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Similarly, the supply curve in a market shows the amount that firms willingly produce and supply to the market at various prices. It is assumed that for those firms actually producing the good the price is covering their costs of production plus earning them enough profit to keep them in business. Keep in mind these costs include everything that a producer must give up in order to produce a good. See the supply curve below.
At the current market price of $5, 3 million units are produced. If price falls to $1.00, the supply curve tells us that production falls to 1 million as some producers go out of business at that price. But some producers are still producing the good. These are firms that have lower costs of production. Since these producers are able to produce at a lower price, they would be earning what is known as a producer surplus at the current market price of $5. The producer surplus is the difference between the current market price and the full cost of production at each level of output. At the first one million units produced, the amount of producer surplus would be $3 million [$5million revenue = ($5 times one million: revenue for selling 1 million units @ $5/unit)] minus a cost of [$2 million (($2.00 times one million: revenue for selling 1 million units @ $2.00/unit)]. Similarly the second one million units produced would generate additional producer surplus but less than the first million as this was produced with firms with higher costs of production. See the second rectangle in the diagram below. The total value of the producer surplus received by the firms in this market iis roughly equal to the shaded area of the triangle in the diagram below.
INLINE 5 1. Using the graph just shown in the lecture notes, the producer surplus is a. $6 b. $6 million c. $7.5 million d. $11 million 2. Define producer surplus. Markets Maximize the Sum of Producer and Consumer Surplus The graph below illustrates the amount of consumer and producer surplus in the market if the quantity of the good demanded equals the quantity of the good supplied. Consumer surplus is the red shaded area and producer surplus is the blue shaded area. When supply and demand interact freely, competitive markets maximize the sum of consumer and producer surplus. The market produces what people want at the least cost that is they are efficient.
To see this more clearly, let’s consider what happens to these surpluses if production were to be reduced to 2 million for some reason. You can clearly see there would be a loss of both consumer and producer surplus. The same effect occurs if production is expanded to 4 million units: there is a loss of both consumer and producer surplus. The total loss of production from under production or from over production is referred to as a deadweight loss. This is shown as the area in the shaded triangles to the left of 2. Clearly this is a reduction in both the consumer and producer surplus.
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