Labor Market

DEFINITION of 'Labor Market'

The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. It is a major component of any economy, and is intricately tied in with markets for capital, goods and services.

BREAKING DOWN 'Labor Market'

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 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 hours the employee works and compensation she receives in wages, salary and benefits.

The U.S. Labor Market

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 the opportunity to lead fulfilling lives.

In the U.S., unemployment was around 4 to 5% before the financial crisis, 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 4.9% in January 2016.

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, in recent years due to advancements in technology and other improvements in efficiency.

In the U.S., however, growth in output per hour has not translated into similar growth in income per hour. Workers are creating more goods and services per unit of time, but not earning more compensation. Growth in the employment cost index averaged under 0.7% per year from 2001-2015, while growth in productivity exceeded 2%. 

Macroeconomic Theory 

According to macroeconomic theory, the fact that wage growth lags productivity growth indicates that 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 litter. 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.

A number of 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 if newly arrived workers are willing to accept lower pay. 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 health care increases. Not every worker who loses his job can simply move into health care work, particularly if the jobs in demand are highly skilled and specialized, such as doctors. 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.

Microeconomic Theory

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 wage increases. 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 dollars an hour than $5.

Gains in supply may accelerate as wages increase, since the opportunity cost of not working additional hours grows. But supply may then decrease at a certain wage level: the difference between $1000 an hour and $1050 is hardly noticeable, and the highly-paid worker who's presented with the option of working an extra hour or spending her money on leisure activities may well opt for the latter.

Demand at the microeconomic level depends on two factors, marginal cost 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 a number of 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 a number of professions in the arts and non-profit 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.