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What Factors Influence the Supply of Labour in an Economy?

The supply of labour is defined as the total number of labour hours offered for work at a given
wage rate. This will increase as more people enter the workforce and / or as more workers
agree to do overtime. How we illustrate this on a labour markets diagram depends on which
factor has changed. In general, when labour supply expands due to rising wages, this is seen as
a movement along the supply curve. In other words, the supply of labour (in Figure 1) has
increased from N1 to N2, but only in response to wages rising first from W 1 to W2. Conversely,
a fall in wages will cause a contraction of labour supply.

Figure 1

W
S

W2
W1

N1 N2 Employment

However, a change in any other factor affecting labour supply will cause a shift of the curve. If
this is a rightward shift (as in Figure 2) then, other things being equal, this should reduce the
wage rate from W1 to W2, while also increasing the number of people at work from N 1 to N2.

Figure 2

W
S1
S2
W1
W2

N1 N2 Employment

There are numerous factors affecting the supply of labour, such as migration patterns, changes
in income tax, benefit reform, trade unions, government labour regulations, the retirement age
and female participation. We shall begin by looking at the most obvious one, the wage rate.
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The wage rate

In a particular industry, higher wages act as an incentive so that more people offer themselves
for work. Other things being equal, a higher rate of pay will mean:
 new workers join the market from outside the workforce;
 workers transfer from other labour markets where wages have not risen by as much; and
 existing workers in the industry are now willing to do more overtime, thereby substituting
work for leisure.

In June 2000 London’s Metropolitan Police Service faced a recruitment crisis which had
reduced its manpower to just over 25,000 officers – 3,000 short of what it needed. The
government sought to end this crisis by increasing pay. Partly as a result, the Metropolitan
Police saw a rise in the number of people wanting to join, such that by 2003 they had to impose
a temporary pause in recruitment until the huge backlog of applications was cleared.

It is likely that most of these additional recruits came from other labour markets – perhaps
some were intending lawyers or soldiers who were now persuaded by the higher pay to become
police officers instead. But it is also possible that some had joined from outside the workforce
altogether – for example, some new recruits may have been school-leavers abandoning their
plans to go to university. It is also possible that higher pay has increased the willingness of
existing officers to do overtime, such that there is now less urgency to find new recruits 1. In any
event, we can see how wages have acted as a signal to workers about which sectors are offering
the best returns to work, thereby allocating resources to where they are most needed in society.

Migration patterns
Inward migration directly adds to the workforce, thereby increasing the supply of labour. In
recent years this has proven to be one of the most significant factors affecting labour markets in
the developed world. For example, with EU enlargement in 2004, nationals from 10 new
member states (with a combined population of 74.2 million at the time) were given virtually
free access to the UK labour market 2. By the end of 2008, 482,000 workers from the A8
countries alone were either working or seeking work in the UK, with a further 500,000 having
also registered to work in Britain. Furthermore, as many East Europeans are known for their
work ethic and willingness to do long hours, the UK’s labour supply has clearly benefitted from
EU enlargement.

It should come as no surprise that so many A8 nationals wish to work here. With many of the
new EU countries suffering high unemployment and average incomes running at less than half
UK levels, Britain’s economy has offered these workers clear hope for a better standard of
living. A similar situation exists in the United States vis-à-vis inward migration from Latin
America.

1
Interestingly, at the time of writing there is a minor furore over a small number of low ranking officers using
overtime to earn more than £100,000 per year.
2
Nationals from Cyprus and Malta were given full rights to work in the UK, while nationals from the
remaining member states – the so-called A8 countries, consisting of Estonia, Latvia, Lithuania, Poland, Czech
Republic, Slovakia, Hungary and Slovenia – were subject to some minor formalities and restrictions on
claiming welfare benefits.
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Of course, the flip side of inward migration is the outward migration felt by the A8 countries.
In many cases, countries like Poland have lost skilled professionals and hard-working manual
labour, with negative consequences for both their labour supply as well as the macroeconomic
supply-side of their economies.

Changes in income tax

A reduction in income tax will raise disposable income, thereby increasing work incentives.
Those in voluntary unemployment may decide to enter the workforce, while those already in
work will feel more encouraged to do overtime as they get to keep more of their income. Either
way, the supply of labour increases. In the UK, the 2p cut in the basic rate of income tax in
April 2008 was partly intended to achieve this aim, although the effects were compromised by
the abolition of the 10p starting rate. 3

Conversely, an excessively progressive tax system may lead to an exodus of high earners out of
the country and an unwillingness amongst remaining workers to do overtime or to seek
promotion in order to increase their salaries. This was certainly the case in 1974 when the
Labour government raised the top rate of income tax to a staggering 83% on income greater
than £20,000.

Since 1979 the top rate has fallen to 40% with predictably positive effects on the supply of
labour, particularly amongst the higher-paid. However, these positive effects may be partially
offset next year when the government introduces its new top rate of 50% on income greater
than £150,000. Alistair Darling has argued that the new tax rate will only affect 1% of earners
(around 350,000 people), and thus will have an insignificant effect on the workforce. But once
again, arguments have resurfaced that the tax system is encouraging the UK’s most talented
and skilled workers to leave, just as the economy desperately needs them to navigate us out of
recession.

However, aside from the few geographically mobile workers who can easily relocate to lower
tax economies, we may question whether higher income taxes will really deter the rest of us
from working. So far, our only assumption is that work and leisure are substitutes, such that
higher income taxes reduce the reward from each additional hour worked, thereby decreasing
the opportunity cost of leisure. This ostensibly leads to a substitution effect whereby people
substitute leisure for work, hence decreasing the supply of labour. But we mustn’t forget that
some people have financial commitments like mortgages, personal debt and families to support.
For them, the income effect is likely to prevail, whereby an increase in income tax will
encourage these workers to seek overtime or a second job in order to maintain their previous
level of ‘take home pay’ and to meet their financial obligations. This would clearly increase the
supply of labour rather than decrease it.

Whether the income or substitution effect will dominate in the event of a tax rise is not always
clear, though with average household debt now running at £58,320 4 (i.e. higher than average
household income), it is likely that most people simply do not have the luxury of choosing
between work and leisure.

3
For further details, see Robert Chote’s article ‘Abolition of the 10p starting rate’ at:
http://www.ifs.org.uk/publications/4195
4
http://www.creditaction.org.uk/debt-statistics.html
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Benefit reform
Welfare benefits include jobseeker’s allowance, housing benefit, council tax benefit and
incapacity benefit, amongst others. If these are too generous and easy to obtain they may
discourage labour force participation, particularly amongst low-income workers who may find
they are better off living on welfare. Conversely, if benefits are reduced or made more difficult
to obtain, this increases the opportunity cost of not being in work and will trigger an increase in
labour supply.

In 1998 the UK government introduced the New Deal programme, which brought a package of
active labour market policies such as training, subsidised employment and voluntary work for
the unemployed, along with the right to withdraw benefits from those who refuse ‘reasonable
employment’. The aim was partly to ensure people speed up their job hunting efforts and do not
get comfortable living on benefits. To reinforce this, jobseeker’s allowance is deliberately kept
at the legal minimum required for subsistence 5.

More recently, in October 2008 the government introduced employment and support allowance
(ESA) to gradually replace incapacity benefit (IB). The key difference between the two is that
IB is paid to all claimants who are too sick or disabled to carry on in their current job, while
ESA is only paid continuously to those who are too sick or disabled to do any reasonable
employment. Essentially, ESA assesses what claimants can do, as opposed to what they can’t
do. To illustrate, under the old system a builder who damaged his back would qualify for IB
simply because he cannot carry on building. Under the new system, however, claimants will
receive work-focused help. So if that same builder is still fit and able enough to take on an
administrative role in a building firm, he will be expected to try this rather than continuing to
seek ESA. The emphasis is therefore shifting away from benefits and towards the redeployment
of labour.

In October 2008, when the reforms were introduced, the government claimed that of the 2.6
million people on IB, around one million of them can still take on some form of employment
outside their immediate area of expertise. If this is true, then as IB is phased out and totally
replaced with ESA, the supply of labour in the UK economy could potentially increase by up to
one million people, approximately 3% of the current workforce.

Trade unions
Through collective bargaining, trade unions negotiate better work conditions such as more
generous holiday entitlements, flexible hours of work and caps on workload. These all make
work more attractive and should increase the supply of labour. In addition, trade unions often
push wages up and beyond the levels that would otherwise prevail in an undistorted labour
market. This expands the supply of labour for the same reasons mentioned above in relation to
the wage rate.

Government labour regulations

Government labour regulations can both increase and decrease the supply of labour. For
example, the national minimum wage (NMW) introduced in 1999 ensures that all workers

5
According to Jobcentre Plus, this is currently capped at £50.95 per week for 16-24 year olds and £64.30 per
week for those aged 25 and over.
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(with the exception of some apprentices) are entitled to a minimum amount of remuneration 6.
According to the government, almost one million workers benefit from these rates and would
probably have faced lower pay in the absence of a NMW. This has therefore expanded labour
supply or, at the very least, has prevented a contraction of supply and voluntary unemployment
amongst the low-paid.

Conversely, the EU Working Time Directive has restricted labour supply to a maximum of 48
hours per week, per employee. While Britain maintains an ‘opt out’ (meaning individual
workers can choose not to enforce the 48 hour maximum), France has adopted even stricter
legislation limiting the maximum working week to only 35 hours. Indeed the impact on French
firms and their supply of labour has been so controversial that President Sarkozy has promised
to repeal the legislation.

Changes in the retirement age

Due to the demographic time-bomb brought about by an ageing population, most developed
countries are urgently focusing on pension reform. Take the retirement age for instance. In
2007 the German parliament voted to raise this from 65 to 67 so that workers will contribute
more towards, and draw less money from, the state pension scheme. And following the Turner
report in the UK, the government here will also raise the retirement age (from its current 60 for
women and 65 for men) to 66 for both sexes by 2024, to 67 in 2034 and to 68 in 2044 7. The
result is that large numbers of people will have to remain in the workforce for longer, thereby
increasing the supply of labour.

On the other hand, we could argue that the demographic time-bomb also entails falling birth
rates – for example, in 2007 Germany had one of the lowest in Europe at only 1.37 births per
woman – so the numbers entering the workforce post 16 are in fact dwindling. In such a case, a
higher retirement age will probably maintain the size of the workforce rather than increase it.

Female participation in the workforce

Since the 1960s, society has become more accepting of wives and mothers working and also of
women in high profile or senior roles. This has encouraged the participation of women in the
workforce and has increased the supply of labour, although many would argue the UK still has
a long way to go in this area. Other factors that have increased female participation include:
 changing household structures – in particular, the deferral of marriage and the rise in
divorce rates which necessitate financial independence amongst women;
 easier availability of childcare facilities (some with government subsidies);
 a trend towards flexible working hours, which suits young mothers;
 higher levels of female education; and
 improvements in equal opportunities brought about by a raft of laws on sex discrimination.

6
Since October 2009, this has been increased to £5.80 per hour for workers aged 22 and over, £4.83 per hour
for workers aged 18 to 21 and £3.57 per hour for those aged 16 to 17. For further details, see
http://www.lowpay.gov.uk/
7
In a recent BBC interview, the pensions regulator David Norgrove hinted that the age of retirement in the
UK will probably rise to 70, to account for rising life expectancies and the fact that we’re not, as a nation,
saving as much for retirement as we did in the past.
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This is in stark contrast to some Middle Eastern countries where, for cultural reasons that call
for a segregated workplace, female participation has remained low. For example, according to
University World News, women make up 58% of the total student population at university in
Saudi Arabia, yet only 16% of Saudi women work. And this is mostly in education, where
classroom segregation provides opportunities for women not usually seen in the private sector.
The Saudi government is against any quick changes to the rules on gender segregation, hence
the supply of indigenous labour remains relatively low and the economy continues to employ
migrant workers to plug the gap.

Conclusion: the Significance of Labour Supply

Issues relating to the supply of labour cut across both micro and macroeconomics. On a micro
level, labour supply is a key variable determining the equilibrium wage paid to workers. Other
things being equal, an increase in labour supply (seen as a rightward shift in Figure 1, above)
will mean there are more people competing for the same jobs, hence a fall in the wage rate
from W1 to W2. Conversely, a fall in labour supply will mean fewer people available to work,
so firms will have to offer higher wages in order to fill their vacancies. In theory, this latter
scenario can be expected to have played out in the A8 countries, where scores of skilled and
hard-working labour have left to find work elsewhere in the EU.

On a macro level, the supply of labour is a key variable affecting the productive capacity of an
economy. Other things being equal, the more people there are to fill vacancies, the more goods
and services can be produced (seen as a rightward shift of the AS curve, in Figure 3), hence the
greater the GDP and the lower the rate of inflation. Consequently, there should be a rise in UK
price-competitiveness so the balance of payments should also improve. Not surprisingly,
boosting the supply of labour has been a cornerstone of government supply-side policies, both
here and abroad.

Figure 3

PL AS1 AS2

P1
P2
AD

Y1 Y2 RO