The Labor Market and Full Employment Equilibrium
Learning Objectives
By the end of this section, you will be able to:
- Analyze the tendency toward full employment through flexible wages in the labor market
- Apply supply and demand models to unemployment and wages
- Explain the relationship between sticky wages and employment using various economic arguments
We have seen that unemployment varies across times and places, but that, at least according to orthodox economics, capitalist economies should tend toward the natural rate of unemployment in the long run. Below, you’ll read about how this tendency is supposed to work and why, according to orthodox theory, it often doesn’t.
The Tendency toward Full Employment
Earlier in this chapter, you learned that the economy should, in the long run, reach an equilibrium level of output at potential GDP. This occurs at the intersection of the aggregate demand (AD) and the long-run aggregate supply (LRAS) curves and is consistent with full employment (or the natural rate of unemployment). The labor market model is one way of understanding how, at least in the absence of sticky prices, this would occur. Recall that higher prices for the things firms sell, relative to input costs for producing those things, will induce firms to produce and sell more output. It follows then that lower input costs, relative to prices, would also lead to firms hire more workers and produce more output.
This suggests that we can understand the long run tendency for capitalist economies to fully employ their resources (that is, inputs like labor) in terms of the prices of those inputs. Below, we’ll look at how the competitive market for labor should ensure full employment. (Note, however, that these arguments should apply to any of the real resources that firms use as inputs to produce the goods and services that make up GDP.)
Labor Market
Orthodox economists understand the processes of firms hiring and workers working for pay by using the standard supply-and-demand model. Demand represents the firms paying for workers’ time and effort, and supply represents the workers supplying their labor. The wage rate, then, is the price of the labor, and if the labor market is in equilibrium (at a wage rate of We in the figure below), then the quantity of work that workers want to do (or supply) will be equal to the quantity that firms want to hire (or demand).
One possibility for any observed unemployment is that people who are unemployed are those who are not willing to work at the current equilibrium wage, say $10 an hour, but would be willing to work at a higher wage, like $20 per hour. The monthly Current Population Survey would count these people as unemployed, because they say they are ready and looking for work (at $20 per hour). However, from an economist’s perspective, these people are choosing to be unemployed, so they’re ignored in terms of the tendency to full employment.
Hence, orthodox economists argue that the key to full emp