How Do the Laws of Supply & Demand Affect the Labor Market?

Just as the laws of supply and demand affect the prices consumers pay for goods and services, they also affect the labor market. Instead of directly dealing with consumer goods, the labor market involves the relationship between workers and firms in the marketplace. Firms in essence are the buyers and individuals provide the labor or supply. However, both act as wage-takers; firms must take and pay the rates the market demands and workers must accept these wages for the work provided.

Firms need workers to produce goods for consumers. The amount of labor demanded by a firm depends on several factors, including how much the labor costs -- as determined by the market wage rate -- and how much labor the firm needs. To maximize profits, firms ideally want to hire more workers at lower wages. This creates a downward-sloping demand curve as it relates to labor wage rates. As firms buy up more labor, wage rates decrease. When firms demand and hire less workers, wages increase.

Individual workers in the market make up the labor supply by deciding how willing they are to provide service to firms given a set wage. When workers anticipate higher wages, the supply of labor increases. The labor supply decreases when wages are low. As such, the supply curve is an upward-sloping line, although the line may be different for individual workers. In other words, each person has different opportunities and can make choices about how to spend their time.

Equilibrium in a perfectly competitive labor market occurs when the supply of labor equals the labor demand. On a graph, you can see equilibrium as the intersection between the two curves. Referred to as "full employment," this intersection assumes that each individual that wants to work has a job. Shifts in equilibrium create either a labor surplus or labor shortage. When the market wage rate increases, the theoretical demand for labor decreases and a labor surplus (more workers than jobs) occurs. As market wages decrease below the equilibrium rate, the demand for labor is greater than the supply, creating a shortage of workers.

Several different forces can affect both the demand for labor and the supply of labor, affecting wages, employment levels and thus equilibrium. For example, changes in firms' demand for labor could result from consumer demand for products or a change in government regulations that affect labor costs. Changes in the supply of labor can result from the population, such as a growth that expands the size of the labor force or a change in the age composition of workers, such as more elderly or younger workers. Labor supply can also change because of workers' preferences and attitudes toward the labor market.