3.10. Producer Surplus—Revenue minus Variable Cost

#cfa #cfa-level-1 #economics #microeconomics #reading-13-demand-and-supply-analysis-introduction #study-session-4

In this section, we discuss a concept analogous to consumer surplus called producer surplus. It is the difference between the total revenue sellers receive from selling a given amount of a good, on the one hand, and the total variable cost of producing that amount, on the other hand. Variable costs are those costs that change when the level of output changes. Total revenue is simply the total quantity sold multiplied by the price per unit.

The total variable cost (variable cost per unit times units produced) is measured by the area beneath the supply curve, and it is a little more complicated to understand. Recall that the supply curve represents the lowest price that sellers would be willing to accept for each additional unit of a good. In general, that amount is the cost of producing that next unit, called marginal cost. Clearly, a seller would never intend to sell a unit of a good for a price lower than its marginal cost, because she would lose money on that unit. Alternatively, a producer should be willing to sell that unit for a price that is higher than its marginal cost because it would contribute something toward fixed cost and profit, and obviously the higher the price the better for the seller. Hence, we can interpret the marginal cost curve as the lowest price sellers would accept for each quantity, which basically means the marginal cost curve is the supply curve of any competitive seller. The market supply curve is simply the aggregation of all sellers’ individual supply curves, as we showed in section 3.5.

Marginal cost curves are likely to have positive slopes. (It is the logical result of the law of diminishing marginal product, which will be discussed in a later reading.) In Exhibit 13, we see such a supply curve. Because its height is the marginal cost of each additional unit, the total variable cost of Q1 units is measured as the area beneath the supply curve, up to and including that Qth1 unit, or the area of the vertically crosshatched trapezoid. But each unit is being sold at the same price P1, so total revenue to sellers is the rectangle whose height is P1 and base is total quantity Q1. Because sellers would have been willing to accept the amount of money represented by the trapezoid, but they actually received the larger area of the rectangle, we say they received producer surplus equal to the area of the shaded triangle. So sellers also got a “bargain” because they received a higher price than they would have been willing to accept for each unit.

Exhibit 13. Producer Surplus


Calculating the Amount of Producer Surplus

A market supply function is given by the equation Qs = −15 + P. Determine the value of producer surplus if price were equal to 65.


First, insert 65 into the supply function to find quantity supplied at that price: Qs = –15 + (65) = 50. Then, to make drawing the supply curve easier, invert the supply function by solving for P in terms of Q: P = 15 + Q. Note that the price intercept is 15, and the quantity intercept is −15. Draw the supply curve:

Find the area of the triangle below the price, above the supply curve, up to a quantity of 50: Area = 1/2 Base × Height = (1/2)(50)(50) = 1,250.


Do you want to join discussion? Click here to log in or create user.