftward shift of the demand curve down along the supply curve. At the new equilibrium (2) wage falls from bold italic W subscript bold E bold 1 end subscript to , and the quantity of labor falls from bold italic Q subscript bold E bold 1 end subscript to . Wage and the number of workers are now both lower.

key concept

An increase in demand or a reduction in supply will increase the equilibrium wage.
A reduction in demand or an increase in supply will reduce the equilibrium wage.

3. Simultaneous Changes in Supply and Demand

Let’s now consider one scenario of simultaneous change in supply or demand (ceteris paribus):

Suppose that the labor market experiences changes in both supply and demand simultaneously. What will the effect be on wages in the labor market? Let’s consider two events, ceteris paribus.

Event 1: A pandemic causes parents to choose caregiving over paid employment. This event affects suppliers of labor, in particular, parents with children. If parents choose to withdraw from their jobs, then the supply of labor will decrease, and the supply curve will shift to the left.

Event 2: A surge in demand for goods and services for computer tablets and learning apps raises the price of those goods and service. The higher price will incentivize profit-maximizing firms to produce more products, which will require more workers. The demand for labor will increase, and the demand curve will shift to the right.

A supply and demand graph on a coordinate plane with the x-axis labeled ‘Quantity of Labor’; one point QE is marked on the x-axis. The y-axis is labeled ‘Price of Labor, Wage per hour’ with points WE1 and WE2 marked on it, such that WE2 is at a higher point. Two downward-sloping lines, representing demand curves, extend from left to right. The upper one is labeled ‘D2’ and the lower one is labeled ‘Demand’. Two upward-sloping parallel lines, representing supply curves, start from two points on the y-axis—the upper one is labeled ‘S2’ and the lower one is labeled ‘Supply’—and both intersect the demand curves. S2 intersects the D2 curve at the point labeled ‘2’. The curve labeled ‘Supply’ intersects the curve ‘Demand’ at the point labeled ‘1’. One vertical dashed line rises from the points QE and extends upward to meet the intersection points 1and 2, respectively. Two horizontal dashed lines from the points WE1 and WE2 extend to meet the intersection points 1 and 2, respectively. A horizontal arrow is placed between the demand curves, pointing rightward, and a horizontal arrow is placed between the supply curves, pointing leftward. — Demand and Supply Shifts in the Labor Market

Assuming all else is the same (ceteris paribus), an increase in demand for labor causes a rightward shift of the demand curve up along the supply curve, while the decrease in the supply of labor causes a leftward shift of the supply curve up along the demand curve.

At the new equilibrium (2) wage rises from bold italic W subscript bold E bold 1 end subscript to , and the quantity of labor appears to not have changed from bold italic Q subscript bold E . It is clear that wages rose. What is not clear is what happened to quantity—in this situation, we say that quantity is indeterminate. It cannot be accurately determined, because the magnitude of the line shifts could result in different quantity outcomes. Shifting the demand curve further to the right would appear to result in a higher quantity. Shifting the supply curve further to the left would appear to result in a lower quantity of labor.

hint

When working with supply and demand, first decide which side of the market (supply or demand) has been affected by the changing event, then sketch the basic supply and demand model identifying the equilibrium. Next, add the new curve and identify the new equilibrium. Finally, interpret the market outcomes on price and quantity.

Complete the following Try It activity to explore one more simultaneous change situation:

try it

Suppose that a nation has an open immigration policy. At the same time product demand for goods produced by low-skill workers declines.

What will be the effect on wages in the market for low-skill workers?

Assuming all else is the same (ceteris paribus), a decrease in demand for labor causes a leftward shift of the demand curve down along the supply curve, while the increase in the supply of labor causes a rightward shift of the supply curve down along the demand curve. While the quantity of labor increases due to open immigration, the effect on wages is indeterminate.

key concept

An increase in demand and a decrease in supply will raise equilibrium wages.
An increase in supply and a reduction in demand will leave equilibrium wages indeterminate.

watch

This video will review the perfectly competitive labor market.

term to know

Indeterminate

Cannot be accurately determined.

summary

In Wage Determination and Equilibrium you learned how wages are determined in a competitive labor market. You also learned that the price of labor (wage per hour) is determined by the intersection of the supply of labor and the demand for labor curves. If excess demand or excess supply exists, an adjustment in price will move the market back toward equilibrium.

In Partial Changes in Supply or Demand you learned that if wages are determined by the interaction of supply and demand, then changes in supply and demand should cause wages to change. In Scenario 1 - An Increase in Supply you learned that assuming all else is the same (ceteris paribus), an increase in supply causes a rightward shift of the supply curve down along the demand curve. With more workers in the market, wages are lower. In Scenario 2 - A Decrease in Supply you learned that assuming all else is the same (ceteris paribus), a decrease in supply causes a leftward shift of the supply curve up along the demand curve. With fewer workers in the market, wages are higher. In Scenario 3 - An Increase in Demand you learned that assuming all else is the same (ceteris paribus), an increase in demand causes a rightward shift of the demand curve up along the supply curve. Wages and the quantity of workers increase. In Scenario 4 - A Decrease in Demand you learned that assuming all else is the same (ceteris paribus), a decrease in demand causes a leftward shift of the demand curve down along the supply curve. Wages and the number of workers decrease.

In Simultaneous Changes in Supply and Demand you learned that when both curves shift, the effect can be more difficult to determine. An increase in demand and a decrease in supply will raise equilibrium wages. An increase in supply and a reduction in demand will leave equilibrium wages indeterminate.

Source: THIS TUTORIAL HAS BEEN ADAPTED FROM OPENSTAX “PRINCIPLES OF ECONOMICS 2E”. ACCESS FOR FREE AT https://openstax.org/books/principles-economics-2e/pages/1-introduction. LICENSE: CC ATTRIBUTION 4.0 INTERNATIONAL.

REFERENCES

Torpey, E. (n.d.). Career Outlook: Education Pays, 2020. U.S. Bureau of Labor Statistics. Retrieved September 6, 2022, from www.bls.gov/careeroutlook/2021/data-on-display/education-pays.htm

U.S. Bureau of Labor Statistics. (2022, April 19). Employment Projections: Fastest Declining Occupations. U.S. Bureau of Labor Statistics. Retrieved September 6, 2022, from www.bls.gov/emp/tables/fastest-declining-occupations.htm#1

Terms to Know

Excess Demand: The difference between the quantity demanded over the quantity supplied at a below-equilibrium price, which is sometimes referred to as a market shortage.
Excess Supply: The difference between the quantity supplied over the quantity demanded at any above-equilibrium price, which is sometimes referred to as a market surplus.
Indeterminant: Cannot be accurately determined.
Market Power: The ability of a firm to influence market price.