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83 Chapter 4 | Labor and Financial Markets

4 | Labor and Financial
Markets

Figure 4.1 People often think of demand and supply in relation to goods, but labor markets, such as the nursing
profession, can also apply to this analysis. (Credit: modification of work by “Fotos GOVBA”/Flickr Creative Commons)

Baby Boomers Come of Age

The Census Bureau reports that as of 2013, 20% of the U.S. population was over 60 years old, which means
that almost 63 million people are reaching an age when they will need increased medical care.

The baby boomer population, the group born between 1946 and 1964, is comprised of approximately
74 million people who have just reached retirement age. As this population grows older, they will be
faced with common healthcare issues such as heart conditions, arthritis, and Alzheimer’s that may require
hospitalization, long-term, or at-home nursing care. Aging baby boomers and advances in life-saving and life-
extending technologies will increase the demand for healthcare and nursing. Additionally, the Affordable Care
Act, which expands access to healthcare for millions of Americans, has further increase the demand, although
with the election of Donald J. Trump, this increase may not be sustained.

According to the Bureau of Labor Statistics, registered nursing jobs are expected to increase by 16% between
2014 and 2024. The median annual wage of $67,490 (in 2015) is also expected to increase. The BLS
forecasts that 439,000 new nurses will be in demand by 2022.

These data tell us, as economists, that the market for healthcare professionals, and nurses in particular, will
face several challenges. Our study of supply and demand will help us to analyze what might happen in the

84 Chapter 4 | Labor and Financial Markets

labor market for nursing and other healthcare professionals, as we will discuss in the second half of this case
at the end of the chapter.

Introduction to Labor and Financial Markets
In this chapter, you will learn about:

• Demand and Supply at Work in Labor Markets

• Demand and Supply in Financial Markets

• The Market System as an Efficient Mechanism for Information

The theories of supply and demand do not apply just to markets for goods. They apply to any market, even markets
for things we may not think of as goods and services like labor and financial services. Labor markets are markets for
employees or jobs. Financial services markets are markets for saving or borrowing.

When we think about demand and supply curves in goods and services markets, it is easy to picture the demanders and
suppliers: businesses produce the products and households buy them. Who are the demanders and suppliers in labor
and financial service markets? In labor markets job seekers (individuals) are the suppliers of labor, while firms and
other employers who hire labor are the demanders for labor. In financial markets, any individual or firm who saves
contributes to the supply of money, and any who borrows (person, firm, or government) contributes to the demand
for money.

As a college student, you most likely participate in both labor and financial markets. Employment is a fact of life for
most college students: According to the National Center for Educational Statistics, in 2013 40% of full-time college
students and 76% of part-time college students were employed. Most college students are also heavily involved in
financial markets, primarily as borrowers. Among full-time students, about half take out a loan to help finance their
education each year, and those loans average about $6,000 per year. Many students also borrow for other expenses,
like purchasing a car. As this chapter will illustrate, we can analyze labor markets and financial markets with the same
tools we use to analyze demand and supply in the goods markets.

4.1 | Demand and Supply at Work in Labor Markets

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

• Predict shifts in the demand and supply curves of the labor market

• Explain the impact of new technology on the demand and supply curves of the labor market

• Explain price floors in the labor market such as minimum wage or a living wage

Markets for labor have demand and supply curves, just like markets for goods. The law of demand applies in labor
markets this way: A higher salary or wage—that is, a higher price in the labor market—leads to a decrease in the
quantity of labor demanded by employers, while a lower salary or wage leads to an increase in the quantity of labor
demanded. The law of supply functions in labor markets, too: A higher price for labor leads to a higher quantity of
labor supplied; a lower price leads to a lower quantity supplied.

Equilibrium in the Labor Market
In 2015, about 35,000 registered nurses worked in the Minneapolis-St. Paul-Bloomington, Minnesota-Wisconsin
metropolitan area, according to the BLS. They worked for a variety of employers: hospitals, doctors’ offices, schools,
health clinics, and nursing homes. Figure 4.2 illustrates how demand and supply determine equilibrium in this labor
market. The demand and supply schedules in Table 4.1 list the quantity supplied and quantity demanded of nurses at
different salaries.

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85 Chapter 4 | Labor and Financial Markets

Figure 4.2 Labor Market Example: Demand and Supply for Nurses in Minneapolis-St. Paul-Bloomington The
demand curve (D) of those employers who want to hire nurses intersects with the supply curve (S) of those who are
qualified and willing to work as nurses at the equilibrium point (E). The equilibrium salary is $70,000 and the
equilibrium quantity is 34,000 nurses. At an above-equilibrium salary of $75,000, quantity supplied increases to
38,000, but the quantity of nurses demanded at the higher pay declines to 33,000. At this above-equilibrium salary,
an excess supply or surplus of nurses would exist. At a below-equilibrium salary of $60,000, quantity supplied
declines to 27,000, while the quantity demanded at the lower wage increases to 40,000 nurses. At this below-
equilibrium salary, excess demand or a shortage exists.

Annual Salary Quantity Demanded Quantity Supplied

$55,000 45,000 20,000

$60,000 40,000 27,000

$65,000 37,000 31,000

$70,000 34,000 34,000

$75,000 33,000 38,000

$80,000 32,000 41,000

Table 4.1 Demand and Supply of Nurses in Minneapolis-St. Paul-Bloomington

The horizontal axis shows the quantity of nurses hired. In this example we measure labor by number of workers, but
another common way to measure the quantity of labor is by the number of hours worked. The vertical axis shows
the price for nurses’ labor—that is, how much they are paid. In the real world, this “price” would be total labor
compensation: salary plus benefits. It is not obvious, but benefits are a significant part (as high as 30 percent) of labor
compensation. In this example we measure the price of labor by salary on an annual basis, although in other cases we
could measure the price of labor by monthly or weekly pay, or even the wage paid per hour. As the salary for nurses
rises, the quantity demanded will fall. Some hospitals and nursing homes may reduce the number of nurses they hire,
or they may lay off some of their existing nurses, rather than pay them higher salaries. Employers who face higher
nurses’ salaries may also try to replace some nursing functions by investing in physical equipment, like computer
monitoring and diagnostic systems to monitor patients, or by using lower-paid health care aides to reduce the number
of nurses they need.

As the salary for nurses rises, the quantity supplied will rise. If nurses’ salaries in Minneapolis-St. Paul-Bloomington
are higher than in other cities, more nurses will move to Minneapolis-St. Paul-Bloomington to find jobs, more people
will be willing to train as nurses, and those currently trained as nurses will be more likely to pursue nursing as a full-
time job. In other words, there will be more nurses looking for jobs in the area.

86 Chapter 4 | Labor and Financial Markets

At equilibrium, the quantity supplied and the quantity demanded are equal. Thus, every employer who wants to hire a
nurse at this equilibrium wage can find a willing worker, and every nurse who wants to work at this equilibrium salary
can find a job. In Figure 4.2, the supply curve (S) and demand curve (D) intersect at the equilibrium point (E). The
equilibrium quantity of nurses in the Minneapolis-St. Paul-Bloomington area is 34,000, and the equilibrium salary
is $70,000 per year. This example simplifies the nursing market by focusing on the “average” nurse. In reality, of
course, the market for nurses actually comprises many smaller markets, like markets for nurses with varying degrees
of experience and credentials. Many markets contain closely related products that differ in quality. For instance, even
a simple product like gasoline comes in regular, premium, and super-premium, each with a different price. Even in
such cases, discussing the average price of gasoline, like the average salary for nurses, can still be useful because it
reflects what is happening in most of the submarkets.

When the price of labor is not at the equilibrium, economic incentives tend to move salaries toward the equilibrium.
For example, if salaries for nurses in Minneapolis-St. Paul-Bloomington were above the equilibrium at $75,000 per
year, then 38,000 people want to work as nurses, but employers want to hire only 33,000 nurses. At that above-
equilibrium salary, excess supply or a surplus results. In a situation of excess supply in the labor market, with many
applicants for every job opening, employers will have an incentive to offer lower wages than they otherwise would
have. Nurses’ salary will move down toward equilibrium.

In contrast, if the salary is below the equilibrium at, say, $60,000 per year, then a situation of excess demand or a
shortage arises. In this case, employers encouraged by the relatively lower wage want to hire 40,000 nurses, but only
27,000 individuals want to work as nurses at that salary in Minneapolis-St. Paul-Bloomington. In response to the
shortage, some employers will offer higher pay to attract the nurses. Other employers will have to match the higher
pay to keep their own employees. The higher salaries will encourage more nurses to train or work in Minneapolis-St.
Paul-Bloomington. Again, price and quantity in the labor market will move toward equilibrium.

Shifts in Labor Demand
The demand curve for labor shows the quantity of labor employers wish to hire at any given salary or wage rate,
under the ceteris paribus assumption. A change in the wage or salary will result in a change in the quantity demanded
of labor. If the wage rate increases, employers will want to hire fewer employees. The quantity of labor demanded
will decrease, and there will be a movement upward along the demand curve. If the wages and salaries decrease,
employers are more likely to hire a greater number of workers. The quantity of labor demanded will increase, resulting
in a downward movement along the demand curve.

Shifts in the demand curve for labor occur for many reasons. One key reason is that the demand for labor is based
on the demand for the good or service that is produced. For example, the more new automobiles consumers demand,
the greater the number of workers automakers will need to hire. Therefore the demand for labor is called a “derived
demand.” Here are some examples of derived demand for labor:

• The demand for chefs is dependent on the demand for restaurant meals.

• The demand for pharmacists is dependent on the demand for prescription drugs.

• The demand for attorneys is dependent on the demand for legal services.

As the demand for the goods and services increases, the demand for labor will increase, or shift to the right, to meet
employers’ production requirements. As the demand for the goods and services decreases, the demand for labor will
decrease, or shift to the left. Table 4.2 shows that in addition to the derived demand for labor, demand can also
increase or decrease (shift) in response to several factors.

Factors Results

Demand for

Output

When the demand for the good produced (output) increases, both the output price and

profitability increase. As a result, producers demand more labor to ramp up

production.

Table 4.2 Factors That Can Shift Demand

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87 Chapter 4 | Labor and Financial Markets

Factors Results

Education A well-trained and educated workforce causes an increase in the demand for that

and labor by employers. Increased levels of productivity within the workforce will cause the

Training demand for labor to shift to the right. If the workforce is not well-trained or educated,

employers will not hire from within that labor pool, since they will need to spend a

significant amount of time and money training that workforce. Demand for such will

shift to the left.

Technology Technology changes can act as either substitutes for or complements to labor. When

technology acts as a substitute, it replaces the need for the number of workers an

employer needs to hire. For example, word processing decreased the number of

typists needed in the workplace. This shifted the demand curve for typists left. An

increase in the availability of certain technologies may increase the demand for labor.

Technology that acts as a complement to labor will increase the demand for certain

types of labor, resulting in a rightward shift of the demand curve. For example, the

increased use of word processing and other software has increased the demand for

information technology professionals who can resolve software and hardware issues

related to a firm’s network. More and better technology will increase demand for

skilled workers who know how to use technology to enhance workplace productivity.

Those workers who do not adapt to changes in technology will experience a decrease

in demand.

Number of An increase in the number of companies producing a given product will increase the

Companies demand for labor resulting in a shift to the right. A decrease in the number of

companies producing a given product will decrease the demand for labor resulting in a

shift to the left.

Government Complying with government regulations can increase or decrease the demand for

Regulations labor at any given wage. In the healthcare industry, government rules may require that

nurses be hired to carry out certain medical procedures. This will increase the demand

for nurses. Less-trained healthcare workers would be prohibited from carrying out

these procedures, and the demand for these workers will shift to the left.

Price and Labor is not the only input into the production process. For example, a salesperson at

Availability a call center needs a telephone and a computer terminal to enter data and record

of Other sales. If prices of other inputs fall, production will become more profitable and

Inputs suppliers will demand more labor to increase production. This will cause a rightward

shift in the demand curve for labor. The opposite is also true. Higher prices for other

inputs lower demand for labor.

Table 4.2 Factors That Can Shift Demand

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88 Chapter 4 | Labor and Financial Markets

Shifts in Labor Supply
The supply of labor is upward-sloping and adheres to the law of supply: The higher the price, the greater the quantity
supplied and the lower the price, the less quantity supplied. The supply curve models the tradeoff between supplying
labor into the market or using time in leisure activities at every given price level. The higher the wage, the more
labor is willing to work and forego leisure activities. Table 4.3 lists some of the factors that will cause the supply to
increase or decrease.

Factors Results

Number of An increased number of workers will cause the supply curve to shift to the right. An

Workers increased number of workers can be due to several factors, such as immigration,

increasing population, an aging population, and changing demographics. Policies that

encourage immigration will increase the supply of labor, and vice versa. Population

grows when birth rates exceed death rates. This eventually increases supply of labor

when the former reach working age. An aging and therefore retiring population will

decrease the supply of labor. Another example of changing demographics is more

women working outside of the home, which increases the supply of labor.

Required The more required education, the lower the supply. There is a lower supply of PhD

Education mathematicians than of high school mathematics teachers; there is a lower supply of

cardiologists than of primary care physicians; and there is a lower supply of physicians

than of nurses.

Government

Policies

Government policies can also affect the supply of labor for jobs. Alternatively, the

government may support rules that set high qualifications for certain jobs: academic

training, certificates or licenses, or experience. When these qualifications are made

tougher, the number of qualified workers will decrease at any given wage. On the

other hand, the government may also subsidize training or even reduce the required

level of qualifications. For example, government might offer subsidies for nursing

schools or nursing students. Such provisions would shift the supply curve of nurses to

the right. In addition, government policies that change the relative desirability of

working versus not working also affect the labor supply. These include unemployment

benefits, maternity leave, child care benefits, and welfare policy. For example, child

care benefits may increase the labor supply of working mothers. Long term

unemployment benefits may discourage job searching for unemployed workers. All

these policies must therefore be carefully designed to minimize any negative labor

supply effects.

Table 4.3 Factors that Can Shift Supply

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89 Chapter 4 | Labor and Financial Markets

A change in salary will lead to a movement along labor demand or labor supply curves, but it will not shift those
curves. However, other events like those we have outlined here will cause either the demand or the supply of labor to
shift, and thus will move the labor market to a new equilibrium salary and quantity.

Technology and Wage Inequality: The Four-Step Process
Economic events can change the equilibrium salary (or wage) and quantity of labor. Consider how the wave of
new information technologies, like computer and telecommunications networks, has affected low-skill and high-skill
workers in the U.S. economy. From the perspective of employers who demand labor, these new technologies are often
a substitute for low-skill laborers like file clerks who used to keep file cabinets full of paper records of transactions.
However, the same new technologies are a complement to high-skill workers like managers, who benefit from the
technological advances by having the ability to monitor more information, communicate more easily, and juggle a
wider array of responsibilities. How will the new technologies affect the wages of high-skill and low-skill workers?
For this question, the four-step process of analyzing how shifts in supply or demand affect a market (introduced in
Demand and Supply) works in this way:

Step 1. What did the markets for low-skill labor and high-skill labor look like before the arrival of the new
technologies? In Figure 4.3 (a) and Figure 4.3 (b), S0 is the original supply curve for labor and D0 is the original
demand curve for labor in each market. In each graph, the original point of equilibrium, E0, occurs at the price W0
and the quantity Q0.

Figure 4.3 Technology and Wages: Applying Demand and Supply (a) The demand for low-skill labor shifts to the
left when technology can do the job previously done by these workers. (b) New technologies can also increase the
demand for high-skill labor in fields such as information technology and network administration.

Step 2. Does the new technology affect the supply of labor from households or the demand for labor from firms? The
technology change described here affects demand for labor by firms that hire workers.

Step 3. Will the new technology increase or decrease demand? Based on the description earlier, as the substitute for
low-skill labor becomes available, demand for low-skill labor will shift to the left, from D0 to D1. As the technology
complement for high-skill labor becomes cheaper, demand for high-skill labor will shift to the right, from D0 to D1.

Step 4. The new equilibrium for low-skill labor, shown as point E1 with price W1 and quantity Q1, has a lower wage
and quantity hired than the original equilibrium, E0. The new equilibrium for high-skill labor, shown as point E1 with
price W1 and quantity Q1, has a higher wage and quantity hired than the original equilibrium (E0).

Thus, the demand and supply model predicts that the new computer and communications technologies will raise the
pay of high-skill workers but reduce the pay of low-skill workers. From the 1970s to the mid-2000s, the wage gap
widened between high-skill and low-skill labor. According to the National Center for Education Statistics, in 1980,
for example, a college graduate earned about 30% more than a high school graduate with comparable job experience,
but by 2014, a college graduate earned about 66% more than an otherwise comparable high school graduate. Many
economists believe that the trend toward greater wage inequality across the U.S. economy is due to improvements in

90 Chapter 4 | Labor and Financial Markets

technology.

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relevance in today’s workforce.

Price Floors in the Labor Market: Living Wages and Minimum Wages
In contrast to goods and services markets, price ceilings are rare in labor markets, because rules that prevent people
from earning income are not politically popular. There is one exception: boards of trustees or stockholders, as an
example, propose limits on the high incomes of top business executives.

The labor market, however, presents some prominent examples of price floors, which are an attempt to increase the
wages of low-paid workers. The U.S. government sets a minimum wage, a price floor that makes it illegal for an
employer to pay employees less than a certain hourly rate. In mid-2009, the U.S. minimum wage was raised to $7.25
per hour. Local political movements in a number of U.S. cities have pushed for a higher minimum wage, which they
call a living wage. Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable
standard of living. They base this conclusion on the calculation that, if you work 40 hours a week at a minimum wage
of $7.25 per hour for 50 weeks a year, your annual income is $14,500, which is less than the official U.S. government
definition of what it means for a family to be in poverty. (A family with two adults earning minimum wage and two
young children will find it more cost efficient for one parent to provide childcare while the other works for income.
Thus the family income would be $14,500, which is significantly lower than the federal poverty line for a family of
four, which was $24,250 in 2015.)

Supporters of the living wage argue that full-time workers should be assured a high enough wage so that they can
afford the essentials of life: food, clothing, shelter, and healthcare. Since Baltimore passed the first living wage law
in 1994, several dozen cities enacted similar laws in the late 1990s and the 2000s. The living wage ordinances do not
apply to all employers, but they have specified that all employees of the city or employees of firms that the city hires
be paid at least a certain wage that is usually a few dollars per hour above the U.S. minimum wage.

Figure 4.4 illustrates the situation of a city considering a living wage law. For simplicity, we assume that there is
no federal minimum wage. The wage appears on the vertical axis, because the wage is the price in the labor market.
Before the passage of the living wage law, the equilibrium wage is $10 per hour and the city hires 1,200 workers at
this wage. However, a group of concerned citizens persuades the city council to enact a living wage law requiring
employers to pay no less than $12 per hour. In response to the higher wage, 1,600 workers look for jobs with the
city. At this higher wage, the city, as an employer, is willing to hire only 700 workers. At the price floor, the quantity
supplied exceeds the quantity demanded, and a surplus of labor exists in this market. For workers who continue to
have a job at a higher salary, life has improved. For those who were willing to work at the old wage rate but lost
their jobs with the wage increase, life has not improved. Table 4.4 shows the differences in supply and demand at
different wages.

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91 Chapter 4 | Labor and Financial Markets

Figure 4.4 A Living Wage: Example of a Price Floor The original equilibrium in this labor market is a wage of $10/
hour and a quantity of 1,200 workers, shown at point E. Imposing a wage floor at $12/hour leads to an excess supply
of labor. At that wage, the quantity of labor supplied is 1,600 and the quantity of labor demanded is only 700.

Wage Quantity Labor Demanded Quantity Labor Supplied

$8/hr 1,900 500

$9/hr 1,500 900

$10/hr 1,200 1,200

$11/hr 900 1,400

$12/hr 700 1,600

$13/hr 500 1,800

$14/hr 400 1,900

Table 4.4 Living Wage: Example of a Price Floor

The Minimum Wage as an Example of a Price Floor
The U.S. minimum wage is a price floor that is set either very close to the equilibrium wage or even slightly below
it. About 1% of American workers are actually paid the minimum wage. In other words, the vast majority of the U.S.
labor force has its wages determined in the labor market, not as a result of the government price floor. However, for
workers with low skills and little experience, like those without a high school diploma or teenagers, the minimum
wage is quite important. In many cities, the federal minimum wage is apparently below the market price for unskilled
labor, because employers offer more than the minimum wage to checkout clerks and other low-skill workers without
any government prodding.

Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skill
labor. A typical result of such studies is that a 10% increase in the minimum wage would decrease the hiring of
unskilled workers by 1 to 2%, which seems a relatively small reduction. In fact, some studies have even found
no effect of a higher minimum wage on employment at certain times and places—although these studies are
controversial.

Let’s suppose that the minimum wage lies just slightly below the equilibrium wage level. Wages could fluctuate
according to market forces above this price floor, but they would not be allowed to move beneath the floor. In
this situation, the price floor minimum wage is nonbinding —that is, the price floor is not determining the market
outcome. Even if the minimum wage moves just a little higher, it will still have no effect on the quantity of

92 Chapter 4 | Labor and Financial Markets

employment in the economy, as long as it remains below the equilibrium wage. Even if the government increases
minimum wage by enough so that it rises slightly above the equilibrium wage and becomes binding, there will be
only a small excess supply gap between the quantity demanded and quantity supplied.

These insights help to explain why U.S. minimum wage laws have historically had only a small impact on
employment. Since the minimum wage has typically been set close to the equilibrium wage for low-skill labor
and sometimes even below it, it has not had a large effect in creating an excess supply of labor. However, if the
minimum wage increased dramatically—say, if it doubled to match the living wages that some U.S. cities have
considered—then its impact on reducing the quantity demanded of employment would be far greater. As of 2017,
many U.S. states are set to increase their minimum wage to $15 per hour. We will see what happens. The following
Clear It Up feature describes in greater detail some of the arguments for and against changes to minimum wage.

What’s the harm in raising the minimum wage?

Because of the law of demand, a higher required wage will reduce the amount of low-skill employment either
in terms of employees or in terms of work hours. Although there is controversy over the numbers, …