Producer Surplus

Producer Surplus is used to measure the welfare of a group of firms who sell a particular product at a particular price. Producer surplus is defined as the difference between what producers actually receive when selling a product and the amount they would be willing to accept for a unit of the good. Firms' willingness to accept payments can be read off of a market supply curve for a product. The market supply curve shows the quantity of the good that firms would supply at each and every price that might prevail. Read the other way, the supply curve tells us the minimum price that producers would be willing to accept for any quantity demanded by the market.

A graphical representation of producer surplus can be derived by considering the following exercise. Suppose that only one unit of a good is demanded in a market. As shown in the adjoining Figure, some firm would be willing to accept the price P₁ if only one unit is produced. If two units of the good were demanded in the market then the minimum price to induce two units be supplied is P₂. A slightly higher price would induce another firm to supply an additional unit of the good. Three units of the good would be made available if the price were raised to P₃, etc.

The price that ultimately prevails in a free market is that price which equalizes market supply with market demand. That price will be P in the diagram. Now go back to the first unit demanded. Some firm would have been willing to supply one unit at the price P₁ but ultimately receives P for the unit. The difference between the two prices represents the amount of producer surplus that accrues to the firm. For the second unit of the good, some firm would have been willing to supply the unit at the price P₂ but ultimately receives P. The second unit generates a smaller amount of surplus than the first unit.

We can continue this procedure until the market demand at the price P is reached. The total producer surplus in the market is given by the sum of the areas of the rectangles. If many units of the product are sold then the one-unit width would be much smaller than shown in the diagram. Thus, total producer surplus can reasonably be measured as the area between the supply curve and the horizontal line drawn at the equilibrium market price. This is shown as the yellow triangle in the diagram. The area representing producer surplus is measured in dollars.

Producer surplus can be interpreted as the amount of revenue allocated to fixed costs and profit in the industry. This is because the market supply curve corresponds to industry marginal costs. Recall that firms choose output in a perfectly competitive market by setting price equal to marginal cost. Thus marginal cost is equal to the price P in the Figure at industry output equal to Q. Marginal cost represents the addition to cost for each additional unit of output. As such it represents additional variable cost for each additional unit of output. This implies that the area under the supply curve at an out put level, such as Q represents total variable cost (TVC) to the industry and is shown as the blue area in the diagram.

On the other hand, the market price times the quantity produced (P x Q) represents total revenue received by firms in the industry. This is represented as the sum of the blue and yellow areas in the diagram. The difference between total revenue and total variable cost, in turn, represents payments made to fixed factors of production (TFC) and any short-run profits () accruing to firms in the industry. (The yellow area in the diagram, i.e., the area between the price line and the supply curve). This area is the same as producer surplus as defined above.

Since fixed factors of production represents capital equipment that must be installed by the owners of the firms before any output can be produced, it is reasonable to use producer surplus to measure the well-being of the owners of the firms in the industry.

Changes in Producer Surplus

Suppose the demand for a good rises, represented as a rightward shift in the demand curve from D to D' in the adjoining diagram. At the original price P₁, producer surplus is given by the yellow area in the diagram. (That's the triangular area between the P₁ price and the supply curve) The increase in demand raises the market price to P₂. The new level of producer surplus is now given by the sum of the blue and yellow areas in the Figure. (That's the triangular area between the price P₂ and the supply curve) The change in producer surplus, PS, is given by the blue area in the Figure. (i.e., the area between the two prices and the supply curve) Note that the change in producer surplus is determined as the area between the price that prevails before, the price that prevails after and the supply curve. In this case producer surplus rises because the price increases and output rises. The increase in price and output raises the return to fixed costs and the profitability of firms in the industry. The increase in output also requires an increase in variable factors of production such as labor. Thus one additional benefit to firms, not measured by the increase in producer surplus, is an increase in industry employment.

International Trade Theory and Policy - Chapter 90-6B: Last Updated on 8/19/04