Thinking about deadweight loss

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This post from the UC Berkeley Energy Institute got me thinking that we’re not grasping the fullness of Venezuela’s crazy gasoline subsidy.

The post is about Indonesia, and how it recently raised the price of gas without the streets lighting up in protests. In the post, they explain the concept of deadweight loss in the context of this market.

The basic point of deadweight loss is the following. Let’s say you’re selling Toddy, and you’re a Toddy monopolist. The Toddy costs BsF2 to produce, but since you’re a monopolist, you sell it at BsF10. There are people who value the Toddy at, say, BsF5 who will not be able to buy the Toddy because you are charging BsF10. See, if something is worth 5 to me, and the price is 10, I don’t buy it.

In a perfectly competitive market, anyone who values Toddy at BsF5 would be able to buy it because Toddy costs BsF2, and that would be its competitive price. Monopoly raises prices so that people whose benefit exceeds the cost of production don’t get their Toddy.

That’s deadweight loss – whenever a transaction that should take place because it makes sense from an economic point of view DOESN’T take place, we are all worse off. The government collects less taxes because fewer Toddys are sold. Producers of Toddy bottles sell fewer bottles. Consumers consume less Toddy. It’s a Toddy-less world – a tragedy.

But wait, there is also deadweight loss when you subsidize something!

By lowering the price of something below cost, people get to purchase something that, to them, is worth less than what it costs, but since it’s so darn cheap, they go ahead and buy it anyway.

Think, for example, of the people that live close to the Caracas Metro and who choose to drive anyway just because it’s so darn cheap. The benefit of the gas subsidy for these folks is not very large – after all, they probably take longer driving than they do in the Metro – and the cost of producing the gasoline exceeds the benefit they personally get. Because gas is so cheap thanks to the subsidy, they end up consuming more gas than they actually would want to consume in a competitive market. This is also a deadweight loss because, in a way, you’re giving somebody a tiny benefit at a huge cost.

Back to the Toddy – if the Toddy costs BsF2 to produce and I give it to people for BsF0.50, then whoever values the Toddy at, say BsF1 (people who sorta, kinda like Toddy, but can live without it … you freaks know who you are) and is buying it at BsF0.50, those people are getting a perk … that costs BsF2 to make but one they value at just BsF1!

Anyway, I don’t want to bore you with geeky economic technical details, but so far I have not thought about the deadweight loss in the calculations on the gasoline subsidy. I’ll try and do so whenever I run the numbers again.

PS.- The posts linked above have some graphs explaining this stuff with more detail, this is just my run-down of the intuition.

1 COMMENT

  1. Please! bore us – It is absolutely great to have some technical details and background over the issues, specially when it is something that can be modelled as simple as a offer-demand curve

  2. Of course is ECON 101 ( in Unimet at least) that you could calculate the cost of the monopoly (even I remember That) And of course, please details, and graph!!!!

  3. This post has inspired me to something fruitless, useless, and futile: Explain this concept to die-hard chavista I know.
    I feel I learn something new about these blind fanatics every time I try to explain an economic concept.
    Here goes nothing…

  4. Well, when you sell something below cost, is not exactly deadweight loss, it is more of an antitrust practice, that in turn, generates monopolies or oligopolies, and therefore a deadweight loss for society.

    P.S.: Keep up with the geeky economic technical details, the way I see it, you guys both entertain your readers but at the same time you inform them in a profound way, kind-off like Levitt & Dubner from Freakonomics, and we sure as hell need to see more places like this instead of Patillazos or Aporreazos.

    • I think the point is that subsidies are not predatory pricing, they are simply wasteful. But I don’t know much Public Finance, so this is a slippery slope for me.

  5. Offering people an idea that helps them understand something previously not grasped is always worthy of praise , specially where there is a term which we can hold on to , to mentally visualize the concept (‘deadweight) , thank you !!

  6. Add to this that the money used to cause the deadweight loss comes from taking a greater income percentage from the pockets of those who value Toddy less…

  7. This reminds me of my studies of the European colonization. They took so much, yet benefited very little. In the end, Britain was giving independence away because colonies cost so much to run. Looking back at the system, we can see they failed because of bad economic policies. Spain took all the gold it found and put it in Spain, then wondered why they suffered from runaway inflation, etc.

    Basically, it doesn’t matter how rich a country is, as long as they refuse to follow good economics, they will fall in power.

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