[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

duction and hire more workers. Second, as wages fall relative to
the cost of machines, it pays firms to substitute workers for
machines. Thus, the demand curve for labor slopes down, as shown
in the figure.
The two reasons for the negative slope of the aggregate labor
demand curve stress the importance of wages relative to the costs
of other inputs and the price of the output being produced. If
wages fall and all other prices in the economy also fall in proportion,
the demand for labor will not change. That is why we show the
demand for labor as a function of the real wage, w/P.
The figure also shows an aggregate labor supply curve. To
simplify matters, the labor supply curve is drawn as a vertical
line—we assume that the labor supply is perfectly inelastic. That
is, either individuals are in the labor force, working a full (fortyhour)
workweek, or they are not. In principle, workers might enter
and exit the labor force as real wages go up or down, or they might
reduce or increase the hours they work in response to such
changes. When real wages rise, two factors are at work. First,
higher wages mean the returns for working are greater. Thus
workers should want to work more hours—the opportunity cost
of leisure is now higher, and the substitution effect works to induce
individuals to work more as real wages rise. But higher wages
mean that workers have higher incomes, which lead them to want
to increase their consumption—including their consumption of leisure. So there is
an income effect acting to reduce labor supply as real wages rise. The income and
substitution effects act in opposite directions. 2 In Figure 24.2, we assume they offset
one another, so that as real wages change, labor supply remains constant.
Basic supply and demand analysis implies that market equilibrium should occur
at the intersection of the demand and supply curves, point E. The reason for this is
straightforward. If the real wage happens to be above the equilibrium real wage w 1 /P—
say, at w 2 /P—the demand for labor will be L 2 , much less than the supply, L 1 . There
will be an excess supply of workers. Those in the labor force without jobs will offer
to work for less than the going wage, bidding down the average wages of those already
working. The process of competition will lead to lower wages, until eventually demand
again equals supply at point E. Likewise, if the real wage is lower than w 1 /P—say, at
w 3 /P—firms in the economy will demand more labor than is supplied. Competing
with one another for scarce labor services, they will bid the wage up to w 1 /P.
REAL WAGE (w/P )
w 2 /P
w 1 /P
w 3 /P
Figure 24.2
Labor supply
curve
L 2 L 1 L 3
QUANTITY OF LABOR
(L, NUMBER OF WORKERS OR HOURS)
EQUILIBRIUM IN THE LABOR MARKET
E
Labor demand
curve
Equilibrium in the labor market is at the intersection of the
labor demand and labor supply curves. If the real wage is
above w 1 /P, where demand equals supply, there will be unemployment,
putting pressure on wages to fall as workers compete
to offer their services. Below w 1 /P there will be excess
demand for labor, which will put pressure on wages to rise.
SHIFTS IN THE DEMAND AND
SUPPLY OF LABOR
The full-employment model makes clear predictions about the consequences of
shifts in the demand and supply of labor. First, let’s consider shifts in the supply
curve of labor. These can occur because young people reaching working age
2 To review the definitions of income and substitution effects, see Chapter 5.
THE LABOR MARKET ∂ 529