Producer Surplus

Producer Surplus for Suppliers of Medicines and Health Services

Producer surplus is the money measure of the gain that selling brings to those who supply health care, whether a manufacturer of medicines, a hospital or a clinician offering extra sessions. Each unit sold earns its supplier the price less the lowest payment that would still have brought that unit onto the market, and the sum over all units is the suppliers' share of the gains from trade. Together with consumer surplus it makes up the total surplus of a market, so it enters any cost-benefit analysis or pricing policy that changes what suppliers are paid. In health economics it is discussed most often for patented medicines, where the price a payer accepts decides how the value of an innovation is split between the health system and the manufacturer. The NICE reference case leaves it out of the account altogether, which is why the line between a price as a cost to the payer and a price as a gain to the seller matters.

Marshall's surplus of the worker, the saver and the appliance

Alfred Marshall set out the idea in his Principles of Economics as the supplier's side of the surplus he had already described for buyers. A worker paid the same rate for all of his work as for the part he does most unwillingly obtains, in Marshall's words, a producer's surplus from the rest. In Appendix K he separates a worker's surplus, earned because all work is paid at the rate needed for the last part that is only just worth doing, from a saver's surplus on accumulated wealth. He also treats the extra income from rare natural gifts as a producer's surplus or rent, as distinct from the return on special training.

Marshall gave material appliances, such as plant and buildings, a third kind of surplus. In short periods they earn a quasi-rent, the excess of total money returns over direct outlay, but over long periods he found no distinction between immediate and total outlay, and earnings in general only just pay for the efforts and sacrifices needed to provide the appliance. He warned that surpluses of buyers and sellers are not independent and that it would be easy to count the same thing twice when adding them up. The first point is why fixed and sunk costs fall outside the area, and the second is why each gain is counted only once in a cost-benefit analysis.

The area between the price line and the supply curve

The supply curve of a market, read sideways, gives for each unit the lowest price at which a supplier would offer it. Producer surplus is the area between that curve and the price actually received, up to the quantity sold.

$$PS = \int_{0}^{Q} \big( P - S(q) \big)\, dq = P\,Q - \int_{0}^{Q} S(q)\, dq$$

where $PS$ is producer surplus, $P$ is the price received, $Q$ is the quantity sold, $S(q)$ is the inverse supply curve, giving the lowest price at which the $q$-th unit would be supplied, and $q$ is a variable of integration over quantity. With a straight-line supply curve that starts at a price $a$, the area is a triangle equal to $(P - a)Q/2$.

Appraisal usually needs the change in producer surplus when a price moves, which is the area to the left of the supply curve between the two prices.

$$\Delta PS = \int_{p^0}^{p^1} Q_s(s)\, ds$$

where $\Delta PS$ is the change in producer surplus, $p^0$ and $p^1$ are the prices before and after the change, $Q_s(s)$ is the quantity supplied at price $s$, and $s$ is a variable of integration over price. A rise in price makes the change positive and a fall makes it negative.

Producer surplus, profit and rent

For a single supplier the lowest acceptable price for each extra unit is its marginal cost, so summing price less marginal cost over the units sold gives revenue less variable cost. Fixed costs do not move with output and play no part in the area.

$$PS = R - VC, \qquad \pi = R - VC - F = PS - F$$

where $R$ is revenue, $VC$ is variable cost, $F$ is fixed cost and $\pi$ is profit. Producer surplus therefore exceeds profit by the fixed cost, and a supplier can earn a positive surplus while making a loss. This is Marshall's quasi-rent in modern form. In the long run every cost becomes avoidable, so a supplier stays only if the price covers its average cost.

For a patented medicine the cost of making one more pack is usually small next to its price, so most revenue counts as producer surplus. The research and development spending behind the product is sunk by the time of launch and does not enter the area, yet the surplus expected after launch is what pays for that spending. Only the part of producer surplus earned by a gift of nature, such as a rare natural ability, is a rent in Marshall's sense, while the surplus on a patented medicine is closer to his quasi-rent, a return over direct outlay that over the life of the product must repay the sunk research spending.

Producer surplus in the welfare accounts of a health programme

In a cost-benefit analysis grounded in welfare economics, the change in producer surplus is set beside the change in consumer surplus and in public revenue to give the net benefit of an option. A change in price with no change in quantity shifts surplus between buyers and sellers, and the two entries cancel in the social total. Surplus is lost only when the quantity traded moves away from the point where value at the margin equals marginal cost, and that net loss is the deadweight loss of a tax, a subsidy, market power or a price set too low.

Two choices change the total. The first is standing, meaning whose surplus is counted. A national appraisal may leave out the surplus of overseas shareholders while counting the full price paid by the domestic health system as a cost. The second is the perspective of the analysis, which decides whether any supplier gains are counted at all.

Who captures the value of a new medicine

The split of surplus between buyers and the manufacturer is central to debates on the pricing of medicines. Jena and Philipson, analysing cost-effectiveness analysis in a standard market setting, argue that a technology's cost-effectiveness is closely related to the consumer surplus it creates, so improving cost-effectiveness often clashes with policies such as patents that raise producer surplus. For an illustrative sample of technologies they infer that the median technology lets its producer appropriate about 15% of the social surplus. In an earlier working paper Philipson and Jena estimated that innovators captured only 5% of the social surplus from the HIV/AIDS therapies that entered the market from the late 1980s onwards.

Claxton and colleagues make the reverse point for the NHS. If a price is negotiated at which the ICER just equals the cost-effectiveness threshold, the health benefits of the drug are just offset by the health displaced elsewhere, all the benefits of the innovation go to the manufacturer as revenue and net health benefits to the NHS are zero. They argue that a menu of prices tied to guidance on use in subgroups can leave the NHS a share of the benefit. How such prices are derived is set out under threshold price, value-based pricing and differential pricing. The producer surplus view adds that a lower price for the same volume is a transfer, while a price that excludes patients who would gain more than the cost of supply reduces total surplus.

Where producer surplus sits in NICE appraisal

The NICE manual for technology appraisal and highly specialised technologies (PMG36) sets the reference-case perspective on costs as that of the NHS and personal social services, and asks for resources to be valued at the prices relevant to the NHS and personal social services. The price of a medicine therefore enters as a cost, and the manufacturer's gain from that price is not counted as a benefit. PMG36 asks for expected net health benefit to be presented with a QALY valued at GBP 25,000 and GBP 35,000, which measures the health system's side of the trade only. Within this framework a price cut that leaves use unchanged raises net health benefit even though, in a full welfare account, it would only shift surplus between the manufacturer and the NHS.

Worked example with a generic medicine bought by tender

All figures are illustrative. A health service buys 10 million packs a year of a generic medicine. Five manufacturers can each supply up to 2 million packs, and their lowest acceptable prices, equal to the avoidable cost per pack, are GBP 0.60 for A, 0.80 for B, 1.00 for C, 1.20 for D and 1.50 for E. The health service values each pack at GBP 4.00 in terms of the health gain it brings. Every supplier is paid the same price per pack.

1. Producer surplus at a price of GBP 1.60. All five supply. Their surpluses per pack are 1.00, 0.80, 0.60, 0.40 and 0.10, which sum to 2.90, so producer surplus is 2.90 × 2 million = GBP 5.8 million. As a check, spending is 1.60 × 10 million = GBP 16.0 million and variable cost is (0.60 + 0.80 + 1.00 + 1.20 + 1.50) × 2 million = GBP 10.2 million, and 16.0 less 10.2 is GBP 5.8 million.

2. A price cut to GBP 1.50. All five still supply. Producer surplus falls to (0.90 + 0.70 + 0.50 + 0.30 + 0) × 2 million = GBP 4.8 million, a fall of GBP 1.0 million. The health service saves 0.10 × 10 million = GBP 1.0 million. The cut is a pure transfer and total surplus stays at 4.00 × 10 million less GBP 10.2 million, or GBP 29.8 million.

3. A price cut to GBP 1.10. Suppliers D and E would lose on every pack and withdraw, so only 6 million packs are supplied. Producer surplus is (0.50 + 0.30 + 0.10) × 2 million = GBP 1.8 million. The health service gains (4.00 less 1.10) × 6 million = GBP 17.4 million, so total surplus is GBP 19.2 million. The loss against step 2 is GBP 10.6 million, which equals the surplus on the 4 million packs no longer supplied, (4.00 less 1.20) × 2 million = GBP 5.6 million for D and (4.00 less 1.50) × 2 million = GBP 5.0 million for E.

4. Fixed costs and profit. Suppose each supplier also bears a fixed cost of GBP 0.5 million a year for its licence, site and safety monitoring. At GBP 1.50, supplier E has a producer surplus of zero and a profit of minus GBP 0.5 million. Supplier D has a surplus of 0.30 × 2 million = GBP 0.6 million and a profit of GBP 0.1 million. E's average cost is 1.50 plus 0.5 million / 2 million, or GBP 1.75 a pack, so in the long run E stays only at a price of at least GBP 1.75.

5. Interpretation. The cut to GBP 1.50 looks like a gain of GBP 1.0 million to the payer and is one, but in welfare terms it only moves surplus from manufacturers. The cut to GBP 1.10 looks cheaper still, yet it destroys GBP 10.6 million of surplus because patients lose packs worth far more than they cost to make. Step 4 shows that any tender price between GBP 1.50 and GBP 1.75 would leave E a positive surplus and a loss, so E would leave the market once its fixed costs fall due.

Assumptions behind the measure

The area is a measure of suppliers' gain only under some conditions. The supply curve must reflect the true opportunity cost of the resources used, which fails when taxes or regulation distort the prices of inputs. A firm with market power has no supply curve, so its surplus is measured directly as revenue less variable cost. The analysis is partial, holding prices in other markets fixed, and gains that pass through to suppliers of inputs, such as staff or active ingredients, are counted once, at the stage where they finally rest, to avoid the double counting Marshall warned about. The time horizon matters for medicines, since a surplus earned during patent protection may fall sharply once generic versions enter.

Common misreadings in health economics

Producer surplus is often treated as profit, although it is larger by the amount of fixed cost. A higher price is sometimes reported as a social gain because supplier revenue rises, when it is a transfer unless output changes. A low share of surplus for innovators is read as proof that prices are too low, although the right share depends on how much innovation each extra unit of reward would bring. Within a cost-utility analysis with an NHS perspective, savings on the price of a medicine are counted in full while the matching loss to the manufacturer is not counted, which is a deliberate choice of perspective and not a measure of total welfare.

Sources

• Claxton K, Briggs A, Buxton MJ, Culyer AJ, McCabe C, Walker S, Sculpher MJ. Value based pricing for NHS drugs: an opportunity not to be missed? BMJ. 2008;336(7638):251-254. https://doi.org/10.1136/bmj.39434.500185.25
• Jena AB, Philipson TJ. Cost-effectiveness analysis and innovation. Journal of Health Economics. 2008;27(5):1224-1236. https://doi.org/10.1016/j.jhealeco.2008.05.010
• Marshall A. Principles of Economics. 8th ed. London: Macmillan; 1920 (first published 1890). Book IV, Chapter I; Book VI, Chapter V; Appendix K. https://archive.org/details/in.ernet.dli.2015.149776
• National Institute for Health and Care Excellence. NICE technology appraisal and highly specialised technologies guidance: the manual (PMG36). Published 31 January 2022, last updated 13 October 2026. Sections 4.2.9, 4.2.16 and 4.4.1. https://www.nice.org.uk/process/pmg36
• Philipson TJ, Jena AB. Who benefits from new medical technologies? Estimates of consumer and producer surpluses for HIV/AIDS drugs. NBER Working Paper 11810. Cambridge, MA: National Bureau of Economic Research; December 2005. https://doi.org/10.3386/w11810