Labor Market Explained: Theories and Who Is Included

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.

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.

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 labour 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.

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.

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. 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. 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.

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.

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.

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.