Unit 1 Micro: Revision on Producer Surplus

Here is a planned answer to an exam question on producer surplus

“The demand for cider falls. Using a diagram, explain what happens to producer surplus.”

This is an explanation question so no evaluation is needed

Clear reasoning, accurate diagrams, precise definitions are key to a good answer here

Planned answer

Definition: Producer surplus is a measure of producer welfare. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive.

The level of producer surplus is shown by the area above the supply curve and below the market price.

In the diagram above the area of producer surplus is marked by the labels ABC. The market price is C and the minimum price that the producer is willing and able to supply the cider is at price B.

If the market demand for cider falls, this will bring about an inward shift of demand from D1 to D2 and ceteris paribus will cause the equilibrium price and quantity traded to fall. The new market price is E and the quantity bought and sold is G.

The effect is that producer surplus has fallen. This is because the difference between the price paid and the price that a producer is prepared to accept has decreased. The new area of producer surplus is shown by BEF. A fall in demand hits the revenues and profit margins of cider producers and returns the returns from operating in the market.

This assumes that other conditions of demand and supply have remained unchanged.