Below Is a Guide to the Example of the Crop Subsidy Creating a Deadweight Loss (DWL)

Econ 98 - Salazar Welfare Recap Fall 04

Below is a guide to the example of the crop subsidy creating a deadweight loss (DWL).

Remember,

Producer Surplus (PS) is the area above the S curve below the price up to the quantity.

Consumer Surplus (CS) is the area below the demand curve above the price up to the quantity.

The types of questions are usually, what is the DWL associated with this policy? To analyze the welfare you:
1.  Setup the problem
2.  Change S or D, or implement the policy on the graph
3.  Label each area a letter.
4.  Conduct a welfare analysis.
This type of price subsidy sets a price floor at P2. The government allows the public to buy as much as it wants at the given price. It will then goes out and buys any excess supply from suppliers at the market price. In this example we give away the crops the government purchased to consumers who value crops the most but did not purchase crops at the new price. /
Producer Surplus
Producers now get a higher price for their crops and thus increase output. There surplus increases from the first to the second diagram. /
Consumer Surplus
Consumers lose some surplus as a result of the price increase but dramatically gain it back because the government gives the food that it buys away for free. /
Government
As stated in the problem, government must buy out all the excess crops not cleared by the market. It thus has to pay a cost of the red area depicted to the right. /
Conducting a Welfare Analysis
Welfare analysis is simple. You look at the total surplus before and after you implement the policy. The welfare analysis for this problem is shown below.
/ Total Surplus = CS + PS + GOV
Before / After / Change
CS / A+B+C / A+C+E+H+I / E+H+I-B
PS / D+E / B+C+D+E+F / B+C+F
Government / 0 / -(C+E+F+G+H+I) / -(C+E+F+G+H+I)
Total / A+B+C+D+E / A+B+C+D+E-G / -G
Since the area G is the amount of surplus lost we call it the DWL.