The labour market is one of the most fascinating aspects of economics because it directly connects people and work. It is where job seekers (suppliers of labour) meet employers (buyers of labour). At its core, the labour market is driven by two simple forces: demand for labour and supply of labour. But beneath this simple idea lies a wide range of factors, theories, and modifications that influence how wages are set and how people and organizations make decisions.
Labour Market Factors
Economists describe two basic types of markets: the quoted price and the bourse. Stores that label each item’s price or ads that list a job opening’s starting wage are examples of quoted-price markets (Amazon). Bourse markets allow for haggling to occur over the terms and conditions until an agreement is reached (e-Bay).
In both the bourse and the quoted market, employers are the buyers and the potential employees are the sellers. People and jobs match up at specified pay rates.
How Labour Markets Work
Theories of labour markets usually begin with four basic assumptions:
- Employers always seek to maximize profits;
- People are homogeneous and therefore interchangeable; a business school graduate is a business school graduate is a business school graduate;
- The pay rates reflect all costs associated with employment (e.g., base wage, bonuses, holidays, benefits, even training);
- The markets faced by employers are competitive, so there is no advantage for a single employer to pay above or below the market rate.
Understanding how markets work requires analysis of the demand and supply of labour. The demand side focuses on the actions of the employers: how many employees they seek and what they are able and willing to pay those employees. The supply side looks at potential employees: their qualifications and the pay they are willing to accept in exchange for their services.
Labour Demand
How many people will a specific employer hire? The answer requires an analysis of labour demand.
In the short term, an employer cannot change any other factor of production (i.e., technology, capital, or natural resources). Under such conditions, a single employer’s demand for labour coincides with the marginal product of labour.
Marginal Product of Labour
The marginal product of labour is the additional output associated with the employment of one additional human resource unit, with other production factors held constant.
Diminishing marginal productivity results from the fact that each additional employee has a progressively smaller share of the other factors of production with which to work. In the short term, other factors of production (e.g., office space, number of computers, telephone lines) are fixed. As more business graduates are brought into the firm without changing other production factors, the marginal productivity must eventually decline.
Marginal Revenue of Labour
The marginal revenue of labour is the additional revenue generated when the firm employs one additional unit of human resources, with other production factors held constant.
Marginal revenue is the money generated by the sale of the marginal product, the additional output from the employment of one additional person. Therefore, the employer will continue to hire graduates until the marginal revenue generated by the last hire is equal to the costs associated with employing that graduate.
Because other potential costs will not change in the short run, the level of demand that maximizes profits is that level at which the marginal revenue of the last hire is equal to the wage rate for that hire.
A manager using the marginal revenue product model must do only two things:
- Determine the pay level set by market forces, and
- Determine the marginal revenue generated by each new hire.
This will tell the manager how many people to hire.
The model provides a valuable analytical framework, but it oversimplifies the real world. In most organizations, it is almost impossible to quantify the goods or services produced by an individual employee, since most production is through joint efforts of employees with a variety of skills.
So neither the marginal product nor the marginal revenue is directly measurable. However, if compensable factors define what organizations value, then job evaluation reflects the job’s contribution and may be viewed as a proxy for marginal revenue product.
Labour Supply
This model assumes that many people are seeking jobs, that they possess accurate information about all job openings, and that no barriers to mobility (discrimination, licensing provisions, or union membership requirements) among jobs exist.
If unemployment rates are low, offers of higher pay may not increase supply – everyone who wants to work is already working. If competitors quickly match a higher offer, the employer may face a higher pay level but no increase in supply.
Modifications to the Demand Side
When we change our focus from all the employers in an economy to a particular employer, models must be modified to help us understand what actually occurs. A particularly troublesome issue for economists is why an employer would pay more than what theory states is the market-determined rate.
Compensating Differentials
If a job has negative characteristics then employers must offer higher wages to compensate for these negative features. Such compensating differentials explain the presence of various pay rates in the market. Although the notion is appealing, it is hard to document, due to the difficulties in measuring and controlling all the factors that go into a net-advantage calculation.
Efficiency Wage
According to efficiency-wage theory, high wages may increase efficiency and actually lower labour costs if they:
- Attract higher-quality applicants
- Lower turnover
- Increase worker effort
- Reduce “shirking” (what economists say when they mean “screwing around”)
- Reduce the need to supervise employees (“monitoring”)
Basically, efficiency increases by hiring better employees or motivating present employees to work smarter or harder. The underlying assumption is that pay level determines effort – again, an appealing notion that is difficult to document.
In one study, higher wages were associated with lower shirking. Shirking was also lower where high unemployment made it more difficult for fired or disciplined employees to find another job.
Do higher wages actually attract more qualified applicants? Research says yes. But higher wages also attract more unqualified applicants. So, an above-market wage does not guarantee a more productive workforce.
Does an above-market wage allow an organization to operate with fewer supervisors? Some research evidence says yes.
Signalling
Signalling theory holds that employers deliberately design pay levels and mix as part of a strategy that signals to both prospective and current employees the kinds of behaviours that are sought.
An employer that combines lower base with high bonuses may be signalling that it wants employees who are risk takers. Its pay policy helps communicate expectations.
A study of college students approaching graduation found that both pay level and mix affected their job decisions. Pay level was most important to materialists and less important to those who were risk-averse.
So, applicants appear to select among job opportunities based on the perceived match between their personal dispositions and the nature of the organization, as signalled by the pay system. Both pay level and pay mix send a signal.
Signalling works on the supply side of the model, too, as suppliers of labour signal to potential employers. People who are better trained, have higher grades in relevant courses, and/or have related work experience signal to prospective employers that they are likely to be better performers.
Modifications to the Supply Side
Reservation Wage
Non-compensatory – job seekers have a reservation-wage level below which they will not accept a job offer, no matter how attractive the other job attributes. If pay level does not meet their minimum standard, no other job attributes can make up for this inadequacy.
Job seekers who are satisfiers take the first job offer they get where the pay meets their reservation wage. A reservation wage may be above or below the market wage. The theory seeks to explain differences in workers’ responses to offers.
Human Capital
The theory of human capital, perhaps the most influential economic theory for explaining pay-level differences, is based on the premise that higher earnings flow to those who improve their potential productivity by investing in themselves (by acquiring additional education, training, and experience).
The theory assumes that people are in fact paid at the value of their marginal product. Improving productive abilities by investing in training or even in one’s physical health will increase one’s marginal product.
Researchers also find that different types of education get different levels of pay. However, job seekers with degrees in education, languages, and the arts will earn the same as or even less than what they would have earned if they had not gotten their degrees but had gained work experience instead.
Product Market Factors and Ability to Pay
Any organization must, over time, generate enough revenue to cover expenses, including compensation. It follows that an employer’s pay level is constrained by its ability to compete in the product/service market. So, product market conditions to a large extent determine what the organization can afford to pay.
Product Demand
The product market puts a lid on the maximum pay level that an employer can set. If the employer pays above the maximum, it must either pass on to consumers the higher pay level through price increases or hold prices fixed and allocate a greater share of total revenues to cover labour costs.
Degree of Competition
Employers in highly competitive markets are less able to raise prices without loss of revenues. At the other extreme, single sellers are able to set whatever price they choose. However, too high a price often invites the eye of political candidates and government regulators.
Conclusion
The functioning of the labour market is much more than just supply meeting demand. While basic models provide a framework—employers hire until marginal revenue equals wages, and workers supply their labour at a certain wage—real-world labour markets are influenced by many factors.
Compensating differentials, efficiency wages, signalling, reservation wages, human capital, and product market constraints all shape how wages are set and how people and organizations behave. In short, the labour market is not a perfect machine but a dynamic system shaped by economic theory, human behavior, and business realities.
