The labor market refers to the market in which the workers and businesses exchange wages for labor and vice versa. The labor force includes all working age individuals who are legally and physically able to work and are actively seeking employment. This notably excludes children, retirees, and working age individuals who are not actively seeking employment. Equilibrium in the labor market determines the prevailing wage rate and the number of hours worked. It occurs when the supply of labor, or the number of hours individuals are willing and able to work at a given wage rate, equals the demand for labor, the hours of work employers are willing and able to pay for at a given wage rate. 

To understand why markets are naturally disposed to reaching equilibrium, it is useful to visualize the market graphically. The supply curve for labor is upward sloping because people are willing to work more hours at higher wages. Conversely, the demand curve for labor is downward sloping because businesses are less willing to hire workers as labor costs increase.

Equilibrium in the labor market, represented by point E, occurs when the supply of labor, or the number of hours individuals are willing and able to work at a given wage rate, equals the demand for labor, the hours of work employers are willing and able to pay for at a given wage rate. 

• Point A: At this point, there are more companies willing to hire employees at the prevailing wage than there are individuals willing to work. Because there are not enough workers willing to work at the prevailing wage, wages will rise (causing employers to demand less labor) resulting in equilibrium point E.
• Point B: At this point, workers are supplying much more labor than companies are willing to pay at that wage rate. The resulting surplus of workers will push wages back down (causing workers to supply less labor) resulting in equilibrium at point E.

The labor market can be analyzed on both the microeconomic level as well as the macroeconomic level:

• At the macroeconomic level, the labor market is comprised of the entire labor force (working age population either actively working or searching for work) and all the firms in the economy, with analysis generally focused on the aggregate level of both wages and hours of work.
• At the microeconomic level, the labor market is comprised of individuals seeking work and individual firms seeking labor. Supply increases in conjunction with wages until the marginal utility of an additional hour of pay begins to decrease, while demand is determined by the intersection of marginal cost and marginal revenue of the output of the labor. Marginal utility can be understood as the additional benefit of hiring one more unit of labor. When the marginal utility of hiring another worker falls below the cost of hiring the additional worker, employers will no longer be willing to hire that individual.

The classic economic model discussed thus far assumes a completely free market, but this is rarely true. According to economic theory, market distortions occur when the government, private industry, or another actor take any action to influence the market and in doing so, impede the market from reaching equilibrium. Examples include labor regulations, environmental regulations, minimum wage, downward rigidity of wages, payroll taxes, extensive hiring processes, trade regulations, social safety nets, collusion amongst employers, and unions. As a result of market distortions, equilibrium may not be reached leaving either a surplus of workers actively seeking employment or a surplus of employers unable to fill jobs. In the case of surplus workers, the result is unemployment. For example, if a minimum wage is set higher than the equilibrium wage, more people will be willing to work at that price than employers will be willing to hire. Similarly, if a union negotiates a wage higher than the equilibrium wage, more individuals will be willing to work at that price and an employer may choose to hire less workers, resulting in a worker surplus.

When an economy is operating at its full capacity the economy is in a state of full employment; however, there is still unemployment present due to frictional and structural unemployment. The rate of unemployment in this situation is called the natural rate of unemployment. Frictional unemployment refers to unemployed individuals who are temporarily between jobs. It is caused by the existence of hiring processes and the lack of perfect information, which impedes individuals seeking work from finding employers immediately and vice versa. Structural unemployment occurs when there is a mismatch between the skills of people seeking employment and the needs of companies seeking to hire workers. For example, if a law firm is seeking to hire a new associate, but the only applicant has not completed a law degree. Another main type of unemployment is referred to as cyclical unemployment. This happens during the natural dips in the business cycle when an economy is not operating at full capacity.

Labor Market Regulations

Even though market distortions can hinder the labor market’s ability to reach equilibrium, certain regulations are introduced to account for externalities that cause the equilibrium price to differ from the true costs and benefits of the good or service in question, in this case labor. In the US, major regulations in the labor market have included the introduction of a minimum wage, unemployment insurance, and welfare training. 

The first minimum wage in the United States was introduced by Massachusetts in 1912, followed by 12 other states and the District of Columbia in the following years, but those laws were struck down by a 1923 Supreme Court ruling that it violated employers’ and workers’ 5th Amendment rights to liberty of contract. In an unexpected reversal, the Supreme Court upheld a Washington state minimum wage law in 1937, paving the way for a federal minimum wage, which was first introduced at $0.25 per hour with the passage of the Fair Labor Standards Act in 1938. The minimum wage, which has been raised a number of times in the decades since the passage of the Fair Labor Standards Act, stands at $7.25 per hour and is a topic of contentious political debate, with one side pointing to the increased income of workers and the other pointing to increased unemployment it would create if the minimum wage is set above the equilibrium wage. Most recently, the prospect of raising the federal minimum wage to $15 per hour was under consideration for inclusion in the American Rescue Plan until the parliamentarian determined it was not allowed under the Senate’s budget reconciliation rules. 

Unemployment: Causes, Provisions, and Policy Tools

Additional causes of unemployment include increasing frequencies of workers being displaced by outsourcing and automation. Outsourcing is when a U.S. company shifts its production to use foreign workers rather than American workers. This happens in various ways. The classic example is a company shutting down a factory in the US and instead shifting production to a factory in China or Mexico. A less frequently discussed form of outsourcing occurs through provision of H-1b visas to foreign nationals that allow them to work in the United States. This is most frequently seen with tech companies in Silicon Valley. Automation, with respect to unemployment, refers to companies that choose to use technology in their production rather than employees. Analysis from the Brookings Institution found no evidence of layoffs following automation investment spikes by their employers. However, it was found that workers at such firms experienced income losses in the following five years.

The first unemployment insurance provisions were contained in the 1935 Social Security Bill, its objectives being “to offer workers income maintenance during periods of unemployment…to help maintain purchasing power and to stabilize the economy; and… to help prevent dispersal of the employer’s trained labor force…during temporary unemployment.” The program has evolved substantially since its beginnings, with the current unemployment insurance program in the US being a joint federal-state venture, financed by federal and state unemployment taxes. However, it has retained its original intent to exist as a stopgap measure of support for people experiencing unemployment. 

Most recently, unemployment insurance has been a topic of debate due to the COVID-19 pandemic, with unemployment insurance benefits being expanded under the CARES Act and again under the American Rescue Plan. Debates are typically centered on whether an overly generous UI system can discourage workers from returning to work. A recent analysis from the Federal Reserve Bank of SF reported that the supplemental payments offered under the CARES Act had little or no adverse impact, while research from the Federal Reserve Bank in Atlanta indicated that an expansion of unemployment benefits during the 2008-2009 recession kept the jobless rate higher than it otherwise would have been. In order to actively target the unemployment rate, the government has several policy tools at its disposal, which can be broken into two subcategories: monetary policy and fiscal policy. Through what is known as expansionary fiscal policy, the government can create jobs through increased spending on government projects. The most famous example of this in the United States was the passage of the New Deal following the Great Depression. Additionally, the government can influence unemployment through less direct measures. For example, the government can cut taxes, thus increasing household disposable income and spending, which spurs job growth. Monetary policy impacts unemployment through manipulation of the money supply and the federal funds rate. For a detailed explanation on how the Federal Reserve uses monetary policy to impact the unemployment rate, look out for a forthcoming piece by my colleagues Rachel Zhang and Jamie Davis.