Deadweight Loss & Government Intervention
Economics: IB Diploma, topic 1.3.4
Inefficiency of Price Floors and Price Ceilings
The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome.
Effects of price ceilings and floors
- The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome.
- This is reflected in the existence of a 'deadweight loss', which is defined as the loss in social surplus that occurs when a market produces an inefficient quantity.
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Price ceiling example (1 of 3)
Price ceiling example (2 of 3)
- Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy is left to the market, the equilibrium price will be $600 per month and 20,000 people will use the drug, as shown in this diagram.
- The original level of consumer surplus is T + U and producer surplus is V + W + X.
- However, the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000.
Price ceiling example (3 of 3)
- This price ceiling causes an inefficient outcome.
- 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.
- The deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher, in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.
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Price floor example (1 of 2)
- This shows a price floor example using a string of struggling movie theaters, all in the same city.
Price floor example (2 of 2)
- The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is G + H + J, and producer surplus is I + K.
- The city government is worried that movie theaters will go out of business, 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 G, and the new producer surplus is H + I. In effect, the price floor causes the area H to be transferred from consumer to producer surplus, but also causes a deadweight loss of J + K.
Test yourself on Deadweight Loss & Government Intervention
In this diagram, which area shows the deadweight loss created by the price ceiling?
In this diagram, which area shows the deadweight loss created by the price floor?