The Welfare Costs of Market Restrictions

[Author Affiliation]David Colander, Middlebury College Department of Economics, Warner Hall, Middlebury, VT 05753, USA, colander@middlebury.edu; corresponding authorSieuwerd Gaastra, Middlebury College, Box 2877, Middlebury, VT 05753, USA, sgaastra@middlebury.eduCasey Rothschild, Middlebury College Department of Economics, Warner Hall, Middlebury, VT 05753, USA, crothsch@middlebury.edu[Acknowledgment]We are thankful to Ted Bergstrom and Laura Razzolini (the editor) for making important suggestions that improved the exposition in the article.1. IntroductionMany of the central ideas in economics are conveyed to students in graphs that provide a visual picture of economists' insights. One of the most well known of these pictures is the Harberger triangle, which is used to illustrate the deadweight loss from market restrictions such as monopoly power, quantity restrictions, and price ceilings and floors. Although it is generally known that the Harberger triangle misses important elements of these restrictions' inefficiency costs (see, for instance, Friedman and Stigler 1946; Glaeser and Luttmer 2003), this insight has not been integrated into economic textbooks. This is problematic because these overlooked inefficiency costs are theoretically important and in many cases are larger than the inefficiencies conveyed by the Harberger triangle.In this short article we show why the Harberger triangle significantly understates the efficiency costs of any restriction that does not inherently direct (or provide incentives for) agents to efficiently deal with it. We then provide a simple graphical method of capturing the additional deadweight loss in the form of a second triangle that can be seen as a measure of this additional deadweight loss. This graphical method should make it easier to integrate these insights into the textbooks and thereby help remedy the deficiencies of presentations based only on the Harberger triangle.1 We focus on the example of price controls but discuss how the analysis caries over to other restrictions such as quotas. We argue that, together, the second triangle and the Harberger triangle provide students with a much better picture of the costs of these market restrictions, a better sense of the relative magnitudes of the two types of deadweight loss, and a better segue into a discussion of the costs of market restrictions.The problem with using the Harberger triangle--the area between the demand and supply curve and between the pre- and post-control quantities--as a measure of the inefficiency resulting from, for example, a price floor is that it captures only one type of restriction-induced inefficiency: the inefficiency that arises because the market restriction prevents some mutually beneficial trades from taking place. Such inefficiencies might be called "top-down" inefficiencies because they would exist even if each side of the market consisted of a single representative agent reacting optimally to restrictions and dealing with the restriction in as efficient a manner as possible. When there are many agents affected by a price control, representative agent assumptions are inappropriate, and such controls will impose additional "bottom-up" costs on society. This bottom-up inefficiency occurs because, in addition to preventing mutual beneficial trades , price controls remove incentives for the right trades to take place. They therefore impose wrong -trade , bottom-up, social costs: They lead some of the wrong agents to do the supplying or demanding. A price floor, for example, both causes an inefficiently low quantity of the good to be supplied and fails to incentivize the lowest-cost potential suppliers to do that supplying. For example, faced with a minimum wage restriction, jobs will have to be rationed, but McDonald's and other minimum wage employers will have no incentive to ration those jobs in the most efficient manner--for example, to those who benefit the most from receiving them. …