A government can impose various restrictions that will lead to an imbalance in the quantity and price equilibrium resulting in a deadweight loss.
These interventions include:
- Price ceilings and price floors
- Taxes and trade restrictions
- Minimum wages
- Subsidies and Quotas
A price ceiling is the highest price at which it is legal to trade a particular good or service.
Assume that the demand and supply of housing determines the equilibrium rent of $550 a month and the equilibrium quantity of 4,000 units of housing.
The following graph shows the efficient housing market with maximum consumer and producer surplus.
Suppose the government imposes a rent ceiling of $400 per month which is below the equilibrium price. As a result the following changes happen.
- Rent ceiling restricts quantity supplied. Supplied quantity is 3000 and quantity demanded is 6000. Shortage of 3000 units.
- Rent ceiling creates a black market. Some people will be willing to pay $625 per month for a house.
- Resources get used in costly search activity including both time and cost.
- A dead weight loss arises.
A price floor makes it illegal to pay a price lower than a specified level. An example of price floor is minimum wage.
Let’s say the equilibrium wage rate per hour is $5 at the equilibrium quantity of 5000 workers.
Minimum wage is imposed at $7 per hour. The graph will change as follows:
- The minimum wage restricts the quantity demanded by the firms. At $7 per hour, only 3000 jobs are available.
- People will find it hard to find jobs, and some people will be willing to take a job at lower rate. Someone will be ready to take a job at $3 per hour also. Illegal wage rates will range from $3 to below $7.
- The firms’ surplus and the workers’ surplus shrinks.
- A deadweight loss arises.
- Other resources are used up in job search activity.
Taxes will increase the equilibrium price and decrease the equilibrium quantity, creating a deadweight loss.
A production quota is an upper limit to the quantity of a good that may be produced in a specified time period.
With a production quota, the quantity decreases, the consumer surplus shrinks, the producer surplus expands, and a dead weight loss arises.
Subsidies are payments made by governments to producers such as farmers. Subsidies lower the prices paid by buyers and increase the prices received by sellers. With a subsidy, the quantity increases, and a dead weight loss arises due to overproduction.