Understanding full employment in macroeconomics: when labor demand outpaces supply and unemployment falls

Think of the labor market as a bustling job fair that never closes. Employers show up with needs, applicants bring skills and hopes, and the dance between demand and supply shapes pay, chances of getting hired, and how people feel about their work. When the crowd on the employer side is bigger than the crowd on the job-seeker side, employers have to compete. They offer higher wages, better benefits, or different perks just to attract workers. And when that happens, unemployment tends to fall. In other words, the scenario described in your question points to a state we call full employment.

A quick way to lock this in: the correct answer is A, full employment. But let’s unpack what that really means, because “full employment” isn’t the same as “no one is unemployed.” It’s a bit like aiming to hit your balance in a game where there’s always a touch of noise in the system.

What full employment actually means

Full employment doesn’t mean a perfect job-for-everyone, 0% unemployment, and a perfectly flat economy. It means the labor market is functioning well enough that nearly everyone who wants to work, and is capable of working, can find a job. There’s still some natural unemployment left—people are switching jobs, entering the workforce for the first time, or returning after a break. Economists often talk about the natural rate of unemployment, a sort of baseline that the economy tends toward in the long run.

So when demand for labor exceeds supply, wages rise a bit as firms bid for workers. This is a sign of strength: businesses are expanding, consumer demand is firm, and entrepreneurs are hiring. The result is a lower unemployment rate, which makes full employment feel not just theoretical but visible in the streets—more job postings, more new hires, and a sense that the economy is humming.

Let me explain why this isn’t the same as chasing zero unemployment. If you tried to push unemployment all the way to zero, you’d likely spark a supply shortage so severe that wages would spiral up, price levels could rise, and a whole new set of frictions would appear. In real life, a bit of unemployment is normal, and that is part of what economists mean by the natural rate.

A quick tour of the other options

• Underemployment: This is when someone is working, but not at a level that matches their skills or their desired hours. Picture a skilled engineer taking a part-time gig at a coffee shop because full-time roles aren’t available. That’s underemployment. It can happen even when the headline unemployment rate looks decent. It signals inefficiencies in matching people to jobs and can mask the real health of the labor market.

• Inflation: A rise in the general price level. Inflation can be caused by a lot of things—demand-pull pressures when the economy is booming, cost shocks, or monetary policy dynamics. It’s about prices, not directly about how many people have work. But the two can be connected: when unemployment is very low and wages climb, demand for goods and services can push prices up unless supply can keep up.

• Stagflation: That’s the nasty combo of stagnating growth, high unemployment, and inflation at the same time. It’s the economic equivalent of a traffic jam in a thunderstorm—growth at a crawl, prices rising, and people still looking for work. Not what you want, and very different from a healthy, robust labor market.

Why the labor market behaves the way it does

To ground this a bit, think about the mechanics. When employers want more workers, they compete. They offer higher wages, improved benefits, or flexible hours to attract people with the right skills. If many people are unemployed or in lower-paying jobs, those wage rises can quickly translate into more people moving into better-paid roles. More people employed means lower unemployment, which we call moving toward full employment.

But the picture isn’t static. The economy can tilt toward tighter or looser labor markets. In a booming period, demand for goods grows, companies expand, and the push for labor intensifies. Wages rise, and the unemployment rate drops toward the natural rate. In a downturn, demand shrinks, firms slow hiring or lay off workers, and unemployment can rise even if the economy is still producing something. That shifting pulse is one reason economists pay close attention to unemployment rates, labor force participation, and wage trends.

A note on H/L core concepts for IB Economics

If you’re studying IB Economics at Higher Level, you’ll see these ideas pop up in both micro and macro contexts. The labor market is a classic example of a factor market, where the price is the wage and the quantity is the number of workers employed. The demand for labor comes from firms seeking to produce goods and services, while the supply of labor comes from people offering their time and skills.

Full employment also ties into the concept of the natural rate of unemployment, which includes:

• Frictional unemployment: folks between jobs, graduates, and others who are briefly searching for the right match.

• Structural unemployment: a mismatch between the skills people have and the skills the economy needs.

• Seasonal unemployment: jobs that come and go with the season (think tourism, agriculture, and retail cycles).

Cyclical unemployment—the downturn-related unemployment caused by insufficient demand—varies with the business cycle and is the one economists watch most closely when talking about how close we are to full employment. When cyclical unemployment is near zero, you’re in the neighborhood of full employment, even if a small amount of frictional and structural unemployment remains.

What to watch for in the real world

• Wage pressures: As labor markets tighten, wages tend to rise. If you’re eyeing the labor market as a student or a future worker, that wage growth can be a good sign of opportunity, but it can also feed into inflation if it pushes up costs across the board.

• Job switching: In a healthy market, people move more easily from role to role, finding positions that fit their skills and ambitions. That movement is part of what keeps unemployment from sticking to zero and helps ensure that people aren’t stuck in roles that don’t suit them.

• Regional differences: Some areas might experience tight labor markets while others lag. The national headline can mask pockets of strength and weakness. For IB HL learners, this is a reminder to connect the macro picture with micro realities.

A lighter digression that still lands back on the point

Have you ever noticed that certain industries feel “hot” for a stretch, while others cool off? It’s a gentle reminder that full employment isn’t uniform across sectors. Tech hubs might be buzzing with hiring and rapid wage growth, while a rural town might struggle with seasonal work and skill mismatches. The beauty of the concept is that it helps economists ask the right questions: Where is demand strongest? Where is supply flowing freely? Where are frictions that slow the match between workers and jobs?

A practical snapshot for students of IB Economics HL

• Remember the core definition: full employment is the condition where the labor market is so healthy that nearly all willing and able workers find work. It does not imply zero unemployment, but a low level—around the natural rate—where frictional and structural unemployment persist.

• Distinguish the terms quickly: underemployment is about mismatched hours or skills; inflation is about rising prices; stagflation is the ugly combo of stagnation, high unemployment, and inflation.

• Tie to policy levers: fiscal and monetary policy can influence demand for labor. If unemployment is low and wages rise too fast, central banks might step in to keep inflation in check. If unemployment is high, governments might deploy stimulus or training programs to boost demand for labor and reduce frictional unemployment.

A final thought to carry with you

Full employment is less a magical state than a balance—between the number of jobs available and the number of people seeking work, between wage growth and price stability, between efficient job matching and the reality that some people are still in transition. It’s a useful lens: when you hear people talk about a booming economy, ask yourself, “Is the labor market tight enough that wages are rising, but not so tight that prices explode?” If the answer is yes, you’re looking at a labor market moving toward, or hovering around, full employment.

To wrap it up

If you’re ever unsure about what a term means, remember the mental image of that job fair with demand and supply doing their dance. When demand for labor exceeds supply, competition for workers surges, wages move up, and unemployment falls. That, in its simplest form, is full employment — a signal that the economy is functioning with vitality, even if lurking in the background are the tiny, persistent notes of frictional and structural unemployment.

If you want to keep exploring, you can compare this to how different countries experience labor market tightness: some show very low unemployment with modest inflation, others struggle with inflationary pressures or mismatches between skills and jobs. The more you connect the idea to real-world patterns, the more sense it makes—and the easier it becomes to talk about these concepts with clarity, whether in class, in a study group, or simply in everyday conversations about the economy.