Deadweight Loss

Deadweight loss refers to the cost borne by society when there is an imbalance between the demand and supply. It is a market inefficiency that is caused by the improper allocation of resources. 

In a free market scenario, the price of goods and services depends majorly on their demand and supply. But sometimes, market inefficiency is caused by an external force—government laws, taxation, subsidies, monopoly, price floors, or price ceilings. In such a market, commodities are either overvalued or undervalued.

• Deadweight loss is the economic cost borne by society. It is a market inefficiency caused by an imbalance between consumption and allocation of resources.
• The deadweight inefficiency of a product can never be negative; it can be zero. Deadweight loss is zero when the demand is perfectly elastic or when the supply is perfectly inelastic.
• This market inefficiency is represented by the following formula:
  Deadweight Loss = ½ * (New Price – Original Price) * (Original Quantity
  – New Quantity)

A deadweight loss is a market inefficiency caused by a mismatch between goods consumption and demand. Due to the inefficiency, products are either overvalued or undervalued.

In such scenarios, demand and supply are not driven by market forces. Instead, demand and supply are moved artificially—by factors like taxation, subsidies, product surplus, consumer surplus, monopoly, oligopoly, price ceiling, and price floor. Highly elastic commodities are prone to such inefficiencies. Price changes significantly impact the demand for a highly elastic commodity.

Deadweight losses also arise when there is a positive externality. In such scenarios, the marginal benefit from a product is higher than the marginal social cost. Deadweight losses are not seen in an efficient market—where the market is run by fair competition.

While the value of deadweight loss of a product can never be negative, it can be zero. Deadweight loss is zero when the demand is perfectly elastic or when the supply is perfectly inelastic.

A deadweight inefficiency occurs when the market is unnaturally controlled by governments or external forces. Deadweight market inefficiency is caused by the following causes:

#1 - Price Ceiling

The government ascertains a maximum price for products—to prevent overcharging. However, price ceilings discourage sellers, as it curtails the possibility of earning high returns. Thus, price ceilings bring down goods supply.

#2 - Price Floor

Often, the government fixes a minimum selling price for goods. This increases product prices. Similarly, governments often fix a minimum wage for laborers and employees. But high wages result in job loss for incompetent employees.

#3 - Monopoly

When a single market player has a monopoly, the regulation of goods price and supply is unnatural. The selling price set by the monopolist is significantly higher than the marginal cost—the market becomes inefficient. Further, if customers are unable to afford the product or service—demand falls.

#4 - Taxation

When the government raises the taxes on certain goods or services, it influences the price and demand for that product. When taxes raise a product’s price, its demand starts falling. But this cuts into producers' profit margin.

#5 - Subsidy

Governments provide subsidies on certain goods or services—bringing the price down. As a result, the product demand rises. However, this artificially created demand drives consumers to buy a particular commodity in more quantity.

#6 - Product Surplus

When the market is flooded with excessive goods and the demand is low, a product surplus is created. When demand is low, the commodity’s price falls. Manufacturers incur losses due to the gap between supply and demand.

For calculations, deadweight loss is half of the price change multiplied by the change in demand. It is computed using the following formula:

Or,

Here, 

• ∆P is the price difference.
• ∆Q is the difference in the quantity demanded.
• P1 is the original price.
• Q1 is the original quantity.
• P2 is the new price.
• Q2 is the new quantity.

Let us assume that economic equilibrium will be achieved for a product at the price of $8.The demand at this price is 8000 units. The government then imposes a price floor; the price is increased to $10. At this price, the expected demand falls to 7000 units.

Based on the given data, calculate the deadweight loss.

Solution:
Dead weight = 0.5 * (P2-P1) * (Q1-Q2)

= 0.5 * (10-8) * (8000-7000)

= $1000

Thus, due to the price floor, manufacturers incur a loss of $1000.

The deadweight loss is the gap between the demand and supply of goods. Graphically is it represented as follows:

In the above graph, the demand curve intersects with the supply curve at point' E,' i.e., equilibrium. Equilibrium is a scenario where the consumption and the allocation of goods are equal.

However, due to the price ceiling, the demand curve shifts to the left—P2 is the new price. Similarly, Q2 is the new demanded quantity. Subsidies also shift the demand curve to the left. In contrast, price floors and taxes shift the demand curve towards the right.

This is a guide to what is Deadweight Loss and its Definition. We explain deadweight loss in economics, its meaning, calculation, graphs, & causes like monopoly, tax, price floor & price-ceiling. You can learn more about it from the following articles –

• Deadweight Loss Formula
• Antitrust Acts
• Supply-Side Economics