The Tug-o-War of Labor Markets | Cash Course: Economics | PragerU Kids

Before we start this episode, here's a quick preview of what's coming. Ready to take charge of your finances and master the art of money management? Cash course is your ultimate guide to financial literacy from personal budgeting to macroeconomics. Check out more episodes at prageru.com. In a market economy, prices of products and services are determined by fluctuating supply and demand. This allows for efficient allocation of resources producing only what consumers are willing and able to pay for. In the same way, the amount a worker is paid to do a job, called a wage, is determined by supply and demand in a competitive labor market. One side of this marketplace is labor demand. That's the total amount of labor businesses will hire at different wages to help to make our products and services to sell. As a general rule, as wages rise, businesses will hire less since the cost of labor increases. And as wages decrease, the cost of labor will decrease, so there could be more hiring. On the other side is labor supply. This is how much labor workers are willing to provide at a certain wage, usually measured in hours. Just like customers seeking the best price for a product, workers like myself seek the best price for their labor. Opposite of labor demand, labor supply tends to increase as wages increase since higher wages make work more attractive. The equilibrium wage is when labor supply and demand meet, where an employer offers a wage that a worker is willing to accept. Deal. There are additional factors that play an important role in shaping labor markets and wages. The marginal product of labor, the substitution effect, and the income effect. Let's take a look at each of them. First, the marginal product of labor or MPL. This is mainly a demand side consideration. It's the additional output that a business produces when it hires another worker with all other factors remaining the same. For example, a business has two employees and they produce 10 units total. It believes that adding a third worker will increase the total product to 20 units. Meaning the third worker's MPL is 10. Great. Then let's hire him. Hold on. You need to multiply the MPL with the revenue of each unit of production. This places a dollar value on what each additional worker brings to the production process. So say the revenue for each unit is $50. Since the third worker's MPL is 10 units, the additional revenue of adding the third employee is $500. As long as the wage of the worker is less than the additional revenue he brings in, the business has a very strong incentive to Great, you're hired. So, if the additional revenue of a new worker is greater than the additional cost, the business will make more money by hiring him or her. This increases the labor demand. And if the additional cost of the new worker is greater than the additional revenue, the business will lose money hiring him or her. This decreases labor demand. Additionally, outside interventions like a minimum wage can reduce the labor demand. This is because it increases the business's cost even if productivity remains the same. Next, there's the substitution effect. This is mainly a supply side consideration. This influences the labor supply as wages change with all other factors constant. When wages are lower, the opportunity cost of not working is low. This can lead workers to prefer more leisure and reduce the labor supply. When wages are higher, however, the opportunity cost of not working becomes more expensive and workers may reduce their leisure time to increase their labor supply. Got to work, work, work. As workers earn more, there is an offsetting effect, the income effect. This influences the labor supply as income changes with all other factors constant. When workers become wealthier, they may feel they don't need to work as many hours and are satisfied with what they're earning. This could cause workers to cut back their supply of labor and enjoy more leisure. And the opposite is also true that if workers have a sudden decrease in their income, they may provide more labor and enjoy less leisure. Back to work, work, work. Which of these two effects dominates in any labor market will determine the supply of labor. If the substitution effect dominates, workers will supply more hours as wages increase. This effect is particularly strong for workers with low initial wages, few leisure desires, or strong preferences for material goods. If the income effect dominates, workers will supply fewer hours as wages increase. This effect is particularly strong for workers with already high incomes, strong leisure desires, or high tax obligations. These situations where income or substitution effects heavily dominate the other happen most often in the short term or for a small segment of workers. However, in the long run, when we look at the entire labor market, these effects will largely cancel out, meaning that the amount of work supplied remains more stable over time than in these scenarios. With so many factors to consider, including individual preferences, it's not easy to know what is the right wage. Both workers and businesses have their own considerations to make, and at some point, those factors will balance out into an agreed upon wage. Deal. When wages are allowed to function freely, businesses and workers will make the best individual decisions for themselves, remain productive, and keep an economy moving. Nope. No. No [Music] thanks. Watch more at prageruids.com and parents don't forget to subscribe.