Producer Surplus: How to Calculate It, Examples and Benefits
By Indeed Editorial Team
Published 16 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When determining the price to sell products, manufacturers use the surplus from selling at the market to evaluate the potential profitability of their business. The difference between the lowest price a business wants to sell its goods and the amount people pay for the merchandise results in benefits for the organisation. Knowing how to evaluate this surplus accurately can help companies improve their pricing strategy to leverage customer behaviour and market trends.
In this article, we define producer surplus, explain how it differs from consumer surplus, discuss how to calculate it and highlight ways to apply it for improved organisational efficiency.
What is producer surplus?
Producer surplus or producer's total benefit is the difference between the lowest price a manufacturer wants to sell an item and what people buy it for in the market. This term is an important tool for evaluating the value or benefit a company can derive from selling its products in the market. Anything above the producer's minimum price is a surplus, increasing their profit and cash flow. Demand and supply forces determine this surplus, which makes it important for companies to study market trends carefully to maximise their benefits.
For example, a producer wants to sell a good for $20. At the market, the company's salespeople sold the items for $28 per unit. The $8 difference is the producer's total benefit and represents the marginal gains from selling at the market price. Being able to calculate this value not only reveals how much your employer can gain by selling at the market price, but can also provide valuable insights to improve the effectiveness of the company's pricing strategy. It can help the company determine the ideal number of units to produce to maximise the benefits of market forces.
What's the difference between the producer's total benefit and consumer surplus?
The producer's total benefit and consumer surplus have an inverse relationship. While the former represents the difference between the market price and the producer's minimum price point, the latter is what the buyer saves on how much they want to purchase an item after deducting the market rate. Calculating the surplus benefits a producer gains from selling at the market price at different quantities of a product yields a marginal cost curve. Meanwhile, determining the price consumers are ready to pay based on the supply of different quantities of a product creates a demand curve or marginal benefit curve.
When plotting a graph of the consumer surplus, the area above every extra unit the buyer purchases is called the total consumer surplus. For the producer, the area above the supply curve for every extra unit a company sells in the market is the producer's total benefit. To get the total surplus or total welfare, add the producer and consumer surplus together. The total surplus represents the benefits everybody in the market enjoys from the transaction and it's a critical metric for assessing the market well-being. In a perfect market state, the producer and consumer surpluses achieve equilibrium.
How to calculate the producer's total benefit
Measuring the producer's total benefit can help businesses determine the markets that offer the highest benefits for their products and improve pricing mechanisms. Here are steps you can follow when calculating this metric:
1. Determine supply costs
The first step when calculating this metric is to determine your supply curve, which is the acceptable price for producing a specific quantity of goods without making a loss. To do this, calculate production costs for different unit quantities, determine operating costs and gather information about other marginal expenses. A supply curve is a graph that slopes upward from left to right. Its vertical axis represents the price per unit, while the horizontal axis represents the number of units in the market.
The price of a unit along the supply curve represents the marginal cost, and it decreases with an increase in unit cost. The primary reason for calculating the surplus is to determine whether the market price is going to cover the cost of production, which is essential for profitability and growth.
2. Evaluate demand data
Charting the demand curve is the next step. The graph typically slopes downward from left to right. The vertical axis represents the price customers pay per unit and the horizontal axis represents different numbers of units available on the market that change customers' readiness to pay. If you plot the graph correctly, you can see how supply affects the price. Lower supplies results in higher competition in the market and customers are ready to pay more for goods. Increasing supply saturates the market, reducing competition and lowering prices.
3. Get the equilibrium price
The equilibrium price is the point where the demand curve and supply curve intersect. To make your work easier, plot the two curves on the same graph. The intersection point is where the producer can sell the highest quantity of units at the maximum price possible.
4. Calculate the producer's total benefit area
To calculate the area of the producer's total benefit, draw a horizontal line from the point where the supply curve intersects with the demand curve to the leftmost axis of the chart. The producer supply is the area between the supply curve and the horizontal line. It shows the number of units a producer sold for a higher price than the minimum amount they wanted to sell them to recover production costs and avoid losses. If your supply curve has a straight line, the area usually takes the form of a triangle.
To calculate the producer's total benefit for such a graph, you can use the geometric equation for a triangle, which is 1/2 x (base x height). The height is the price of the commodity and the base is the quantity sold at the equilibrium point.
5. Calculate the area of consumer surplus
If you intend to use the previous calculation to find the total welfare, it's important to calculate the consumer surplus area. The area of consumer surplus is the part of the demand curve where the consumer bought goods at a lower price than they planned. To get this, calculate the value of the area between the horizontal line and the demand curve. The resulting shape is going to be a triangle if your demand curve is straight, so you can calculate the area with a geometric equation.
Use the formula for calculating areas for other shapes if the curve is not straight and produces something other than a triangle. Once you have the consumer surplus, add it to the producer's total benefit to get the total welfare, which is the overall benefit the market offers the producer and consumer.
Producer surplus calculation examples
Here are some examples of how to calculate this important metric:
Calculation for a single product area of surplus
Here's an example calculation for a single product area of surplus:
A doll maker starts selling its popular product at a new mall in town. After studying the market data and sales records, it adjusts its supply to achieve demand equilibrium. The point of equilibrium is 500 units at $10 per unit. Using the geometric equation for finding the area of a triangle where the base is 500 units and height is $10, the value of the producer surplus for the company is:
(10x500)/2 = 5000/2 = 2500
Calculation through total cost and total revenue
Here's an example calculation that considers total cost and total revenue:
A watch company produced 700 units of its popular chronograph timepiece with a total cost of $40,000. It sold 650 units at $100 per watch. What is the producer's total benefit? Besides using a graph, you can calculate the surplus of the producer by deducting total revenue from the total cost of production. Here, you can get total revenue by multiplying the total cost by the number of units sold, which is:
Total revenue = unit price x total units sold = $100 x 650 = $65,000
Producer's total benefit = total revenue - total cost = $65,000 - $40,000 = $20,000
What's the importance of the producer's total benefit?
The producer's total benefit is important for cutting production costs, increasing profits and pricing goods correctly in a competitive market. The insights from the calculation of this metric can help businesses estimate the amount of goods to supply and the ideal prices to charge to achieve maximum benefits from their economic activities. It's important to note that the forces of demand and supply determine what customers are ready to pay for goods.
Competition, income, preferences, demographics and several other factors can also influence the value customers place on commodities. This makes it essential for producers to evaluate the different factors that can affect demand for their goods and customers' readiness to pay. That way, they can target the perfect combination of production, supply and pricing to achieve optimal benefits from the market.
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