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Labor Market Equilibrium

Winter 2000

Last updated: January 14, 2000

Note: These notes are preliminary and incomplete and they are not guaranteed to be free of errors. Please let me know if you find typos or other errors.

Equilibrium in the Labor Market

Combining the behavioral models for labor demand and labor supply together allows us to deduce the equilibrium real wage and the equilibrium amount of employment.

In equilibrium, ND = NS which determines the equilibrium values of the real wage and employment. It is implicitly assumed that in equilibrium everyone who wants a job has a job. In this sense, the equilibrium value of employment is also called full employment.

When the labor market is in equilibrium, there is no tendency to move away from equilibrium. That is, at the equilibrium values of w and N there are no forces acting in the labor market to move the market away from the equilibrium values.

Understanding Equilibrium

To understand equilibrium, it is helpful to see what happens when the labor market is out of equilibrium. The figure below illustrates a situation where the current real wage is higher than the equilibrium real wage.

At w0 the supply of labor, NS0 is greater than the demand for labor, ND0 , and so there is an excess supply of labor in the labor market. Workers bid down the real wage until it falls to the equilibrium value, w.

The above graph demonstrates that when the current wage is such that it is not equal to the equilibrium real wage competitive market forces act to push the wage toward the equilibrium wage. As the wage adjusts, labor demand and labor supply move closer to equality.

Combining the Production with the Labor Market: The Determination of Full Employment Output

The labor market determines the equilibrium or full employment level of labor input to the aggregate production function.  Therefore, we define full employment output, Y*,  in the following way:

Y* = A0F(K0, N* )

where N* denotes the full employment labor amount determined by equilibrium in the labor market.

Note: The textbook by Abel and Bernanke uses "bars" on top of equilibrium values. Since I can't figure out how to put bars on top of letters in HTML, I will denote an equilibrium value with a superscript "*" and the color red.

Full employment output is depicted in the graph below

Factors that Affect Potential Output

Since the production function is linked with the labor market to determine full employment (or potential) output, anything that shifts the production function (which shifts labor demand) or the labor supply curve will affect potential output. To illustrate, the graph below shows how potential output is affected by an increase in productivity.

An Increase in productivity from A0 to A1 shifts up both the production function and labor demand (red curves). The labor market then adjusts to a new equilibrium with a higher amount of employment and a higher real wage. The increase in employment leads to a higher level of potential output. Notice that output is higher both because the production function shifts up and because employment increases.