The graph below shows supply and demand in the local market for pet insurance. Suppose the government mandates that the price of pet insurance can go no higher than $25. The reduction in social welfare as a result of this policy (relative to the unregulated market equilibrium) is equal to area(s)

Question

BlackTom AI · Accepted Answer

When a price ceiling is imposed at 25 and this price is binding (i.e., it lies below the market clearing price in the unregulated equilibrium), the market is constrained and quantity traded falls from the equilibrium quantity to a lower quantity determined by the intersection of the ceiling with the supply and demand curves. The reduction in social welfare due to this binding price ceiling is the deadweight loss (DWL), which arises from the forgone trades that would have occurred at quantities between the unrestricted equilibrium and the constrained quantity.

In most supply–demand diagrams, the DWL from a binding price ceiling is represented by two triangular areas that lie between the demand and supply curves over the range of the reduced quantity. These two triangles capture the lost gains from trades that no longer occur: some trades would have benefited buyers and sellers but do not happen because the ceiling prevents the price from rising to the equilibrium level. Therefore, the DWL is the sum of the two triangular regions, commonly labeled as areas H and I in many diagrams.

Evaluating the other options:
- B + E: This would omit one of the DWL triangles, leaving out part of the lost surplus that arises from the binding restriction.
- A + B + C + D + E: This overcounts by including areas that are not part of the deadweight loss under a binding price ceiling; it mixes consumer surplus losses and producer surplus transfers that do not represent the forgone gains from trade.
- A + B: Similar issue of either missing one DWL triangle or combining regions that don’t correspond to the net loss from trades forgone due to the price ceiling.
- D + E: This would cover only one side of the DWL or misattribute the areas to transfers rather than forgone trades, depending on the diagram’s labeling, and thus does not equal the total DWL.

Thus, the correct description of the reduction in social welfare under a binding price ceiling is the sum of the two deadweight triangles, which correspond to areas H and I.

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