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Concept Version 6
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Understanding and Finding the Deadweight Loss

In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal.

Learning Objective

  • Define deadweight loss, Explain how to determine the deadweight loss in a given market.


Key Points

    • When deadweight loss occurs, there is a loss in economic surplus within the market.
    • Causes of deadweight loss include imperfect markets, externalities, taxes or subsides, price ceilings, and price floors.
    • In order to determine the deadweight loss in a market, the equation P=MC is used. The deadweight loss equals the change in price multiplied by the change in quantity demanded.

Terms

  • equilibrium

    The condition of a system in which competing influences are balanced, resulting in no net change.

  • deadweight loss

    A loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal.


Full Text

Deadweight Loss

In economics, deadweight loss is a loss of economic efficiency that occurs when equilibrium for a good or service is not Pareto optimal. When a good or service is not Pareto optimal, the economic efficiency is not at equilibrium. As a result, when resources are allocated, it is impossible to make any one individual better off without making at least one person worse off. When deadweight loss occurs, there is a loss in economic surplus within the market. Deadweight loss implies that the market is unable to naturally clear.

Causes of Deadweight Loss

Deadweight loss is the result of a market that is unable to naturally clear, and is an indication, therefore, of market inefficiency. The supply and demand of a good or service are not at equilibrium. Causes of deadweight loss include:

  • imperfect markets
  • externalities
  • taxes or subsides
  • price ceilings
  • price floors

Determining Deadweight Loss

In order to determine the deadweight loss in a market, the equation P=MC is used. The deadweight loss equals the change in price multiplied by the change in quantity demanded. This equation is used to determine the cause of inefficiency within a market.

For example, in a market for nails where the cost of each nail is $0.10, the demand will decrease from a high demand for less expensive nails to zero demand for nails at $1.10. In a perfectly competitive market, producers would charge $0.10 per nail and every consumer whose marginal benefit exceeds the $0.10 would have a nail. However, if one producer has a monopoly on nails they will charge whatever price will bring the largest profit. If they charge $0.60 per nail, every party who has less than $0.60 of marginal benefit will be excluded. When equilibrium is not achieved, parties who would have willingly entered the market are excluded due to the non-market price.

An example of deadweight loss due to taxation involves the price set on wine and beer. If a glass of wine is $3 and a glass of beer is $3, some consumers might prefer to drink wine. If the government decides to place a tax on wine at $3 per glass, consumers might choose to drink the beer instead of the wine. At times, policy makers will place a binding constraint on items when they believe that the benefit from the transfer of surplus outweighs the adverse impact of deadweight loss .

Deadweight loss

This graph shows the deadweight loss that is the result of a binding price ceiling. Policy makers will place a binding price ceiling when they believe that the benefit from the transfer of surplus outweighs the adverse impact of the deadweight loss.

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