Understanding Welfare Loss (Cambridge International A-Level Economics)

Understanding the deadweight welfare loss

• Deadweight welfare loss occurs when resources are not allocated at the socially efficient level of output where MSB = MSC

  • If MSB > MSC, output is too low, meaning society would benefit from greater production or consumption
  • If MSC > MSB, output is too high, meaning society would benefit from less production or consumption
  • In both cases, the difference between MSB and MSC creates a welfare loss to society

Calculating the welfare loss that is caused by the positive externality of consumption

Step 1: Identify the area of welfare loss (potential welfare gain)

• This product is underconsumed – there should be higher levels of consumption
• Welfare loss to society is the triangle formed by the arrowhead which points forwards towards the socially optimal quantity
• Assume Qe = 70,000 and Qopt = 100,000
• Assume Pe = £40 and Popt = £80

Step 2: Calculate the area of the triangle

$\text{Welfare} \text{loss} ( \text{potential} \text{welfare} \text{gain} ) = 1 \frac{1}{2} \mathrm{x} \text{base} \mathrm{x} \text{height} \text{Welfare} \text{loss} ( \text{potential} \text{welfare} \text{gain} ) = \frac{( 100 , 000 - 70 , 000 ) \mathrm{x} ( \pounds 80 - \pounds 40 )}{2}$

$\mathrm{Welfare} \mathrm{loss}(\mathrm{potential} \mathrm{welfare} \mathrm{gain})=\frac{30,000x40}{2}\,\,\mathrm{Welfare} \mathrm{loss}(\mathrm{potential} \mathrm{welfare} \mathrm{gain})=\frac{30,000x40}{2}$

$Welfare \text{loss} \text{stretchy} ( \text{potential} \text{welfare} \text{gain} \text{stretchy} ) = \pounds 600 , 000$

• More factors of production should be allocated to producing the optimal quantity, as societal welfare will be gained (pink triangle)
• There is an opportunity for government intervention (subsidies, partial provision, etc.) to force this market to be more socially efficient
• Any intervention that gains welfare will be beneficial

Calculating the welfare loss that is caused by the negative externality of production

Step 1: Identify the area of welfare loss

• The good is overproduced (Qe > Qopt), so output should fall to the socially optimal quantity

• Deadweight welfare loss is the triangular area between the MSC and MSB curves between Qopt and Qe

  • Qopt = 70,000 (social optimum where MSC = MSB)
  • Qe = 100,000 (free-market equilibrium where MPC = MPB)

Step 2: Calculate the area of the triangle

$\text{Welfare} \text{loss} = \frac{( 100 , 000 - 70 , 000 ) \mathrm{x} ( \pounds 80 - \pounds 40 )}{2}

\text{Welfare} \text{loss} = \frac{30 , 000 \mathrm{x} 40}{2}

\text{Welfare} \text{loss} = \pounds 600 , 000$

• Less factors of production should be allocated to producing the optimal quantity, as societal welfare will be lost
• There is an opportunity for government intervention (indirect taxes, regulation, etc.) to force this market to be more socially efficient
• Government intervention, such as taxes or regulation, can reduce over-production and move the market closer to the socially efficient outcome