What is Producer Surplus and How is it Measured

At point J, consumers were willing to pay $90, but they were able to purchase tablets at the equilibrium price of $80, so they gained $10 of extra value on each tablet. This is exactly analogous to the “profit” Bill earned from buying apples that we described in the previous page of reading. If we add up the gains at every quantity, we can measure the consumer surplus as the area under the demand curve up to the equilibrium quantity and above the equilibrium price. We usually think of demand curves as showing what quantity of some product consumers will buy at any price, but a demand curve can also be read the other way. If we choose a quantity of output, the demand curve shows the maximum price consumers would be willing to pay for that quantity.

This means new entrants can break a monopoly by selling below market price and still make a profit. Producer surplus directly measures a company’s profit based on the difference between production cost and market price. It is not always necessary for every company to earn a surplus; if the market is at equilibrium, it is a healthy condition for both the consumer and the producer. The producer surplus definition is crucial for studying producers’ what is producer surplus contribution to the economy.

What Is Total Surplus?

The market is efficient and both consumer and producer surplus are maximized at the equilibrium point of $5. The familiar demand and supply diagram holds within it the concept of allocative efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another.

The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry, and an indicator of the amount of competition among them. The HHI is calculated by summing the squares of the percentage market shares of all participants in the market. The HHI for perfect competition is zero; for a monopoly, it is 10,000. But, if consumer acceptance has been negative at the same manufacturing cost of $4, it can be sold only at $3.

Impact of Changing Price on Producer Surplus

If no individual participant in the market has significant market power, then anti-competitive behavior can take place only through collusion, or the exercise of a group of participants’ collective market power. Sometimes, to remedy this imbalance, the government will step in and implement a price floor or set a minimum price for which a good must be sold. This often results in higher prices than consumers have been paying, thus benefiting the businesses. Say that there are 20 companies that make widgets, each producing them at slightly different costs. In the market, there is an equilibrium point where the amount of widgets supplied meets demand at $3.00.

The consumer surplus area is highlighted above the equilibrium price line. The market price is $25 with quantity supplied at 20 units (what the producer actually ends up producing), while $5 is the minimum price the producer is willing to accept for a single unit. Changes in the price level, the demand and supply curves, and price elasticity all influence the total amount of producer surplus, other things held constant. A surplus occurs when there is some sort of disconnect between supply and demand for a product, or when some people are willing to pay more for a product than others. Hypothetically speaking, if there were a set price for a certain popular toy that everyone was unanimously expected and willing to pay, neither a surplus nor a shortage would occur.

Because it is essentially the same across all producers, coffee is a good example of a product for our purposes. However, depending on where it is sold, the price of a cup of coffee can vary widely. The difference between the lowest available price for a cup of coffee and the highest price is the producer surplus.

When supply and demand curves are drawn on a graph, demand is a downward slope, and an upward curve represents supply. Quantity is depicted on the x-axis, and the price is depicted on the y-axis. Producer surplus aggregates all producer profits generated by selling a particular product at market price. It is the difference between the price offered by the market and the price at which the producer is willing to sell.

This imbalance means that the product cannot efficiently flow through the market. Fortunately, the cycle of surplus and shortage has a way of balancing itself out. Referring to a graph like the one shown above, the formula for calculating producer surplus is 1/2 the length of the base multiplied by height. When supply is perfectly elastic, it is depicted as a horizontal line.

1. Hypothetically speaking, if there were a set price for a certain popular toy that everyone was unanimously expected and willing to pay, neither a surplus nor a shortage would occur.
2. Decreases in the supply curve will cause decreases in producer surplus.
3. The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest).
4. We can formalize this idea of how good a deal consumers get on a transaction using the concept of consumer surplus.
5. The market is efficient and both consumer and producer surplus are maximized at the equilibrium point of $5.
6. The supply curve as depicted in the graph above represents the marginal cost curve for the producer.

Market Power

For example, a manufacturer who over-projects future demand for a given product may create too many unsold units, which may consequently contribute to quarterly or annual financial losses. A surplus of perishable commodities like grains could cause a permanent loss, as inventory spoils and the items become unsellable. Total economic surplus is equal to the producer surplus plus the consumer surplus. Put simply, the producer surplus is the difference between the price that companies are willing to sell products for and the prices that they actually get for them. A producer is willing to sell 500 toys at $5 each, and consumers are willing to purchase these toys for $7 each. If the producer sells all of the toys to consumers for $7, he receives $3500.

Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others. When the price for the good on the market increases, the producer surplus also increases. When the price of the good on the market decreases, the producer surplus likewise decreases. Producer surplus is affected by changes in price, the demand and supply curve, and the price elasticity of supply. A monopoly, a price maker with market power, can raise prices and retain customers because the monopoly has no competitors. If a customer has no other place to go to obtain the goods or services, they either pay the increased price or do without.

Producer Surplus vs Consumer Surplus

To find the resulting total producer surplus, all of the rectangles for the individual price levels are added together, and the total area is the total producer surplus. Below, the total producer surplus is made of all three pink rectangles – the surpluses at price levels of \(P_1\), \(P_2\), and \(P_3\) – added together. The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. However, being a large firm does not necessarily equal market power. For example, while conglomerates may be very large, they may play only small roles in many different markets and have no ability to influence prices in any of them.

Economic Surplus

However, that doesn’t mean that those customers will end up paying $90. Figure 1 shows that the equilibrium price is $80 and the equilibrium quantity is 28 million tablets. At that price, each customer who would have been willing to pay $90 for a tablet is getting a good deal. We all know what a good deal is—it’s when you get something for less than you think it’s worth.