What’s it: Deadweight loss is the loss of surplus by producers or consumers because the market is in disequilibrium. These losses reduce the economic surplus (social welfare) because it is not captured by either party transacting in the market (producers or consumers) or the government.
Markets operate inefficiencies, causing a loss of economic well-being. The causes can come from monopolies, externalities, taxes, and price controls.
Deadweight loss occurs when the market is at a point of disequilibrium. As a result, prices and quantities do not reflect the best interests of supply and demand forces. This, in turn, leads to an inefficient economic resource allocation.
Calculates deadweight loss
To calculate deadweight losses in the market, let’s take an example of a tax on sellers. Deadweight loss is equal to half of the multiplication of the change in price and the change in quantity demanded.
In the chart above, the gray triangle represents deadweight losses. The total deadweight loss equals the area of the triangle. So, you can calculate it using the following formula:
Deadweight loss = 1/2 x (Qe-Q1) x (P1-P2)
For example, suppose the market equilibrium price is $4 per unit each. While the equilibrium quantity is as much as 100 units.
The government sets a tax on sellers of $2 per unit. Say, the producer passes the tax on to the selling price. Thus, the selling price rises to $6 ($2 + $4). At that price, producers can only sell less of the goods. Finally, they reduce the market supply to 50 units.
From this case, the total deadweight loss is $50 = 1/2 x (100-50) x (6-4). Government tax revenue is $100 ($2 x 50), coming from some lost consumer and producer surpluses.
Examples of deadweight loss
Deadweight losses occur due to market inefficiencies, which occur when supply and demand are out of equilibrium. Thus, the market price and quantity of goods do not reflect the sellers’ and buyers’ best results.
The causing factors of deadweight loss are:
- Price controls
- Imperfect competition
Price control can take two forms:
- Price floor
- Price ceiling
Under the price floor, the government sets minimum prices for goods and services. Its purpose is to help a manufacturer or supplier by keeping prices from falling too low. An example of the price floor is the minimum wage.
To be effective, the government sets it above the equilibrium price. As a result, the market experiences an excess supply, where the quantity supplied exceeds the quantity demanded.
Now, take the minimum wage, for example. In the labor market, labor represents producers and acts as a supplier. Meanwhile, companies represent consumers and act as buyers.
The government fixes the minimum wage above the equilibrium wage. Because wages are higher, more individuals are willing to supply labor services. On the other hand, fewer employers are willing to pay high wages, reducing market demand. As a result, the quantity supplied (Q2) exceeds the quantity demanded (Q1), resulting in a surplus.
It then gives rise to deadweight losses in the economy. The quantity demanded in the market is less than the welfare-maximizing quantity (Qe).
Producer surplus decreases by the lower gray triangle. Welfare is lost as the market faces more unemployment as a result of lower demand. Employment shranks than it should be when the minimum wage doesn’t exist. However, those who work receive higher wages. At the same time, producers receive a consumer surplus transfer.
On the other hand, the consumer surplus also decreases. The total lost surplus equals the box above equilibrium price (transferred to producers) plus the upper gray triangle. Companies now have to pay higher wages and face a more generous supply of less qualified labor.
Meanwhile, under the price ceiling, the government sets maximum prices for goods and services. The government prohibits producers from selling at a higher price. Its purpose is to preserve consumers from conditions that can make goods extremely expensive.
To be effective, the government sets a price ceiling below equilibrium. The government feels that the equilibrium is too high. Thus, to keep the product affordable for the public, the government sets a price ceiling below equilibrium. An often-cited example of a price ceiling is rent control.
The price ceiling can also create deadweight losses. The market is experiencing shortages. Producers are only willing to supply fewer goods (Q1) than they should (Qe) because they have to bear lower prices. As a result, the market suffers from shortages, and some consumers don’t get the goods (consumer surplus is lost). Producer surpluses diminish, some are transferred to consumer surplus (square area below the equilibrium price), and others disappear (lower gray triangle).
Taxes are a source of market inefficiency and distort the free market. Taxes result in higher production costs and prices.
Imposing a tax on the final price (a tax on buyers) prevents people from making the purchases they are supposed to make. As a result, it shifts the demand curve to the left to D2. Demand for goods decreases, so producers can only produce and sell at Q1. As a result, consumer and producer surpluses decrease. Some of the two surpluses become government tax revenue; the rest make up a deadweight loss due to underproduction (area of the gray triangle).
Likewise, if the government taxes producers, it shifts the supply curve to the left, from S1 to S2. Consequently, the market price rises to P1, and the equilibrium quantity falls to Q1.
The consumer surplus decreases because they have to pay more (from Pe to P1). Likewise, the producer surplus is reduced. Despite higher prices, producers can only produce and sell fewer goods (from Qe to Q1).
Some lost consumer and producer surpluses are transferred to the government (tax revenue, area colored orange). Meanwhile, other parts are missing and form a deadweight loss (gray triangle).
Deadweight losses also arise from externalities. Pollution is an example of an externality. The costs of pollution to third parties (not involved in the production or consumption of goods) are not reflected in market prices. Hence, if market prices consider pollution’s costs, the optimal supply level will be lower than the equilibrium quantity.
In general, deadweight losses will be zero if the market operates under perfect competition. Supply-demand forces determine the equilibrium price and quantity.
The demand force works for the best result for the consumer. Whereas the supply force acts for the best result for the benefit of the producer. The market works to resolve both forces. Thus, market outcomes (equilibrium price and quantity) are best for producers and consumers.
Otherwise, under imperfect competition, the market does not reach equilibrium as perfect competition. Several parties have the market power to influence market supply and demand. Examples of imperfect competition are monopoly, oligopoly, oligopsony, and monopsony.
Take the case of the monopoly market. The market consists of one seller, thus determining the market supply. Monopolists can limit supply to raise prices, which restrict consumers from enjoying the goods. Conceptually, the working principle is similar to a tax on sellers.
Remember: If the monopolist can set perfect price discrimination, it does not produce a deadweight loss. It captures all lost consumer surplus and renders it a producer surplus. Thus, the economic surplus remains the same, which is equal to the producer surplus. All economic benefits from the exchange in the market belong to the monopolist.
Impacts of deadweight loss on the economy
Market inefficiencies arise due to disequilibrium. As a result, there is lost economic welfare. Ideally, the lost benefits are transferred to one of the transacting parties. But, in the case of deadweight loss, the benefits lost by one party are not fully captured by the other party (either consumers or producers) or the government (through tax revenue).
In the case of the price floor above, the price is higher than the equilibrium price. It benefits the producer as it enjoys a higher price. On the other hand, it hurts the buyer by paying a higher price than they should. Still, not all consumer losses (consumer surplus) are transferred to producer profits.
Likewise, as in the price ceiling, prices are lower for consumers because they are below equilibrium. On the other hand, it is less profitable for producers. They lose some of the benefits of exchanges on the market. Not all the benefits lost by the producer (reduced producer surplus) are converted into consumer surplus.