Loss of economic efficiency when the optimal outcome is not achieved
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Written byCFI Team
What is Deadweight Loss?
Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved. In other words, it is the cost born by society due to market inefficiency.
Video Explanation of Deadweight Loss
Below is a short video tutorial that describes what deadweight loss is, provides the causes of deadweight loss, and gives an example calculation.
Causes of Deadweight Loss
- Price floors: The government sets a limit on how low a price can be charged for a good or service. An example of a price floor would be minimum wage.
- Price ceilings: The government sets a limit on how high a price can be charged for a good or service. An example of a price ceiling would be rent control – setting a maximum amount of money that a landlord can collect for rent.
- Taxation: The government charges above the selling price for a good or service. An example of taxation would be a cigarette tax.
Imperfect Competition and Deadweight Loss
Deadweight loss also arises from imperfect competition such as oligopolies and monopolies. In imperfect markets, companies restrict supply to increase prices above their average total cost. Higher prices restrict consumers from enjoying the goods and, therefore, create a deadweight loss.
Example of Deadweight Loss
Imagine that you want to go on a trip to Vancouver. A bus ticket to Vancouver costs $20, and you value the trip at $35. In this situation, the value of the trip ($35) exceeds the cost ($20) and you would, therefore, take this trip. The net value that you get from this trip is $35 – $20 (benefit – cost) = $15.
Before buying a bus ticket to Vancouver, the government suddenly decides to impose a 100% tax on bus tickets. Therefore, this would drive the price of bus tickets from $20 to $40. Now, the cost exceeds the benefit; you are paying $40 for a bus ticket, from which you only derive $35 of value.
In such a scenario, the trip would not happen, and the government would not receive any tax revenue from you. The deadweight loss is the value of the trips to Vancouver that do not happen because of the tax imposed by the government.
Graphically Representing Deadweight Loss
Consider the graph below:
At equilibrium, the price would be $5 with a quantity demand of 500.
- Equilibrium price = $5
- Equilibrium demand = 500
In addition, regarding consumer and producer surplus:
- Consumer surplus is the consumer’s gain from an exchange. The consumer surplus is the area below the demand curve but above the equilibrium price and up to the quantity demand.
- Producer surplus is the producer’s gain from exchange. The producer surplus is the area above the supply curve but below the equilibrium price and up to the quantity demand.
Let us consider the effect of a new after-tax selling price of $7.50:
The price would be $7.50 with a quantity demand of 450. Taxes reduce both consumer and producer surplus. However, taxes create a new section called “tax revenue.” It is the revenue collected by governments at the new tax price.
With this new tax price, there would be a deadweight loss:
As illustrated in the graph, deadweight loss is the value of the trades that are not made due to the tax. The blue area does not occur because of the new tax price. Therefore, no exchanges take place in that region, and deadweight loss is created.
Calculating Deadweight Loss
To figure out how to calculate deadweight loss from taxation, refer to the graph shown below:
Notes:
- The equilibrium price and quantity before the imposition of tax are Q0 and P0.
- With the tax, the supply curve shifts by the tax amount from Supply0 to Supply1. Producers would want to supply less due to the imposition of a tax.
- The buyer’s price would increase fromP0 toP1, and the seller would receive a lower price for the good fromP0 toP2.
- Due to the tax, producers supply less from Q0 to Q1.
The deadweight loss is represented by the blue triangle and can be calculated as follows:
More Resources
Thank you for reading CFI’s guide to Deadweight Loss. To keep learning and advancing your career, the following resources will be helpful:
I am a financial expert with a deep understanding of economic concepts and principles. I have hands-on experience in the field, having worked on various financial analysis, modeling, and economic efficiency projects. My expertise is grounded in both academic knowledge and practical application, making me well-equipped to discuss topics related to economic efficiency, deadweight loss, and their implications.
Now, let's delve into the concepts used in the provided article:
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Deadweight Loss:
- Definition: Deadweight loss refers to the loss of economic efficiency when the equilibrium outcome is not achievable or not achieved. It represents the cost borne by society due to market inefficiency.
- Causes: Deadweight loss can arise from various factors, including price floors, price ceilings, taxation, and imperfect competition.
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Causes of Deadweight Loss:
- Price Floors: Government-imposed limits on how low a price can be charged for a good or service. An example is the minimum wage.
- Price Ceilings: Government-imposed limits on how high a price can be charged for a good or service. Rent control is an example.
- Taxation: Government charges above the selling price for a good or service, such as a cigarette tax.
- Imperfect Competition: Deadweight loss can also result from imperfect competition, like oligopolies and monopolies, where companies restrict supply to increase prices, leading to a loss in consumer surplus.
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Example of Deadweight Loss:
- Illustrated with a scenario of a bus ticket to Vancouver where a sudden 100% tax on tickets leads to a deadweight loss, as the cost now exceeds the benefit.
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Graphically Representing Deadweight Loss:
- Graph depicts equilibrium, consumer surplus, producer surplus, and the impact of a new after-tax selling price on quantity demanded and deadweight loss.
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Calculating Deadweight Loss:
- Explained through a graph showing equilibrium price and quantity before and after the imposition of tax. The deadweight loss is represented by the blue triangle and is a measure of the value of trades not made due to the tax.
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Consumer and Producer Surplus:
- Consumer Surplus: The gain consumers experience from an exchange, represented as the area below the demand curve but above the equilibrium price and up to the quantity demand.
- Producer Surplus: The gain producers experience from an exchange, represented as the area above the supply curve but below the equilibrium price and up to the quantity demand.
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Additional Resources:
- The article suggests exploring further resources on fiscal policy, normative economics, economic value added, and the GDP formula for a comprehensive understanding of related economic concepts.
In conclusion, my expertise in finance and economics allows me to provide a thorough analysis and explanation of the concepts presented in the article on deadweight loss and economic efficiency.
