Labor Market
The labour market is the market in which labour services are exchanged, with workers supplying their time and effort and employers demanding labour to produce goods and services. It differs from markets for goods in important ways: labour is not a commodity that can be separated from the person who supplies it, contracts are often long-term and relational, and institutions such as unions, minimum wages, and employment protection shape outcomes. The labour market determines wages, employment, and unemployment, and it is central to the analysis of inflation, growth, and inequality.
Demand for labour
The demand for labour is a derived demand, arising from the demand for the goods and services that labour helps to produce. A firm hires labour up to the point at which the value of the additional output produced equals the additional cost of employing it. The marginal revenue product of labour therefore determines the demand, and it depends on the productivity of labour and on the price of the output. Higher productivity or higher output prices raise the demand for labour.
The demand for labour is more elastic over longer horizons, because firms can substitute capital for labour and can adjust their scale. It is also more elastic when the output is traded internationally, since firms face more competition, and less elastic when labour is specialised and difficult to replace. The elasticity of labour demand determines how much employment changes in response to changes in wages and to shocks.
Supply of labour
The supply of labour comes from individuals deciding how much to work at prevailing wages. The decision reflects the wage offered, the value of leisure, the income and wealth of the household, and the institutional context, including hours regulations and the availability of childcare. The labour supply of the population depends on participation decisions, on the size and composition of the population, and on migration.
Higher wages generally increase the quantity of labour supplied, through the substitution effect, as work becomes more attractive relative to leisure, but they also raise income, which may reduce the desire to work through the income effect. For the economy as a whole, the response of labour supply to wages is modest, and the participation rate, the hours worked, and the extent of migration are the channels through which supply adjusts.
Equilibrium and frictions
In a simple model, the labour market clears at the wage at which the quantity of labour supplied equals the quantity demanded. In practice, the market is characterised by frictions and institutions that prevent instantaneous clearing. Search and matching frictions mean that workers and jobs take time to find each other, so that vacancies and unemployment coexist. Information is imperfect, and the skills of workers may not match the requirements of employers.
Institutions shape outcomes. Minimum wages set a floor below which wages cannot fall, potentially reducing employment if set above the market-clearing level. Employment protection makes dismissal costly, which can reduce hiring and slow adjustment. Collective bargaining determines wages for many workers, and its coverage affects the distribution of wages and the response to shocks. Unemployment insurance and other benefits affect the incentive to seek work and the level of wages that workers will accept.
Unemployment
Unemployment arises from several sources. Frictional unemployment reflects the time taken to match workers and jobs, and it exists even in a healthy labour market. Structural unemployment arises from mismatches between the skills and locations of workers and the requirements of employers, and it persists because adjustment is slow. Cyclical unemployment arises from deficient aggregate demand, and it rises in recessions and falls in recoveries.
The distinction matters for policy. Frictional and structural unemployment are addressed through information, training, and mobility policies, while cyclical unemployment is addressed through macroeconomic policy that raises demand. The natural rate of unemployment, or the non-accelerating inflation rate of unemployment, is the level consistent with stable inflation, and it reflects the structural and institutional features of the labour market. Policies that reduce the natural rate, by improving matching or reducing barriers, can lower unemployment without generating inflation.
Wage determination
Wages are determined by a combination of market forces and institutions. In competitive markets, wages reflect the marginal revenue product of labour, adjusted for differences in skills, working conditions, and other characteristics. Compensating differentials explain why unpleasant or risky jobs pay more, and why workers accept lower pay for desirable locations or conditions. Human capital differences, reflecting education, training, and experience, explain much of the variation in wages across individuals.
Institutions modify these outcomes. Collective bargaining, minimum wages, and employment protection affect the level and distribution of wages, and the coverage of bargaining affects how widely the terms apply. Efficiency wages, in which employers pay above the market rate to reduce turnover and to motivate workers, can also keep wages above the competitive level, contributing to unemployment. The interaction of market forces and institutions determines the wage structure and the level of employment.
Labour market institutions and performance
The design of labour market institutions affects employment and unemployment. Employment protection, which raises the cost of dismissal, can reduce hiring and slow adjustment, particularly for young and less experienced workers, though it can also encourage investment in training by extending the expected duration of employment. Unemployment benefits protect incomes and support job search but can raise the wage that workers will accept and lengthen the duration of unemployment.
The effects depend on the combination of institutions rather than on any single one. Systems that combine high benefits with strong activation policies and with moderate employment protection can achieve both security and flexibility, while systems that combine rigid protection with weak activation may produce high and persistent unemployment. The design of the package, rather than the level of any single policy, is therefore the key consideration, and it explains the variety of institutional arrangements observed.
Adjustment and structural change
Labour markets must adjust to structural change, including changes in technology, in trade, and in the composition of demand. The adjustment occurs through changes in employment across sectors and occupations, through changes in wages, and through the movement of workers between jobs and regions. The speed and cost of adjustment depend on the flexibility of wages, on the availability of retraining and of transferable skills, and on the mobility of workers.
Policies can facilitate adjustment. Education and training raise the adaptability of workers, and active labour market policies support job search and skill development. Housing and transport policies affect mobility, and the portability of benefits and pensions supports movement between jobs. Where adjustment is slow, the costs fall on displaced workers, and policies that combine support with incentives to re-enter employment can reduce the persistence of unemployment and the loss of skills that accompanies long spells out of work.