Question

Through analyzing supply, demand and equilibrium in the context of competition, how do labor markets work? Use a graph to illustrate your explanation.

Answer 1

In a competitive labor market, equilibrium wage rate and quantity of labor (employment) is determined b the equality of labor demand and labor supply curves. If wage rate rises above equilibrium level, quantity of labor demanded falls but quantity of labor supplied rises, leading to a surplus, which pushes wage rate downward until it is equal to the equilibrium wage rate. If wage rate falls below equilibrium level, quantity of labor demanded rises but quantity of labor supplied falls, leading to a shortage, which pushes wage rate upward until it is equal to the equilibrium wage rate.

In following graph, D0 & S0 are demand and supply curves of labor, intersecting at point A with equilibrium wage rate w0 and employment L0. If wage rates rises higher to w1, quantity of labor demanded falls to L1 and quantity of labor supplied rises to L2, creating a surplus equal to (L2 - L1). Similarly, if wage rates falls lower to w2, quantity of labor demanded rises to L3 and quantity of labor supplied falls to L4, creating a shortage equal to (L3 - L4).