What are Efficiency and Inefficiency in Economics?
Economists generally define efficiency as when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation gets inefficient, a party will benefit more than the other without imposing costs on others.
“Efficiency is basically where the economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved.” This means that the optimal amount of each good & service is produced and consumed.
The demand and supply model emphasizes that prices are not just set by demand or supply but also by the interaction the two curves have with each other. In 1890, the famous economist Alfred Marshall wrote that “asking whether supply or demand determined a price was like arguing “whether it is the upper or the under the blade of a pair of scissors that cuts a piece of paper.” The answer is that both blades of the demand and supply scissors are always involved.”
What is a Deadweight Loss?
“Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved.” It indicates the cost borne by society due to market inefficiency.
Reasons for deadweight loss
- Price floors: The government controls and sets a limit on the lowest price, which can be charged for a good or service. An example would be minimum wage.
- Price ceilings: The government sets a limit on the highest price which can be charged for a good or service. An example would be rent control, by setting a maximum amount of money that a landlord can collect for rent.
- Taxation: something that the Government charges over and above the normal
The Government imposed price floor, or a price ceiling, does not allow the market to get back to its equilibrium price and quantity, and which will further create inefficient results. However, there is another controversy here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to the supplier or some producer surplus to buyers.
Imagine that several firms develop a promising but expensive new drug for treating knee pain. If this therapy is left to the market, the equilibrium price will be $600 per month, and 20,000 people will use the drug; however, if the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, the firm in the market will now produce only 15,000.
In this scenario, two changes will occur. First, an inefficient outcome occurs, and the total surplus of society will reduce. “The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss.” It is like money thrown away that benefits neither the supplier nor the buyer. When deadweight loss exists, both buyer and supplier surplus can be higher, in this case, because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.
A second chance from the price ceiling is that some of the supplier surpluses are transferred to the buyer. Note that the gain to buyers is less than the loss to the supplier, which is just another way of seeing the deadweight loss.
The deadweight loss also arises in imperfect markets where demand and supply scenarios are not perfect. Example oligopolies and monopolies. In imperfect markets, suppliers restrict supply to increase prices above their average total cost. Higher prices lower the demand; thus, the produce is wasted, and this creates a deadweight loss.
For example, if you are planning a trip to Vancouver. A Bus ticket to Vancouver costs $25, and your value for the trip is $40. In this situation, the value of the trip ($40) is more than the cost ($25), and you would, therefore, take this trip. The net value that you get from this trip is $15.
However, now before buying a bus ticket to Vancouver, the government suddenly decides to impose a 100% tax on bus tickets. Therefore, this would drive the price of bus tickets from $25 to $50. Now, the cost exceeds the benefit; you are paying $50 for a bus ticket from which you only derive $40 of value. Since you do not find the benefit higher than the cost in this situation, you end up not going to the true.
Accordingly, since the trip would not happen and the government would not receive any tax revenue from you, the supplier or bus owners won’t get revenue, and the consumer will remain cash-rich. In these scenarios, the deadweight loss is the value of the trips to Vancouver that do not happen because of the tax imposed by the government.
What is the meaning of Consumer and Producer Surplus?
- Consumer surplus is the consumer’s gain from trade. “The consumer surplus is the area below the demand curve but above the equilibrium price and up to the quantity demand.”
- Producer surplus is the producer’s gain from trade. “The producer surplus is the area above the supply curve but below the equilibrium price and up to the quantity demand.”
It is explained with demand and supply curves.
In the example, at equilibrium, the price would be $5 with a quantity demand of 500.
Above $5, there will be a consumer surplus. Below will be producer surplus.
- Equilibrium price = $5
- Equilibrium demand = 500
Let us now consider the effect a new after-tax selling price of $7.50 will have on-demand:
The price would be $7.50, with a quantity demand will reduce to 450. Thus creating excess supply and deadweight loss. Deadweight loss is the value of the trades that are not made due to the introduction of the tax. Accordingly, 50 units in our above example are deadweight losses.
- Applying the methods without having the correct demand and supply curves
- Not considering the factors affecting the demand and supply curves efficiently
Context and Application
This topic is significant in the professional exams for both undergraduate and graduate courses related to marketing especially following:
- B. Com –Economics
- Ph.D. in Economics
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