What is the Impact of Government Policies on Consumer and Producer Surplus under Perfect Competition?

Consumer and producer surplus measure the net benefits to consumers and producers respectively as shown in Fig. 10.16 by the shaded areas, where demand curve AD and supply curve BS intersect at equilibrium point ‘E’.

Total Welfare Benefit

= Consumer Surplus + Producer Surplus = CS + PS

Now, suppose the government intervenes and imposes price ceiling such that producers cannot sell above the ceiling price. Price ceiling at or above the equilibrium price is meaningless or non-binding.

Suppose the original equilibrium is attained at point ‘E’, through the intersection of demand AD and supply BS curves. OP is the resultant equilibrium price and OQ is the corresponding equilibrium output.

Now, assume that the price ceiling OP is imposed by the government on necessity like sugar, wheat, rice, salt or natural gas. It can also be imposed as a rent control. At this maximum ceiling price, supply is OQ_1, which the demand is OQ₂ units resulting in shortage of supply of Q₁Q₂ (Fig. 10.17).

Change in Consumer Surplus:

Before price ceiling, consumer surplus is given by the area (C + D) in Fig. 10.17. After price ceiling OP_m, consumers can purchase OQ₁ units. Consumer surplus now is equal to the area (C + F) in the figure. Thus, net change in consumer surplus is area (F – D), which is positive. However, some consumers are better off, while some others are worse off.

Change in Producer Surplus:

With price ceiling, producers will receive a lower price for their reduced output OQ₁. So, producers with relatively lower costs only will be able to stay in the market, while others will leave the market. Producer surplus without price control is area (F + G + H). This decreases to area (H) after price ceiling. Total change (loss) in producer surplus is given by the area – (F + G).

Dead Weight Loss:

Dead weight loss is something which is neither enjoyed by the consumers nor producers. It is the net loss of total surplus due to inefficiency in government policy of price control.

Dead Weight Loss = Loss in Producer Surplus – Gain in Consumer Surplus

= Area (F + G) – (F – D) = Area (D + G)

It is so because loss is producer surplus is more than gain in consumer surplus. Further, when demand is relatively inelastic, the consumers suffer a net loss from price control making them worse off and here area (D) exceeds area (F).