Producer Surplus
In Consumer Surplus, it was explained how most consumers enjoy a surplus of benefits that exceeds the purchase price, which is called consumer surplus, equal to the price that they are willing to pay minus the price 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 exceeding 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 does not exceed 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, equal to the 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 = the selling price, then there is no producer surplus, so the seller is considered a marginal seller, indifferent to continuing to produce the product or doing something else. If the market price dropped, the marginal seller 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 a 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 = the area bounded by the selling price and the supply curve of the 3 carpenters.
Because all sellers have some economic costs, no seller will sell for less than this, so the minimum cost of any product will equal the economic 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 exceeds 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, which is set by competition. So the producer surplus = the area under the market price above the supply curve.
How Does Producer Surplus Differ from Economic Rent?
When a supplier starts earning more than a normal profit, then that supplier is earning an economic profit, which is higher than the profit required to keep the supplier in the market. This excess profit is known as economic rent, and usually arises when competition is imperfect, such as in the formation of a monopoly or oligopoly.