SAD - Deadweight Loss Lesson

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Deadweight Loss Lesson

First Theorem of Welfare Economics

When a competitive market is operating at equilibrium, it is operating in a state of Pareto efficiency. Pareto efficiency is comprised of the First Theorem of Welfare Economics. To be in a state of Pareto efficiency, three conditions must be met.

  1. The MB = MC for the last unit bought and sold.
  2. The MBs for all consumers are equal.
  3. The MCs for all producers are equal.

In a state of Pareto efficiency, it is impossible to make one person or group better off without harming another person or group.

At the competitive equilibrium, consumer and producer surplus are maximized. Therefore, the total net benefit to society is maximized. Allocative efficiency is established.

Consumer Surplus is the difference between what consumers are willing to pay for a unit of a good and what they actually paid for the good. Therefore, graphically, it can be identified as the area below the demand curve (which represents what consumers would pay for the good, or the marginal benefit) to the price line (which represents what consumers actually paid for the good) for each unit of the good up to the equilibrium (where MB = P).

It takes the shape of a triangle on the graph. That means you can use the formula for finding the area of a triangle to find the value of consumer surplus (1/2 x base x height). Using a schedule, it can be found by summing the differences of marginal benefit and price for each unit consumed. So, if MB = P at 8 units, consumer surplus would be (MB1 - P1) + (MB2 - P2), etc up to 8 units.

Image correction below: The consumer surplus is labeled △BAD when it should be labeled △BAC.

Consumer Producer Surplus Graph X-axis - Quantity Y-axis - Price (in dollars) Producing at the competitive equilibrium (point A) will maximize the sum of consumer and producer surplus. That is, total net benefit to society is maximized. It is represented by △BAC. Consumer Surplus = △BAC (8 x $3)/2 = $12 Producer Surplus = △CAD (8 x $4)/2 = $16

Producer Surplus is the difference between what producers are willing to accept for a unit of a good and the price they actually receive for the good. Therefore, graphically, it can be identified as the area above the supply curve (which represents what suppliers would accept for the good, or the marginal cost) to the price line (which represents what suppliers actually received as payment for the good) for each unit of the good up to the equilibrium point. It also takes the shape of a triangle on the graph.

Again, you can use the formula for the area of a triangle to find the value of producer surplus. Using a schedule, it can be found by summing the differences of price and marginal cost for each unit produced. So, if MC = P at 8 units, producer surplus would be (P1 - MC1) + (P2 - MC2), etc up to 8 units.

Deadweight Loss

Deadweight loss represents the loss to society of consumer and/or producer surplus that results whenever the market deviates from its point of allocative efficiency. It can be the result of price controls and taxes because these measures result in production/consumption at levels other than the competitive equilibrium. The graphs below demonstrate deadweight loss due to price controls. We will discuss deadweight loss due to taxation in a future module.

Price Floor Graph

Price Floor Graph X-axis – Quantity Y-axis – Price (in dollars) A Price Floor is established at $9.00. Too much is produced. DWL is reflected to the right of the competitive equilibrium. The supply curve reflected at the marginal cost of producing and the demand curve reflects the marginal benefit of consuming. For all quantities >5, the MC > MB and the total net benefit to society decreases. It decreases by the value of the DWL △ABC.

Price Ceiling Graph

Price Ceiling Graph X-axis – Quantity Y-axis – Price (in dollars) A Price Ceiling is set at $4.00. Too little is produced. DWL is reflected to the left of the competitive equilibrium. For quantities up through 5, MB>MC and society would like to see those quantities produced. It would increase of maximize total net benefit. Unfortunately, the maximum total net benefit can’t be obtained and is reduced by the DWL △ADE.

Because deadweight loss is a loss of net benefit to society, it can be comprised of lost consumer surplus and/or lost producer surplus. It will take the shape of a triangle and its value (using the graph) can be found by calculating the area of the triangle it represents.  

Allocative efficiency is important because resources are scarce. Society does not want too little or too much of a good produced. Therefore, minimizing deadweight loss is desirable. 

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IMAGES CREATED BY GAVS (Creative Commons License Attribution)