So, the first term we're going to define today is producer surplus, PS.

We'll use PS in future.

Producer surplus has a clumsy definition but it says,

it's the net revenue above what is needed to have that unit of production on the market.

It's the net that the firm is getting above and

beyond what it has to have to put that particular unit on the market.

So, let's think about this in our favorite way to do it on a graph.

What we're trying to come up with is a number that

tells us if there's some residual the firm is walking away with.

Then you can say well,

maybe there is since you call that residual profit.

Again, I think by the time we get done with this next picture, will have a better idea.

So, we have our typical supply function here.

Suppose we start with some arbitrary price in the market of P0.

This price of P0 will produce a market output of cap Q0.

But, let's focus on one of these interior outputs.

Imagine this particular output point here,

let's call this output point alpha.

For output alpha, we know that in fact if we had just

offered the industry this price piece of alpha,

they would've given us that unit alpha.

That's what the supply curve says.

The supply curve go back to day one.

The supply curve says how much will

producers willingly put on the market for different possible prices?

You call out different prices,

and we know that curve is upward sloping in this two-dimensional depiction.

But, what it also means is that for every point here

there is a price that we could have gotten that product for,

if we had just offered that price.

That's what the supply curve says.

If you don't believe that, then you did a bad job of constructing your supply curve.

You must believe it someplace else.

But for this particular construction of the supply curve,

which is the sum of the marginal cost curves of the players in this industry,

we could've had a society,

we could've had alpha for that little price.

Instead, they actually earn this price.

Suppose that the price in the market is say $1.50.

This price here is actually $0.65.

Well, what that means is that for this firm we've got an 85 percent premium.

Okay. It would have sold that unit alpha for 65.

That market would have sold you alpha for $0.65.

But since the market price drove it to a buck 50,

this vertical gap of $0.85 is exactly what this definition is saying.

What's the net revenue above the amount it

would take to have had that unit of production actually appear on the market?

In this case, it's $0.85.

We could have chosen a different one, how about beta?

Beta looks like costs are higher.

We know that the supply curve is the sum of the marginal costs.

We know that the law of diminishing marginal product means it's

getting increasingly expensive to produce this product,

and therefore the firm in this case,

the firms would need something like about a dollar.

If we had offered them a dollar,

they would have given us beta.

Instead, they get buck 50 so they're netting this.

We don't need to continue with this.

You can see that if you were to sum up all of these,

this would be producer surplus.

So, the definition of producer surplus on the graph is that

producer surplus is the area above supply,

that is marginal cost but below price.

The firm is getting the market price,

and from that market price subtract the marginal cost

associated with that particular unit and you have producer surplus.

Now, many times in this little video I mentioned that it's not quite profit.

You see, this gap is the difference between price and marginal cost.

Doesn't have anything to do with fixed costs,

and that's because in the short run, it doesn't matter.

We're stuck with fixed costs no matter what.

Whether you produce zero, whether you produce this,

whether you produce that, the fixed cost is the same no matter what level you produce.

Even if you lock the doors.

So, that's really irrelevant to our analysis here.

Okay. That money is already been spent.

That's what fixed cost means. It's out the door.

So, what we're doing is we're looking on the margin at the outcome that

eventually will arrive because we still haven't put these together,

to see where the sum of what

the outcome that the market arrives at are perfectly competitive equilibrium.

What's the sum of the surpluses to consumers,

and the sum of the surpluses to producers?

That's going to produce a pie,

a big steaming pie of net value.

Okay. What we want to do is to make that pie bigger and bigger and bigger.

The more efficient our market outcome,

the bigger that pie is. We're going to find out in a minute.

If you don't like the allocation,

you can go back later with a sharp knife and cut

it up and move it all over the place taxes,

and refunds, and rebates, and everything else.

But right now, we're thinking about just how does the market

work its magic in terms of rationing these products.