How a producer surplus helps the suppliers to decide the right level output to produce?

In this world full of competition and evolving entrepreneurs every now and then someone comes up with the new idea for making money. Having the idea and make it ready to use for the consumer is not the only game in the market. Most of the time entrepreneurs just try to sell the good or service in their inner circle means friends and relatives to get an idea of how much they should charge for their product. But introducing the good or service in the market is need some general understanding of the market that how many related goods present, the cost of production, the number of sellers in the market, taxes, cost of resources that will be used in the production and others things like these.

After getting the idea of how the market works the next big step is to analyze the marginal cost of producing this good or service. In this case, we are not only just going to add the cost of producing a unit like the cost of resources only but also the cost of rent, loans, interests, wages, land, capital, and other expenses as well. Moreover, we will also add the cost of making pollution and the opportunity cost of keeping the resources that will be needed to produce the goods or services from other suppliers. For example, Ayesha wants to launch her own brand of perfumes. Now the resources that she needed to make perfumes are also used in the production of other goods. To Keep these resources from other suppliers, Ayesha has to pay some extra cost this cost is the opportunity cost of keeping the resources to herself. 

 The suppliers want to get paid the maximum amounts for their goods and services. However, the minimum cost they agree to accept is the cost that would enable him to breakeven after paying his all expenses. For the market work efficiently the supply curve must represent the full cost of production. Now the next question is how the producer gets to know how much benefit would be there for him if we produce this product or services. 

Producer Surplus: 

The benefit the supplier would earn in the market is called producer surplus. Producer surplus is actually the difference between the equilibrium price and the minimum price that he or she is ready to accept which is basically equal to the production cost of the unit. 

Take the example of wheat production for which the number of suppliers is present in the market. But the minimum price that is acceptable for each supplier would be different. If we consider the five suppliers in the market as shown in the table we can see that for each supplier minimum price is different. 

ConsumerMinimum cost acceptable to suppliersEquilibrium PriceProducer Surplus
AhmedRs. 10Rs. 14Rs. 4

In this example, the market equilibrium price is Rs. 14. Ahmed earns producer surplus of Rs. 4 because the minimum acceptable for him is Rs. 10 and Ali earns the no producer surplus because the minimum price he agrees to receive is Rs. 14. The reason for the difference in the minimum price for each producer is that maybe the resources that are available to Ahmed make his production less costly like the land on which Ahmed plant his crops is more suitable for the growth of wheat than Zafar’s, but on another hand, Zafar’s land needs more care like more irrigation, better fertilizers which makes the production of wheat costly for Zafar and hence the minimum that he is agreed to accept is higher than Ahmed’s.    

Graphical Analysis: 

In the previous example, we consider only five suppliers in the market but these are not the only ones in the market, and if we combined the producer surplus or all those suppliers in the market we can get the total benefit that suppliers are getting in the market. This total producer surplus could also be represented through the graph no.1 as shown below. The triangular shaded area in the graph represents the combined surplus of all producers and can be calculated through the formula of the area of a triangle (1/2P*Q).

Graph no.1

In this graph the Rs. 14 that is the equilibrium price and any producer whose minimum price less than this would earn the producer surplus according to the difference between his minimum acceptable price and equilibrium price. But if anyone minimum price would be higher than the equilibrium price like Rs. 15 would not earn any producer surplus and his existence in the market is meaningless because if his production expenses are higher he would not be able to earn any profit. 

Equilibrium price and Producer Surplus:

From the graph below it is clear that as the equilibrium price increase the producer surplus increase and more suppliers would want to produce and as the equilibrium price decrease the producer surplus decreases and less supplier would want to produce. This illustration also helps to understand the law of supply which says as the prices increase more suppliers want to produce and as the prices decrease less number of suppliers would be in the market. 

Graph no.2

Also Read: How does consumer surplus explain why markets are efficient?