Supply and Demand Together at Last
How are wages determined in a competitive market? Why do wages vary and differ between labor markets, individual workers and employers? The starting point to the answer lies in the market supply and market demand, and continues with how the labor market is structured. In a purely competitive labor market structure, (what are the conditions that must exist for there to be a perfectly competitive market?) supply and demand forces alone interact to determine the price of labor, wage rates. If wages are above their equilibrium level, a labor surplus will appear and eventually put downward pressure on wage rates. Likewise, when wages currently lie below their equilibrium, a labor shortage will arise, which eventually places upward pressure on market wage rates. Recognize how crucial it is to understand whether or not a labor market is in equilibrium. Think how the public debate over legal immigration turns on whether immigration is filling a labor shortage, alleviating a disequilibrium, or generating a surplus, assuming the labor market is starting from an equilibrium and absorbs a labor supply increase.
If any of the determinants of labor demand change—such as greater product demand, productivity, prices of alternative resources and number of employers—labor demand will shift outward and put upward pressure on market wage rates. Labor supply will increase if there are declining wages in alternative occupations, non-wage sources of income, and preferences for nonwork (leisure) time, or improving (quality of) working conditions and growing number of qualified workers.
What happens to labor market outcomes when pure competition conditions do not prevail? If firms are monopolies in their product/service markets, this leads to a lower level of hiring in the equilibrium. This is not too surprising since microeconomic theory holds that monopolies restrict output. This negative property thus extends to monopolies being detrimental also because they restrict input, and thus reduces the overall market level of employment opportunities as a result. A monopsony situation is where there is a sole buyer, in this case, of the input, labor. That is, if you wish to sell your labor services of a particular type, there is "only one game in town" who would buy your labor. Can you think of "one company towns" for a geographic labor market, or a dominant employer in an industry labor market (mining towns, the county hospital, a college town)?