Question

With the aid of diagrams explain the effect of simultaneous increase in labor demand and decrease in labor supply on wage rate and employment

Answer 1

Labor demand is a decreasing function of wage rate and supply of labor is an increasing function of the wage rate. The decrease in the supply of labor moves the labor market along the demand curve. This implies a fall in labor employment and a rise in wages. On the other hand, an increase in demand for labor moves the market along the supply curve. That is the wage rate increases and labor employment also increases. Therefore, for both the movement the wage rate rises, hence for a simultaneous rise in demand and fall in supply, the wage rate in the new equilibrium definitely rises. However, the effect of these movements on equilibrium labor employment is ambiguous. Based on the magnitude of the shift the employment may rise, or fall, or remain unchanged at the new equilibrium.

The three cases are given below, in all cases, the initial demand and supply were D0 and S0, the initial equilibrium labor employment was L0 and the wage was w0. As the demand rises the new demand curve becomes D1.

Case 1: Supply falls at the same magnitude as the rise in demand.

The new supply curve becomes S1, the rise in labor employment due to demand is exactly outweighed by a fall in employment due to a fall in supply. The equilibrium employment remains constant at L0 and wage rises to w1.

Wage W D1 LO Employment

Case 2: Supply falls in a lower magnitude than the rise in demand.

The new supply curve becomes S1, the rise in labor employment due to demand is outweighed by a fall in employment due to a fall in supply. The equilibrium employment rises L1 and wage rise to w1.

Wage . Si OS DO LO L1 Employment

Case 3: Supply falls at a higher magnitude than the rise in demand.

The new supply curve becomes S1, the rise in labor employment due to demand is cannot be outweighed by a fall in employment due to a fall in supply. The equilibrium employment falls to L2 and wage rises to w1.

Wage so wo D1 DO L2 LO Employment