Equilibrium in Labour Market

Have you ever had difficulty finding a job when you needed it? Economists explain such phenomena using the concept of labour market equilibrium. Labour is the manpower or effort used to produce a firm's goods and services. The labour market is influenced by the supply and demand for workers in an economy. When the supply equals the demand, the market reaches equilibrium. Let's dive deeper into the concept of labour market equilibrium and the conditions for it to happen.

What is labour market equilibrium?

The labour market contains two main participants: workers and firms. Typically, more workers will join the labour market when the wage is higher, while firms will want to hire more workers at a lower wage rate.

The equilibrium in the labour market occurs when the supply of labour (workers) equals the firms’ demand for labour. In reality, this is unlikely to happen since economic and political shocks will continuously shift the supply and demand curves in the labour market.

What are the conditions for the labour market to reach equilibrium?

We assume the following four characteristics for labour market equilibrium:

1. Firms are price-takers. They can’t influence the price of output as well as the wage rate.
2. The supply of labour is elastic. The supply will increase as the industry wage rate increases.
3. Firms in the market all aim for profit maximisation.
4. The marginal product of labour (MPL) curve is downward sloping.

A firm’s demand for labour is a derived demand. The demand for labour is derived from the demand for the company’s products. If the firm needs more output, it will hire more workers. On the other hand, a lower output will reduce the need for labour.

One way for the firm to determine the number of workers it needs is to calculate the marginal product of labour.

Equilibrium in a perfectly competitive labour market

At an industry wage rate, firms will hire more workers until the marginal product of labour equals the market wage rate. When this happens, we say that the market has reached an equilibrium.

Figure 1. Equilibrium in the labour market, StudySmarter Originals

Figure 1 depicts the labour market equilibrium. This is where the supply curve (S) and demand curve (D) for labour meet. At the wage rate w*, there is no involuntary unemployment in the market. Those not employed are simply not willing to work at the going wage rate.

In a perfectly competitive labour market, the competitive wage rate is determined by the industry rather than a particular firm. Thus, each firm will hire employees up to the point that the marginal product of labour is equal to this competitive wage rate to maximise their profits.

The difference between the demand for labour curve and the market wage (w*) gives us the worker surplus, whereas the difference between the supply curve and the market wage represents the producer surplus. In a perfectly competitive labour market, the gains from trade (A+B) are maximised, reflecting an efficient allocation of labour resources.

Optimising capital and labour

To ensure labour market efficiency, a firm needs to maximize the output from its two primary inputs: labour and capital.

According to the marginal decision rule, a firm can shift its spending on these inputs as long as the marginal benefit exceeds the marginal cost of hiring more labour.

Let’s assume the firm decides to spend an additional pound hiring one more worker. The marginal benefit of that pound is calculated by dividing the marginal product of labour by its price (MPL/PL).

Meanwhile, spending one extra pound on labour means that the capital will be decreased by one pound. Thus, the marginal cost of that lost capital is the marginal product of capital divided by the price of capital (MPK/PK).

The efficiency in the labour market happens when MPL/PL = MPK/PK.

Involuntary unemployment

Involuntary unemployment occurs when workers would be willing to work at the current wages, but they can’t simply find employers that would hire them.

Figure 2. Involuntary unemployment, StudySmarter Originals

Real wages are the wage a person receives after taking into account the rate of inflation. As you can see in Figure 2, when the real wage rate is higher than the labour market equilibrium, there is a surplus of workers (involuntary employment) who are unable to find work at the current wage rate.

When do employers increase wages?

Employers sometimes increase the wage rate for their employees. This happens when they’re keeping up with the rate of inflation or due to the pressure from the trade unions.

Figure 3. Change in labour market equilibrium as wages increase, StudySmarter Originals

Consider Figure 3. Due to inflation, the real wage rate drops, causing a disequilibrium of the labour market and a shortage of labour. To bring back the equilibrium, employers must increase wages. When inflation is high, people will also want higher wages to cover their living expenses.

Impact of a minimum wage on the labour market

Figure 4. Impact of minimum wage on the labour market, StudySmarter Originals

When the minimum wage rate required by law is set above the industry wage rate, the equilibrium wage level can’t be reached. At the higher wage rate, the labour supply will exceed the labour demand, causing an increase in unemployment.