Price Ceilings: Deadweight Loss

Today we'll be looking at how price ceilings create what economists call a "deadweight loss." This video will be short since the ideas ought to be pretty familiar by now. Let's dive in.

So let's remind ourselves that when we have a free market, all of the mutually profitable gains from trade are exploited. That's another way of saying that a free market maximizes producer plus consumer surplus. Now, when the mutually profitable gains from trade are not fully exploited, there's lost consumer and producer surplus, or a "deadweight loss." The basic idea -- as long as the price the consumers are willing to pay exceeds the price that sellers are willing to accept, there are mutually profitable trades that can be made. And what we're going to show is that price ceilings create a deadweight loss. Not all of the mutually profitable trades will be made.

Let's take a look. Okay, here's our standard diagram. I've just labeled some things we talked about in earlier lectures, mainly, the shortage of the controlled price and the total value of wasted time. The key point for understanding the reduced gains from trade is that at the free market equilibrium, at this price and this quantity, Qm, we have more units exchanged than at the price controlled equilibrium. So with a free market, we get Qm units exchanged, with a price control, only Qs units are exchanged -- a smaller amount.

Now notice that these trades, which fail to take place, they are mutually profitable. That is, the buyers are willing to pay more for these units than the sellers require to sell those units. So, because of the price control, buyers and sellers are not allowed to come to a mutually profitable deal at a price above, in this case, $1. They would like to, however. The buyers are willing to pay $3 for another gallon of gasoline. The sellers are willing to sell that gasoline for $1. So there's a mutually profitable trade. This trade would be worth $2 in mutual profit, to the buyers and sellers. They would like to make this deal. But it is illegal, it is illegal to sell at a price above $1.

So these trades between Qm and Qs do not occur. In a free market they would occur, and because they would occur, they would generate additional gains from trade. So compared to the free market equilibrium, under the price control, we have lost consumer surplus, in the amount of area A. And we have lost producer surplus in the amount of area B. Together, A + B is the lost gains from trade. These are the mutually profitable exchanges which fail to take place because they're illegal, because of the price control. So price ceilings reduce the gains from trade, creating a deadweight loss.