Source: Image of Producer Surplus Graph created by Kate Eskra
Hi, welcome to macroeconomics. This is Kate. This tutorial is on producer surplus. As always, my key terms are in red and my examples are in green.
So in this tutorial we'll define producer surplus. I'll walk you through some examples of producer surplus. And I'll show you how to recognize the area of producer surplus given a supply curve.
So I need you to keep in mind what supply is all about. And it's all about producers ability to produce something. But, also, their willingness to supply it at a given price.
So when we look at this, how much a firm is going to be willing to supply at any given price will really depend on it's costs. And there are two different kinds of costs that businesses or firms face. They have fixed costs which stay the same every single month. They're exactly the same whether they produce nothing or produce a lot. And those will be things like rent and property taxes.
But they also have variable costs. Which by its name you can tell these would be costs that vary. So the more they produce their variable costs increase. The less they produce the lower their variable costs. So these are things like wages to workers and raw materials. So you need to keep that in mind in a couple of slides when we talk about some things.
So if we look at a single farmers willingness to supply apples, you can notice that at high prices he's willing to supply more apples and at low prices it's not worth it or not profitable enough so he is willing to supply fewer apples.
If we looked at it in terms of an overall market supply this would be because at low prices not that many farmers would be able to be profitable or be able to even produce at all and hang in there at such low prices. So there's a positive relationship between price and quantity with supply and you can see that as we plotted the points. The supply curve is upward sloping.
Each of these price and quantity combinations shows a producer's willingness to produce. But the question here is, what if a farmer could charge a higher price than what he's actually willing to accept? That's the idea of producer surplus. So producer surplus is the difference between the actual market price and the least amount a producer would have agreed to receive for the good.
So my husband's been selling baseball cards on eBay and one night he told me he posted something. And he was like, yeah, I mean, I'd be willing to accept as little as $25 for this one. Well, then to his surprise he woke up the next morning and someone had offered him $40 for it. Which he never thought. He's usually pretty good at guessing what he's going to get. So in that situation he enjoyed a producer surplus of $15. That's all this really is.
OK, so when we plot that point we have that supply curve here. Let's say that the market price for apples was $1. You can see that at $1 3,000 bushels of apples will be produced. The shaded area here in red represents the total amount of producer surplus.
Let's think about it. All of these people down here we're actually willing to produce for less than $1. But the current market price is $1 so they're getting $1. So this person down here enjoys the largest producer surplus. And as we get closer and closer and closer to the actual market price the producer surplus is smaller but it still exists. All of these people up here would not be producing because they were only willing and able to supply at higher prices than the current market price.
So that area, really, what it's showing us is the total benefit received by producers who were receiving a higher price than what they were willing to accept. And sometimes we refer to the lowest price they're willing to accept-- we refer to that as the reservation price.
A lot of people confuse this sometimes with profit. Oh, it must represent the profit. And actually that's not the case. Very often firms, sometimes at least in the short run, could be losing money in this situation. If you think about the classic example, as you know, an ice cream store in the middle of the winter where it's cold. Very often those places might stay open in the winter.
Keep in mind, they have to pay their rent. They have to pay taxes every month. So if they can at least cover their variable, they're operating expenses, and their opportunity costs, so they can cover the cost of their workers and the cost of their materials, then it actually will benefit them to stay open. They're not making a profit necessarily in those months but they will, in fact, be better off staying open than just having to shut down and pay their fixed costs.
So in this case they're enjoying producer surplus but they're not necessarily profiting. Keep in mind that in the summer they'll make up plenty to make up for the fact that they're losing a little bit of money in the winter.
So this person right here, all of these people were willing to supply for less. And then we get up to that point right there that person technically enjoys zero producer surplus. And his revenue would be exactly equal to those variable and opportunity costs. If he were to produce it would be just to cover exactly what it's costing him to bring the workers in and he would only be making that much revenue. So that's why from this point up along the supply curve these people choose not to supply.
So in this tutorial we talked about how the producer surplus is just the difference between the minimum price at which producers will sell, their reservation price, and the market price. And that area of producer surplus on a graph is everything above the supply curve up to the market price.
Thank you so much for listening. Have a great day.
The difference between actual payment for a good and the least amount a producer would have willingly agreed to receive for the good.