Deadweight Loss: Sources and Solutions

David A. AndersonCentre CollegeChief Reader

Presenter

Presentation Notes

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Deadweight Loss

• What is it?

• How do we teach it?

• What do the AP questions on DWL look like?

Defining Deadweight Loss

“Losses associated with quantities of output that are greater than or less than the efficient level, as can result from market intervention such as taxes, or from externalities such as pollution.”

– Krugman’s Economics for AP, p. G-3

Quantity0 10 20 30

Price

5

10

15

20

25

Consumer Surplus

Producer Surplus

In the Absence of Externalities

SUPPLY = MSC

DEMAND = MSB

Quantity0 10 20 30

Price

5

10

15

20

25

Deadweight Loss of Underproduction

Deadweightloss

SUPPLY = MSC

DEMAND = MSB

Quantity of Soda0 10 20 30

PriceSUPPLY = MSC

0.50

1.00

1.50

2.00

2.50

DEMAND = MSB

Deadweight Loss Caused by a TaxSUPPLY with TAX

Per-unit Tax

Quantity of Taxi Rides0 10 20 30

PriceSUPPLY = MSC

5

10

15

20

25

DEMAND = MSB

Deadweight Loss Caused by a Quota

QUOTA Amount

Quantity of Milk0 10 20 30

PriceSUPPLY = MSC

DEMAND = MSB

Deadweight Loss Caused by a Price Floor

Price FLOOR

0.50

1.00

1.50

2.00

2.50

Quantity of Apartments0 10 20 30

PriceSUPPLY = MSC

DEMAND = MSB

Deadweight Loss Caused by a Price Ceiling

Price CEILING

500

1000

1500

2000

2500

Quantity of Vaccinations0 10 20 30

PriceSUPPLY = MSC

5

10

15

20

25

Marginal Social Benefit

Deadweight Loss Caused by a Positive Externality

DEMAND

Marginal External Benefit

Quantity

Price

5

10

15

20

25

Deadweight Loss of Overproduction

Deadweightloss

0 10 20 30

SUPPLY = MSC

DEMAND = MSB

Quantity

Price

5

10

15

20

25

The “Arrow” Points to the Socially Optimal Quantity

0 10 20 30

SUPPLY = MSC

DEMAND = MSB

Quantity0 10 20 30

Price

5

10

15

20

25

Deadweight Loss of Underproduction

SUPPLY = MSC

DEMAND = MSB

Fruit Cakes

Price

5

10

15

20

25

The Deadweight Loss of ChristmasJoel Waldfogel, American Economic Review, 1993,

vol. 83, issue 5, pp. 1328-36.

0 10 20 30

SUPPLY = MSC

DEMAND = MSB

Quantity of Gasoline

PriceSocial Marginal Cost

1

2

3

4

5

DEMAND

Deadweight Loss of Overproduction Due to an Externality

0 10 20 30

SUPPLY

Marginal External Cost

Quantity of Cola

$/unit

0 1 2 3

Quantity of Cola

$/unit

Demand(additional benefit per unit)

0 1 2 3

Quantity of Cola

$/unit

Supply(additional cost per unit)

0 1 2 3

Quantity of Cola

$/unit

Demand

Supply

0 1 2* 3

Quantity of Cola

$/unit

Supply

True Additional Cost per Unit = Marginal Social Cost

Demand

0 1* 2 3

Quantity of Cola

$/unit

Supply

Marginal Social Cost

Demand

0 1* 2 3

Quantity of Cola

$/unit

Supply

Marginal Social Cost

Demand

0 1* 2 3

Deadweightloss

Teaching Net Gains

Utility Gains from a Sack Lunch

• Time required: 10-15 minutes

• Materials: Each person needs one or more random knick-knack worth about 25 cents (lunch sack optional).

How Happy Are You?

• With what you brought?

How Happy Are You?

• With what you brought?

• After Trading with Neighbors

How Happy Are You?

• With what you brought?

• After Trading with Neighbors

• After Trading with Anyone

The Gains from Trade

• The net gains enjoyed when trade can occur,

• And the increases in those net gains when more trade can occur,

• Are the types of gains foregone asDEADWEIGHT LOSS when the amount of trade is reduced by quotas, taxes, price ceilings, and price floors.

Teaching Externalities

THE ECOMEDY CLUB

• Time required: 15-20 minutes

• Materials required: – 2 random books, identical or not– 10 knock-knock jokes

This experiment involves:

2 independent producers of human capital (memorizers) and

2 joint consumers of humor (comedians).

The comedians sit on opposite sides of the room, with the memorizers seated roughly in the middle.

How to Play

The memorizers’ goal is to memorize as many consecutive words in a randomly selected sentence as they can in 30 seconds.

• First with silence

• Then with comedy

How to Play

Knock Knock!Who’s there?Amos.Amos who?Amosquito just bit me!Knock Knock!Who’s there?Andy.Andy who?Andy bit me again!Knock Knock!Who’s there?House.House who?House it going?Knock Knock!Who’s there?Olive.Olive who?Olive You!Knock Knock!Who’s there?Sarah.Sarah who?Sarah doctor in the house?

Knock Knock!Who’s there?Boo.Boo who?Stop crying, it’s just a joke!Knock Knock!Who’s there?Goat.Goat who?Goat to the door and find out!Knock Knock!Who’s there?Leaf.Leaf who?Leaf me alone!Knock Knock!Who’s there?Justin.Justin who?Justin time for supper!Knock Knock!Who’s there?Les.Les who?Les go for a swim!

You will find that there are negative externalities from comedy!

Source

• David Anderson and James Chasey, Favorite Ways to Learn Economics 3e, Worth Publishers, 2011.

SCORING GUIDELINES

(d) 1 point:

• One point is earned for concluding that, owing to the tax, the market is no longer allocatively efficient AND that total surplus decreases or the tax creates a deadweight loss.

2011 AP Questions

10. Overseas Micro 2 (a)(iii)

Question: Suppose research shows that the more college education individuals receive, the more responsible citizens they become and the less likely they are to commit crimes.

(a) Draw a correctly labeled graph for the education market and show …

(iii) Deadweight loss at the market equilibrium, completely shaded.

PRIC

E

Supply = Marginal Social Cost

Quantity of Educations

Demand = Marg. Private Ben.

Marginal Social Benefit

0

PM

QM QS

Deadweight loss from underproduction

5. Overseas Micro 2 part (b)

Question: Assume that the government imposes an effective (binding) price ceiling on the price of college education.

(ii) Does this price ceiling increase, decrease, or have no impact on the deadweight loss in this industry? Explain.

PRIC

E

Supply = Marginal Social Cost

Quantity of Educations

Demand = Marg. Private Ben.

Marginal Social Benefit

0

PM

QM QS

PRIC

E

Supply = Marginal Social Cost

Quantity of Educations

Demand = Marg. Private Ben.

Marginal Social Benefit

0

PCeiling

P1

PM

QM QSQC

Answer: Deadweight loss will increase because the quantity supplied will decrease.

5. Overseas Micro 2 part (b)

1. Micro 3 (a)

Question: Draw a correctly labeled graph of the market for good X [known to create a negative externality] and show …

(iv) The area of deadweight loss, shaded completely

PRIC

E

Marginal Private Cost

QUANTITY

Demand = MSB

QM

Marginal Social Cost

QS

Deadweight loss from over

production

Market Quantity

Answer:

4.1% answered correctly

2010 AP Question

The Graph Provided

PRIC

E

Supply = MPC

QUANTITY

Demand = MSB

q3q2

P1

P2

J

P4

P3

P5

q1 q4 q5

TSR

K

L

M

N

U

1. Micro 3 (c)

Question: Assume that the government imposes a per-unit tax of (p5-p2) to correct for the negative externality. [They were told in part (b) that the negative externality was equal to (p5-p2).] … Identify the area representing the deadweight loss.

The Graph Provided

PRIC

E

Supply = MPC

QUANTITY

Demand = MSB

q3q2

P1

P2

J

P4

P3

P5

q1 q4 q5

TSR

K

L

M

N

U

Deadweight Loss with Negative Externalities

“Quantity levels less than or greater than the efficient quantity create efficiency losses (or deadweight losses).”

“Our analysis of the efficiency loss of a tax assumes no negative externalities …. Where such spillover costs occur, the excise tax on the producers might actually improve allocative efficiency by reducing output and thus lessening the negative externality.”

--McConnell, Brue, Flynn, 18e, p. 129 & 368

PRIC

E

Supply = MPC

QUANTITY

Demand = MSB

q3

MSC = MPC + Marg. External Cost

q2

P1

P2

J

P4

P3

P5

q1 q4 q5

TSR

K

L

M

N

U

Efficient Quantity

PRIC

E

Supply = MPC

QUANTITY

Demand = MSB

q3

MSC = MPC + Marg. External Cost

q2

P1

P2

J

P4

P3

P5

q1 q4 q5

Deadweight loss from over

production

Market Quantity

PRIC

E

Supply = MPC

QUANTITY

Demand = MSB

q3

MSC = MPC + Marg. External Cost

q2

P1

P2

J

P4

P3

P5

q1 q4 q5

TSR

K

L

M

N

U

Efficient Quantity

No deadweight loss at efficient quantity.

Answer: With the tax, the deadweight loss is zero (0.5 percent answered correctly).

1. Micro 3 part (c) cont.