What Causes Deadweight Loss When Government Policies Are Enacted?

We'll start with an ordinary looking market for whatever good or service you want to think of (I choose burritos). The equilibrium in this market is (Q1, P1). We will then hit this thing with a bunch of policies and see how the move to a new post-policy equilibrium (Q2, P2) affects total surplus.

The laundry list of policy types:

1. Tax on Suppliers
2. Tax on Demanders
3. Subsidy to Suppliers
4. Subsidy to Demanders
5. Binding Maximum Quantity Restriction
6. Binding Minimum Quantity Restriction
7. Binding Price Ceiling
8. Binding Price Floor

What this policy looks like: "Suppose government imposes a tax of $3 on producers of burritos..."

What this policy does in the diagram: Suppliers shift their supply curve up by the full amount of the tax because the statutory incidence is on them.

What happens to quantity traded: It drops from Q1 to Q2.

Why we don't like this: Notice that for all of the units no longer traded between Q1 and Q2, the demand curve is above the supply curve. This means society valued these units more than it would have cost to make them. Therefore, these units should be traded to maximize surplus, but the tax prevents them from being traded by messing up suppliers' behavior.

Deadweight loss is the red triangle.

Notice that P2 is above P1 and compare to case 2.

What this policy looks like: "Suppose government imposes a tax of $3 on consumers each time they buy a burrito..."

What this policy does in the diagram: Demanders shift their demand curve down by the full amount of the tax because the statutory incidence is on them.

What happens to quantity traded: It drops from Q1 to Q2.

Why we don't like this: Notice that for all of the units no longer traded between Q1 and Q2, the demand curve is above the supply curve. This means society valued these units more than it would have cost to make them. Therefore, these units should be traded to maximize surplus, but the tax prevents them from being traded by messing up consumers' behavior.

Deadweight loss is the red triangle.

Notice that P2 is below P1 and then compare to case 1.

What this policy looks like: "Suppose government gives a $2 subsidy to producers of burritos for each burrito they make..."

What this policy does in the diagram: Suppliers shift their supply curve down by the full amount of the subsidy because the statutory incidence is on them.

What happens to quantity traded: It rises from Q1 to Q2.

Why we don't like this: Notice that for all of the extra units now traded between Q1 and Q2, the demand curve is below the original "true" supply curve. This means society valued these units less than it costs to make them. Therefore, these units should not be traded to maximize surplus, but the subsidy causes them to be traded by messing up suppliers' behavior (but not their actual costs, which is that the original "true" supply curve represents).

Deadweight loss is the red triangle.

If you do not understand why I am using S and not S2 to get social cost, see the discussion in my solutions to Problem Set 3a for problem 3.

Notice that P2 is below P1 and then compare to case 4.

What this policy looks like: "Suppose government gives a $2 subsidy to consumers of burritos for each burrito they buy..."

What this policy does in the diagram: Demanders shift their demand curve up by the full amount of the subsidy because the statutory incidence is on them.

What happens to quantity traded: It rises from Q1 to Q2.

Why we don't like this: Notice that for all of the extra units now traded between Q1 and Q2, the original "true" demand curve is below the supply curve. This means society valued these units less than it costs to make them. Therefore, these units should not be traded to maximize surplus, but the subsidy causes them to be traded by messing up demanders' behavior (but not their actual happiness from eating the burritos, which is what the original "true" demand represents).

Deadweight loss is the red triangle.

If you do not understand why I am using D and not D2 to get social benefit, see the discussion in my solutions to Problem Set 3a for problem 3.

Notice that P2 is above P1 and compare to case 3.

What this policy looks like: "Suppose government prohibits the sale of more than 25 burritos..."

What this policy does in the diagram: The purple line is the maximum quantity that suppliers are allowed to sell. Since they would like to sell more than this but are prohibited from doing so, they will do the best they can and sell all the way up to the restriction.

What happens to quantity traded: It falls from Q1 to Q2.

Why we don't like this: Notice that for all of the units no longer traded between Q1 and Q2, the demand curve is above the supply curve. This means society valued these units more than it costs to make them. Therefore, these units should be traded to maximize surplus, but the restriction prevents them from being traded.

Deadweight loss is the red triangle.

Notice that P2 is above P1 and compare to case 6.

What this policy looks like: "Suppose government requires the sale of at least 400 burritos..."

What this policy does in the diagram: The purple line is the minimum quantity that suppliers are allowed to sell. Since they would like to sell less than this but are prohibited from doing so, they will do the best they can and sell exactly the minimum allowed.

What happens to quantity traded: It rises from Q1 to Q2.

Why we don't like this: Notice that for all of the extra units now traded between Q1 and Q2, the demand curve is below the supply curve. This means society valued these units less than it costs to make them. Therefore, these units should not be traded to maximize surplus, but the restriction causes them to be traded.

Deadweight loss is the red triangle.

Notice that P2 is below P1 and compare to case 5.

What this policy looks like: "Suppose government prohibits price of burritos from going above $4..."

What this policy does in the diagram: The purple line shows the maximum price that suppliers are allowed to sell burritos for. At this quantity, they are only willing to sell Q2. Lots of people want to buy burritos, but hardly any suppliers are willing to sell burritos to them. Had we left everyone alone, suppliers would have sold the higher quantity Q1 at the higher price P1.

What happens to quantity traded: It falls from Q1 to Q2.

Why we don't like this: Notice that for all of the units no longer traded between Q1 and Q2, the demand curve is above the supply curve. This means society valued these units more than it costs to make them. Therefore, these units should be traded to maximize surplus, but the price ceiling prevents them from being traded.

Deadweight loss is the red triangle.

Notice that reduced quantity supplied is controlling here, and compare to case 8.

Rent Controls are an example of price ceilings.

What this policy looks like: "Suppose government prohibits price of burritos from going below $10..."

What this policy does in the diagram: The purple line shows the minimum price that suppliers are allowed to sell burritos for. At this quantity, they would like to sell a lot of burritos but there are no longer as many people who want to buy burritos. The demanders cut back how much they are willing to buy, and suppliers must be content to just sell Q2. Had we left everyone alone, suppliers would have sold a higher quantity Q1 for a lower price P1.

What happens to quantity traded: It falls from Q1 to Q2.

Why we don't like this: Notice that for all of the units no longer traded between Q1 and Q2, the demand curve is above the supply curve. This means society valued these units more than it costs to make them. Therefore, these units should be traded to maximize surplus, but the price ceiling prevents them from being traded.

Deadweight loss is the red triangle.

Notice that reduced quantity demanded is controlling here, and compare to case 7.

Minimum Wage is an example of a price floor.