Thinking about deadweight loss


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.