Producer Surplus

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.

To calculate producer supply, marginal cost is subtracted from the company's total revenue. Every manufacturer or service provider tries to maximize the manufacturer surplus by maximizing sales and higher prices. But beyond a point, inflated prices reduce market demand.

• Producer surplus is the difference between the price a company is willing to sell and the actual price a consumer pays.
• The supply and demand curve intersect at a point known as economic equilibrium. At equilibrium, both consumer surplus and manufacturer surplus are equal.
• When the market price increases, it works in favor of the producer. In contrast, when demand plummets, the price also declines in favor of the consumer; this is known as the consumer surplus.

In a business transaction, producers often make a hefty profit. But this is at the cost of the consumer, who ends up paying extra. If producers benefit more, the transaction is called a producer surplus.

Obviously, all manufacturers want a surplus in their favor, but in free markets, this is balanced by a consumer surplus. Consumers enjoy lucrative bargains when supply is high and demand is low.

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' contribution to the economy.

There can be multiple companies operating in the same industry. Competition regulates the market price of a particular commodity in competitive markets. However, in a monopoly, producer surplus is the maximum. In a monopoly, a single company becomes the price leader, or a few market leaders set the price. Consumers have no substitutes. Again, whenever producers enjoy huge profit margins, it is at the cost of the consumers.

The producer surplus definition highlights how producers are willing to accept a lower price, but market conditions favor them—resulting in high profits. Low product supply and high commodity demand are common causes of manufacturers' surplus. This means new entrants can break a monopoly by selling below market price and still make a profit.

Now let us look at the producer surplus formula.

Producer surplus = Market price - Producer's Minimum Acceptable Price.

Alternatively, it is also calculated as follows:

Producer surplus = Total Revenue - Production Cost.

The surplus equation is as follows:

Producer surplus = ½ x Q1 x (P1 -P2)

Here,

• Q1 = quantity.
• P1 = price. 
• P2 = producer's minimum acceptable price.

Let us assume that Rachel manufactures handmade jewelry. The production cost is approximately $4 per ornament. Therefore, she decides to sell her product for $9. The market for handmade jewelry rose exponentially, and demand was huge. So now, the market price has risen to $18

Based on the given values, let us calculate producer surplus:

Producer surplus = Market price - Producer's Minimum Acceptable Price.

                               =   $18 - $4

                               = $14

Now, if Rachel sold 900 ornaments in a single year, then she earned:

Surplus = 900 x $14  

Surplus = $12600

Rachel earned a manufacturer’s surplus of $12600.

Now, let us look at another producer surplus example to understand surplus fully.

Jonathan owns a small company of cable wires. He manufactures a single cable wire for $4 and is willing to sell it for the same price in the market. Consumers are willing to pay the general market price of $9. 

In this scenario, Jonathan's manufacturer surplus is as follows.

Surplus = $9 - $4 

Surplus = $5 

But, if consumer acceptance has been negative at the same manufacturing cost of $4, it can be sold only at $3. In such a predicament, Johnathan would incur losses. Also, the scenario would be considered a consumer surplus.

Therefore, the manufacturer's surplus equals the difference between the price companies are willing to sell at and the price the consumers are willing to pay. In the long run, companies try to reduce production costs by adopting cost-cutting measures.

The following representation is a producer surplus graph.

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.

The point where both curves intersect is referred to as the equilibrium. Joining this point with the x-axis and y-axis creates three triangle areas. The equilibrium point denotes the difference between consumer and producer surplus.

In the graph, the area above the equilibrium is referred to as the consumer surplus, and the area below the equilibrium is the manufacturer’s surplus. The third triangle resides on the right side of the surplus: opportunity cost. In this context, opportunity cost refers to the loss arising from not creating a product.

It is called an economic surplus when consumer and producer surplus values are aggregated. The economic surplus reflects the financial health of a particular market.

• Manufacturer surplus is the highest price a producer receives for its product in the market. In contrast, consumer surplus is the lowest price a producer is willing to accept.
• Manufacturer’s surplus benefits the manufacturer or service provider. In contrast, the consumer surplus benefits the customer.
• If the market price is higher than the production cost, it is called a manufacturer surplus. Whereas if a consumer receives a product below the market price, it is considered a consumer surplus. But in real-world scenarios, consumers and producers are impacted by the actual profit margin.

This has been a guide to what is Producer Surplus and its definition. We explain Producer Surplus and consumer Surplus, their formula, example, graph, and how to calculate. You can learn more about it from the following articles -

• Demand and Supply Analysis
• Overheated Economy
• Supply Curve