If you have studied economics, you have likely heard the term “Deadweight Loss” used as a synonym for something bad. However, what exactly is deadweight loss, and why do economists attempt to prevent it? Let’s find out together.
List of Contents
What Exactly Is Deadweight Loss?
A deadweight loss is a societal cost resulting from market inefficiency, which arises when supply and demand are out of balance. When products in a market are overpriced or underpriced, market inefficiency emerges. While some members of society may gain from the imbalance, others may suffer as a result of a move away from equilibrium. Significantly, deadweight loss refers to any shortage produced by improper resource allocation.
In addition, price ceilings such as price limits and rent restrictions, price floors, such as minimum wage and living wage regulations, and taxation can result in deadweight losses. The distribution of a society’s resources may become inefficient if the volume of commerce is diminished.
Example of Deadweight Loss
Imagine that in your town, a new sandwich shop opens. It sells sandwiches for $10. You assume the price of this sandwich is $12 and are willing to pay $10 for it. Nevertheless, assume the government puts a new sales tax on food, raising the sandwich price to $15. You think the sandwich is overpriced at $15, and the new price is not fair. Consequently, you are unwilling to purchase the sandwich at $15.
However, not all consumers feel this way about the sandwich. The sandwich business experiences a drop in demand and earnings. The unsold sandwiches, due to the increased $15 price, are the deadweight loss in this case. If the drop in demand is significant enough, the sandwich shop may close, exacerbating the negative economic impacts of the new tax.
How Is Deadweight Loss Generated?
Minimum wage and living wage rules might result in a deadweight loss by forcing companies to overpay employees. It can also make it difficult for low-skilled people to find work. Moreover, price limits and rent restrictions can also cause deadweight loss by discouraging production and reducing the supply of products, services, or housing to levels below what customers genuinely desire. Consumers face scarcity, while producers earn less than they would otherwise.
Besides, taxes also result in a deadweight loss. The reason is that they discourage consumers from making purchases they would have made otherwise since the final price of the goods exceeds the market equilibrium price. If taxes on an item increase, the burden is generally shared between the manufacturer and the consumer. Finally, this situation results in less profit for the producer and a higher price for the consumer. This leads to less use of the product than in the past, which diminishes the total advantages the consumer market may have gotten and the company’s potential profit gains.
Moreover, monopolies and oligopolies also result in deadweight loss because they eliminate the elements of a perfect market in which precise pricing is determined by fair competition. Importantly, they can control the supply of a particular item or service. Therefore, this inflates its price. This would eventually result in a decrease in the number of products and services sold.
Graph of Deadweight Loss
At equilibrium, the price would be $8 for 800 units of demand.
- Equilibrium Price = $8
- Equilibrium Demand = 800
In addition, the following points contribute to consumer and producer surplus.
- Consumer Surplus
It is the consumer’s profit from a transaction. The consumer surplus is the region beneath the demand curve but above the equilibrium price and up to the quantity demanded.
- Producer Surplus
It is the producer’s exchange gain. The producer surplus corresponds to the region above the supply curve but below the equilibrium price and up to the quantity demand.
Let’s consider the effect of a new after-tax selling price of $5.
With a quantity demand of 450, the price would be $5. Taxation reduces both consumer and production surpluses. On the other hand, taxes establish a new division called “Tax Revenue.” It is the number of money governments collect at the new tax rate. As a result, there would be a deadweight loss with this new tax price.
As seen in the graph, deadweight loss is the value of deals not completed due to the tax. Because of the increased tax pricing, the blue area does not exist. As a result, no exchanges occur in that location, and deadweight loss occurs.
How to Calculate Deadweight Loss
To determine how to calculate deadweight loss from taxation, examine the graph shown below.
- Q0 and P0 represent the equilibrium price and quantity prior to the introduction of tax.
- With the tax, the supply curve moves from Supply0 to Supply1 by the tax amount. Due to the implementation of a tax, producers would prefer to supply less.
- The buyer’s price would climb from P0 to P1, and the seller’s price would decrease from P0 to P2.
- From Q0 to Q1, producers provide less due to the tax.
Formula Used to Calculate the Deadweight Loss
Deadweight Loss = ½ * (P2-P1) x (Q0-Q1)
Conclusion
The term “Deadweight Loss” refers to the reduction in economic efficiency when the equilibrium outcome is unattainable or not reached. In other words, it is the expense incurred by society due to market inefficiencies.
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Read more: Economies
Source: CFI, Investopedia