As in all competitive markets, the equilibrium price and quantity of labor is determined by supply and demand.
All individuals are limited by the time available in a day, and must choose between spending their time working or spending their time enjoying leisure. Leisure is a type of consumption good; individuals gain utility directly from it. Work provides income that, in turn, can be used to purchase goods and services that generate utility. The more work a person does, the greater his or her income, but the smaller the amount of leisure time available. An individual who chooses more leisure time will earn less income than would otherwise be possible. There is thus a trade-off between leisure and the income that can be earned from work.
Two aspects of the demand for leisure play a key role in understanding the supply of labor. First, leisure is a normal good. All other things unchanged, an increase in income will increase the demand for leisure. Second, the opportunity cost or "price" of leisure is the wage an individual can earn. A worker who can earn $10 per hour gives up $10 in income by consuming an extra hour of leisure. The $10 wage is effectively the price of an hour of leisure. A worker who can earn $20 an hour faces a higher price of leisure.
Suppose wages rise. This increases the cost of leisure and causes the supply of labor to rise - this is the substitution effect, which states that as the relative price of one good increases, consumption of that good will decrease. However, there is also an income effect - an increased wage means higher income, and since leisure is a normal good, the quantity of leisure demanded will go up. In general, at low wage levels the substitution effect dominates the income effect and higher wages cause an increase in the supply of labor. At high incomes, however, the negative income effect could offset the positive substitution effect and higher wage levels could actually cause labor to decrease. A worker making $800/hour who receives a raise to $1200/hour may not have much use for the extra money and may choose to work less while maintaining the same standard of living, for example. This creates a supply curve that bends backwards, initially increasing with the wage rate but later decreasing.
People supply labor in order to increase their utility—just as they demand goods and services in order to increase their utility. The supply curve for labor will shift in response to changes in the same factors that shift demand for goods and services. These include changes in preferences, changes in income, changes in population, and changes in expectations. A change in preferences that causes people to prefer more leisure, for example, will shift the supply curve to the left, creating a lower level of employment and a higher wage rate.
An increase in the demand for labor will increase both the level of employment and the wage rate. We have already seen that the demand for labor is based on the marginal product of labor and the price of output. Thus, any factor that affects productivity or output prices will also shift labor demand. Some of these factors include:
- Available technology (marginal productivity of labor)
- The skills or education of the workforce (marginal productivity of labor)
- Level of physical capital (marginal productivity of labor)
- Price of physical capital (price of output)
- Price of substitute or complement goods (price of output)
- Consumer preferences (price of output)
All of the above may cause the demand for labor to shift and change the equilibrium quantity and price of labor.