Labor Market: Definition & Theory

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  • 0:01 Theory of Labor Market…
  • 0:44 Assumptions
  • 1:58 Demand & Supply
  • 3:01 Labor Market Equilibrium
  • 4:02 Imperfect Competition
  • 4:57 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Most of us have to work for a living and that means we must participate in the labor market. In this lesson, you'll learn about what the labor market is, as well as the theory behind it.

Theory of Labor Market Allocation

A labor market is a market where people offer their skills to employers in exchange for wages, salaries and other forms of compensation. Participants in the labor market include any person who is seeking to work for compensation and any person or organization that is looking for people to perform labor.

Under the standard labor market theory, labor is like any other resource. Generally speaking, the market determines the allocation of labor and its costs. In other words, the market determines where people will work and how much they will get paid. Let's take a look at the theory of labor market allocation.


Labor market theory is a model, and a model is a simplification of reality that we use to try to understand a complex concept. A model will make some assumptions to make things simple. The labor market theory is no different, and it makes a few important assumptions:

  • The most important motivation in the labor market for people is a wage or other monetary compensation.
  • Workers are pretty much fungible - you can substitute one for another and it makes little difference.
  • Workers are mobile - they can move to where there is a demand for work.
  • Wages are flexible - they can go up or down.

Now that we have our assumptions, it's time to see how sellers (people seeking employment) and buyers (employers) behave in the labor market under these assumptions. But always keep in mind that these assumptions oversimplify reality so that we can understand the way things work in general. If the assumptions are not true for a particular set of circumstances, the model will not predict the correct outcome. For example, some people consider the nature of the work more important than the compensation being offered and may actually choose a lower paying offer.

Demand and Supply

The demand for labor follows the general economic law of demand. The price for labor is inversely related to the quantity of labor available in the market. This is just a fancy way of saying that employers will hire more people when wages go down, and will hire fewer people when wages rise. In other words, demand for labor increases as wages decrease, and demand for labor decreases as wages increase.

It's probably not too surprising to find out that the general economic law of supply also applies to the labor market. If the price of labor increases, then the supply of labor will increase. On the other hand, if the price of labor decreases, the supply of labor will decrease. In other words, as wages increase, more people will enter the labor market and compete for the higher-paid jobs, but if wages decline, fewer people will seek to compete. This is one of the reasons why overtime works - people are willing to give up some of their leisure time if they are paid enough to do it.

Labor Market Equilibrium

Labor market equilibrium is just another fancy way of saying that the price of labor and quantity of labor in the market have stabilized and will not change unless something significant happens to change the price or quantity. The labor market will reach equilibrium when the supply of labor equals the demand for labor.

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