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Deadweight Loss

Deadweight Loss

Have you ever baked cupcakes for a bake sale but could not sell all of the cookies? Say you baked 200 cookies, but only 176 were sold. The leftover 24 cookies sat out in the sun and went hard, and the chocolate melted, so they were inedible by the end of the day. Those 24 leftover cookies were a deadweight loss. You overproduced cookies, and the leftovers did not benefit you or the consumers.

This is a rudimentary example, and there is much more to deadweight loss. Does deadweight loss seem interesting to you? It sure is for us, so stick around and let's dive right in!

Deadweight Loss Definition

The definition of deadweight loss is the inefficiency in the market that is created by the misallocation of resources. When producers overproduce or underproduce, resources are misallocated. This causes the market to be out of equilibrium and creates a deadweight loss.

Deadweight loss is the inefficiency in the market due to overproduction or underproduction of goods and services, causing a reduction in the total economic surplus.

Consumer Surplus is the difference between the highest price that a consumer is willing to pay for a good or service and the actual price that the consumer pays for that good or service.

Producer Surplus is the difference between the actual price a producer receives for a good or service and the lowest acceptable price that the producer is willing to accept.

A deadweight loss is also called efficiency loss. It is the result of the market's misallocation of resources so that they cannot satisfy society's needs in the best way. This is any situation where the supply and demand curves do not intersect at the equilibrium.

The consumer surplus is the difference between the highest price that a consumer is willing to pay for a good and the market price of that good. If there is a large consumer surplus, the maximum price that consumers are willing to pay for a good is much higher than the market price. On a graph, the consumer surplus is the area below the demand curve and above the market price.

Similarly, the producer surplus is the difference between the actual price a producer receives for a good or service and the lowest acceptable price that the producer is willing to accept. On a graph, the producer surplus is the area below the market price and above the supply curve.

Deadweight loss can also be caused by market failures and externalities. To learn more, check out these explanations:

- Market Failure and the Role of Government

- Externalities

- Externalities and Public Policy

Deadweight Loss Graph

Let us look at a graph illustrating a situation with deadweight loss. To understand deadweight loss, we must first identify the consumer and producer surplus on the graph.

Deadweight Loss Consumer and producer surplus graph StudySmarterFig. 1 - Consumer and Producer Surplus

In Figure 1, we can see that the red shaded area is the consumer surplus and the blue shaded area is the producer surplus. When there is no inefficiency in the market, meaning the market supply is equal to the market demand at E, there is no deadweight loss.

Price Floor and Surpluses

In Figure 2 below, consumer surplus is the red area, and producer surplus is the blue area. The price floor creates a surplus of goods in the market, which we can see in Figure 2 because the quantity demanded (Qd) is less than the quantity supplied (Qs). In effect, the higher price mandated by the price floor reduces the quantity of a good being bought and sold to a level below the equilibrium quantity in the absence of the price floor (Qe). This creates an area of deadweight loss, as seen in Figure 2.

Deadweight Loss Graph showing price floor deadweight loss StudySmarterFig. 2 - Price Floor with Deadweight Loss

Notice that the producer surplus now incorporates the section from Pe to Ps that used to belong to the consumer surplus in Figure 1.

Price Ceiling and Shortages

Figure 3 below shows a price ceiling. The price ceiling causes a shortage because the supply does not keep up with the demand when producers cannot charge enough per unit to make it worthwhile to produce more. This shortage is seen in the graph as the quantity supplied (Qs) is less than the quantity demanded (Qd). Like in the case of a price floor, a price ceiling also, in effect, reduces the quantity of a good being bought and sold. This creates an area of deadweight loss, as seen in Figure 3.

Deadweight Loss Graph showing price ceiling and deadweight loss StudySmarterFig. 3 - Price Ceiling and Deadweight Loss

Deadweight Loss: Monopoly

In a monopoly, the firm produces until the point where its marginal cost (MC) is equal to its marginal revenue (MR). Then, it charges a corresponding price (Pm) on the demand curve. Here, the monopolist firm faces a downward-sloping MR curve that is below the market demand curve because it has control over the market price. On the other hand, firms in perfect competition are price-takers and would have to charge the market price of Pd. This creates a deadweight loss because the output (Qm) is less than the socially optimal level (Qe).

Deadweight Loss Graph showing deadweight loss in a monopoly StudySmarterFig. 4 - Deadweight Loss in Monopoly

Want to learn more about monopolies and other market structures? Check out the following explanations:

- Market Structures

- Monopoly

- Oligopoly

- Monopolistic Competition

- Perfect Competition

Deadweight Loss: Tax

A per-unit tax can create a deadweight loss too. When the government decides to place a per-unit tax on a good, it makes a difference between the price that consumers have to pay and the price that producers receive for the good. In Figure 5 below, the per-unit tax amount is (Pc - Ps). Pc is the price that consumers have to pay, and the producers will receive an amount of Ps after the tax is paid. The tax creates a deadweight loss because it reduces the quantity of the goods being bought and sold from Qe to Qt. It reduces both consumer and producer surplus.

Deadweight Loss Graph showing deadweight loss with a per-unit tax StudySmarterFig. 5 - Deadweight Loss with a Per-unit Tax

Deadweight Loss Formula

The deadweight loss formula is the same as for calculating the area of a triangle because that is all the area of deadweight loss really is.

The formula for deadweight loss is:

\(\hbox {Deadweight Loss} = \frac {1} {2} \times \hbox {base} \times {height}\)

Let's calculate an example together.

Deadweight Loss Graph showing deadweight loss with price floor StudySmarterFig. 6 - Calculating Deadweight Loss

Take Figure 6 above and calculate the deadweight loss after the government has imposed a price floor preventing prices from decreasing towards market equilibrium.

\(\hbox {DWL} = \frac {1} {2} \times (\$20 - \$10) \times (6-4)\)

\(\hbox {DWL} = \frac {1} {2} \times \$10 \times 2 \)

\(\hbox{DWL} = \$10\)

We can see that after the price floor has been set at $20, the quantity demanded decreases to 4 units, indicating that the price floor has reduced the quantity demanded.

Deadweight Loss Units

The unit of the deadweight loss is the dollar amount of the reduction in total economic surplus.

If the height of the deadweight loss triangle is $10 and the base of the triangle (change in quantity) is 15 units, the deadweight loss would be denoted as 75 dollars:

\(\hbox{DWL} = \frac {1} {2} \times \$10 \times 15 = \$75\)

Deadweight Loss Example

A deadweight loss example would be the cost to society of the government imposing a price floor or a tax on goods. Let's work through an example of the resulting deadweight loss of a government-imposed price floor first.

Let's say that the price of corn has been dropping in the U.S. It has gotten so low that government intervention is required. The price of corn before the price floor is $5, with 30 million bushels sold. The U.S. Government decides to impose a price floor of $7 per bushel of corn.

At this price, farmers are willing to supply 40 million bushels of corn. However, at $7, consumers will only demand 20 million bushels of corn. The price where farmers would only supply 20 million bushels of corn is $3 per bushel. Calculate the deadweight loss after the government imposes the price floor.

Deadweight Loss Graph showing Price floor deadweight loss StudySmarterFig. 7 - Price Floor Deadweight Loss Example

\(\hbox {DWL} = \frac {1} {2} \times (\$7 - \$3) \times \hbox{(30 million - 20 million)}\)

\(\hbox {DWL} = \frac {1} {2} \times \$4 \times \hbox {10 million}\)

\(\hbox {DWL} = \hbox {\$20 million}\)

What would happen if the government imposed a tax on drinking glasses? Let's check out an example.

At the equilibrium price of $0.50 per drinking glass, the quantity demanded is 1,000. The government places a $0.50 tax on the glasses. At the new price, only 700 glasses are demanded. The price that consumers pay for a drinking glass is now $0.75, and the producers now receive $0.25 per drinking glass. Because of the tax, the quantity demanded and produced is less now. Calculate the deadweight loss from the new tax.

Deadweight Loss Graph showing tax deadweight loss StudySmarterFig. 8 - Tax Deadweight Loss Example

\(\hbox {DWL} = \frac {1} {2} \times \$0.50 \times (1000-700)\)

\(\hbox {DWL} = \frac {1} {2} \times \$0.50 \times 300 \)

\(\hbox {DWL} = \$75 \)

Deadweight Loss - Key takeaways

  • Deadweight loss is the inefficiency in the market due to overproduction or underproduction of goods and services, causing a reduction in the total economic surplus.
  • Taxation, monopolies, price floors, and price ceilings are some of the things that can cause deadweight losses.
  • The formula for calculating deadweight loss is \(\hbox {Deadweight Loss} = \frac {1} {2} \times \hbox {height} \times \hbox {base} \)

Frequently Asked Questions about Deadweight Loss

The area of deadweight loss is the reduction in the total economic surplus due to the misallocation of resources. 

When producers overproduce or underproduce, it can cause shortages or surpluses in the market which causes the market to be out of equilibrium and creates deadweight loss.   

Deadweight loss can happen because of market failure due to the existence of externalities. It can also be caused by taxation, monopolies, and price control measures. 

An example of deadweight loss is setting a price floor and decreasing the quantity of the goods being bought and sold which reduces the total economic surplus. 

The formula for calculating the triangular area of deadweight loss is 1/2 x height x base.  

Final Deadweight Loss Quiz

Question

What is a deadweight loss?

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Answer

Deadweight loss is the inefficiency in the market due to the overproduction or underproduction of goods and services (misallocation of resources) causing a reduction in the total economic surplus.

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Question

What is another name for deadweight loss?

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Answer

Efficiency loss

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Question

What creates deadweight loss?

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Answer

When producers overproduce or underproduce, it can cause shortages or surpluses in the market which causes the market to be out of equilibrium and creates a deadweight loss. 

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Question

What is consumer surplus?

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Answer

The difference between the highest price that a consumer is willing to pay for a good and the market price of that good. 

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Question

What is producer surplus?

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Answer

The difference between the lowest price a producer is willing to receive for a good and the price they receive.

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Question

When market supply does not equal market demand, the market is ____.

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Answer

out of equilibrium / inefficient.

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Question

Deadweight loss is the result of what?

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Answer

Taxation, monopolies, price floors, and price ceilings can cause deadweight loss. Externalities (market failures) will also lead to deadweight loss.

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Question

What are 3 situations that could produce a deadweight loss?

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Answer

Taxation, monopolies, price floors, and price ceilings

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Question

Why do monopolies create deadweight loss?

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Answer

Because they do not produce where price equals marginal cost but they produce where marginal cost equals marginal revenue while charging a higher price. This creates inefficiency because consumers demand less quantity at the higher price.

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