Question

suppose the government puts a binding price ceiling on baby formula .carefully draw all of the welfare implications with a standard supply _demand diagram. specifically ,show on the graph the
old consumer surplus,old producer surplus ,new consumer surplus, and new producer surplus .clearly specify any transfers and /or deadweight loss.

please explain your answers. thank you

Answer 1

The answer can be explained with the chart below, which is followed by an elaboration on the points.

The initial supply and demand curve for the baby formula is given by S and D respectively. The equilibrium price and equilibrium quantity is given by P and Q respectively.

In this scenario without a price ceiling, the consumer surplus is given by the area "CBP."

In this scenario without a price ceiling, the producer surplus is given by the area "PBA."

The total Welfare is therefore given as = Consumer Surplus + Producer Surplus

Total Welfare is given by the area "ABC."

However,

After the imposition of price ceiling, the price ceiling is represented by the horizontal line marked by P1. It is important to note that the price ceiling is below the equilibrium price. This reduces the incentive for suppliers to supply more as lower price implies lower margins. On the other hand, the consumers demand more at a lower price. The quantity supplied at price ceiling is given by Qs and the quantity demanded at price ceiling is given by Qd.

Clearly, quantity supplied is lesser than the quantity demanded and this creates a "Shortage."

Further, since consumers get the baby formula at a lower price, the consumer surplus increases and is now represented by the area "CP₁DE."

On the other hand, since producers are forced to sell at a lower price, the producer surplus declines and is represented by the area "AP₁D."

Importantly, since the producers are supplying less and there is a "Shortage," a dead weight loss is created and this reduces the total welfare. The dead weight loss is represented by the area "EDB."

The key conclusion is that imposition of price ceiling reduces the total welfare and creates a dead weight loss in the economy. Therefore, in order to maximize total welfare, it is important that there is no government intervention in free markets.