Dear Ask the Economist:
Please explain how the law of supply and demand works with respect to the labor market.
The supply and demand for labor is much like the supply and demand for any other service. Consistent with the law of supply and demand (as price rises, quantity demanded falls and quantity supplied rises), the demand curve has a negative slope and the supply curve has a positive slope.
The supply of labor, like the supply for other services, merely indicates how much labor workers are willing to offer at various prices. The supply curve for each worker will be different as each worker has different opportunity costs and preferences.
The demand for labor indicates how much labor a firm desires at different prices. The demand curve for each firm will differ as each firm faces different labor substitutes (differing rates of potential capital substitution, for instance), preferences, demand curves for the products they produce, and alternative employments for their resources.
Wage rates are simply the price of labor and as such, are determined like all other prices on the market. The intersection of the supply and demand curves for labor indicates the equilibrium, or market clearing, wage rate for certain types of labor. (In a free economy, unhampered by government regulation, wage rates for the same type of labor tend to equalize across markets).
This wage rate at the point of curve intersection tends to equal the discounted value of the marginal productivity of labor (DMVP). I know that sounds like a mouthful but it simply means that workers tend to earn the market value of what they produce (less the rate of interest).
Any worker employed for less than this amount will likely be bid away by another firm, as the firm stands to earn profit by doing so. The process of firms hiring away laborers earning less than their DMVP pushes the wage rate to the point where no firm stands to generate additional profit by bidding away the worker. At this point, the wage rate equals the DMVP. This argument, of course, assumes an efficient, undistorted market.