Triangles, rectangles, trapezoids, stripes, and gaps.
I liked Steve Williamson's post on gaps and triangles. But I think about it a bit differently.
Start with basic micro. There's a Marginal Benefit curve and a Marginal Cost curve, and the optimum quantity is where the two curves cross. That's what we get in a competitive market with no externalities or other market failures.
Now suppose something prevents the market reaching that optimal quantity. It could be a distorting tax, which creates a wedge between the buyer's price Pb and the seller's price Ps. Or monopoly power. Or an externality. There's a Net Welfare loss triangle, measuring the unexploited gains from trade.
Like the red triangle in this picture:
The blue rectangle is the tax revenue. The red triangle is a deadweight loss. The blue rectangle isn't a deadweight loss; it's a transfer, from buyers and sellers to the government.
Microeconomics is usually about triangles.
But microeconomics isn't always about triangles. Sometimes it's about rectangles too. Suppose there's a binding price ceiling at Ps, which creates excess demand. How is the quantity supplied (Qo) rationed between buyers, when there's excess demand? It might be rationed by queuing. Buyers pay Ps per apples in dollars, plus Pb-Ps per apple in queuing costs, giving them a total price of Pb per apple. In this case the rectangle too is a deadweight loss.
What about macroeconomics?
New Keynesian macroeconomics is about trapezoids.
New Keynesian models assume monopolistic competition, so quantity of output is too low even when the economy is at the natural rate, Qn, in neither boom nor recession. So there's always a triangle.
New Keynesian macro models look like this:
In recessions, when output falls to Qd, the triangle gets bigger. The red trapezoid measures the increased size of the triangle, and measures the cost of the recession. In booms, when output rises to Qb, the triangle gets smaller. The green trapezoid meaures the reduced size of the triangle, and measures the benefits of the boom.
But notice the green trapezoid is smaller than the red trapezoid. The benefits of a boom are less than the costs of a recession. So if we could stabilise the economy, and keep output at Qn, we would make net gains. The cost of the business cycle is the red trapezoid minus the green trapezoid....MORE
