We've seen that total economic surplus is maximized in a competitive equilibrium where marginal benefit equals marginal cost. And we've seen some cases where that can break down because of externalities or in the case of public goods. Let's turn now to cases of government intervention in markets that can lead to deadweight loss. We know that prices are a signal and an incentive. So what happens when the government regulates prices?
These are called price controls. and they come in two basic flavors. Price floors require that a price be no less than a certain level.
It's a minimum price. A common example is the minimum wage, a requirement that the buyers of labor companies pay the sellers of labor employees no less than a certain amount. Price ceilings require that a price be no more than a certain level. It's a maximum price. A common example is rent control, a requirement that rents on apartments are no higher than a regulated level.
Let's start with price floors. These are very common in agricultural products with the government introducing them to increase farmers income, but I'm going to go with tacos because I like tacos. So we've got the quantity of tacos on the x-axis and the price of tacos and dollars on the y-axis.
And we've got our usual upward sloping supply. and downward sloping demand. The competitive equilibrium here at point A is where the marginal benefit equals the marginal cost and economic surplus is maximized.
So let's say the equilibrium price of tacos is $3 and the equilibrium quantity is $600. We've got consumer surplus as the difference between people's willingness to pay and the price they have to pay, and producer surplus as the difference between suppliers'willingness to sell and the price that they get. This should all look very familiar. So, what does a price floor do?
Remember, that means you're not legally allowed to buy or sell tacos for less than the price that the government sets. It's a floor. The price has to be at or above that level.
Now, let's say that there's a price floor below the equilibrium price. What does that do? Nothing much. If a taco sells for $3 in the market and the government says you have to sell it for at least $2, it's not going to affect anything.
We all just shrug our shoulders and keep buying and selling tacos at $3. The $2 price floor doesn't bind, so it doesn't affect the market. But what if the government sets a price floor for tacos above the equilibrium price, say at $3? $4. Now it's a different story.
You can't legally sell tacos for less than $4. Well, at $4, consumers want less. They're only willing to buy, let's say, 300 tacos at $4. But producers want to supply more because at a price of $4, they're willing to sell more tacos, let's say, 900. So we get a surplus that's 600 more tacos being offered for sale than people want to buy. 900 offered, 300 bought.
So what happens to consumer and producer surplus? To help guide us, I'm going to mark the parts of the surplus under the market equilibrium. So consumer surplus before was A plus B plus C. So before, consumer surplus was A plus B plus C. And producer surplus was D plus E.
Consumers now only buy 300 tacos and they have to pay $4. That's area A. So after the price floor...
Consumer surplus is now just area A. They've lost parts B and C of their consumer surplus. Producers only sell 300 tacos. It doesn't matter that they were willing to sell 900. You can't make consumers buy more than the 300 they're willing to at $4.
So what happens to producer surplus? Well, they get $4 and the difference between what they get and what they were willing to sell at is the area. B plus D. Notice that producers get area B from consumer surplus, but area C is lost and so is area E. That's deadweight loss.
As we've seen before, these were exchanges that would have led to gains from trade. I was willing to pay $3.50 for a taco and someone was willing to sell it to me for $2.50. We could have had a dollar in gains from trade. That's value being created. But that didn't happen because of the price floor.
That's deadweight loss. C plus E. Now you can tell that producers will gain as long as area B is bigger than area E.
Area B being the producer surplus that they gain. from consumers and area E being the producer surplus that they lose from the lower quantity being sold. And that's usually going to be the case. So producers are probably better off overall in the sense that producer surplus is higher.
But consumers are worse off and economic surplus is lower because of the deadweight loss. Now what happens... happens to all of those extra products that were created by the price floor.
In the case of agricultural products like raisins, what usually happens is that the federal government buys them up and ships them abroad or even just destroys them. Now another good for which there are price floors is labor, minimum wages, and that's the topic of the next video.