LEVERAGING HUMAN CAPITAL – University of California at San Diego

Chris Jager – October 27, 2010

SUPPLY AND DEMAND IN THE LABOR MARKET

INTRODUCTION
According to the principle of supply and demand, first introduced in Alfred Marshall’s book

Principles of Economics in 1890 [1], the price of a productive factor is determined by the amount

available on the market and the amount that consumers are willing to purchase. Based on these

propositions, market equilibrium (or market clearing) will occur, such that the demand for the

productive factor becomes equal to the supply from the market. This means that when the price is

below the equilibrium point, there is a shortage in supply. When the price is above the equilibrium

point on the other hand, there is a supply surplus. Equilibrium is therefore a balance between the

supply and demand of a productive factor on the market.

In light the recent economic crisis and the massive layoffs that have followed, I thought it would be

interesting to examine to what extent the labor market functions according to the supply and

demand model suggested by Marshall. Before having done any research, we can already state that

there are forces in play that inhibit the labor market from functioning according to supply and

demand. This has become apparent due to the ever increasing segment of the working population

that is currently unemployed. This is supported by Bohlander & Snell [5], who state in their HR

book that the impact of supply and demand in the labor market is reduced by various factors like

unions and government regulations.

I first became intrigued about the subject of supply and demand in the labor market by an article

posted in the New York Times [2]. In this article, a century old question forms the introduction of

what follows: “Why doesn’t the labor market ‘clear’?”. The article states that the excess supply, in

this case unemployment, is both prominent and persistent [2]. It reasons that managers have
actually made the problem worse due to their actions to hold and protect their core employees.

This is interesting, as it gives the impression that supply and demand is distorted in part by HR

policies that are in place within organizations.

FACTORS INHIBITING SUPPLY AND DEMAND IN THE LABOR MARKET

In this section I will take the factors mentioned in the New York Times article as the starting point,

and will add to that factors from two scientific publications on labor market rigidities [3, 4].

First of all, from the New York Times article, it can be derived that interviews conducted among

hundreds of managers revealed that the actions of managers are influenced by their concerns with

the emotional state of their core employees. This is why managers don’t cut wages and working

hours of everyone during difficult times. Instead they utilize mass layoffs of non-core employees.

The problem with this practice is that it hurt morale of the core employees, leading them to feel

”survivors guilt”. This again makes things worse, as these core employees with survivors guilt will

have significantly lower consumption levels due to the guilt they feel [2]. As managers are usually

part of this core employee group, they will also invest less money buildings, equipment and

software for the company [2], slowing down the economy even further.

The second article we will be looking at, the scientific paper by Siebert from 1997 [3], compares the

US labor market to the European counterpart. It shows that from about halfway the 1980s,

unemployment rates have been structurally higher in Europe. The article reviews empirical

evidence to show that the European labor market is less flexible than in the US [3]. This results in a

set of factors that contribute to this problem. The article starts with analyzing how the wage rates

respond to unemployment. It is revealed that short-term wage elasticity is very low within Europe,

which inhibits the equilibrium function in the labor market [3]. The second factor mentioned is

wage differentiation. Institutional arrangements have resulted in a drastically reduced

differentiation in wages, distorting the equilibrium, resulting in lower employment levels [3]. The

third factor is the high levels of union powers in Europe, bargaining for higher wages, again

distorting the equilibrium [3]. Also taxes play a role in higher unemployment, as an ever increasing

part of the wage of an employee is designated for social security contributions, increasing labor

costs and increasing unemployment on the long run [3]. Next to this, job protection legislation has

made firing employees a very expensive and complex process. This has caused organizations to

take this into account and hire less people [3]. Another factor is that the duration and wage level of

unemployment benefits have increased (generous unemployment benefits). This has reduced the

incentive for people to work, as the reservation wage does not differ much from the minimum wage

[3]. The article concludes by saying that due to these flexibility reducing labor market factors, the

market does not function properly anymore. It is a vicious circle that a country can get caught up in,

due to the fierce competition on a global scale [3].

The last article, by Nickell [4], adds one important additional factor to the Siebert article. This is

poor educational standards on the bottom end of the labor market [4]. As countries have been

shifting from a traditional production economy to a service oriented economy, the demand for

skilled labor has increased. As a result of this, unemployment among unskilled labor has increased

(surplus of unskilled labor on the market), while the supply of skilled labor has been insufficient.

CONCLUSION
It can be concluded that various factors contribute to the disruption of the labor market functioning

according to the principles of supply and demand. This is due to the human aspect of this

productive factor. Below we present a model which combines the factors identified in the various

articles. Please note that possible existing causal relations between the factors have not been

investigated.
 (Actual Labor Market)

Reduced Impact Supply &

Demand Labor Market

HIGH UNEMPLOYMENT
Impact reducing factors (counter forces)

Low Short-term wage rate Extensive Job Protection

elasticity Legislation

Low wage differentiation Morale issues of management

High union power levels High unemployment benefits

Low educational standards High tax levels

LOW UNEMPLOYMENT

Full Impact Supply &

Demand Labor Market

(Free Market Labor Market)

REFERENCES
[1] A. Marshall, Principles of Economics – Eighth Edition, Cosimo Classics, 2009

[2] R. J. Shiller, The Survival of the Safest, New York Times, 2010

[3] H. Siebert, Labor Market Rigidities: At the Root of Unemployment in Europe, Journal of
Economic Perspectives, 1997

[4] S. Nickell, Unemployment and Labor Market Rigidities: Europe versus North America, Journal of
Economic Perspectives, 1997

[5] G.W. Bohlander & S.A. Snell, Managing Human Resources, South-Western College Pub, 13th
Edition, 2003