What is a Producer Surplus
A producer surplus is a difference between how much of a good the producer is willing to supply versus how much he receives in the trade. The difference or surplus amount is the benefit the producer receives for selling the good in the market. A producer surplus is generated by market prices in excess of the lowest price producers would otherwise be willing to accept for their goods.
BREAKING DOWN Producer Surplus
A producer surplus is shown graphically below as the area above the producer's supply curve that it receives at the price point (P(i)), forming a triangular area on the graph. The size of the producer surplus and its triangular depiction on the graph increases as the market price for the good increases, and decreases as the market price for the good decreases.
A producer surplus combined with a consumer surplus equals overall economic surplus or the benefit provided by producers and consumers interacting in a free market as opposed to one with price controls or quotas. If a producer could price discriminate correctly, or rather charge every consumer the maximum price the consumer is willing to pay, then the producer could capture the entire economic surplus. In other words, producer surplus would equal overall economic surplus.
Example of Producer Surplus
Say a producer is willing to sell 500 widgets at $5 each and consumers are willing to purchase these widgets for $8 each. If the producer sells all of the widgets to consumers for $8, it receives $4,000. To calculate the producer surplus, subtract the amount the producer received by the minimal amount it was willing to accept, in this case, $2,500. The producer surplus is $1,500, or $4,000 - $2,500. It is not static and may increase or decrease as the market price increases or decreases.
Impact on Producer Surplus
Producers would not sell products if they could not get at least the marginal cost to produce those products. The supply curve as depicted in the graph above represents the marginal cost curve for the producer. As such, the producer surplus is the difference between the price received for a product and the marginal cost to produce it. From an economics standpoint, marginal cost includes opportunity cost. In essence, an opportunity cost is a cost of not doing something different, such as producing a separate item.
The existence of producer surplus does not mean there is an absence of a consumer surplus. The idea behind a free market that sets a price for a good is that both consumers and producers can benefit, with consumer surplus and producer surplus generating greater overall economic welfare. Market prices can change materially due to consumers, producers, a combination of the two or other outside forces. As a result, profits and producer surplus may change materially due to market prices.