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Deadweight Loss

Deadweight Loss

Author: Kate Eskra

This lesson covers deadweight loss.

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Source: Image of Consumer and Producer Surplus Graphs before and after rent control created by Kate Eskra, Image of Consumer and Producer Surplus graphs before and after minimum wage created by Kate Eskra

Video Transcription

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Deadweight Loss. As always, my key terms are in red, and my examples are in green. In this tutorial we'll look at how consumer and producer surplus are used to see the impact of different government policies. We'll be comparing consumer and producer surplus before and then after a price ceiling and a price floor, which are called binding constraints. You'll see that when the market is at equilibrium, consumer and producer surplus are maximized. And deadweight loss results from these binding constraints.

So in most cases we know that free markets, meaning without government intervention, function wonderfully. Because producers have the profit motive to provide us with what we want at prices we are willing to pay. So usually unregulated free markets produce the best outcome. And our overall welfare is maximized. Because free markets allow for trade to occur between buyers and sellers. And when the market reaches equilibrium, both consumers and producers are better off. And there's nothing called a deadweight loss, which you'll see later in the tutorial.

Sometimes though, we know the government does need to intervene. How can we measure the impact on consumers, producers, and society as a whole? Because as you'll see throughout this tutorial, these government interventions definitely impact the overall market outcome.

So how can we measure it? We use what we call welfare analysis, where we compare consumer and producer surplus, before and after the government intervention. To see who's better off, who's worse off, and so on. So as a reminder, consumer surplus is the difference between the actual price we pay for something, and the highest amount that we would actually have been willing to pay for the good. Whereas producer surplus is the difference between actual payment for a good, and the least amount a producer would have agreed to receive for the good.

So if we look at a market in equilibrium, here we're looking at the market for apartments in New York City, let's say. I am suggesting that the equilibrium price, the price that would clear the market, would be $2,000 a month to rent. And at that price, 1,000 apartments would be rented. So you can see that consumer surplus is this green triangle here. Because all of these consumers were willing to pay a higher price than the $2,000 rent. And the producer surplus is the blue triangle, because all of these sellers or landlords were willing to rent it for cheaper than $2,000.

When the market is unregulated, this combined area of consumer and producer surplus, is the biggest it can get. So that means that consumers and producers, at least as a whole, are the best off they can be. However, because so many people may be unable to afford such high rent in the city, often the government will step and control rent in a certain area. And that's imposing a maximum price that landlords can charge.

When they do this it can be seen as a binding constraint, which is typically a regulatory constraint that does preempt market equilibrium by setting a different price level. And they can be price ceilings or price floors. I'll show you both of them. In this case, if they set a maximum price, it's a price ceiling. So let's say that they come in and they set a price ceiling at $1,200. Telling the landlords, no, no, no. You cannot charge what you wanted to at $2,000. You can't charge any higher in these apartments than $1,200 per month. That's why a price ceiling, to be effective, to be a binding constraint, must be set below equilibrium.

OK. So what is the impact of this? Well, we know that at lower prices now more people want to rent the apartments, so the quantity demanded is raised up to 2,000. But fewer landlords are willing to rent at that price. So the quantity supplied actually falls down to this 600. And that's what we can call a shortage of apartments occurring.

What's going on with consumer surplus and producer surplus is you can see that producer surplus definitely shrinks. And some of their surplus was transferred to consumers in the form of lower prices. So this area right here was transferred from the producers to the consumers. But this area here in red, we're going to talk about that.

So like I said, there was a shift from sellers to buyers. But that red area represents the trades that are no longer taking place between landlords and renters. Remember, it used to be in equilibrium here. So this amount of apartments used to be rented. There used to be buyers and sellers exchanging things there. But buyers and sellers have lost some surplus. And what we call that red triangle, where these trades are no longer taking place, is deadweight loss.

So deadweight loss is the change in total surplus, which I've shown you is the sum of producer and consumer surplus that results from the imposition of a binding constraint like a price ceiling. Now let's look at a different example. I'll take you through the example of a price floor.

Here there is no binding constraint in the labor market. So when we're talking about this, it's important to keep in mind who is the supply and who's the demand side of it. In the labor market it's a little bit different. In the labor market workers are going to be the suppliers. Because we are providing or supplying our labor. Whereas the employers are on the demand side. Because they're demanding or hiring labor.

So you can see here that in equilibrium, this is suggesting that the equilibrium wage rate would be $6 an hour. And 3 million workers would be working or hired at that wage rate. But minimum wage law prevents the market from establishing equilibrium. There's no deadweight loss at equilibrium. However, we know that this is not going to be the case. Because like I said, there's a minimum wage law. And a minimum wage law is an example of a price floor.

So the government says, no. You have to pay workers a minimum of, let's say $7.25 an hour. When we put that binding constraint on, sure more workers are willing to supply their labor. So the quantity supplied goes up. But employers are less willing to hire or demand labor now. So quantity for labor demanded falls, and that's what we call a surplus of workers.

Here you can see that the consumer surplus certainly has shrunk, and the producer surplus has gotten bigger. But again, we're going to have this deadweight loss. So there was a shift in surplus from the employers to the workers, who remember are the suppliers in this situation. But both workers and employers have lost some surplus. Who are the workers who are better off? Well, only the ones who can actually get the jobs.

You can't force employers to hire people. You can force them to pay a minimum wage. But you can't force them to hire people. So this area, this deadweight loss, represents the trades that are no longer taking place between workers and employers.

So the question then becomes impose are not impose a binding constraint. We know as we've seen here that imposing a binding constraint will transfer some surplus from one group to another. But it will also create a deadweight loss overall, due to trades that are no longer taking place between some buyers and sellers.

So often what a regulator is doing is they're really interested in looking at a targeted group of people. And they're interested in hoping that there is a large expected benefit to that targeted group of people. So if in the examples we've used here, renters in New York City who are able to get those apartments at a cheaper price would be the benefited target group of people. Or workers who were able to get jobs at a higher wage benefit from a minimum wage, or that price floor.

But since not all renters or all workers will benefit from those trades that no longer take place, and certainly we know that landlords and employers lose out, then what do we do? The key question becomes really will that targeted group benefit more than the overall loss to the group or society.

So will the transfer of surplus to the benefiting group be larger than the deadweight loss created? If that's the case or if policymakers believe that's going to be the case that this transfer of surplus to the benefiting group will be larger, then usually they will go forward with the policy. If not, then it's not a good idea, at least from an economic standpoint, to proceed with the policy. Because the deadweight loss would be greater to the overall group.

So in this tutorial we looked at how consumer and producer surplus are used to see the impact of these different government policies. We talked about how ceilings transfer surplus from producers to consumers. While floors transfer some surplus from producers to consumers. But both ceilings and floors, which are binding constraints, create a deadweight loss. And they reduce the overall sum of consumer and producer surplus. Thanks so much for listening. Have a great day.

Notes on "Deadweight Loss"


Terms to Know

Deadweight Loss

A situation, often caused by an imposed constraint, that results in either excess demand or supply occurring at the market price due to the inability of the market to adjust to market clearing price and quantity.

Consumer surplus

Determined by the difference between actual price paid for a good and the highest amount the consumer would have willingly paid for the good.

Producer surplus

The difference between actual payment for a good and the least amount a producer would have willingly agreed to receive for the good.