Producers' surplus and net social benefit

2.4.2 Producers' surplus and net social benefit

Figure 2.8 is a replica of the supply curve in Figure 2.6 . As stated earlier, the supply curve could be interpreted as showing the minimum prices producers are willing to accept to provide various levels of output in a market. For example, P L represents the lowest price producers require before participating in any

production activity. Similarly, P e is the minimum price the producers would accept to provide the last unit of the equilibrium output, Q e . Alternatively, as discussed earlier, the supply curve is intimately related to production costs. More specifically, the supply curve represents nothing more than the mapping of the incremental (marginal) costs of production. Thus, if we employ these two interpretations of the supply

curve, P e can be understood in the following two ways. In one sense it shows the minimum price producers are willing to accept in order to bring forth the last unit of Q e in the market. Alternatively, it represents the marginal cost of producing a given level of output. Note that these dual interpretations equally apply to all prices along the supply curve.

If the supply curve in fact represents the mapping of the incremental costs of production, in Figure 2.8 trapezoid area OP L RQ e represents the total cost of production at the output level where the long-run equilibrium is attained, Q e . This area is obtained by summing the marginal costs (or the minimum acceptable prices to producers) along the relevant output range. In a competitive market setting (where producers are price-takers and resources are freely mobile), this long-run production cost is minimized and accurately reflects the opportunity costs of the scarce resources being used in the production process.

In Figure 2.8 we have already established that area OP L RQ e represents the total cost of producing the equilibrium level of output, Q e . However, at the equilibrium level of output and price, the total producers’ receipt (revenue) is represented by area OP e RQ e . The difference between the total revenue and total production cost, triangle area P L P e R in Figure 2.8 , is producers’ surplus. What can this surplus be attributed to? There is no clear-cut answer to this question in the existing economic literature. For our purpose we consider producers’ surplus as the cumulative payments to those producers exhibiting entrepreneurial capacity which is above that of the marginal producer (the last producer to enter the market).

To provide numerical illustrations of the concepts of producers’ surplus and production cost, again let the market equilibrium price and quantity be $5 and 2,000 units, respectively. Furthermore, let P L , the minimum price acceptable to the producers, be $2. Given this information, producers’ surplus (the area of the shaded triangle in Figure 2.8 ) would be $3,000 (½× 3×2,000). Furthermore, the total receipts (revenue) of the

producers from the sale of 2,000 units would be $10,000 (5×2,000) or area OP e RQ e . Thus, the total

SCARCITY, EFFICIENCY AND MARKETS 25

Figure 2.8 Producers' surplus

production cost would be $7,000 ($10,000–$3,000), or the area of the trapezoid OP L RQ e . This total value represents either the sum of all the minimum prices that producers are willing to accept or the sum of all the marginal costs in producing the output ranging from 0 to 2,000 units.

Finally, let us go back to Figure 2.6 to tie together what we have been discussing so far concerning the long-run equilibrium condition under a competitive market setting. In Figure 2.6 we noted that area OP m RQ e represents the consumers’ total willingness to pay (private benefit) associated with the consumption of the

equilibrium level of output, Q e . As discussed earlier, under a perfectly competitive market setting this benefit is maximized. On the other hand, area OP L RQ e shows the cost of producing the equilibrium level of output, Q e . As previously discussed, this cost is minimized. Thus, area P L P m R represents the net surplus, which is composed of the consumers’ and the producers’ surpluses. From the above arguments, it should be noted that this social (consumers’ and producers’) surplus is maximized—one of the hallmarks of an ideal market system.