Loss of economic efficiency when the optimal outcome is not achieved Show
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 LossBelow 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
Imperfect Competition and Deadweight LossDeadweight 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 LossImagine 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 LossConsider the graph below: At equilibrium, the price would be $5 with a quantity demand of 500.
In addition, regarding consumer and producer surplus:
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 LossTo figure out how to calculate deadweight loss from taxation, refer to the graph shown below: Notes:
The deadweight loss is represented by the blue triangle and can be calculated as follows: More ResourcesThank you for reading CFI’s guide to Deadweight Loss. To keep learning and advancing your career, the following resources will be helpful:
How is the deadweight loss of a tax is related to the elasticity of demand and supply?The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is smaller, because the quantity bought or sold varies less with price. With perfect inelasticity, there is no deadweight loss.
What is deadweight loss on a supply and demand curve?A deadweight loss occurs when supply and demand are not in equilibrium, which leads to market inefficiency. Market inefficiency occurs when goods within the market are either overvalued or undervalued.
How does price elasticity affect deadweight loss?For a more elastic market a price change causes a greater decrease in quantity therefore a policy in a more elastic market will cause a greater deadweight loss.
How should the price elasticities of demand and or supply change to reduce the deadweight loss?These elasticities also influence the size of the dead-weight loss caused by the tax because they determine the total reduction in the quantity of exchange. When either demand or supply is relatively inelastic, fewer trades will be eliminated by imposition of the tax, so the resulting dead-weight loss is smaller.
|