Evaluating the Welfare Effects of Government Policy: CS & PS
Price
10
Consumer
Surplus
S
7
Between 0 and Q0
consumers A and B
receive a net gain from
buying the product-consumer surplus
5
Producer
Surplus
D
0
Consumer A
Q0
Consumer B
Consumer C
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
Price Ceilings and the Welfare Loss
Suppose the government
imposes a price ceiling Pmax
which is below the
market-clearing price P0.
Price
S
Deadweight Loss
The gain to consumers is
the difference between
the rectangle A and the
triangle B.
B
P0
A
C
The loss to producers is
the sum of rectangle
A and triangle C. Triangle
B and C together measure
the deadweight loss.
Pmax
D
Q1
Chapter 9
Q0
Q2
Quantity
Slide 2
Price Ceiling: Demand Is Inelastic
Price
D
If demand is sufficiently
inelastic, triangle B can
be larger than rectangle
A and the consumer
suffers a net loss from
price controls.
S
B
P0
Pmax
C
A
Q1
Chapter 9
Example
Oil price controls
and gasoline shortages
in 1979
Q2
Quantity
Slide 3
Price Controls and Natural Gas Shortages
Price
($/mcf)
D
S
The gain to consumers is
rectangle A minus triangle
B, and the loss to
producers is rectangle
A plus triangle C.
2.40
B
2.00
C
A
(Pmax)1.00
0
Chapter 9
5
10
15 18 20
25
30 Quantity (Tcf)
Slide 4
Price Floors and the Welfare Loss
When price is
regulated to be no
lower than P2 only Q3
will be demanded. The
deadweight loss is given
by triangles B and C
Price
S
P2
A
P0
B
What would the deadweight
loss be if QS = Q2?
C
D
Q3
Chapter 9
Q0
Q2
Quantity
Slide 5
Price Floor: The Minimum Wage
Firms are not allowed to
pay less than wmin. This
results in unemployment.
w
S
wmin
A
The deadweight loss
is given by
triangles B and C.
B
C
w0
Unemployment
L1
Chapter 9
L0
D
L2
L
Slide 6
Price Floors: Airline Deregulation
Prior to deregulation
price was at Pmin and
QD = Q1 and Qs = Q3.
Price
S
Area D is the cost
of unsold output.
Pmin
A
P0
B
After deregulation:
Prices fell to PO. The
change in consumer
surplus is A + B.
C
D
D
Q1 Q3 Q0
Chapter 9
Q2
Quantity
Slide 7
Agricultural Price Floors: Price Supports and
Production Quotas
Price
S
The cost to the
government is the
speckled rectangle
Ps(Q2-Q1)
Qg
Ps
A
P0
To maintain a price Ps, the
government buys quantity Qg .
The change in CS = -A – B; the
change in PS = A + B + D.
Total welfare loss is D-(Q2-Q1)ps
D
B
Total
Welfare
Loss
D + Qg
D
Q1
Chapter 9
Q0
Q2
Quantity
Slide 8
Price Floors: Supply Restrictions
•Supply restricted to Q1
•Supply shifts to S’ @ Q1
Ps is maintained with production
quota and/or financial incentive
S+ C + D
Cost to government = B
S’
Price
PS
D
A
B
P0
•CS reduced by A + B
•Change in PS = A - C
•Deadweight loss = BC
C
D
Q1
Chapter 9
Q0
Quantity
Slide 9
Import Tariff or Quota: General Case

The increase in price can be
achieved by a quota or a tariff

A = the gain to domestic
producers

The loss to consumers = A + B +
C+D

If a tariff is used the government
gains D, so the net domestic
product loss is B + C.

If a quota is used instead, D
becomes part of the profits of
foreign producers, and the net
domestic loss is B + C + D.
S
Price
P*
A
B
Pw
D
C
D
QS
Chapter 9
Q’S
Q’D
QD Quantity
Slide 10
US Sugar Quota in 1997
B and C = the DWL =
$800 m.
DUS
SUS
Price
(cents/lb.)
D = the gain to
foreign firms with
quota rights = $600m
PUS = 21.9
The cost of the quotas
to consumers was
A + B + C + D, or $2.4b.
The gain to producers
was area A, or $1b.
20
A
D
16
B
C
PW = 11
11
8
4
0
Qd = 24.2
5
QS = 4.0
10
15
Q’S = 15.6
20
25
Q’d = 21.1
30
Quantity
(billions of pounds)
Incidence of a Specific Tax
Pb is the price (including
the tax) paid by buyers.
PS is the price sellers receive,
net of the tax. The burden
of the tax is split evenly.
Price
Pb
A
D
Buyers lose A + B, and
sellers lose D + C, and
the government earns A + D
in revenue. The deadweight
loss is B + C.
B
P0
C
t
S
PS
D
Q1
Chapter 9
Q0
Quantity
Slide 12
Incidence of a Specific Tax

Conditions that must be satisfied after the tax
is in place:
1) Quantity sold and Pb must be on the
demand line: QD = QD(Pb)
2) Quantity sold and PS must be on the
supply line: QS = QS(PS)
3) QD = QS
4) Pb - PS = tax
Chapter 9
Slide 13
Impact of a Tax Depends on Es & Ed
Burden on Buyer
Burden on Seller
D
Price
Price
S
Pb
S
t
Pb
P0
P0
PS
t
D
PS
Q1 Q0
Quantity
Q1 Q 0
Quantity
Impact of a 50 Cent Gasoline Tax
Deadweight loss = $2.75 billion/yr
D
Price
($ per
1.50
gallon)
S
Lost Consumer
Surplus
Pb = 1.22
P0 = 1.00
The annual revenue
from the tax is .50(89)
or $44.5 billion. The buyer
pays 22 cents of the tax, and
the producer pays 28 cents.
A
D
t = 0.50
Lost Producer
Surplus
PS = .72
.50
11
0
Chapter 9
50 60
89 100
150
Quantity (billion
gallons per year)
Slide 15
Effect of a Subsidy
Price
S
PS
s
P0
Pb
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.
D
Q0
Chapter 9
Q1
Quantity
Slide 16
The Efficiency of a Competitive Market:
Any Market Failure?
1) Externalities: Costs or benefits that are not
reflected in the market price (e.g. pollution)
2) Lack of Information: Imperfect information
prevents consumers from making utilitymaximizing decisions.

Government intervention in these markets
can increase efficiency.

Government intervention without market
failure creates inefficiency or DWL.
Chapter 9
Slide 17