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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:
- Firms are price-takers. They can’t influence the price of output as well as the wage rate.
- The supply of labour is elastic. The supply will increase as the industry wage rate increases.
- Firms in the market all aim for profit maximisation.
- 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.
Derived demand is the demand for a factor of production that results from the demand for another intermediate good. In the case of labour demand, it is derived from the demand for a product or a service that labour produces.
One way for the firm to determine the number of workers it needs is to calculate the marginal product of labour.
The marginal product of labour (MPL) is the extra revenue earned by the firm when hiring one more unit of labour.
To learn more about demand and supply in the labour market check our explanations on The demand for labour and The supply for 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.
To find out more about wage setting in the labour market check our explanation on the Marginal productivity theory.
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.
Involuntary unemployment occurs when workers would be willing to work at the current wage, but they can't find a job.
Check out or explanation on the Types of unemployment to learn more.
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.
Equilibrium in the Labour Market - Key takeaways
- The equilibrium in the labour market occurs at the intersection of the labour supply and demand curves.
- Four conditions for labour market equilibrium to happen are:
- Firms are price takers.
- Elastic supply of labour.
- Firms aim for profit maximisation.
- The marginal product of labour is downward sloping.
- In the perfectly competitive labour market, the equilibrium occurs at the going wage rate where supply equals demand.
- When the real wage rate exceeds the rate at equilibrium, there is a surplus of workers or involuntary employment.
- When prices in the economy increase, the real wage rate drops, which causes disequilibrium in the labour market. Wages are raised to bring back the equilibrium.
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Frequently Asked Questions about Equilibrium in Labour Market
What determines the equilibrium wage of labour?
When the supply equals the demand, the labour market reaches equilibrium. This creates a competitive wage rate w*, also called equilibrium wage of labour. Each firm will hire employees up to the point that the marginal product of labour is equal to this competitive wage rate.
When is a perfectly competitive labour market in equilibrium?
The perfectly competitive labour market is one where the wage rate is determined by the industry, rather than a dominant firm. This means there's a competitive wage rate in the market, and the supply for labour is completely elastic at the going wage.
How do you find equilibrium wage?
In the perfectly competitive labour market, the equilibrium occurs at the going wage rate where supply equals demand.
What is labour market equilibrium?
The equilibrium in the labour market occurs when the supply of labour (workers) equals the firms’ demand for labour.
What determines the equilibrium of wages of labour?
The supply of labour (from workers) and demand for labour (from firms).
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