The fundamental dynamics of supply and demand apply as much to labor as they do to markets for goods and services. Unemployment, the bane of white and blue collar workers alike, occurs whenever there are more people seeking a particular job than there are employers looking to fill such positions. Thus, unemployment is a constant that varies only in degree and kind. How employers determine the number of workers they require at any given time and the number of hours workers are willing to spend on the job at a given wage- rate are both micro-economically quantifiable. No less important (but harder to precisely pin down) is the microeconomic impact of unemployment. Consumer spending accounts for almost two thirds of all purchases in developed economies, and the vast majority of consumers here are wage earners. So, higher unemployment rates slow or cause negative economic growth that can lead to more lay-offs.
Keywords Collective Bargaining; Frictional Unemployment; Full Employment; Human Capital; Law of Diminishing Returns; Marginal Physical Product of Labor; Marginal Resource Cost of Labor; Monopoly; Oligopoly; Opportunity Cost; Structural Unemployment; Substitution Effect; Utility Function; Utility-Maximizing Behavior; Wage Elasticity
Economics: Labor Economics
All wealth stems from a nation's productive capacity; the harnessing of land, raw materials, capital and labor for the express purpose of creating saleable goods and services. Collectively, the earnings garnered through labor amount to some three-quarters of an industrially-developed country's total national income. Consequently, the earnings fund much of the consumer spending that typically makes up some two-thirds of a country's overall economic activity. No wonder, then, that public anxiety quickly mounts when the national unemployment figure exceeds a certain level and why the goal of government economic policy is full employment. The more people working, essentially, the more money they have to spend on discretionary items like electronics, cosmetics, etc. This increased demand leads suppliers to ramp up production and eventually hire additional workers. Alas, the converse also holds true: If demand for too many goods drops appreciably, producers lay-off workers. And their subsequent belt-tightening causes demand to drop further, triggering more lay-offs and even sharper drops.
Even the most penny-pinching industrialist has a long-term vested-interest in paying more than a subsistence wage. But exactly how much should a given employer pay its hourly workers? When exactly should it hire or lay-off additional ones? Can a firm maximize its profits and compensate its workers with a fair and living wage or are the two objectives in the final analysis incompatible? And what about the worker: Does he or she economically benefit from many years of schooling or from joining a union? Questions like these are the focus of inquiry in labor economics, a field that draws heavily on the microeconomic principles of supply and demand (Cleaver, 2002). Laborers basically sell services that employers are willing to buy. The greater the demand for a particular service, the higher the price or wage. However, this is not true past a certain point, as few producers can afford to pay out more in costs than they earn in sales revenue for very long. This very real constraint tempers union demands made of employers during contract negotiations. Employers face the countervailing constraint of a strike; a strong union can leverage its sole supplier status to its advantage just like a business monopoly can.
Microeconomic theory presupposes perfect competition and perfect information — ideal conditions that rarely (if ever) occur in real-world markets. Competition is said to be perfect when every market participant can enter and exist at will and none face outside restraints on how they conduct their business. Similarly, information is said to be perfect when every participant knows the range of prices on offer for a good or service it supplies and the identity of all of its competitors. Much is gained, though, by suspending disbelief and buying into this simplified model, for several of its fundamental concepts and principles can now be applied to very good effect. Indeed, market equilibrium, marginal analysis, opportunity costs, price elasticity, the utility function, and the substitution effect as we are about to see add to and deepen our understanding of how labor markets function.
Supply of Labor
The labor force is made up every one either employed or seeking employment. Children and the stay-at-home parents who care for them are excluded, as are the institutionalized. Market-wise, moreover, atypical constraints are built into the labor force: Namely, that there is an upward limit to the number of employable people at any given time and not one of them is capable, much less willing to work twenty four hours a day. In fact, in developed countries, in-kind payments by governments to the indigent and unemployed effectively eliminate the threat of starvation; not necessarily everyone has to work and earn his or her keep. In industrialized nations, then, the particular utility function of the individual, the sum of goods, services and activities that satisfies him or her, causes people to seek work. That, after all, is what economists expect any rational person to do. An individual exhibits utility-maximizing behavior whenever he or she both works and regularly enjoys a certain amount of leisure time.
Marginal Utility of the Individual
But no two people are exactly alike. Some enjoy material goods more than others and are willing to work longer hours to afford them. Conversely, some enjoy leisure for leisure's sake more and are not willing to work longer hours. When plotted on a graph, the line connecting different degree-points of preference for income measured in hours work versus leisure curves up and inwards to a point, then outwards again above that point. Apparently, people are prepared to sacrifice only so much leisure time to earn added income and vice-versa; only so much income to enjoy added leisure time. The point where leisure time and income converge is referred to as an individual's marginal utility. Of course, the availability of work affects both decisions as Larson (1981) documents; people simply have less choice overall during periods of recession. During periods of economic growth, by contrast, employers come under increasing pressure to raise wages. If they do not, workers will migrate to employers who do. Higher production volumes presumably generate greater profits for the company as well as more work for employees, so the latter feel they truly deserve a raise.
The often unasked question for both then becomes: How will a wage increase affect the existing range of employee preferences for work over leisure? Having more money to spend, after all, enhances one's utility function; by rights, then, the balance should either tip more towards leisure or remain largely unchanged, shouldn't it? Actually, as it turns out, the preference shifts decidedly towards working more hours to earn a higher income. As workers factor in the higher wage, the prospect of missing out on the chance to earn more by pursuing leisure activities instead is simply too onerous. The opportunity cost in potential wages lost by not working additional hours here supersedes the more intrinsic value the employee assigns to leisure activities. And thanks to labor economists, employers know all about this seemingly paradoxical effect. Indeed, they have determined that the cost of hiring new workers exceeds the cost of a raise and wisely opt for the latter.
Price Elasticity of Supply
The preceding example illustrates how the price elasticity of supply can trigger the substitution effect. A higher price (wage per hour) in this instance resulted in a greater number of units of output (hours of labor) from existing employees willing to forgo leisure time. An actual value can be calculated for this index by dividing the percent change in output by the percent change in price. Just how elastic this supply is, though, differs in the short and the long run. Generally speaking, the farther out the time horizon, the greater the amount of production capacity on stream, the more the number of established providers and the greater the likelihood of available product substitutes. Labor's elasticity of supply tends to be more elastic in the long-run for skilled workers but not for unskilled ones (Acemoglu, 2001). It takes much time to train and season skilled workers. Barring their migration from other locales, demand will likely exceed supply, necessitating higher wages that will attract enough trainees eventually to reestablish market equilibrium. Unskilled laborers, on the other hand, are always available and require little or no training, so the price-supply relationship here is much more inelastic and wages rise slowly if at all.
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