The Labor Market and Full Employment Equilibrium

Learning Objectives

By the end of this section, you will be able to:

  • Analyze the tendency toward full employment through flexible wages in the labor market
  • Apply supply and demand models to unemployment and wages
  • Explain the relationship between sticky wages and employment using various economic arguments

We have seen that unemployment varies across times and places, but that, at least according to orthodox economics, capitalist economies should tend toward the natural rate of unemployment in the long run.  Below, you’ll read about how this tendency is supposed to work and why, according to orthodox theory, it often doesn’t.

The Tendency toward Full Employment

Earlier in this chapter, you learned that the economy should, in the long run, reach an equilibrium level of output at potential GDP.  This occurs at the intersection of the aggregate demand (AD) and the long-run aggregate supply (LRAS) curves and is consistent with full employment (or the natural rate of unemployment).  The labor market model is one way of understanding how, at least in the absence of sticky prices, this would occur.  Recall that higher prices for the things firms sell, relative to input costs for producing those things, will induce firms to produce and sell more output.  It follows then that lower input costs, relative to prices, would also lead to firms hire more workers and produce more output.

This suggests that we can understand the long run tendency for capitalist economies to fully employ their resources (that is, inputs like labor) in terms of the prices of those inputs.  Below, we’ll look at how the competitive market for labor should ensure full employment.  (Note, however, that these arguments should apply to any of the real resources that firms use as inputs to produce the goods and services that make up GDP.)

Labor Market

Orthodox economists understand the processes of firms hiring and workers working for pay by using the standard supply-and-demand model.  Demand represents the firms paying for workers’ time and effort, and supply represents the workers supplying their labor.  The wage rate, then, is the price of the labor, and if the labor market is in equilibrium (at a wage rate of We in the figure below), then the quantity of work that workers want to do (or supply) will be equal to the quantity that firms want to hire (or demand).

The graph reveals the complexity of unemployment in that, presumably, the number of jobs available should equal the number of individuals pursuing employment.
Figure 1. The Unemployment and Equilibrium in the Labor Market. In a labor market with flexible wages, the equilibrium will occur at wage We and quantity Qe, where the number of people who want jobs (shown by S) equals the number of jobs available (shown by D).

One possibility for any observed unemployment is that people who are unemployed are those who are not willing to work at the current equilibrium wage, say $10 an hour, but would be willing to work at a higher wage, like $20 per hour. The monthly Current Population Survey would count these people as unemployed, because they say they are ready and looking for work (at $20 per hour). However, from an economist’s perspective, these people are choosing to be unemployed, so they’re ignored in terms of the tendency to full employment.

Hence, orthodox economists argue that the key to full employment is flexible wages. As in the figure below, unemployment is defined as an excess supply of labor, relative to demand for it from firms, and the supply-and-demand model tells us that this is resolved through a drop in the wage rate.  Of course, this was implied by the idea that firms will produce more when the prices of the things they sell go up relative to the costs of producing those things. If we treat the wage rate in the figure above as the real (that is, inflation-adjusted) wage rate, then a decrease in how much firms pay their workers is the same as an increase in prices (which corresponds to a decrease in the real, inflation-adjusted wage rate).

The graph provides a visual of how sticky wages impact the unemployment rate.
Figure 2. Unemployment in the Labor Market When the wage rate is at W, above the equilibrium, the number of those who want jobs (Qs) is greater than the number of job openings (Qd). The result is unemployment, shown by the bracket in the figure.

It follows, then, that persistent involuntary unemployment that cannot be attributed to structural or frictional causes must be due a breakdown in the price mechanism itself.  That is, the unemployment must be a result of something keeping the real wage rate from falling.  Orthodox economists often refer to these situations as wages being ‘sticky downward’.

Why Wages Might Be Sticky Downward

If a labor market model with flexible wages does not describe unemployment very well—because it predicts that anyone willing to work at the going wage can always find a job—then it may prove useful to consider economic models in which wages are not flexible or adjust only very slowly. In particular, even though wage increases may occur with relative ease, wage decreases are few and far between.

One set of reasons why wages may be “sticky downward,” as economists put it, involves economic laws and institutions. For low-skilled workers receiving minimum wage, it is illegal to reduce their wages. For union workers operating under a multiyear contract with a company, wage cuts might violate the contract and create a labor dispute or a strike. However, minimum wages and union contracts are not a sufficient reason why wages would be sticky downward for the U.S. economy as a whole. After all, out of the 150 million or so employed workers in the U.S. economy, only about 2.6 million—less than 2% of the total—do not receive compensation above the minimum wage. Similarly, labor unions represent only about 11% of American wage and salary workers. In other high-income countries, more workers may have their wages determined by unions or the minimum wage may be set at a level that applies to a larger share of workers. However, for the United States, these two factors combined affect only about 15% or less of the labor force.

Economists looking for reasons why wages might be sticky downwards have focused on factors that may characterize most labor relationships in the economy, not just a few. Many have proposed a number of different theories, but they share a common tone.

One argument is that even employees who are not union members often work under an implicit contract, which is that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong. This wage-setting behavior acts like a form of insurance: the employee has some protection against wage declines in bad times, but pays for that protection with lower wages in good times. Clearly, this sort of implicit contract means that firms will be hesitant to cut wages, lest workers feel betrayed and work less hard or even leave the firm.

Efficiency wage theory argues that workers’ productivity depends on their pay, and so employers will often find it worthwhile to pay their employees somewhat more than market conditions might dictate. One reason is that employees who receive better pay than others will be more productive because they recognize that if they were to lose their current jobs, they would suffer a decline in salary. As a result, they are motivated to work harder and to stay with the current employer. In addition, employers know that it is costly and time-consuming to hire and train new employees, so they would prefer to pay workers a little extra now rather than to lose them and have to hire and train new workers. Thus, by avoiding wage cuts, the employer minimizes costs of training and hiring new workers, and reaps the benefits of well-motivated employees.

The adverse selection of wage cuts argument points out that if an employer reacts to poor business conditions by reducing wages for all workers, then the best workers, those with the best employment alternatives at other firms, are the most likely to leave. The least attractive workers, with fewer employment alternatives, are more likely to stay. Consequently, firms are more likely to choose which workers should depart, through layoffs and firings, rather than trimming wages across the board. Sometimes companies that are experiencing difficult times can persuade workers to take a pay cut for the short term, and still retain most of the firm’s workers. However, it is far more typical for companies to lay off some workers, rather than to cut wages for everyone.

The insider-outsider model of the labor force, in simple terms, argues that those already working for firms are “insiders,” while new employees, at least for a time, are “outsiders.” A firm depends on its insiders to keep the organization running smoothly, to be familiar with routine procedures, and to train new employees. However, cutting wages will alienate the insiders and damage the firm’s productivity and prospects.

Finally, the relative wage coordination argument points out that even if most workers were hypothetically willing to see a decline in their own wages in bad economic times as long as everyone else also experiences such a decline, there is no obvious way for a decentralized economy to implement such a plan. Instead, workers confronted with the possibility of a wage cut will worry that other workers will not have such a wage cut, and so a wage cut means being worse off both in absolute terms and relative to others. As a result, workers fight hard against wage cuts.

These theories of why wages tend not to move downward differ in their logic and their implications, and figuring out the strengths and weaknesses of each theory is an ongoing subject of research and controversy among economists. All tend to imply that wages will decline only very slowly, if at all, even when the economy or a business is having tough times. When wages are inflexible and unlikely to fall, then either unemployment, in both the short-run or long-run, can result.

This analysis helps to compensate for the limited instances in which we have observed capitalist economies moving toward a full employment equilibrium on their own.  In essence, orthodox economists maintain that full employment is guaranteed by flexible wages; and if full employment doesn’t appear to be happening, it must be because wages are not flexible.

The St. Louis Federal Reserve Bank is the best resource for macroeconomic time series data, known as the Federal Reserve Economic Data (FRED). FRED provides complete data sets on various measures of the unemployment rate as well as the monthly Bureau of Labor Statistics report on the results of the household and employment surveys. QR Code representing a URL


Cyclical unemployment rises and falls with the business cycle. In a labor market with flexible wages, wages will adjust in such a market so that quantity demanded of labor always equals the quantity supplied of labor at the equilibrium wage. Economists have proposed many theories for why wages might not be flexible, but instead may adjust only in a “sticky” way, especially when it comes to downward adjustments: implicit contracts, efficiency wage theory, adverse selection of wage cuts, insider-outsider model, and relative wage coordination.


adverse selection of wage cuts argument
if employers reduce wages for all workers, the best will leave
efficiency wage theory
the theory that the productivity of workers, either individually or as a group, will increase if the employer pays them more
implicit contract
an unwritten agreement in the labor market that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong
insider-outsider model
those already working for the firm are “insiders” who know the procedures; the other workers are “outsiders” who are recent or prospective hires
relative wage coordination argument
across-the-board wage cuts are hard for an economy to implement, and workers fight against them


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Principles of Economics: Scarcity and Social Provisioning (2nd Ed.) Copyright © 2020 by Rice University; Dean, Elardo, Green, Wilson, Berger is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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