2
$\begingroup$

Suppose we have 1 firm and the firm has three options:

(1) Produce and get \$100 in revenue - \$200 in costs = -\$100 in profit.

(2) Temporarily shut down and pay fixed costs = -\$50 in profit.

(3) Permanently shut down and pay nothing = \$0 in profit.

We think about "producer surplus" in terms of profit or loss (with a discrepancy for fixed costs). So if the firm picked option (3) they would lose $0. But producer surplus is supposed to be a net concept that looks at benefits versus costs. So shouldn't we consider option (2) an opportunity cost of option (3)? It is the "next best alternative". So in a way, you can say that the "producer surplus" of choosing (3) is a positive \$50. Does this make sense?

A similar thought experiment would be if we had two firms with the same options as above. Firm 1 picked option (3) and firm 2 picked option (2). What is the difference in their "producer surplus"? Is it \$50, by comparing profit or loss, or is it \$100, by comparing this "new" producer surplus? When would the latter make sense?

$\endgroup$
7
  • 1
    $\begingroup$ Your definition or understanding of producer surplus seems a little different from the conventional definition found in theory. Could you explain what do you mean by producer surplus here? $\endgroup$ – Dayne Oct 29 '20 at 18:29
  • $\begingroup$ I am thinking of producer surplus as: the benefit of what you get for doing something minus cost of producing that good. So in option (3) they have no revenues and no costs in the strict sense, but they do forego the \$50 loss which is a benefit. If our only options are (2) and (3), should that \$50 count as a surplus or benefit? Maybe I am not using the correct terms. But would it ever make sense to compare the difference between (2) and (3) for firm 1 and (3) and (2) for firm 2? What would you say the "benefit" is to being firm 1 versus firm 2? $\endgroup$ – K Carroll Oct 29 '20 at 18:36
  • $\begingroup$ Based on this definition, how is producer surplus different from profit? $\endgroup$ – Dayne Oct 29 '20 at 18:38
  • $\begingroup$ It is not, but producer surplus is profit excluding fixed costs. I guess I am asking if we want to know how well a firm relative to another firm, do we just compare their profits/surplus? Or should we compare their profits relative to their next best alternative? Would that ever make sense? $\endgroup$ – K Carroll Oct 29 '20 at 18:42
  • $\begingroup$ If we assume the objective of the firm is to maximize profit, then in comparing two firms, the one with more profit is clearly better. For measure of 'how better' we can simply take difference in profit (note that the objective of profit maximization inherently assumes risk-neutral players). While comparing profits relative to next best alternative, the question of two firms is unclear. It would be irrational for a firm to not choose the best alternative. $\endgroup$ – Dayne Oct 29 '20 at 18:59

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.