Labor Market Explained: Theories and Who

Is Included
By
Will Kenton
Updated May 31, 2024

What Is the Labor Market?

The labor market, also known as the job market, refers to the supply of and demand for labor, for
which employees provide the supply and employers provide the demand. It is a major component
of any economy and is intricately linked to markets for capital, goods, and services.

Key Takeaways

 The labor market refers to the supply of and demand for labor, for which employees
provide the supply and employers provide the demand.
 The labor market should be viewed at macroeconomic and microeconomic levels because
each offers valuable insight into employment and the economy as a whole.
 Unemployment rates and labor productivity rates are two important macroeconomic
gauges.
 Individual wages and the number of hours worked are two important microeconomic
gauges.
 In the United States, the Bureau of Labor Statistics compiles detailed reports on national
and local labor markets.

Understanding the Labor Market

It's important and useful to study both the macroeconomic and the microeconomic views of the
labor market. Each view can inform government and business outlooks, policies, and actions
regarding employment. And the labor market plays a major role in any economy.

At the macroeconomic level, supply and demand are influenced by domestic and international
market dynamics, as well as factors such as immigration, the age of the population, and
education levels. Relevant measures include unemployment, productivity, participation rates,
total income, and gross domestic product (GDP).

At the microeconomic level, individual firms interact with employees, hiring them, firing
them, and raising or cutting wages and hours. The relationship between supply and demand
influences the number of hours employees work and the compensation they receive in wages,
salary, and benefits.

The U.S. Labor Market

The macroeconomic view of the labor market can be difficult to capture, but a few data points
can give investors, economists, and policymakers an idea of its health. The first is
unemployment. During times of economic stress, the demand for labor lags behind supply,
driving unemployment up. High rates of unemployment exacerbate economic stagnation,
contribute to social upheaval, and deprive large numbers of people of the opportunity to lead
fulfilling lives.

In the U.S., unemployment was around 4% to 5% before the Great Recession, when large
numbers of businesses failed, many people lost their homes, and demand for goods and services
—and the labor to produce them—plummeted.

As of April 2023, the unemployment rate in the U.S. is 4.8%. Youth unemployment rate
(workers aged 15-24) is 10.2%, the lowest value since 2005.1

Labor productivity is another important gauge of the labor market and of broader economic
health. It measures the output produced per hour of labor. Productivity has risen in many
economies, the U.S. included, due to advancements in technology and other improvements in
efficiency.

In the U.S., growth in output per hour has not translated into similar growth in income per hour.
In other words, workers have been creating more goods and services per unit of time, but they
have not been earning much more in compensation. What is called a productivity gap is created
when labor productivity increases more rapidly than wages.

In the U.S. between 1979 and 2021, productivity has increased by 64.6% while hourly salaries
have only increased 17.3%, meaning that productivity has grown 3.7 times more than pay.2

The fact that productivity growth has outstripped wage growth means that the supply of labor has
outpaced the demand for it.

The Labor Market in Macroeconomic Theory

According to macroeconomic theory, the fact that wage growth lags productivity growth
indicates that the supply of labor has outpaced demand. When that happens, there is downward
pressure on wages, as workers compete for a scarce number of jobs and employers have their
pick of the labor force.

Conversely, if demand outpaces supply, there is upward pressure on wages, as workers have
more bargaining power and are more likely to be able to switch to a higher paying job, while
employers must compete for scarce labor.3
Image by Julie Bang © Investopedia 2019

Factors That Influence Supply and Demand

Some factors can influence labor supply and demand. For example, an increase in immigration to
a country can grow the labor supply and potentially depress wages, particularly for unskilled
jobs.4 An aging population can deplete the supply of labor and potentially drive up wages.

These factors don’t always have such straightforward consequences, though. A country with an
aging population will see demand for many goods and services decline, while demand for
healthcare increases.

Not every worker who loses their job can simply move into healthcare work, particularly if the
jobs in demand are highly skilled and specialized, such as those for doctors and nurses. For this
reason, demand can exceed supply in certain sectors, even if supply exceeds demand in the labor
market as a whole.

Factors influencing supply and demand don’t work in isolation, either. If it weren’t for
immigration, the U.S. would be a much older—and potentially less dynamic—society. So while
an influx of unskilled workers might exert downward pressure on wages, it likely offsets declines
in demand.

Other factors influencing contemporary labor markets, and the U.S. labor market, in particular,
include the threat of automation as advanced technologies gain the ability to do more complex
tasks; the effects of globalization as enhanced communication and better transport links allow
work to be moved across borders; the price, quality, and availability of education; and a whole
array of policies, including the minimum wage.

The Labor Market in Microeconomic Theory

The microeconomic theory analyzes labor supply and demand at the level of the individual firm
and worker.5 Supply—or the hours an employee is willing to work—initially increases as wages
increase. No workers will work voluntarily for nothing (unpaid interns are, in theory, working to
gain experience and increase their desirability to other employers), and more people are willing
to work for $20 an hour than $7 an hour.

Supply

Gains in supply may accelerate as wages increase, as the opportunity cost of not working
additional hours grows. However, supply may then decrease at a certain wage level: The
difference between $1,000 an hour and $1,050 is hardly noticeable, and the highly paid worker
who’s presented with the option of working an extra hour or spending their money on leisure
activities may well opt for the latter.
Image by Julie Bang © Investopedia 2019

Demand

Demand at the microeconomic level depends on two factors: marginal cost of production and
marginal revenue product. If the marginal cost of hiring an additional employee, or having
existing employees work more hours, exceeds the marginal revenue product, it will cut into
earnings, and the firm would theoretically reject that option. If the opposite is true, it makes
rational sense to take on more labor.5

The neoclassical microeconomic theories of labor supply and demand have received criticism on
some fronts. Most contentious is the assumption of rational choice—maximizing money while
minimizing work—which to critics is not only cynical but not always supported by the evidence.

Homo sapiens, unlike Homo economicus, may have all sorts of motivations for making specific
choices. The existence of some professions in the arts and nonprofit sector undermines the notion
of maximizing utility.

Defenders of neoclassical theory counter that their predictions may have little bearing on a given
individual but are useful when taking large numbers of workers in aggregate.6

How Does a Minimum Wage Affect the Labor Market?

The effects of a minimum wage on the labor market and the wider economy are controversial.
Classical economics and many economists suggest that a minimum wage, like other price
controls, can reduce the availability of low-wage jobs. On the other hand, some economists say
that a minimum wage can increase consumer spending, thereby raising overall productivity and
leading to a net gain in employment.7

How Does Immigration Affect the Labor Market?

The effects of immigration are difficult to measure precisely, due to the size and complexity of
the modern economy. The classical model of economics predicts that high levels of immigration
may cause wages to fall due to an increased supply of labor. However, some studies suggest that
immigration can also have a positive effect on aggregate demand, depending on the skillset of
the new arrivals. Because new workers are also consumers, the research found that immigration
can increase the demand for labor as well as the supply.8

How Does the Government Calculate the Unemployment

Rate?
The Bureau of Labor Statistics compiles a monthly employment report, based on a survey of
around 60,000 representative households in the United States. Data from the survey are used to
estimate the employment figures for the entire country. The unemployment rate is based on the
percentage of people who are not employed but actively looking for a job, as a percentage of the
total labor force. Those who have no job and are no longer looking are not included in the
unemployment rate.9

The Bottom Line

The labor market is an economic term for the availability of workers and the cost of
employment. It plays a major role in the overall economy. As in other markets, the price for
labor is largely determined by supply and demand, although the labor market is also heavily
regulated in many countries.

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