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Course: Microeconomics > Unit 4
Lesson 2: Market interventions and deadweight loss- Rent control and deadweight loss
- Minimum wage and price floors
- How price controls reallocate surplus
- Price ceilings and price floors
- Price and quantity controls
- The effect of government interventions on surplus
- Taxation and dead weight loss
- Example breaking down tax incidence
- Percentage tax on hamburgers
- Taxes and perfectly inelastic demand
- Taxes and perfectly elastic demand
- Economic efficiency
- Lesson Overview: Taxation and Deadweight Loss
- Tax Incidence and Deadweight Loss
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Economic efficiency
Read about consumer surplus, producer surplus, and deadweight loss.
Key Points
- Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
- If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
- Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
- Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
- Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
- Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.
Introduction
Did you know that demand and supply diagrams can help us understand more than supply and demand curves and equilibrium? They can also help us understand economic efficiency!
Efficiency is one of those words you might hear in day-to-day conversation, but it means something a little different to economists. In economics, efficiency means it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.
The meaning of efficiency can become even more specific than that, though! In the demand and supply model, efficiency means that the economy is getting as much benefit as possible from its scarce resources and all possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.
Consumer surplus, producer surplus, and social surplus
The idea of economic efficiency and inefficiency can feel a little abstract. Let's dig deeper into some case studies to understand these concepts better.
Consider a market for tablet computers. The equilibrium price is $80 and the equilibrium quantity is 28 million—shown in the demand and supply diagram below. The segment of the demand curve above the equilibrium point and to the left represents the benefit to consumers. It shows that at least some demanders would have been willing to pay more than $80 for a tablet.
For example, point
Remember, the demand curve traces consumers’ willingness to pay for different quantities. The amount that individuals would have been willing to pay minus the amount that they actually paid, is called consumer surplus. We can understand this concept graphically as well; consumer surplus is represented by the area labeled
The supply curve shows the quantity that firms are willing to supply at each price. For example, point
The amount that a seller is paid for a good minus the seller’s actual cost is called producer surplus. Graphically, this surplus is represented by the area labeled
The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus. In our diagram, social surplus is the area
Think back now to the definition of economic efficiency—it is impossible to improve the situation of one party without imposing a cost on another.
At the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus. This efficient level is the market equilibrium!
Price floors and price ceilings are inefficient
So, if equilibrium is economically efficient, under what circumstances can we find economic inefficiency? A price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, thus creating an inefficient outcome. But there's an additional twist! In addition to creating inefficiency, price floors and ceilings also transfer some consumer surplus to producers or some producer surplus to consumers.
Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy were left to the market, the equilibrium price would be $600 per month and 20,000 people would use the drug, as you can see in our demand and supply model A, on the left below. In this situation, the level of consumer surplus would be
Now, let's imagine that the government imposes a price ceiling of $400 to make the drug more affordable. We know based on model A below that at this price ceiling, firms in the market would only produce 15,000. As a result, two changes would occur.
First, we would get an inefficient outcome and the total social surplus would be reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In model A below, the deadweight loss is the area
A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is
Now let's look at how price floors affect efficiency. Demand and supply model B, on the right above, represents a string of struggling movie theaters, all in the same city. The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is
The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is
So, price ceilings transfer some producer surplus to consumers—which helps to explain why consumers often favor them. Conversely, price floors transfer some consumer surplus to producers, which explains why producers often favor them.
However, both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, creating deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, increases the economy’s social surplus.
Summary
- Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
- If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
- Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
- Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
- Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
- Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.
Self-check questions
Does a price ceiling increase or decrease the number of transactions in a market? Why? What about a price floor?
If a price floor benefits producers, why does a price floor reduce social surplus?
Review questions
- What is consumer surplus? How is it illustrated on a demand and supply diagram?
- What is producer surplus? How is it illustrated on a demand and supply diagram?
- What is total surplus? How is it illustrated on a demand and supply diagram?
- What is the relationship between total surplus and economic efficiency?
- What is deadweight loss?
Critical thinking questions
- What term would an economist use to describe what happens when a shopper gets a “good deal” on a product?
- Explain why voluntary transactions improve social surplus.
- Why would a free market never operate at a quantity greater than the equilibrium quantity? Hint: What would be required for a transaction to occur at that quantity?
Want to join the conversation?
In the discussion about the "Reduced social surplus from a price ceiling", the price ceiling transfers the area of surplus should be—
V—from producers to consumers?(9 votes)
After going deeper into the chapter, I am understanding more and more about surplus. So from the model Equilibrum is the best for the market. When I look at model how IPhone producers sell their phones... They are reducing customers surplus to minimum. In the beginning they sell phones are really high price, so they only satisfy the group of buyers that is willing to pay the most, then prices drop more and more with time, so the remaining group of the buyers gets their chance. In that case. Producers surplus is maximized and consumers minimized. Unfortunately for the consumers.... Finally they (Apple) will reach the equilibrum (or maybe go over with lower prices)... in order to maximize the quantity sold.(7 votes)
You are right over the short run, apple can enforce higher price on their products but over the long run the price will eventually shift to market equilibrium because of competition. But i assume you already know that if you kept with your studies.(6 votes)
What is a good answer for, "Explain why voluntary transactions improve social surplus."?(6 votes)
My interpretation would be that a voluntary transaction results when market price is at a point where at least one consumer is willing to pay (i.e., demands) the good and at least one consumer is willing to produce (i.e., supply) the good. Given the typical relationship between price and demand (inverse: lower price = higher demand and vice versa) and price and supply (direct: lower price = lower supply and vice versa), more voluntary transactions would indicate the market price is approaching the equilibrium price. And, given the equilibrium price is the point at which social surplus is maximized, more voluntary transactions can be thought to be improving social surplus. The graphs above may help solidify this understanding.(5 votes)
In answer to the final critical thinking question.. Perhaps in some cases a free market will operate at a quantity greater than equilibrium quantity! Perhaps a large firm is trying to establish a name for itself as the most competitive on the market so they are willing to produce more units at a higher marginal cost than the marginal benefit from consumers. This would obviously only exist in the short run, but with so much emphasis based on competitiveness, surely this must happen quite often in the real world?(5 votes)
Isn't the following statement incorrect?
"When deadweight loss exists, it is possible for both consumer and producer surplus to be higher"
"both" should be replaced with "either". Assuming there is no change to supply or demand, both consumer and producer surplus cannot be higher. When deadweight loss exists, some non-zero quantity of surplus transfers from one to the other.(2 votes)
It would be better to say the sum. The sum of consumer and producer surplus can increase when there is deadweight loss. It is possible for either to increase even when there is no deadweight loss.(2 votes)
- When the producer or consumer eats each other surplus is that bite allways smaller than the deadweight loss??(2 votes)
- No. It isn't. Producer surplus, for instance, can increase by far more than deadweight loss. Of course, that would mean that consumer surplus is decreasing by the deadweight loss + the increase in producer surplus.(2 votes)
- I'm new to economics so bare with me!
I have to write about a personal positive externality (I chose going back to earn a higher level of education)
Now the next question is "State why, in an economists perspective, this would be considered market inefficiency"
Should I change my externality topic? I'm unsure how to answer the second question and would love to hear ideas and opinions.(2 votes)
An externality is a cost or benefit that affects a third party who did not choose to incur that cost of benefit. In other words, externalities can also colloquially be called the 'side effects' of a market transaction. These side effects can be both desirable (positive externality) or undesirable (negative externality) to the third party.
In your case, you picked higher education as your positive externality which is true (you needn't change your topic) because the benefits of education are not only restricted to you and the supplier (College, school, etc.) but rather extend to the society as a whole.
Your externality is a market inefficiency because the more educated people are, the more the society benefits as a whole. However, when left to its own devices the market fails to achieve the desired level/requirement of educated people (from the standpoint of the society) which is an inefficiency because the society isn't making the best use of its scarce resources.
In general, all externalities (positive or negative) are market inefficiencies because when left alone, the market on its own may produce too much of the good (in the case of a negative externality) or may produce too little of the good (in the case of a positive externality).(2 votes)
- no deadweight means more social surplus?(2 votes)
It doesn't necessarily mean more social surplus unless consumer or producer surplus goes up. But deadweight definitely means less social surplus.(2 votes)
- I think 'X' should be 'V':
"In other words, the price ceiling transfers the area of surplus—X—from producers to consumers."(2 votes) 
"Assuming that people obey the price ceiling, the market price will be above equilibrium, which means that \text{Qd}QdQ, d will be less than \text{Qs}QsQ, s. Firms can only sell what is demanded, so the number of transactions will fall to \text{Qd}QdQ, d. To see this better, try creating a demand and supply model.
By analogous reasoning, with a price floor, the market price will be below the equilibrium price, so \text{Qd}QdQ, d will be greater than \text{Qs}QsQ, s. Since the limit on transactions in this situation is demand, the number of transactions will fall to \text{Qd}QdQ, d. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is reduced."
Isn't this backwards? A price ceiling would limit the market price to one below equilibrium, no?(2 votes)