Barry Haworth
University of Louisville
Department of Economics
Economics 301

Factor Markets and Surplus

Just as in output markets, factor markets give rise to consumer and producer surplus. We can define these surpluses in the same manner as with output markets. Consumer surplus in a factor market is the difference between maximum acceptable factor price and the actual factor price for all units purchased. Producer surplus becomes the difference between the actual factor price and the minimum acceptable factor price for all units purchased.

Let's consider a world where there is only one variable factor (labor). In a competitive labor market, firms hire where their labor demand equals the existing labor supply. Considering the labor market as a whole, this implies an equilibrium such as that found in the left-side graph below. Consumer surplus is the greenish area bordered by wC and DL - all the way out to QC. Producer surplus is the purplish area bordered by wC and SL - all the way out to QC. These surpluses are labelled as CS and PS respectively.

If the labor market is monopsonistic, then the monopsonist hires labor to the point where MEL crosses DL. The wage (wM) comes from the point on SL that is directly above QM.

Because MEL is above SL, the monopsonist hires less labor than would be hired in a more competitive labor market. As a result, the surpluses change in size. Consumer surplus extends down into former producer surplus, whereas producer surplus shrinks. If labor is not hired at the point where demand equals supply, then we also have some deadweight loss (given in the graph as the tan area called DWL).

Although the existence of DWL implies an inefficient allocation of labor, the size of this area can differ across otherwise similar labor markets. This is because DWL results from the substitution that occurs within the demand or supply side of the market. For example, the graph below shows that an increasingly inelastic labor demand curve decreases the size of DWL. As the labor demand curve becomes steeper, we realize that the labor from other labor markets is an increasingly poorer substitute for the labor in this market. At the extreme, where DL is perfectly inelastic (i.e. DL is vertical), there would be no DWL at all.

Click here

If you click on the "Click here" link, the graph will change as described above. By clicking on the link a second time, the graph returns to its original position, where you may begin the process again if you like.