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Deadweight Loss: Sources and Solutions
David A. AndersonCentre CollegeChief Reader
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.
