What is a producer surplus?
The producer surplus is the difference between the amount that a person would be willing to accept for a given quantity of a good compared to what he can receive by selling the good at the market price. The difference or surplus is the advantage that the producer receives for the sale of the good on the market. A producer surplus is generated by market prices above the lowest price that producers would otherwise be willing to accept for their products. This may be related to the law of Walras.
Key points to remember
- Producer surplus is the total amount that a producer derives from the production and sale of a quantity of a good at market prices.
- The total income that a producer receives from the sale of his products less the total cost of production is equal to the producer’s surplus.
- The producer surplus plus the consumer surplus represent the total benefit to everyone on the market of participating in the production and trade of the good.
Understanding the producer surplus
A producer surplus is shown graphically below as the area above the producer supply curve it receives at the price point (P (i)), forming a triangular area on the graph. The producer’s sales income from the sale of units Q (i) of the product is represented by the area of the rectangle formed by the axes and the red lines, and is equal to the product of Q (i) multiplied by the price of each unit, P (i).
Since the supply curve represents the marginal cost of production of each unit of the good, the total cost of the producer for the production of Q (i) units of the good is the sum of the marginal cost of each unit from 0 to Q ( i) and is represented by the area of the triangle under the supply curve from 0 to Q (i). Subtracting the total cost of the producer (the triangle under the supply curve) from their total income (the rectangle) shows the total advantage of the producer (or producer surplus) as the area of the triangle between P (i) and the supply curve.
Total revenue – total cost = producer surplus.
The size of the producer surplus and its triangular representation on the graph increases as the market price of the good increases and decreases as the market price of the good decreases.
Producers would not sell products if they could not at least get the marginal cost of producing those products. The supply curve illustrated in the graph above represents the marginal cost curve for the producer.
From an economic point of view, marginal cost includes opportunity cost. In essence, an opportunity cost is a cost of not doing something different, such as producing a separate item. The producer surplus is the difference between the price received for a product and the marginal cost of its production.
Because the marginal cost is low for the first units of the good produced, the producer derives the most profit from the production of these units to sell them at market prices. Each additional unit is more expensive to produce because more and more resources have to be withdrawn from alternative uses, so that the marginal cost increases and the producer net surplus for each additional unit becomes smaller and smaller.
Consumer surplus and producer surplus
A producer surplus combined with a consumer surplus is equal to the overall economic surplus or the benefit provided by producers and consumers interacting on a free market, as opposed to price or quota controls. If a producer could properly discriminate prices, or charge each consumer the maximum price they are willing to pay, then the producer could capture all of the economic surplus. In other words, the producer surplus would be equivalent to the overall economic surplus.
However, the existence of a producer surplus does not mean that there is no consumption surplus. The idea behind a free market that fixes the price of a good is that consumers and producers can benefit from it, the consumer surplus and the producer surplus generating higher overall economic well-being. Market prices can change considerably due to consumers, producers, a combination of the two or other external forces. As a result, producer profit and surplus can change significantly due to market prices.