Producer Surplus

In Consumer Surplus, it was explained how most consumers enjoy a surplus of benefits that is above the purchase price, which is called consumer surplus, equal to the price that they are willing to pay minus the price that they actually paid. Producers, likewise, also enjoy a surplus.

In a market of sellers, each will have their own cost of production. A producer is willing to produce a product if she can receive a price equal to or greater than the economic cost of producing it. Economic cost not only includes the cost of materials and labor, but also the opportunity cost of the seller's time. Hence, economic cost includes what economists call a normal profit.

Each seller has a different efficiency of producing a product. In a purely competitive market, however, producers are price takers, so they can only participate in the market if their economic cost is less than or equal to the market equilibrium price. However, because some producers are more efficient than others, they will make more than just the economic cost of their production. They will earn a producer surplus, which is equal to the actual sale price minus their economic cost of production.

Producer Surplus = Actual Sale Price – Economic Cost

No seller is willing to sell for less than his economic cost, and if a seller's economic cost is equal to the selling price, then he earns no producer surplus, so he is considered a marginal seller, because he would be indifferent as to whether he would produce his product to sell in the market or not. If the market price dropped, he would be the first to leave the market to pursue better opportunities elsewhere.

For instance, suppose you wanted to build 3 doghouses. Since you just bought the dogs, you want to get the dog houses built quickly. You hire 3 independent carpenters – John, Kelly, and Pete – to build 3 dog houses according to your specification. They decide to charge you $300 for each doghouse, for a total of $900. However, John's cost of production is actually only $100, Kelly's cost of production is $200, and Pete's cost of production is $300. Hence, John earns a producer surplus of $200, Kelly earns a producer surplus of $100, and Pete earns no producer surplus, so he is the marginal seller, because he is selling his service at his economic cost, where he is indifferent as to whether he gets the job or not. The total producer surplus of the 3 carpenters is $300, which can be seen from the graph below. As you can see from their supply curve, the producer surplus is equal to the area bounded by the selling price and the supply curve of the 3 carpenters.

Producer surplus diagrams showing how the producer surplus of the market is equal to the area under the market price and above the supply curve.

Because all sellers have some economic costs, no seller will sell for less than this, so the minimum cost of any product will be equal to the cost of the most efficient producer, so the supply curve begins with the most efficient producers, because they are the ones who can produce for the minimum price. As the market price increases, other sellers who are not as efficient will enter the market as long as the market price is greater than their economic cost of production. Note that the most efficient producers have a maximum producer surplus, while the marginal sellers have no producer surplus.

Economists use the concept of the willingness to sell that is comparable to the consumer's willingness to pay. Obviously sellers will be glad to sell their product for any price higher than their economic cost. Indeed, the higher the price, the greater their willingness to sell, but the market price is limited by what buyers are willing to pay. In fact, the producer surplus is limited by the market price. So the producer surplus is equal to the area under the market price is above the supply curve.