The concept of producer surplus is the primary element in explaining the driving incentives of entrepreneurs and business owners.
Adam smith, one of the most prominent figures in Economics, once proposed that markets based on Individuals’ self-interest would promote the general welfare of society as a whole. He believed that the self-regulating forces of the market would prevent chaos and the possibility of a total collapse. Smith’s ideas are widely discussed and have garnered various opponents and proponents.
However, everyone can agree that markets function and economic transactions happen because they generate benefits for the Individuals involved. In every scenario, some groups reap benefits, and others suffer losses. On top of this, economic transactions often result in third-party effects – when individuals not directly involved in the activity feel the costs/benefits of it.
Due to this, it is vital to know how to measure net social welfare under various market conditions. Producer surplus is a part of social welfare that accounts for the benefits producers gain from the market.
This article will help you understand the concept of producer surplus, how to calculate it, and how to visualize it with a diagram.
Producer Surplus on a diagram
Producer surplus, in a sense, tells us the added profit that a producer receives by calculating the difference between the market price and the production cost.
On a diagram, producer surplus is represented by the area above the supply curve and below the equilibrium price. As we can see in the diagram below, the market reaches an equilibrium – a point where quantity supplied equals quantity demanded and the market is in balance- at price P*. The equilibrium quantity is at point Q*.
The purple shaded triangle below the equilibrium price and above the supply curve is producer surplus. It depicts the difference between the minimum price the producers could accept, which is where the supply curve intersects the Y axis – Point P0, and the actual market price the product is being sold at aka the equilibrium price.
To put it in a nutshell, producer surplus is the benefit that producers receive by selling their products at the market price instead of the minimum price they were willing to accept. The formula for calculating it is:
Producer Surplus = Total Revenue – Marginal Cost
Marginal cost is the extra cost of producing an additional unit of output, in this case, depicted by the supply curve. A simpler and more widely used way to represent this formula is:
Producer Surplus = (Market Price – Minimum Price) x Quantity Sold
Since producer surplus takes up a triangular area on the diagram, it can also be calculated by the mathematical equation to measure the area of a right triangle.
Producer Surplus = 1/2 x Base x Height
Where the base is equal to the quantity supplied at the market price (the industry equilibrium price) and the height is the difference between the market price and the minimum price a supplier would accept. Let’s go through a few examples to grasp the theory better and see the formula in practice.
Jenny started a small business by selling hand-knitted toys. Crocheting one average-sized toy costs approximately $5, which is why she decided to sell each toy for $12. However, due to the baby boom and the resulting rise in the demand for baby gifts, the price of knitted toys unexpectedly grew to $20 for each unit. If Jenny sold 55 crocheted teddy bears, what is her producer surplus equal to?
This is a fairly simple example. The market price for knitted toys is $20, while jenny was essentially willing to accept $12. We just need to plug the numbers into the formula.
Producer Surplus = ($20 – $ 12) x 55 = 8 x 55 = 440
Quantity demanded is given by Qd = 80-5P, while quantity supplied is given by Qs = -4 + 2P. Find the equilibrium price and quantity and calculate the producer surplus.
We know that at the equilibrium demand and supply are equal. Thus, in order to solve for P (price) we need to equate Qd and Qs.
Qd = Qs
80 – 5P = -4 + 2P
84 = 7P
Equilibrium Price = $12
Find the equilibrium quantity by plugging the equilibrium price into one of the equations:
Qd = 80 – 5 x 12 = 80-60 = 20
Qs = -4 + 2 x 12 = -4 + 24 = 20
Find the minimum price a producer would accept by finding the Y intersect of the Qs equation.
-4 + 2P = 0
P = $2
Knowing the minimum price that a manufacturer is willing to sell their products gives us all the components we need to find the producer surplus, we just need to plug it into the formula.
Producer Surplus = ($12 – $2) x 20 x 1/2 = 100
Another way to solve this example would be by drawing a diagram according to the equations. We would find the equilibrium price as in the previous Step 1. Following that:
We can create Demand and Supply schedules, which we can use to draw a diagram.
|Price $||Quantity Demanded||Quantity Supplied|
Even in the schedule given above, we can see the price point where the market is in equilibrium. Based on that we can draw the diagram below (it is not accurate based on numbers and is drawn just for the example).
Producer Surplus =
While the concepts of producer surplus and profit may be similar, they are not the same. Profit looks at the aggregate picture – it considers the total revenue and costs that a firm has generated. On the other hand, producer surplus is concerned with the direct revenue and the cost incurred after selling one item. Economic profit considers all costs, while producer surplus looks only at variable costs.
Producer surplus is very important in combination with consumer surplus. Together they are used to evaluate the economic surplus. By measuring the benefits and costs that consumers and producers enjoy in the market, economists and policymakers strive to create environments that will maximize overall welfare.
Furthermore, the calculations used to determine producer surplus are useful in determining social efficiency. Social efficiency is the way of allocating the available resources in a way that will maximize the net benefits to society. However, an important aspect to keep in mind, is that while something may be optimal or efficient, does not mean it is also fair, the most justified, or even the most environmentally sustainable way.
To put it in another way, when considering social welfare, you aim to maximize the net aggregate in the market. However, these maximized benefits may not be equally distributed. They may accrue more to some specific participants, rather than everyone equally.
Additionally, if a company has a monopoly in the market, it will be able to maximize its producer surplus. This is due to the fact, that as a monopoly they have control over the market price levels. However, if this happened, consumers would suffer the cost. This is why governments usually intervene in market activities to regulate them and avoid situations where one market player is abusing their position of power. Governments’ involvement in market activities is also a widely discussed and controversial topic. There are different groups and theories with their ideas and beliefs that we will not currently get into.
Marginal cost is the incremental cost created by producing one more unit of a good. A supply curve of a company tells us how much product it is willing to supply at various price points. Most economic theories and scenarios are based on a perfectly competitive market, where firms do not have the power to set the market price. While, in reality, most markets are not perfectly competitive, the majority of the firms still do not have as much dominance to set their prices. Thus, they will sell at a point where the price equals their marginal cost to maximize profits. Meaning, the marginal cost curve is their supply curve.
This is only a snippet of the information on the topic. The explanations go more in-depth and can further be read.