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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- 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. Ok,
here's our standard diagram. I've just

labeled some things we just 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 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.
That smaller amount. Now notice that these

trades, which failed 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, one dollar.

They would like to, however. The buyers
are willing to pay three dollars for

another gallon of gasoline. The sellers
are willing to sell that gasoline for one

dollar. So there's a mutually profitable
trade. This trade would be worth two

dollars in mutual profit. To the buyers
and sellers, they would like to make this

deal. But it is illegal to sell at a price
above one dollar. So these trades between

QM and QS do not occur. In a free market
they would occur, 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 failed to take place because they're
illegal, because of the price control.

Price ceilings reduce the gains from
trade creating a deadweight loss.

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