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Learn how markets fail to realize all gains from trade and create deadweight loss due to monopoly, taxes, subsidies, and other distortions. See how elasticities affect the tax burden and the deadweight loss.
- Overview
- Key Points
- Introduction
- Consumer surplus, producer surplus, and social surplus
- Price floors and price ceilings are inefficient
- Summary
- Self-check questions
- Review questions
- Critical thinking questions
- GeneratedCaptionsTabForHeroSec
Read about consumer surplus, producer surplus, and deadweight loss.
•Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
•If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
•Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
•Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
•Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
•Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.
Did you know that demand and supply diagrams can help us understand more than supply and demand curves and equilibrium? They can also help us understand economic efficiency!
Efficiency is one of those words you might hear in day-to-day conversation, but it means something a little different to economists. In economics, efficiency means it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.
The idea of economic efficiency and inefficiency can feel a little abstract. Let's dig deeper into some case studies to understand these concepts better.
Consider a market for tablet computers. The equilibrium price is $80 and the equilibrium quantity is 28 million—shown in the demand and supply diagram below. The segment of the demand curve above the equilibrium point and to the left represents the benefit to consumers. It shows that at least some demanders would have been willing to pay more than $80 for a tablet.
For example, point J shows that if the price were $90, 20 million tablets would have been sold. Consumers who would have been willing to pay $90 for a tablet but who were able to pay the equilibrium price of $80 clearly received a benefit—they received the same utility they were willing to pay $90 for at a reduced price.
Remember, the demand curve traces consumers’ willingness to pay for different quantities. The amount that individuals would have been willing to pay minus the amount that they actually paid, is called consumer surplus. We can understand this concept graphically as well; consumer surplus is represented by the area labeled F in the diagram below—the area above the market price and below the demand curve.
The supply curve shows the quantity that firms are willing to supply at each price. For example, point K in the diagram above illustrates that if tablet computers cost $45, firms still would have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at $45 but who were instead able to charge the equilibrium price of $80 received an extra benefit beyond what they required to supply the product.
The amount that a seller is paid for a good minus the seller’s actual cost is called producer surplus. Graphically, this surplus is represented by the area labeled G in the diagram above—the area between the market price and the segment of the supply curve below the equilibrium.
So, if equilibrium is economically efficient, under what circumstances can we find economic inefficiency? A price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, thus creating an inefficient outcome. But there's an additional twist! In addition to creating inefficiency, price floors and ceilings also transfer some consumer surplus to producers or some producer surplus to consumers.
Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy were left to the market, the equilibrium price would be $600 per month and 20,000 people would use the drug, as you can see in our demand and supply model A, on the left below. In this situation, the level of consumer surplus would be T+U and producer surplus would be V+W+X .
Now, let's imagine that the government imposes a price ceiling of $400 to make the drug more affordable. We know based on model A below that at this price ceiling, firms in the market would only produce 15,000. As a result, two changes would occur.
First, we would get an inefficient outcome and the total social surplus would be reduced. 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. In model A below, the deadweight loss is the area U+W . When deadweight loss exists, it is possible for both consumer and producer surplus to be higher than they currently are, in this case because a price control is blocking some suppliers and demanders from transactions they would both be willing to make.
A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T+V , while the new producer surplus is X . In other words, the price ceiling transfers the area of surplus—V —from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.
Now let's look at how price floors affect efficiency. Demand and supply model B, on the right above, represents a string of struggling movie theaters, all in the same city. 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 .
•Economic efficiency is the idea that it is impossible to improve the situation of one party without imposing a cost on another.
•If a situation is economically inefficient, it becomes possible to benefit at least one party without imposing costs on others.
•Consumer surplus is the gap between the price that consumers are willing to pay—based on their preferences—and the market equilibrium price.
•Producer surplus is the gap between the price for which producers are willing to sell a product—based on their costs—and the market equilibrium price.
•Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price.
•Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.
Does a price ceiling increase or decrease the number of transactions in a market? Why? What about a price floor?
[See solution.]
If a price floor benefits producers, why does a price floor reduce social surplus?
[Show solution.]
•What is consumer surplus? How is it illustrated on a demand and supply diagram?
•What is producer surplus? How is it illustrated on a demand and supply diagram?
•What is total surplus? How is it illustrated on a demand and supply diagram?
•What is the relationship between total surplus and economic efficiency?
•What term would an economist use to describe what happens when a shopper gets a “good deal” on a product?
•Explain why voluntary transactions improve social surplus.
•Why would a free market never operate at a quantity greater than the equilibrium quantity? Hint: What would be required for a transaction to occur at that quantity?
[Attribution]
Learn how to measure economic efficiency using consumer surplus, producer surplus, and social surplus. Find out how price floors and ceilings create inefficiency and deadweight loss in the market.
Written by CFI Team. What is Deadweight Loss? Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved. In other words, it is the cost born by society due to market inefficiency. Video Explanation of Deadweight Loss.
When the total output is less than socially optimal, there is a deadweight loss, which is indicated by the red area in Figure 31.2.8 "Deadweight Loss". Deadweight loss arises in other situations, such as when there are quantity or price restrictions. It also arises when taxes or subsidies are imposed in a market.
In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit (to society) does not equal marginal cost (to society) – in other words, there are either goods being produced despite the cost of doing so being larger than the benefit, or additional goods are ...
Jul 17, 2023 · In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal. When a good or service is not Pareto optimal, the economic efficiency is not at equilibrium.
May 25, 2022 · A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. Mainly used in economics, deadweight loss can...
