Price Ceilings: Deadweight Loss

In this video, we explore the fourth unintended consequence of price ceilings: deadweight loss. When prices are controlled, the mutually profitable gains from free trade cannot be fully realized, creating deadweight loss. With price controls, less trading occurs and both buyers and sellers miss out on the mutually profitable gains that could have occurred. We’ll show how to calculate deadweight loss using our example of a price ceiling on gasoline.

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- [Alex] 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.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

Or, if you're ready to move on,
just click "Next Video."

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