What is a Producer Surplus?

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Definition:

Producer surplus is the amount of money a producer receives from selling goods that is above the minimum amount they were willing to accept for them.

🤔 Understanding producer surplus

Producer surplus refers to the gain a seller gets from a sale - the amount of money they receive in excess of the minimum price at which they would sell the item. It’s a producer’s revenue minus their direct costs of production minus their opportunity costs, or the cost of foregoing the value another use of their resources might bring. It’s a way of considering the workings of a free market in which both producers and consumers benefit. For a transaction to be successful, the price must fall between the minimum the seller will accept, and the maximum the buyer will pay. Consequently, the seller receives more than their lowest acceptable price (producer surplus), and the buyer gets the item for less than they were willing to pay (consumer surplus).

Example

Suppose Tom has an old car he wants to sell. He would accept anything over $2,500 for it. If he can’t get at least that much, he would rather give it to his niece for her birthday than let a stranger have it that cheaply. When a buyer comes along, he ends up selling the car for $2,750. That’s $250 more than his minimum, and that $250 is his producer surplus.

Takeaway

Producer surplus is like getting a raise you didn’t ask for at work…

When you work, you agree to sell an hour of your time for a certain amount of money - your salary. Your paycheck is what you expect to get, the minimum you’re willing to accept for the work you do. Imagine that one day when you clock out and you get your paycheck, it’s $100 more than you expected, and there’s a note from your boss that says, “I’m giving you a raise because of all your hard work!” The raise means you’re getting more money than the minimum you required to show up. You’re getting paid more, and that’s similar to producer surplus.

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What is a producer surplus?

Producer surplus describes the benefit that a seller gets when they make a sale. If the seller is willing to accept no less than $100 for their product, anything above $100 is producer surplus. A seller must cover all of their direct costs of producing the item, plus their opportunity costs (the costs of foregoing the value of another way they might have used their resources), to break even. Anything above that breakeven price would be a producer surplus. The sum of producer surpluses from all sales must cover a business’s fixed costs for them to make a profit.

Why is producer surplus important?

Producer surplus is the incentive for an entrepreneur to risk their time, money, and energy in a business pursuit. Without producer surplus, there would be no reward for innovation. Capitalism and a free-market economy are based on business owners reaping benefits by bringing products to customers that want them.

What is the difference between a producer surplus and a consumer surplus?

In a voluntary trade, everyone wins; if they didn’t, they’d simply walk away and not make the deal. A trade that improves everyone's position is said to generate an economic surplus, which is shared between the seller and the buyer. The seller’s gains are called producer surplus, and the buyer’s gains are consumer surplus.

Imagine the owner of an old book wants to sell it. The owner gets some value from keeping it; maybe they’ll reread it someday. That implies there is a minimum price the owner needs to receive in order to be prompted to sell it, representing whatever amount they place on the joy of owning it. Assume that value is $5.

Now consider a potential buyer for the book. Other copies of the book are available online for $10, and the buyer is willing to pay that much for the copy the owner has. Because the buyer is willing to pay more than the minimum price the seller needs, a transaction is possible, and there are $5 in potential economic gains that can be split between them (the buyer’s maximum of $10 minus the seller’s minimum of $5).

That $5 will become consumer and producer surplus, divided between the buyer and seller depending on what price they agree on. For instance, if they agree to a $6 sales price, the buyer gets $4 of consumer surplus (the buyer’s $10 maximum minus $6), while the seller gets $1 of producer surplus (the $6 sales price minus the seller’s $5 minimum, which covers the loss of value from no longer owning the book).

What is the difference between a producer surplus and profit?

Profit is total revenues minus total costs. Conversely, producer surplus is the revenue from the sale of one item minus the marginal, direct cost of producing that item - i.e., the increase in total cost caused by that item. If a business’s only costs are marginal, direct costs, then profit and producer surplus are the same. But if there are fixed or sunk costs - costs like rent or new equipment that don’t change no matter how much or little you produce - those costs are factored into the calculation of profit, and profit is less than producer surplus.

Assume you buy a $10,000 machine that makes picture frames. You sell these picture frames for $10 each. The materials and direct labor required to make each picture frame is $6. On each sale, you earn $4 of producer surplus. But it would be wrong to say that you made $4 in profit after your first sale. In reality, you’re still $9,996 in the hole. Until you sell your 2,500th picture frame, you haven’t recovered the machine’s cost. Every sale after that point contributes to your profit.

In accounting, the cost of that machine gets spread over time or production units. Assume the expected life of the machine is 5,000 picture frames. After that, it must be replaced. In that case, you can allocate the initial cost of the machine to each picture frame it makes. To do so, you would depreciate (reduce the asset value of the machine) by $2 per picture frame, or the $10,000 cost of the machine divided by 5,000 frames. Subtracting the depreciation from the producer surplus generates net income, a measure of profit.

How is producer surplus measured?

Producer surplus is the sales price minus the minimum price a seller would accept. In business, that minimum price is the marginal cost of production, or the cost of creating or acquiring an item, including any marginal opportunity costs. A company might sell a product below that cost for specific reasons, but they would go out of business if that happened too often.

Therefore, the formula to calculate a producer's surplus is:

Producer surplus = Revenue – Marginal cost

Plotting the marginal cost of production on a graph produces a supply curve. The area under the supply curve represents the direct costs of production. The area above the supply curve represents the net benefit to the seller, or producer surplus.

Plotting the sales price on the same graph allows you to visualize where that producer surplus is, and how to measure it. The sales price and the number of units sold form a rectangle on the graph, representing total sales revenue. The supply curve bisects that rectangle to form two triangles. The triangle below the supply curve represents the marginal costs; the one above the supply curve represents the producer surplus.

As long as the supply curve is linear, with marginal costs increasing by the same amount for each unit, the math is easy. The producer surplus is the area of the upper triangle - the base times the height of the triangle, divided by 2. (The calculation for nonlinear supply curves is more complex.)

Mathematically, it is the total revenue minus the sum of marginal costs for each unit:

Total producer surplus = Total revenue – Sum of marginal costs

Imagine Sally selling seashells by the seashore for $5 each. And assume her marginal cost of acquiring these seashells increases by $0.25 for every seashell she collects. Given that supply curve, Sally should stop retrieving seashells when she gets to 20 shells, because the marginal cost would then hit $5. ($0.25 x 20 = $5.)

That means her producer surplus equals $5, the height of the upper triangle, times 20 shells, the base, divided by 2 - or $50. (See the accompanying graph.) We can also calculate producer surplus by using the formula above First, her total revenue is $5 times 20 shells, or $100.

Marginal costs are the size of the triangle below the supply curve, using the same method of height of $5 times base of 20 shells divided by 2:

Sum of marginal costs = ($5 x 20 shells) / 2 = $50

So, using the producer surplus formula.

Producer surplus = $100 revenue - $50 costs = $50

Of course, Sally should make sure there are at least 20 people willing to pay $5. To do that, she needs to understand the demand curve for her product. If there are exactly 20 people willing to pay $5, that would be considered the equilibrium price.

Is producer surplus good or bad?

A producer surplus is good for the seller. It is what encourages the seller to be in business. And, if any producer surplus exists, it implies that there is also some consumer surplus (benefit to a buyer) on the other side of the transaction.

However, the negotiations over the price of a transaction are a zero-sum game - when one person gains, the other loses. Any increase in producer surplus results in a decrease in consumer surplus. Therefore, from the buyer’s perspective, an increase in producer surplus is a bad thing. It implies a higher price, which means the buyer pays more.

How do you maximize producer surplus?

The maximum amount of producer surplus that is possible would occur if a seller could get a buyer to pay their maximum price. If so, the seller would capture all the potential gains from a transaction. A business that sells to many buyers would maximize producer surplus if it could capture the maximum price that each consumer is willing to pay, an outcome known as perfect price discrimination. In most situations, that is hard to do.

Instead, sellers in a competitive market post one price that all buyers are willing to pay. But there are some ways to charge different prices to different groups of people — which would increase producer surplus. Offering coupons or senior discounts are examples of this. Using auctions can also get different people to pay different prices.

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