The shaded area shows the reduction in overall economic surplus—the
deadweight loss—created by the quota system.
The equilibrium in the free-market case is at point E, with price and
quantity When the government introduces an output quota, it
restricts total output of this product to units and then distributes
quotas—“licences to produce”—among the producers. With output
restricted to units, the market price rises to the price that
consumers are willing to pay for this quantity of the product. The purple
shaded area—the deadweight loss of the output quota—shows the overall
loss of economic surplus as a result of the quota-induced output
restriction.
As you can see from Figure 5-8 , the output restriction created by the
quota leads to an increase in the product’s price. If demand for the
product is inelastic, as is the case in the dairy markets where quotas are
commonly used, total income to producers rises as a result of the
reduction in output. (Refer back to Figure 4-5 in Chapter 4 .) But since
their output falls, firms’ production costs are also reduced. The
introduction of a quota system therefore leads to a rise in revenues and a
fall in production costs—a clear benefit for producers! Not surprisingly,
individual producers are often trying to increase their holdings of quotas
so as to increase their production and profits.
There is a catch, however: Producers must incur a very high cost in order
to purchase the quotas. (The high price for quotas reflects the profits they
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