Welfare, Efficiency, and Deadweight Loss in Market Outcomes
Welfare Criteria and Efficiency in Markets
Defining Welfare and Efficiency
Welfare Criteria: In this course, market outcomes are measured by the total surplus they generate.
Total Surplus (TS): The sum of consumer surplus (CS) and producer surplus (PS) at a given outcome.
Efficiency: An outcome is defined as efficient if:
It has higher total surplus than any other possible outcome in the market.
It maximizes total surplus out of all possible outcomes.
A key property is that it is impossible to make one person better off without making another person worse off. For instance, you cannot increase CS without simultaneously lowering PS, and vice versa.
Outcome Definition: An outcome constitutes a specific price, quantity supplied, and quantity demanded.
Market Equilibrium and Efficiency
Key Finding: The equilibrium outcome in a market is inherently efficient.
The market equilibrium maximizes the total feasible surplus.
It is also the only outcome that maximizes total surplus; any other outcome would yield a lower total surplus.
Impact of Non-Equilibrium Prices: Price Above Equilibrium
Scenario: Let's consider a price (P) above the equilibrium price, for example, P = ext{300} (equilibrium was P = ext{200}, Q = ext{30 million}).
Quantity Effects:
Quantity demanded (Q_D) would be 20 ext{ million}.
Quantity supplied (Q_S) would be 45 ext{ million}.
There is excess supply (QS > QD).
Only 20 ext{ million} units will be sold, as sellers cannot sell more than what buyers are willing to buy.
Total Surplus (TS) Changes:
TS decreases significantly compared to equilibrium.
10 ext{ million} units (from 20 ext{ million} to 30 ext{ million}) that were sold in equilibrium are no longer sold.
The surplus from these lost transactions is not generated, leading to an overall reduction in TS. The total surplus becomes a trapezium bounded by the demand and supply curves up to 20 ext{ million} units, which is smaller than the equilibrium triangle.
Consumer Surplus (CS) Changes:
CS decreases in two ways:
Lost Transactions: Buyers lose the surplus from the 10 ext{ million} units no longer sold.
Surplus Transfer: For the 20 ext{ million} units still sold, consumers pay a higher price, transferring some of their surplus to producers. This means the CS triangle (Area 1) is smaller than the original equilibrium CS triangle.
Producer Surplus (PS) Changes:
Producers lose surplus from the 10 ext{ million} lost transactions.
However, producers gain surplus (Area 2) from consumers on the 20 ext{ million} units sold due to the higher price.
Therefore, PS may go up or down depending on the relative magnitudes of the lost surplus from fewer transactions and the gained surplus from the higher price per unit sold.
Deadweight Loss (DWL):
The lost surplus from the transactions that no longer happen (the gray area, labeled Area 4 plus Area 5 in the diagrams) is called deadweight loss.
DWL explicitly measures how much less total surplus there is compared to the equilibrium outcome.
For prices above equilibrium, TS is strictly less than under the equilibrium outcome.
Impact of Non-Equilibrium Prices: Price Below Equilibrium
Scenario: Let's consider a price below the equilibrium price, for example, P = ext{100}.
Quantity Effects:
Quantity supplied (Q_S) would be 15 ext{ million}.
Quantity demanded (Q_D) would be 40 ext{ million}.
There is excess demand (QD > QS).
Only 15 ext{ million} units will be sold, as buyers cannot purchase more than what suppliers are willing to sell.
Total Surplus (TS) Changes:
TS decreases compared to equilibrium because 15 ext{ million} units (from 15 ext{ million} to 30 ext{ million}) that were sold in equilibrium are no longer sold.
The total surplus becomes a trapezium, again smaller than the equilibrium triangle.
Consumer Surplus (CS) Changes:
Consumers lose surplus from the 15 ext{ million} units no longer sold (Area 4).
However, for the 15 ext{ million} units still sold, consumers pay a lower price, transferring some surplus from producers to them (Area 2).
Therefore, CS may go up or down depending on the relative sizes of lost transactions and gained surplus per unit.
Producer Surplus (PS) Changes:
Producers unambiguously lose surplus because they sell fewer units at a lower price. Their PS becomes a smaller triangle (Area 3), a strict subset of their equilibrium PS.
Deadweight Loss (DWL):
The lost surplus from the units not being sold (Area 4 plus Area 5 in the diagrams) represents the DWL.
Prices below equilibrium also lead to a strictly lower total surplus.
Why Equilibrium Maximizes Total Surplus
Total Surplus Formula: TS = CS + PS which can also be expressed as the sum of (willingness to pay (WTP) of consumers - willingness to supply (WTS) of producers) for all units traded.
Quantities Below Equilibrium:
If the quantity sold is below the equilibrium quantity (e.g., 15 ext{ million} units where equilibrium is 30 ext{ million}), there are still units between 15 ext{ million} and 30 ext{ million} where WTP > WTS.
For each of these units, selling them would generate positive additional total surplus.
By not selling these units, the market imposes a deadweight loss, meaning there are