In the last two chapters we investigated the determination of aggregate supply. The key question was, looking at the economy from the point of view of the firm sector, what determines the amount of GDP produced? The simple answer was technology and factor inputs. That answer is only partial in the sense that it immediately raises the question, what determines technology and factor inputs? Although we touched on this question in the earlier chapters, our answer – especially with respect to factor inputs – was limited. We have a special interest in the answer because ordinary people provide the labor input and it forms the basis for most incomes in the economy. In this chapter we ask what in ideal circumstances (i.e., when the economy is running smoothly and all markets are in equilibrium) determines the amount of labor available to production. The analysis can be applied with appropriate modifications to capital as well. We concentrate on labor because of its overwhelming importance to the typical person.

The nearly universal answer to all economic questions is supply and demand. If we wish to know why a certain amount of labor is available and used in the production process, a good starting place is to notice that firms demand labor and workers supply it. Our analysis, then, has three parts: (1) What factors govern the decisions of firms to hire labor? (2) What factors govern the willingness of workers to supply it? (3) How do the decisions of firms and workers interact to determine the amount of labor used in production?