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16.1 The Labor Market

The labor market is the market in which labor services are traded. Individual labor supply comes from the choices of individuals or households about how to allocate their time. As the real wage (the nominal wage divided by the price level) increases, households supply more hours to the market, and more households decide to participate in the labor market. Thus the quantity of labor supplied increases. The labor supply curve of a household is shifted by changes in wealth. A wealthier household supplies less labor at a given real wage.

Labor demand comes from firms. As the real wage increases, the marginal cost of hiring more labor increases, so each firm demands fewer hours of labor input—that is, a firm’s labor demand curve is downward sloping. The labor demand curve of a firm is shifted by changes in productivity. If labor becomes more productive, then the labor demand curve of a firm shifts rightward: the quantity of labor demanded is higher at a given real wage.

The labor market equilibrium is shown in Figure 16.1 "Labor Market Equilibrium". The real wage and the equilibrium quantity of labor traded are determined by the intersection of labor supply and labor demand. At the equilibrium real wage, the quantity of labor supplied equals the quantity of labor demanded.

Figure 16.1 Labor Market Equilibrium

Key Insights

  • Labor supply and labor demand depend on the real wage.
  • Labor supply is upward sloping: as the real wage increases, households supply more hours to the market.
  • Labor demand is downward sloping: as the real wage increases, firms demand fewer hours of work.
  • A market equilibrium is a real wage and a quantity of hours such that the quantity demanded equals the quantity supplied.