Question

a) What does the deadweight loss (DWL) represent? How can you identify it? Explain and show graphically the two main reasons for its existence?

b) Tickets to certain football games are in high demand (relative to stadium capacity). Sometimes, a lottery is used to allocate the tickets, or sometimes individuals have to wait in line to purchase the tickets. Compare these allocation mechanism to a market mechanism to allocate tickets. Would subsequent trading among ticket holders produce a better outcome (i.e. is it Pareto efficient)? Why do some countries ban such a trade?

Answer 1

a) Dead weight loss is the loss/cost to the society resulting due to the inefficiency in the market which occurs when demand and supply are out of equilibrium. It refers to the deficiency arising due to the inefficient allocation of resources. Dead weight loss can occur when the government imposes price ceiling, price floor, increases the tax rate etc. In the market equilibrium is achieved by the market participants but when this equilibrium gets distorted it results in contracts the total sum of producer and consumer surplus as at least when entity will get negatively impacted due to the distortion. For example when the government puts price ceilings the consumers may benefit from it but it negatively impacts the sellers they will not be able to fully utilize their production capacity though there is demand for the product as they can no longer produce in a feasible and sustainable manner as they will not be able to earn even normal profit when the government puts price ceiling as usually price ceiling is put at a level below the equilibrium price. Thus it results in wastage of factors of production production as they are not fully utilized and due to the price ceiling the units that would have been traded is now not traded and consumers are unable to meet their demands due to contraction in supply.

Another example is when the government increases the tax, it does not matter on whom the tax is imposed either buyer or seller it results in the price and quantity traded moving away from the equilibrium resulting units which would have otherwise been traded getting wasted causing deadweight loss for the society.

Here the equilibrium price was 10 dollars and due to the tax the price increases to 12 Dollars and moves away from the equilibrium , the quantity traded moves away from the equilibrium q1 and contracts to q2.

b) In most of the market mechanism i.e. the proverbial invisible hand of Adam Smith ensures that consumers and producers satisfaction is maximized. Only in cases of public goods and negatives externalities the invisible hand fails in maximizing the satisfaction in the society to the market participants and such cases were the market mechanism fails is very few. The market mechanism more often then not ensures that an equilibrium is reached in the market to maximize producer and consumer surplus. When the demand exceeds the supply in it results in increase in the price of the products. In such cases one should let the market mechanism to influence market participation and not adopt random approaches such as lottery etc to meet the demand. Waiting in the line, lottery etc are not optimal methods.

When the tickets are traded among the ticket holders it results in individuals who want it the most obtaining the ticket by paying higher then the market price. Higher your demand and purchasing power higher the chances of such individuals obtaining the ticket. Here the ticket holder when he sells the ticket above the market price to individuals who most want it he earns a profit and as result he is satisfied and the person who wants to watch the match the most gets to watch it thus even his satisfaction. Thus such an exercise results in the maximization of satisfaction/benefit in the market as the individual satisfaction/benefit of the buyer and seller is maximized. On the other hand waiting in the line or lottery such benefit maximization is not achieved as it does not guarantee one who is willing to pay the highest and wants the ticket the most gets the ticket thus maximizing the seller surplus and the achieving the satisfaction which the buyer aspires. Willing to pay higher then the market price is an indicator of how much the buyer wants the product and this can be ascertained when individual ticket holders trade the tickets among themselves.

The reason some nations oppose such a practice though it is the most optimal and viable option as it maximizes the overall satisfaction/ benefit in the market is because of social factors. There may be some individuals who want the tickets more then those who are willing to pay the highest price for it but are unable to purchase the tickets due to budget constraints in such cases it results in those at the bottom of the pyramid being unable to satisfy their needs as the market does not satisfy their needs due to their budget constraint. The government does not like it when the masses are unable to satisfy their needs due to their budget constraint as in the the market entities with higher purchasing power prevail and their needs are satisfied over those with lower purchasing power. If majority of the population have limited purchasing power then the government will not risk displeasing them as in the election it is these masses which decide the future of the government. Hence it will adopt measures to ensure that the needs of the masses does not get ignored in the market due to their limited purchasing power and by the market meachanism which favours to maximize producer and consumer surplus and does not consider the socila impacts of its functioning.