# Changes in Equilibrium for Shifts in Market Supply and Market Demand

## A shift in the supply or demand of labor will cause a change in the market equilibrium.

#### Key Points

• The opportunity cost of leisure is the wages lost while not working; as wages rise, the cost of leisure increases.

• The substitution effect means that when wages rise, people are likely to substitute more labor for less leisure.

• However, the income effect means that as people become wealthier, their demand for normal goods such as leisure increases.

• Typically the substitution effect dominates the supply of labor at normal wage rates, but the income effect may come to dominate at higher wage rates. This creates a backward bending labor supply curve.

• The supply curve for labor will shift in response to changes in preferences, changes in income, changes in population, and changes in expectations.

• The demand curve for labor will shift in response to changes in human capital, changes in technology, changes in the price of complements or substitutes for output, and changes in consumer preferences.

#### Terms

• A good for which demand increases when income increases and falls when income decreases but price remains constant.

• The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

#### Figures

1. ##### Backward Bending Supply

While normally hours of labor supplied will increase with the wage rate, the income effect may produce the opposite effect at high wage levels.

As in all competitive markets, the equilibrium price and quantity of labor is determined by supply and demand.

### Labor Supply

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. Figure 1

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.

### Labor Demand

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.

#### Key Term Glossary

capital
Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
##### Appears in these related concepts:
competitive market
A term that encompasses the notion of individuals and firms striving for a greater share of a market to sell or buy goods and services.
##### Appears in these related concepts:
Complement
A good with a negative cross elasticity of demand, meaning the good's demand is increased when the price of another good is decreased.
##### Appears in these related concepts:
consumer
An individual who trades money for goods.
##### Appears in these related concepts:
consumption
In the expenditure approach, the amount of goods and services purchased for consumption by individuals.
##### Appears in these related concepts:
cost
A negative consequence or loss that occurs or is required to occur.
##### Appears in these related concepts:
demand
The desire to purchase goods and services.
##### Appears in these related concepts:
equilibrium
The condition of a system in which competing influences are balanced, resulting in no net change.
##### Appears in these related concepts:
Equilibrium
The condition of a system where competing forces are in balance.
##### Appears in these related concepts:
equilibrium price
The price of a commodity at which the quantity that buyers wish to buy equals the quantity that sellers wish to sell
##### Appears in these related concepts:
equilibrium quantity
A situation in a market when the price is such that the quantity that consumers wish to demand is correctly balanced by the quantity that firms wish to supply. These equal quantities are the equilibrium quantity.
##### Appears in these related concepts:
goods
That which is produced, then traded, bought, or sold, and finally consumed.
##### Appears in these related concepts:
income effect
The change in consumption resulting from a change in real income.
##### Appears in these related concepts:
Income effect
A phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income.
##### Appears in these related concepts:
Income Effect
The change in consumption choices due to changes in the amount of money available for an individual to spend.
##### Appears in these related concepts:
labor
The workers used to manufacture the output.
##### Appears in these related concepts:
leisure
Time free from work or duties.
##### Appears in these related concepts:
marginal
Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
##### Appears in these related concepts:
marginal product
The extra output that can be produced by using one more unit of the input.
##### Appears in these related concepts:
market
one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services (including labor) in exchange for money from buyers.
##### Appears in these related concepts:
Market equilibrium
A condition where a market price is established where the amount of supply is equal to the amount of demand.
##### Appears in these related concepts:
money
A legally or socially binding conceptual contract of entitlement to wealth, void of intrinsic value, payable for all debts and taxes, and regulated in supply.
##### Appears in these related concepts:
normal good
A good for which demand increases when income increases and falls when income decreases but price remains constant.
##### Appears in these related concepts:
normal goods
Goods for which demand increases when income increases and falls when income decreases, but price remains constant.
##### Appears in these related concepts:
opportunity cost
The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
##### Appears in these related concepts:
Opportunity cost
The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
##### Appears in these related concepts:
Opportunity Cost
The value of the best alternative forgone.
##### Appears in these related concepts:
Opportunity Costs
The value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources.
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output
Production; quantity produced, created, or completed.
##### Appears in these related concepts:
Output
What is produced in the country, often measured by GDP.
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physical capital
A physical factor of production (or input into the process of production), such as machinery, buildings, or computers.
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price
The cost required to gain possession of something.
##### Appears in these related concepts:
Price
The quantity of payment or compensation given by one party to another in return for goods or services.
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productivity
A ratio of production output to what is required to produce it (inputs).
##### Appears in these related concepts:
Productivity
the rate at which goods or services are produced by a standard population of workers.
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relative price
Relative price is the price of a commodity or service in terms of another.
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Substitute
A good with a positive cross elasticity of demand, meaning the good's demand is increased when the price of another is increased.
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substitution effect
The change in demand for one good that is due to the relative prices and availability of substitute goods.
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Substitution effect
An effect where a good's demand is increased when the price of another good is increased.
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supply
The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
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supply and demand
An economic model of price determination in a market based upon the quantity demanded by consumers in relation to the quantity supplied by producers.
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Supply curve
A graphical representation of the quantity producers are willing to make when the product can be sold at a given price.
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technology
The study of or a collection of techniques.
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Buying and selling of goods and services on a market.
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utility
The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
##### Appears in these related concepts:
Utility
The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
##### Appears in these related concepts:
workforce
All the workers employed by a specific organization or nation, or on a specific project